blt = σ ' Zlt + ειt ■ Zit = [YClt, GDEBTu, DEMu ] (3)
where bit is country i ’s ratio of net foreign assets to GDP in year t, YCit is its output per capita,
GDEBTit is its level of public debt andDEMit is a set of demographic variables. As the discussion
in the next subsection makes clear, we have followed the main themes developed in the theoretical
literature in selecting these variables as the primary determinants of net foreign asset positions.7 It is
important to take note that all variables should be interpreted as measured relative to global values,
since common movements in output per capita, demographic trends and government debt should not
affect net foreign assets but rather will operate via global variables such as the world real interest rate.
3.1 THEORETICAL CHANNELS
Relative output per capita can affect net foreign asset positions through several channels. First, if the
domestic marginal product of capital decreases as an economy grows richer, domestic investment will
fall and home investors will seek out overseas accumulation opportunities. Second, an increase in
domestic income may lead to a rise in the domestic savings rate. This result is most clearly generated
in models with habit formation in consumption preferences: as an economy grows, consumption will
lag behind output (see, for instance, Carroll, Overland and Weil, 2000). An alternative explanation
has been suggested by Rebelo (1992): under Geary-Stone preferences, the savings rate will also be
increasing in income levels, since the marginal utility of extra consumption sharply diminishes once
basic consumption needs are satisfied. We not that, even if the increase in the savings rate is
temporary, there may be a permanent improvement in the net foreign asset position. A positive
relation between relative output per capita and the net foreign asset position is also captured in the
traditional “stages of the balance of payments” hypothesis (see Halevi, 1971, and Fischer and Frenkel,
1974).
7 Since we have a limited number of time series observations, we are constrained in the number of determinants
that we can include in our empirical work. As is detailed in subsection 3a, there are myriad channels by which
these variables can potentially affect net foreign asset positions and a number of theoretical contributions
highlight some of these individual mechanisms. Building an integrative general equilibrium model that would
nest the various hypotheses is beyond the scope of this paper and our empirical specification will inevitably not
be able to discriminate between all competing theories.