"The Impact of Exchange Rate Movements on U.S. Foreign Debt," the latest edition of the New York Fed's Current Issues in Economics and Finance, is now available.

Cédric Tille, an economist in the Bank’s International Research Function, suggests that a third of the sharp increase in the U.S. foreign debt from the end of 1999 through 2001 can be traced to exchange rate movements—specifically, the impact of a rising dollar on the value of U.S. gross assets. Tille’s contention that a simple valuation effect has played a sizable role in the recent acceleration in net debt suggests that the country’s financial position with the rest of the world may be less worrisome than it appears.

The author begins his analysis by describing how the U.S. net debt is calculated. At the end of 2001, foreign investors owned $9.2 trillion of U.S. assets, including stock and bond holdings, ownership shares of business enterprises, and claims on U.S. banks. U.S. investors, by contrast, owned a more modest $6.9 trillion worth of the equivalent foreign assets. The difference in value between U.S. holdings of foreign assets (officially termed U.S. gross assets) and foreign holdings of U.S. assets (U.S. gross liabilities)—$2.3 trillion—is a measure of the U.S. net debt to the rest of the world, or the U.S. net international investment position.

U.S. net debt, Tille explains, increased throughout the 1990s, particularly in the second half of the decade. The most rapid increase, however, occurred between the end of 1999 and the end of 2001. In these two years, the country’s net foreign debt more than doubled.

To determine how this deterioration came about, Tille quantifies the effects of financial flows and valuation changes on the U.S. gross and net positions. Financial flows capture the new borrowing undertaken by the United States to finance its current account deficit; valuation changes—fluctuations in asset prices or exchange rate shifts—reflect the rise or fall in the value of the existing stock of assets and liabilities.

As Tille observes, the relative importance of each of these mechanisms in determining the U.S. net investment position helps us to assess the magnitude of the debt problem. A debt buildup that results from persistent current account deficits is indeed troubling because it can only be reversed through cutbacks in investment and spending that will slow the country’s growth. However, a debt increase that stems from valuation changes is less worrisome, because offsetting movements in asset prices or exchange rates can quickly reduce the country’s net obligations and improve the U.S. investment position.

Tille’s research shows reveals that while financial flows were the primary mechanism driving the deterioration of the country’s net international investment position in the 1990-2001 period, valuation changes contributed significantly to the decline in this position from the end of 1999 through 2001. Falling asset prices accounted for a small part of the decline after 1999, but the impact of the exchange rate was substantial. The appreciation of the dollar, which averaged 6.8 percent per year from the end of 1999 through 2001, markedly reduced the value of U.S. gross assets—that is, foreign assets held by U.S. investors. At the same time, it did little to lessen U.S. gross liabilities—U.S. assets held by foreign investors—which are largely denominated in dollars and thus insulated from changes in the dollar’s value. Overall, the strengthening of the dollar accounted for 30 percent of the deterioration in the U.S. net international investment position from the end of 1999 through 2001.

"If one-third of the 1999-2001 acceleration" in foreign debt "reflects what is essentially an accounting effect from the strong dollar," Tille concludes, "the rapid increase in the U.S. net foreign debt may be a somewhat less formidable problem than is often assumed." Moreover, the author notes, the fact that the valuation mechanism can operate in reverse suggests that the country’s net investment position may improve: the dollar depreciation that began in 2002 may well reduce the country’s foreign debt going forward.

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