Page 123 - Special Topic Session (STS) - Volume 4

STS570 Mary Everett et al.
3. Result: Quantitative importance
The post-World War II increase in global external financial openness
accelerated sharply between the mid-1990s and the GFC. Spurred by financial
8
liberalisation and innovation, external assets and liabilities surged from a
combined total of less than 150% of GDP in 1995 to over 400% in 2007 (Lane
and Milesi-Ferretti (2018)). The GFC seemingly brought to a halt the rapid rise
in external financial openness, with the global stock of external assets and
liabilities contracting to slightly under 400% of GDP in 2015 (BIS (2017b)).
Given the expansion in gross assets and liabilities, a focus on the trade
balance when measuring external imbalances ignores the dynamics of
international trade in financial assets (Lane (2015), Lane and Milesi-Ferretti
(2018), Forbes et al (2017)). The importance of gross primary income flows
(relative to gross trade flows) rose steadily between the mid-1990s and the
GFC. This largely reflected the rapid pre-crisis expansion of the stocks of cross-
border financial assets and liabilities (discussed above). This trend was most
pronounced for financial centres (FCs), where the ratio of gross primary
income flows to gross trade flows more than quadrupled from 14% in 1995 to
65% in 2007. The relative importance of primary income flows also rose
considerably for (non-FC) advanced economies (AEs) – from 12% in 1995 to
23% in 2007.
The post-GFC pullback in gross external financial positions (together with
the low interest rate environment) reversed this trend, but only partially. The
2015 level of the ratio of gross primary income flows to gross trade flows was
still roughly three times that in 1995 for FCs. By contrast, the respective ratio
remained relatively flat for EMEs both before and after the GFC. Delving
deeper into the main components of primary income flows reveals that the
relative importance of direct investment income has increased sharply since
the 1990s. This is the case not only at the global level, but also for all major
country groups. The rise is especially notable in the case of FCs. The increase
was primarily driven by the growth of offshoring.
The increased relative importance of direct investment income (DII) flows
suggests that global firms’ foreign profits merit special attention. DII reduces
the current account of the country in which it is generated and boosts those
of (i) the country in which the company is headquartered and (ii) the countries
in which the company’s shareholders reside. In economic terms, all the
benefits (abstracting from labour income) accrue to the countries in which the
shareholders reside. In accounting terms, however, the positive current
account impact is split between the countries in groups (i) and (ii) above
because of the asymmetrical treatment of DII relative to portfolio investment

8 The post-World War II increase in external financial openness was a part of the second major
wave of globalisation. The first major globalisation wave, which lasted from the early 1800s to
World War I, also saw a substantial increase in both real and financial cross-border linkages.
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