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Current Account Adjustment and Retained Earnings

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Current Account Adjustment and Retained Earnings Current account adjustment and retained earnings Andreas M. Fischer, Henrike Groeger, Philip Sauré and Pinar Yeşin SNB Working Papers 12/2018 Legal Issues DISCLAIMER The views expressed in this paper are those of the author(s) and do not necessarily represent those of the Swiss National Bank. Working Papers describe research in progress. Their aim is to elicit comments and to further debate. COPYRIGHT© The Swiss National Bank (SNB) respects all third-party rights, in particular rights relating to works protected by copyright (infor- mation or data, wordings and depictions, to the extent that these are of an individual character). SNB publications containing a reference to a copyright (© Swiss National Bank/SNB, Zurich/year, or similar) may, under copyright law, only be used (reproduced, used via the internet, etc.) for non-commercial purposes and provided that the source is menti- oned. Their use for commercial purposes is only permitted with the prior express consent of the SNB. General information and data published without reference to a copyright may be used without mentioning the source. To the extent that the information and data clearly derive from outside sources, the users of such information and data are obliged to respect any existing copyrights and to obtain the right of use from the relevant outside source themselves. LIMITATION OF LIABILITY The SNB accepts no responsibility for any information it provides. Under no circumstances will it accept any liability for losses or damage which may result from the use of such information. This limitation of liability applies, in particular, to the topicality, accuracy, validity and availability of the information. ISSN 1660-7716 (printed version) ISSN 1660-7724 (online version) © 2018 by Swiss National Bank, Börsenstrasse 15, P.O. Box, CH-8022 Zurich Current account adjustment and retained earnings∗ Andreas M. Fischer,† Henrike Groeger,‡ Philip Saur´e§and Pınar Ye¸sin¶ August 2018 Abstract: This paper develops a formal strategy to calculate current accounts with retained earnings (RE) on equity investment and analyzes their adjustment during the global financial crisis. RE are the part of companies’ profits which are reinvested and not distributed to shareholders as dividends. International statistical standards treat RE on foreign direct investment and RE on portfolio investment differently: while the former enter the current and financial account, the latter do not. We show that this differential treatment strongly affects current accounts of several advanced economies, frequently referred to as financial centers, with large positions in equity (portfolio) investment. Our empirical analysis finds that the differential treatment of RE alters the interpretation of current account adjustment for the global financial crisis. Keywords: Current account adjustment, financial centers, retained earnings, equity investment JEL Classification Number: F32, F47, G11 ∗This project was initiated through numerous conversations with Thomas Schlup. The au- thors would like to thank Alex Fl¨uhmann, Robert Kollmann, Gian Maria Milesi-Ferretti, Stefan Zeugner, and especially our discussant Ga¨etan Nicod`emefor comments on a previous draft as well as participants at the SNB Brownbag Seminar, the Global Financial Flows Workshop at the IMF, the BIS-SNB workshop, the Annual Congress of the Swiss Society of Economics and Statistics, and the JIMF Brussels Conference. Chloe Larkou and Anna Raafat provided valuable research assistance. Any remaining errors are our own. The views expressed in this paper are those of the authors and not necessarily those of the Swiss National Bank. †Swiss National Bank and CEPR. Email: andreas.fi[email protected] ‡European University Institute. Email: [email protected] §Johannes Gutenberg University. Email: [email protected] ¶Swiss National Bank. Email: [email protected] 1 1 “... because reinvested earnings are recorded only for equity in direct investment and investment funds, but not for other types of equity, it may be useful for some analysis to have measures of income and the current account with and without reinvested earnings.” Paragraph 11.41 in International Monetary Fund (2009) 1 Introduction Recent studies argue that large wealth transfers materialized during the global financial crisis (GFC).1 In particular, Gourinchas et al. (2012) show that equity (portfolio) investment was an important channel through which these transfers ma- terialized.2 Indeed, the buildup of U.S. equity investment was particularly strong prior to the global financial crisis (GFC), and so was its reversal during the GFC. If dividend flows on equity investment are smoother than retained earnings (RE) on equity investment during crisis periods, then a large part of the wealth transfers is accounted for by RE. The incomplete recording of RE in the current account ac- cording to standard accounting principles (see above quotation) therefore implies that the large wealth transfers that materialized during the GFC may not have been fully captured in the current account. Taken together, these observations suggest that the current account is possibly an incomplete indicator of external adjustments. While this drawback is not worrisome per se, it becomes important as soon as the current account is used as an indicator of global imbalances.3 This paper develops a formal strategy to calculate corrected current accounts with RE on equity investment and then analyzes the behavior between the official current account and the corrected current account with RE during the GFC. The strategy first proxies country-specific payout ratios according to national stock markets. It then combines this information with bilateral positions of equity in- 1See, e.g., Gourinchas et al. (2012), McCauley and McGuire (2009), and McGuire and Goetz (2009). 2Portfolio investment is divided into debt and equity investment. Hereafter, we will refer only to equity investment. 3See, e.g., Lane and Milesi-Ferretti (2012). Obstfeld (2012) writes that “global current account imbalances remain an essential target for policy scrutiny, for financial as well as macroeconomic reasons.” 2 2 “... because reinvested earnings are recorded only for equity in direct investment vestment to assess the size of RE in the respective cross-border equity investment. and investment funds, but not for other types of equity, it may be useful for some Summing a country’s bilateral RE and netting over foreign assets and liabilities analysis to have measures of income and the current account with and without then yields the corrected current account with RE. reinvested earnings.” The empirical analysis provides estimates of current accounts with RE for 44 Paragraph 11.41 in International Monetary Fund (2009) countries from 2001 to 2015. The data coverage is extensive; it accounts for 82% of world GDP and 87% of the world’s total equity investment in assets. The RE correction is computed for 627 country-year pairs. 1 Introduction The paper then presents two sets of empirical findings. First, the estimated RE are time-varying and large for the so-called financial centers (defined as Hong Recent studies argue that large wealth transfers materialized during the global Kong, Ireland, Norway, and Switzerland).4 Figure 1 shows that, in 2015, these financial crisis (GFC).1 In particular, Gourinchas et al. (2012) show that equity countries had equity assets plus liabilities exceeding 150% of GDP and net equity (portfolio) investment was an important channel through which these transfers ma- positions exceeding 50% of GDP in absolute terms.5 We estimate that the absolute terialized.2 Indeed, the buildup of U.S. equity investment was particularly strong value of the RE on average ranges from 1.2 to 7.8% of GDP for these countries. prior to the global financial crisis (GFC), and so was its reversal during the GFC. On the other hand, the estimated RE are small for emerging market economies. If dividend flows on equity investment are smoother than retained earnings (RE) on equity investment during crisis periods, then a large part of the wealth transfers The second finding is that the corrected current accounts with RE clearly il- is accounted for by RE. The incomplete recording of RE in the current account ac- lustrate how global imbalances adjusted during the GFC. The analysis finds that cording to standard accounting principles (see above quotation) therefore implies countries with large net equity imbalances experienced exceptionally large current that the large wealth transfers that materialized during the GFC may not have account adjustments. This result is explained by the behavior of international eq- been fully captured in the current account. Taken together, these observations uity markets during the crisis period. Before the GFC, equity markets experienced suggest that the current account is possibly an incomplete indicator of external large corporate profits and therefore large transfers in RE. As the crisis unfolded, adjustments. While this drawback is not worrisome per se, it becomes important however, corporate profits fell sharply and RE remained small. This implied that as soon as the current account is used as an indicator of global imbalances.3 economies that were highly financially integrated experienced larger adjustments This paper develops a formal strategy to calculate corrected current accounts in income flows in equity investment than the global average. This interpretation of with RE on equity investment and then analyzes the behavior between the official
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