Net foreign assets and real exchange rates revisited

Theory suggests a significant positive relationship in long-run equilibrium between the net foreign assets (NFA) of a country and its real exchange rate. Empirical tests have ignored two issues: the large variation in cross-country trade/GDP ratios, which is likely to induce substantial cross-country differences in coefficients when net foreign assets are scaled by GDP, and the reverse causality associated with valuation effects. A real exchange rate appreciation reduces the absolute value of NFA denominated in foreign currency relative to domestic GDP, because of the sizeable component of non-tradable goods in domestic GDP. This endogeneity biases the test results. New tests are implemented that address these issues. The valuation effect bias is found to be signifi-cant. The new tests nevertheless still support the existence of a long-run positive relationship between NFA and real exchange rates. JEL classification: F31. 1.