24
where we model the country risk premium as inversely (and linearly) related to the ratio of net foreign
assets to exports bxit .35
5.1 EMPIRICAL RESULTS
We confine attention to the industrial country sample. Nominal interest rates are yields on
government bonds, the same employed by Obstfeld and Rogoff (2000, 2001).36 We measure the real
interest rate as the December nominal interest rate in year t minus the actual inflation rate in year t+1.
We report the panel fixed-effects results in Table 9, where the DOLS estimator is again
employed. In panel A, we include all countries and the time dummies soak up the “world real interest
rate” that is common to all countries; in panel B, we employ the real interest differential vis-à-vis the
US. The actual ratio of net foreign assets to exports in employed as a regressor in columns (1)-(4),
whereas we use the fitted values generated in section 3.3.2 in columns (5)-(8).37 The results in
columns (1)-(2) and (5)-(6) are for the 1970-98 period; and for 1980-98 in columns (3)-(4) and (7)-
(8). We also enter the stock of public debt and the rate of real exchange rate appreciation in alternate
specifications.38 In line with the portfolio balance literature, the former is intended to control for
variation in the supply of alternative assets; the latter is to proxy for expected changes in the real
exchange rate.
Across columns (1)-(8), the results show clear evidence of a portfolio balance effect in the
determination of real interest differentials: for instance, according to the point estimate in column (1)
of panel B, a 20 percentage point improvement in the ratio of net foreign assets to exports position is
associated with an 50 basis point reduction in the real interest rate differential. The effect is also
35 We use exports rather than GDP as the denominator to better capture the capacity of the economy to make
overseas payments. The choice of denominator makes little practical difference for the results.
36 Iceland is excluded from the sample. We thank these authors and Jay Shambaugh for generous assistance
with these data.
37 In section 3.3.2, we regressed the ratio of net foreign assets to GDP on output per capita, the stock of public
debt and demographic variables. We multiply the fitted values from this regression by the ratio of GDP to
exports.
38 In line with the method for measuring expected inflation, the actual rate of real exchange rate appreciation in
year t+1 proxies for the expected rate of real appreciation in year t+1. In panel A, we use a multivariate CPI-
based real exchange rate series; in panel B, it is the bilateral CPI-based real exchange rate vis-à-vis the US.