External Financing Risks: How Important is the Composition of the International Investment Position?

IMF Working Papers, January 29, 2021

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Canonical URL: External Financing Risks: How Important is the Composition of the International Investment Position?

Authors: Luis M. Cubeddu, Swarnali A Hannan, Pau Rabanal
Date: January 29, 2021
Research focus: Role of the structure of the international investment position (IIP)—especially currency composition—in affecting countries’ external vulnerabilities.
Sample: 73 advanced and emerging economies.
New input: A new database on the IIP’s currency composition.

The size and structure of external liabilities and assets, especially currency denomination, matter for balance-of-payments pressures.
Higher levels of gross external debt increase the likelihood of an external crisis.
Higher levels of foreign-currency-denominated external debt increase the likelihood of sudden stops.
Foreign reserve assets mitigate external risks, although with diminishing returns.
The combination of flow and stock imbalances amplifies external risks, particularly during periods of heightened global risk aversion.
Results are especially strong for emerging economies: the impacts of flow and stock imbalances and foreign currency mismatches are larger and more robust across specifications.

Monitor not only net external positions but also gross stocks and the currency composition of external assets and liabilities.
Strengthen foreign reserve buffers, recognizing diminishing marginal benefits.
Address foreign-currency-denominated debt exposures to reduce susceptibility to sudden stops.
Coordinate policies to reduce flow and stock imbalances, especially when global risk aversion rises.
Tailor policy priorities for emerging economies, where vulnerabilities from currency mismatches and imbalances are more pronounced.

Empirical strategy uses a sample of 73 advanced and emerging economies and a new database on the IIP’s currency composition.
Outcomes analyzed include external crises and sudden stops, with controls for standard macroeconomic factors used in prior literature.

Findings hold beyond standard macroeconomic controls emphasized in other studies.
Effects are more pronounced and robust in emerging economies compared with advanced economies.
Interaction of flow and stock imbalances with episodes of heightened global risk aversion strengthens external risk outcomes.