International Financial Adjustment

We explore the implications of a country’s external constraint for the dynamics of net foreign assets, returns, and exchange rates. Deteriorations in external accounts imply future trade surpluses (trade channel) or excess returns on the net foreign portfolio (valuation channel). Using a new data set on U.S. gross external positions, we find that stabilizing valuation effects contribute 27 percent of the cyclical external adjustment. Our approach has asset‐pricing implications: external imbalances predict net foreign portfolio returns one quarter to two years ahead and net export growth at longer horizons. The exchange rate is forecastable in and out of sample at one quarter and beyond.