Long-Term Capital Movements

19

dollars): only 8 out of the 38 countries are in the region in which the cross-sectional relation between
output per capita and net foreign assets is slightly negative.³⁰

4. The Dynamics of Net Foreign Assets and the Trade Balance

In the previous section, we focused on the long-run behavior of net foreign assets, arguing that it can
be characterized as a cointegrating relation b_it = σ ' Z_it + ε_it. In this section, we shift our attention to
the “adjustment mechanism”—namely, the role played by our long-run model in shaping the short-
run dynamics of net foreign assets, as well as the implications these dynamics have for the trade
balance.

4.1 THE ECM REPRESENTATION

Since the underlying long-run relation is a cointegration equation, we can obtain the ‘desired’ change
in net foreign assets ∆⅛ as the fitted values from estimating an error correction mechanism
representation

∆ b,t = β'∆ Zit + η∆ bit-1 - λ( bit-1 - σ ' Zit-1)+Vit                       (4)

In order to keep the model specification as parsimonious as possible we impose equality of all slope
coefficients among the industrial and among the developing country samples in estimating this error-
correction specification.

Table 5 reports the estimated error-correction coefficient λ and the overall fit of equation (4)
for the different country groups and samples. The specification of the regression also includes the
lagged change in the dependent variable and contemporary changes in all explanatory variables
(coefficients not reported). Results show that deviations of net foreign assets from their long-run
trend tend to be quite persistent, with a half-life of five-six years, and that the speed of adjustment is
quite similar in industrial and developing countries. Given the restrictive specification of the short-run
dynamics, the fit of the regressions is remarkably good, especially so for developing countries.

³⁰ Caution should be exercised in interpreting these cross-sectional results, because our sample excludes low-
income countries that are typically highly indebted.

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