1) The document analyzes the empirical link between domestic financial development and net foreign asset positions using data from 51 countries from 1970-2007. 2) It finds that greater financial development is associated with lower total net foreign asset positions, higher net equity positions, and lower net debt positions, consistent with the theoretical predictions. 3) The results suggest that in the long run, greater financial development could help diminish global imbalances, though adjustment is slow, with about 15% of the gap closed per year on average.

1. Net Foreign Assets (Com)position:
Does Financial Development Matter?
Robert Vermeulen – De Nederlandsche Bank
Jakob de Haan – De Nederlandsche Bank, RUG & CESIfo
Eesti Pank
Tallinn, 8 May 2012
Views expressed in this presentation do not necessarily coincide with those of De Nederlandsche Bank.

2. The paper in one slide
• Investigate the empirical link between domestic
financial development and
1. Total net foreign asset position
2. Net foreign equity position
3. Net foreign debt position
• Analyse 51 countries during 1970-2007
• Pooled mean group estimator (long run relationship)
• Confirm theoretical predictions of Mendoza et al. (2009)
1. Financial development ↑ → Total net foreign asset position ↓
2. Financial development ↑ → Net equity position ↑
3. Financial development ↑ → Net debt position ↓

3. Motivation
• Global savings glut drives global imbalances (Bernanke,
2005, 2009)
• Potential cause of financial crisis
• Asian countries need to develop financial markets
• Sustained deficits and surpluses create large net foreign
asset positions
• Even larger gross asset and debt positions
• Currency denomination matters
• Large net foreign asset positions undesirable
• EU Commission scorecard indicator
• Mandatory correction when very negative

4. Theoretical framework
• Mendoza et al. (2009, JPE) model
• Basic idea
• 2 identical economies, only difference is the degree of
domestic financial development
• Financial development allows agents to buy state
contingent claims to insure against bad states of
nature
• Agents in the financially more developed country are
willing to take more risk because they have insurance
• In autarky both the return on capital and the interest
rate are higher in the financially more developed
country

5. Theoretical framework
When both countries become financially integrated
• The financially more developed country buys foreign
productive assets and sells domestic bonds
• In equilibrium the financially more developed country
obtains a negative net foreign asset position
• The NFA is negative in equilibrium because the return
on productive assets is higher
• The model generates three testable predictions:
1. Financial development ↑ → Total net foreign asset position ↓
2. Financial development ↑ → Net equity position ↑
3. Financial development ↑ → Net debt position ↓

6. Empirical literature
• First paper to empirically link domestic financial
development to net foreign asset positions
• Preliminary analysis by Lane and Milesi-Ferretti (2000)
• Gross asset positions and capital flows
• Financial development has positive effect on gross
foreign assets and liabilities (Lane, 2000)
• Capital controls affect outflows, but not inflows (Binici
et al, 2011)
• Financial development and current account position
• No relationship (Gruber and Kamin, 2009)
• Nonlinear relationship (Chinn and Ito, 2007)

7. Data
• Net foreign asset (com)position
• Lane and Milesi-Ferretti database
• Large country coverage and timespan (1970-2007)
• Financial development
• Beck et al financial structure database
• Private credit/GDP ratio
• Other control variables
• Current account
• GDP growth
• Exchange rate depreciation
• Capital controls

8. Data
• Calculating net foreign asset positions:
• Total net asset position (= (total assets – total liabilities)
/ GDP)
• Net equity position (= (portfolio equity assets + FDI
assets – portfolio equity liabilities – FDI liabilities) /GDP)
• Net debt position (= (total debt assets – total debt
liabilities) / GDP)
• Private credit / GDP ratio
• Anglo-Saxon view of financial development
• Important for interpretation of results
• Variable is not informative about stability

9. Methodology
• Pooled mean group estimator (Pesaran et al, 1999)
• Account for nonstationarity of variables
• Relatively large number of countries (51)
• Reasonably long time-span (1970-2007)
• Too short for individual country VARs
• Panel VAR too restrictive
• PMG assumes common long run coefficients, while short
run coefficients can differ across countries
• Test appropriateness with Hausman test
• Formally, in error correction form:
ΔNFAp,i,t = φp,i*(NFAp,i,t-1 - θ0,p,i – θ1,p,i *FDi,t) +
γ1,p,i *Δ FDi,t + Λp,i *Xi,t + εp,i,t

10. Benchmark results
NFA NFE NFD
Long-run coefficient:
Private credit / GDP -0.140*** 0.086*** -0.183***
(0.032) (0.024) (0.041)
Error correction
coefficient -0.183*** -0.106*** -0.137***
(0.015) (0.028) (0.019)
Short-run coefficients:
Δ Private credit / GDP 0.048 -0.005 0.052
(0.096) (0.047) (0.085)
Current account (% of GDP) 0.642*** -0.035 0.486***
(0.122) (0.060) (0.083)
GDP growth 0.367*** 0.124*** 0.314***
(0.054) (0.030) (0.042)
Exchange rate depreciation (%) 0.069** 0.097*** 0.031
(0.032) (0.025) (0.028)
Capital account openness -0.006 -0.012*** 0.006
(0.005) (0.004) (0.005)
Observations 1,659 1,659 1,659
Log-likelihood 2697 4081 2956
Hausman test 0.55 0.27 0.57

11. Benchmark results
• Confirm theoretical predictions of Mendoza et al. (2009)
1. Financial development ↑ → Total net foreign asset position ↓
2. Financial development ↑ → Net equity position ↑
3. Financial development ↑ → Net debt position ↓
• Long run cointegrating relationship
• Significant error-correction coefficient, but quite slow adjustment
• Short run coefficients are important for model fit
• Country-individual coefficients
• Only average reported
• Capture cross-country heterogeneity
• Hausman test confirms validity of long-run restriction of a
common coefficient for all countries

12. Benchmark results
(fit NFA)
United States
-0.25
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Thailand
-0.9
-0.8
-0.7
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006

13. Benchmark results
(fit NFE)
United States
0
0.05
0.1
0.15
0.2
0.25
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Thailand
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006

14. Benchmark results
(fit NFD)
United States
-0.45
-0.4
-0.35
-0.3
-0.25
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Thailand
-0.8
-0.7
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006

15. Robustness across countries & time
Industrial (1970-2007) Industrial (1980-2007)
NFA NFE NFD NFA NFE NFD
Long-run coefficient:
Private credit / GDP -0.115*** 0.054** -0.231*** -0.155*** 0.051** -0.127***
(0.033) (0.021) (0.043) (0.036) (0.021) (0.032)
Error correction coefficient -0.225*** -0.215*** -0.154*** -0.255*** -0.242*** -0.190***
(0.023) (0.056) (0.039) (0.033) (0.052) (0.043)
Developing (1970-2007) Developing (1980-2007)
NFA NFE NFD NFA NFE NFD
Long-run coefficient:
Private credit / GDP -0.270*** 0.486*** 0.373** -0.221*** 0.408*** 0.759***
(0.081) (0.072) (0.151) (0.057) (0.062) (0.098)
Error correction coefficient -0.164*** -0.042 -0.135*** -0.171*** -0.037 -0.152***
(0.019) (0.026) (0.021) (0.020) (0.025) (0.020)

16. Further robustness checks
1. Financial development indicator
• Bank credit/bank deposits
• Total deposits/GDP
2. Additional control variables
• Net exports instead of current account
• Real effective exchange rate instead of exchange
rate
3. Extending the long run cointegrated vector
• “Cumulative” current accounts
• GDP per capita

17. Conclusion
• First paper documenting long run relationship domestic
financial development and net foreign asset positions
1. Financial development ↑ → Total net foreign asset position ↓
2. Financial development ↑ → Net equity position ↑
3. Financial development ↑ → Net debt position ↓
• Confirm the theoretical predictions of Mendoza et al
(2009, JPE)
• Results suggest that in the long run financial development
contributes to diminishing current global imbalances
• However, the process is slow: On average every year
about 15 percent of the gap between the current and the
long-run position is closed