External assets

What Are External Assets?

External assets refer to the financial holdings and claims that residents of an economy possess against non-residents. These assets represent wealth generated or accumulated beyond an economy's borders and are a key component of a country's International Investment Position (IIP), a statistical statement within the broader field of International Finance. Unlike purely domestic investments, external assets provide exposure to foreign economies, markets, and currencies. Such assets can range from foreign equities and bonds to direct investments in overseas businesses and international reserve assets held by central banks.

History and Origin

The concept of external assets is intrinsically linked to the evolution of global trade and finance. As economies became more interconnected, the movement of capital across borders became increasingly prevalent. This cross-border investment activity necessitated a framework for tracking a nation's financial claims and obligations with the rest of the world. The International Monetary Fund (IMF) has played a crucial role in standardizing the measurement of these flows and positions through its Balance of Payments and International Investment Position Manual. The manual, now in its sixth edition (BPM6), provides a comprehensive statistical framework for countries to report their external financial transactions and positions, ensuring consistency and comparability across the global economy. The development of these international statistical standards has been essential for analyzing global financial imbalances and capital flows.¹¹, ¹², ¹³

Key Takeaways

• External assets are financial claims held by residents of an economy against non-residents.
• They encompass a wide range of investments, including foreign stocks, bonds, direct foreign investments, and international reserves.
• Holding external assets contributes to a country's International Investment Position (IIP) and its overall balance sheet.
• These assets can offer significant benefits such as portfolio diversification and access to growth opportunities in foreign markets.
• However, they also expose investors to unique considerations like currency risk and geopolitical risk.

Interpreting External Assets

External assets reflect an economy's financial relationship with the rest of the world. A rising level of external assets can indicate a country's increasing wealth and its ability to invest abroad. For individual investors, holding external assets means gaining exposure to different economic cycles, industries, and regulatory environments, which can be part of a robust investment strategy. For nations, the composition of external assets is crucial; a large proportion of liquid assets, like foreign exchange reserves, can enhance a country's ability to manage its foreign exchange rate or respond to economic shocks.

Hypothetical Example

Consider "Alpha Nation," a country with a growing economy. Its national pension fund decides to expand its asset allocation beyond domestic holdings. The fund invests $100 billion in a mix of government bonds issued by "Beta Land" and equity in publicly traded companies in "Gamma Republic." These investments, totaling $100 billion, represent Alpha Nation's newly acquired external assets. Should Beta Land's economy perform well, or Gamma Republic's companies increase in value, the Alpha Nation pension fund's external assets would appreciate, potentially boosting the retirement savings of Alpha Nation's citizens.

Practical Applications

External assets are integral to various aspects of finance and economics:

• Portfolio Management: Individual and institutional investors utilize external assets to achieve portfolio diversification, reducing reliance on a single domestic market and potentially enhancing returns by accessing growth in emerging markets or developed markets.
• Central Bank Reserves: Central banks hold significant external assets, primarily foreign currency reserves, to manage their exchange rates, conduct monetary policy, and act as a buffer against external shocks. Data from institutions like the Bank for International Settlements (BIS) highlight the scale and composition of international banking activity and cross-border claims.⁸, ⁹, ¹⁰
• International Trade and Capital Flows: The accumulation or reduction of external assets is a direct outcome of a country's cross-border investment and trade balances. Surpluses often lead to an increase in external asset holdings.
• Regulatory Oversight: Securities regulators, such as the U.S. Securities and Exchange Commission (SEC), issue guidance and regulations for investors considering foreign assets, covering aspects like disclosure requirements and associated risks.⁶, ⁷

Limitations and Criticisms

While external assets offer significant benefits, they also come with inherent risks and limitations:

• Currency Risk: Fluctuations in foreign exchange rates can diminish the value of external assets when converted back to the domestic currency, even if the underlying asset performs well.
• Political and Sovereign Risk: Investments in foreign jurisdictions are exposed to political instability, changes in government policy, and sovereign default risk, which may not be present in domestic markets.
• Market Volatility: Foreign markets, particularly emerging ones, can experience higher market volatility and less liquidity compared to established domestic markets.
• Information Asymmetry and Regulatory Differences: Obtaining comprehensive and reliable information about foreign companies or markets can be challenging due to differing accounting standards and regulatory environments. The SEC, for example, highlights that foreign companies not publicly listed in the U.S. may not file reports with the SEC, and information may not be available in English or subject to analogous auditing oversight.⁴, ⁵
• Capital Controls: Some countries may impose capital controls, restricting the free movement of funds, which can limit an investor's ability to repatriate profits or divest external assets.
• Declining Diversification Benefits: Some research suggests that the benefits of international diversification have diminished over time due to increasing global economic integration and market correlation. An Economic Letter from the Federal Reserve Bank of San Francisco, for instance, discusses why investors might not diversify internationally as much as expected.², ³ Investors must therefore continually assess their risk management strategies.

External Assets vs. Domestic Assets

The primary distinction between external assets and domestic assets lies in the residency of the issuer or counterparty. Domestic assets are financial claims held by residents of an economy against other residents within the same economy. For example, a U.S. investor holding shares of a U.S.-based company, or a U.S. bank holding a loan to a U.S. borrower, would be considered domestic assets. In contrast, external assets involve a cross-border dimension, where the claim is on a non-resident. Confusion can arise when a foreign company operates significantly within a domestic economy but is legally domiciled elsewhere; its shares, if held by a domestic investor, still represent an external asset. The key is the legal residency of the entity issuing the financial claim.

FAQs

What types of investments are considered external assets?

External assets can include a wide range of investments such as foreign stocks, foreign bonds, real estate located in other countries, direct investments in foreign businesses, loans extended to non-residents, and international reserve assets held by the central bank.

Why do investors hold external assets?

Investors hold external assets primarily for portfolio diversification, which can help reduce overall investment risk by spreading capital across different economic cycles and markets. They also seek potential for higher returns in rapidly growing foreign economies or to gain exposure to industries not available domestically.

How do external assets impact a country's economy?

For a country, external assets contribute to its overall wealth and influence its International Investment Position, which indicates whether the country is a net creditor or debtor to the rest of the world. A strong net external asset position can enhance a country's economic stability and influence in global financial markets. The International Monetary Fund often analyzes these positions for economic assessments.¹

Are there risks associated with investing in external assets?

Yes, investing in external assets carries specific risks, including currency risk, political instability in the foreign country, differences in regulatory and accounting standards, and potential limitations on capital movement (capital controls). These factors can introduce complexity beyond typical domestic investments.