The US today, like Britain under the gold standard, acts as the world’s banker. It is the most important source of international liquidity, thereby leading countries to hold USD-denominated assets. Not only does this allow the US and especially the US Treasury to tap into a large investor base ready to finance current account and fiscal deficits at a lower cost. To the extent that the demand for international liquidity and USD assets exceeds the US balance-of-payments deficit, it allows the US to recycle short-term foreign liabilities into long-term assets. In other words, the US acts like a bank. The US also acts as a venture capitalist (Gourinchas & Rey 2005) to the extent that it borrows from foreigners in the form of debt and, in turn, acquires foreign equity assets. As a result, the US benefits from a so-called “return discount” and a “composition effect”. The return effect is reflected in the fact that the US generates higher returns on its assets than it pays out on its liabilities. The composition effect reflects the fact that the US tends to borrow short and to lend long.
By contrast, the EM incur financial losses as a result of what might be termed the “return premium”: the rate of return on their liabilities is greater than the rate of return on their assets. While the US benefits from the composition effect, the EM can be said to suffer from an “adverse composition effect”: they borrows long (mainly in the form of FDI) and to the extent that they accumulate foreign claims these are heavily concentrated in short-term, but invariably low-yielding debt (aka FX reserves).
Put differently, the US is “long equity” and “short debt”. The EM are generally short equity and most of them are also short debt. Only China and Russia are net long debt (that is, they are net creditors). This explains the amazing fact that the US generates positive investment income in spite of being an international debtor, while both China and Russia generate negative investment income on their positive net international investment position (IIP). The composition of EM international balance sheets translates into them paying more on their liabilities than they earn on their assets
Two other countries that stand out in this respect are Korea and Turkey where the rate of return on foreign assets exceeds the rate of return on its liabilities. In the case of Korea, this seems to be in part attributable to the low share of equity claims in total foreign liabilities as well as a relatively low share of FX reserves in total foreign assets. Technically, Korea is not an emerging but a newly-industrialised economy. It is admittedly more of a puzzle why Turkey should generate a higher return on its assets than its liabilities given the composition of its international balance sheet. In part this may be attributable to the relatively low share of FDI in total liabilities. In other words, the EM are willing to hold low-yielding US (and other advanced economy) assets that offer significant liquidity and low risk, while the US (other advanced economies) investing in the EM tend to hold higher-risk, higher-yielding equity and debt assets. This is why the international financial position of the EM contrasts sharply with that of the major advanced economies (US, Japan, Germany or G-3).
The G3 are all long equity and – with the exception of the US – they are all long debt. Once more, the US is the exception among the G3 due to its short debt position, while China and Russia are the exception in the EM-10 due to their long debt position. Admittedly, this picture would change somewhat if the UK, France and Italy, all of which are net international debtors, were included in the advanced economy sample. Moreover, unlike in the EM, a large share of G3 liabilities is denominated in LCY, while their assets contain a significant FCY component on account of their long foreign equity position. (One might hypothesise that with G-3 FDI somewhat concentrated in other advanced economies, the currency valuation and composition effects will be less pronounced than for EM.) The large share of equity claims on the asset side of their balance as well as the generally lower return on its debt liabilities translate into a greater profitability of the G3’s IIP.
Bottom line: the G-3 tend to earn higher returns on their foreign assets than they pay out on their foreign liabilities, in aggregate. The EM pay out more on their liabilities than they earn on their assets. This is due to both the return and composition effects. Until the EM restructure their international balance sheet significantly, this situation is unlikely to change even once G3 interest rates start to rise.