20
It is useful to ask how well this simple specification accounts for the dynamics of net foreign
assets at the individual country level. For this purpose, Table 6 reports the country-by-country
bivariate correlations between actual and fitted values for changes in net foreign assets for the period
1970-98. For industrial countries, the model does poorly in explaining the short-run dynamics of the
net foreign asset position for most of the ‘large’ economies — Japan, United Kingdom, and United
States — while it tracks the smaller open economies, such as Ireland, Portugal and the Scandinavian
countries, quite nicely.31 For developing countries, the model performs remarkably well across the
board, explaining a substantial fraction of year-to-year changes in net foreign assets, with very few
exceptions.
4.2 IMPLICATIONS FOR THE TRADE BALANCE
The factors driving the net foreign asset position influence the behavior of the trade balance via two
channels. First, changes in the desired net foreign asset position require shifts in the trade balance.
Second, for a given desired net foreign asset position, there is an inverse relation between the
investment returns on the outstanding stock of net foreign assets and the trade balance.
In an accounting sense, changes in the net foreign asset position reflect trade imbalances,
investment income payments and receipts and capital gains and losses. Formally,
Blt - Bit-1 = TBlt + TR + TR. + iltBlt-1 + KGlt (5)
where TBit is the balance of trade in goods and services, TR'tl (TRk ) are net current (capital) transfers,
iitBit-1 is investment income and KGt is the capital gain∕loss on outstanding net external assets. The
current account is given by the sum of TBit, TR and investment income iit Bit-1 .32 Dividing both
sides of equation (5) by GDP measured in US dollars, adding together investment income and capital
31 One reason why the model may not fully capture the dynamics of the net foreign asset position for the former
group of countries is that these are financial centers and high levels of gross international asset trade mean that
the impact of volatile revaluation effects on the net foreign asset position is likely to be especially important.
32 The expression iit Bit-1 for investment income implicitly assumes that the dollar yield on external assets and
liabilities is the same. We discuss below the implications of this assumption.