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the US net external position. Second, Singapore’s spectacular increase in its net foreign assets, even
given its large positive adjusted returns term, has required large trade surpluses.
In summary, the results in this section show that the long-run fundamentals driving the net
foreign asset positions can also explain an important fraction of short-run changes in countries’
external wealth, and that the behavior of the trade balance is tightly related to the dynamics of the net
foreign asset position. The extent to which changes in the underlying fundamentals of the net external
position and correction in any drift from the long-run equilibrium relation are reflected in the trade
balance depends on the ‘adjusted’ returns on the outstanding net foreign asset position.
5. Net Foreign Assets and Real Interest Differentials
Rates of return on assets and liabilities play a crucial role in determining the dynamic behavior of net
foreign assets, and are likely to be influenced by their level and composition. For instance, a home
bias in asset demand and/or an upward-sloping supply of international funds means that interest rates
may be linked to net foreign asset positions: debtor countries should experience higher interest rates
than creditor countries. Applications of this ‘portfolio balance’ approach have typically related
currency returns to shifts in relative asset supplies in different currencies (e.g. a model of dollar
interest rates versus yen interest rates) but the model should hold more generally as a framework for
thinking about country risk (Frankel and Rose, 1995).
In this spirit, the real interest rate differential can be written as
r. - r., = S. - E, [∆RER, .11 (8)
where δit is the country risk premium and the second term on the right hand side is (minus) the
expected rate of real exchange rate appreciation.
If the rate of real appreciation is zero in a steady state, then the long-run real interest
differential just depends on the steady-state country risk premium
rit- rwt = δ,t = -δbχit δ > 0 (9)