Friday, 26 April 2013

External balance sheet interdependence

In the previous post I stated that gross external financial positions were not a problem if they proceeded at a fundamental pace and if countries accepted that they cause greater interdependence. However when they proceed precipitously, like in the case of Cyprus, they are a cause of concern.
There can be other causes than sudden inflows and outflows to precipitous changes in the external gross assets-liabilities positions. For example the adoption of a new currency. Take Germany, a large net external creditor of the euro-area, and assume it changes currency and adopts the Thaler. As a benchmark consider the case where only residents use the Thaler and all non-residents have a different currency, euro, dollar, yen, etc etc. The figure below from the Bundesbank shows the external position of Germany (GDP is around 2600 €bn). The figures are different from those in Eurostat who reports for Germany a 6100 €bn  asset position and 5000 €bn liability position for 2012. In any case Germany is a net creditor when assets and liabilities are valued in euro. With a change in currency there can be three possible cases:

  1. the Thaler exchange rate with the euro is fixed at 1:1, in this case nothing substantial changes in the balance sheet,
  2. the Thaler exchange rate with the euro (and all other currencies) is above parity (devaluation of Germany), in this case the value of the assets increases and the value of the liabilities decreases. Germany's international investment position improves, 
  3. the Thaler exchange rate with the euro (and all other currencies) is below parity (revaluation of Germany), in this case the value of the assets decreases and the value of the liabilities increases. Germany's international investment position worsens.
The size of the gross positions is a multiple of GDP. Therefore even a small revaluation or a small devaluation causes a large balance sheet shock.



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  2. A a small revaluation or a small devaluation can lead to a big mistake. Getting this numbers is really complicated.

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