From Debtor to Creditor Country – An Analysis of Investment Income

Jannick Damgaard, Statistics

INTRODUCTION AND SUMMARY

At the end of 2005, Denmark's external assets exceeded its external liabilities for the first time since WW II. Concurrently with its transition from debtor to creditor country, for the first time in more than 40 years Denmark registered higher investment income receipts from than expenditure to abroad. This broke a prolonged pattern of net external debt and an equivalent interest burden. The question now is whether Denmark will in future continue to hold net external assets and register positive investment income, with a beneficial impact on its balance of payments.

This article reviews the factors that have been decisive to the development in Denmark's external assets and liabilities during the past 45 years. Over time, the balance of the current account of the balance of payments is the determining factor. Nevertheless, in individual years valuation adjustments as a result of changes in exchange rates and prices can lead to strong fluctuation in Denmark's external financial assets and liabilities (the international investment position). Valuation adjustments have a tendency to cancel each other out over time, however.

The article then focuses on the interrelation between Denmark's international investment position and investment income. For a long period, Denmark's net external debt has been substantial, resulting in considerable investment income expenditure. However, the international investment position and investment income are not perfectly correlated, since assets and liabilities yield different returns and moreover can vary over time and between instruments. This has inter alia been the case in the UK and USA, where there has been positive net investment income despite large net debt positions.

With 2005 as the starting point, a sensitivity analysis is performed to show the impact on investment income in various scenarios. The analysis reveals that even minor changes in the level of interest rates and in share yields will have a significant influence on whether investment income is positive or negative.

It can be concluded that even if the current account of its balance of payments continues to show a surplus, Denmark cannot be sure of maintaining its position as a creditor country in the short term, due to the significant role played by valuation adjustments. In addition, the volatility of the rates of return on external assets and liabilities entails that Denmark cannot be certain of positive investment income in the immediate future, even if its international investment position is positive. In particular, asymmetrical changes in returns on direct investment can lead to significant fluctuation in investment income. If the trend of substantial current-account surpluses continues in the years to come, it will in time be reflected in Denmark's international investment position and cement its status as a creditor country with positive investment income, which will benefit the balance of payments.

FROM DEBTOR TO CREDITOR COUNTRY

In 1988, Denmark's external financial liabilities exceeded its external financial assets by an amount equivalent to 47 per cent of GDP for that year, cf. Chart 1.^[1] This was the result of a long period of sustained current-account deficits, which gained momentum in the years after 1960 when there was more or less equilibrium between residents' foreign assets and non-residents' assets in Denmark. In the period after 1988, the situation reversed, and at the end of 2005 Denmark's international investment position was positive for the first time since WW II.

By definition, the numerical development in a country's net assets can be explained by the current and capital accounts balance^[2] and by valuation adjustments, etc.^[3]

Net assets_t = Net assets_t-1 + current and capital accounts balance_t + valuation adjustments, etc._t

Over time, the development in Denmark's net assets could primarily be explained by the current account of the balance of payments. For every year of the period 1960-89, Denmark had a current-account deficit, while for every year of the period 1990-2005, except 1998, it had a
current-account surplus.

In 1960, Denmark's net external liabilities amounted to kr. 0.4 billion, and by 1988 the amount had increased to kr. 359 billion. Of this increase, kr. 257 billion can be attributed to current-account deficits, kr. 9 billion to deficits on the capital account of the balance of payments, and kr. 92 billion to losses as a result of valuation adjustments, etc. In the same way, most of the development from net liabilities of kr. 359 billion in 1988 to net assets of kr. 20 billion in 2005 can be attributed to an aggregate current-account surplus of kr. 347 billion. The surplus on the capital account contributes kr. 13 billion, and valuation adjustment gains contribute kr. 19 billion. The figures illustrate that the development in Denmark's net external assets in the long run is determined primarily by the current account of the balance of payments.

Development in Denmark's net assets as a ratio of GDP
The development in Denmark's net assets as a ratio of GDP cannot be explained solely by the current and capital accounts balance and valuation adjustments, etc. since GDP growth in nominal terms also plays a role. Chart 2 shows the individual contributions of these three factors to the change in Denmark's net assets as a ratio of GDP, and hereby explains the development in Chart 1. In other words, a point on the curve in Chart 2 for a given year corresponds to the difference between the column in the reference year and the preceding year in Chart 1.

It can be seen that each year GDP growth has made a positive contribution. This is because GDP in current prices has risen every year, and since Denmark has held net external liabilities throughout the period up to 2005, all other things being equal, the rising level of GDP brings the negative level of net assets as a ratio of GDP closer to zero. Naturally, this effect is greatest in the years of high GDP growth in nominal terms and substantial net liabilities. There are thus large contributions from GDP to the reduction of the net debt in the 1970s, when inflation was high, and in the 1980s, when the net liabilities peaked.

As previously stated, the current and capital accounts balance drives the development in the net assets in the longer term. Chart 2 shows that the net assets have fallen in most years when the balance was negative. On the other hand, they have generally increased in the years when the balance was positive.

The contribution to the development in net assets from valuation adjustments, etc. was positive in the period 1960-75. At that time, the liabilities were mainly denominated in foreign currency, and most of the valuation adjustments could be attributed to exchange-rate changes, while price changes played only a minor role, cf. Christensen and Hald (2000). In the period 1976-84, there were substantial negative valuation adjustments, primarily attributable to krone devaluations and the appreciation of the dollar. These negative valuation adjustments significantly increased non-residents' assets in Denmark compiled in Danish kroner. Since 1985, the valuation adjustments have fluctuated, and the preceding sign has changed several times. Over time, changes in share and bond prices have gained in significance, and exchange-rate changes no longer account for the dominant share of the valuation adjustments. In addition, the aggregate valuation adjustments can affect the development in the net external assets in individual years to a greater extent than before, due to the large increase in the gross positions, cf. Chart 3. This is seen inter alia in the years around the millennium rollover, when there were very substantial valuation adjustments in view of the large share price increases and decreases resulting from the dotcom bubble.

SUSTAINABILITY OF THE CREDITOR POSITION

The question is whether Denmark in the coming years will be able to maintain its position as a creditor country. Valuation adjustments, etc. play a greater role than before and in some years can far exceed the current account of the balance of payments. This is especially true in the case of Finland, where there is very close correlation between the development in its net external liabilities and the Finnish equity market, due to substantial non-resident holdings of Finnish shares, in particular the Nokia share. A strong increase in the Nokia share price in 1999-2000, followed by a substantial drop in 2000-02, thus brought a large increase in Finland's net external liabilities, followed by an extraordinary improvement when share prices fell.

The scale of valuation adjustments is naturally related to price fluctuations and the structure of Denmark's external assets and liabilities, cf. Table 1. The exposure in shares is seen to be large, especially on the asset side.^[4] This means that stock market fluctuations will affect the size of Denmark's net assets, even if the movements in the Danish and foreign markets are symmetrical. In terms of bonds, the exposure is greatest for liabilities, so that bond price changes will likewise have an immediate impact on Denmark's net assets.

In normal circumstances, a global drop in interest rates will have counterbalancing effects on residents' net foreign assets. Bond prices will increase and, all other things being equal, the share markets will also show a rising trend, since the falling interest rates increase the discounted value of the future dividend payments. As Denmark holds long positions in shares (net assets) and short positions in bonds (net liabilities), rising prices in the share markets will increase Denmark's net assets, while rising prices in the bond markets will reduce the net assets.

Hansen (2005) shows a tendency for counterbalancing movements in share and bond prices in recent years. This phenomenon can arise when there is a change in investors' evaluation of and willingness to accept risk. If investors e.g. assess the risk in the financial markets to be rising, they will reduce their demand for shares and increase their demand for bonds, which are considered to be a safer investment. This will lead to upward pressure on bond prices and downward pressure on share prices, until a new equilibrium is found. In this situation, both the decrease in share prices and the increase in bond prices will reduce Denmark's net external assets.

Sensitivity analysis of Denmark's net assets
Based on the statistics as of end-2005, a static sensitivity analysis can be constructed to show the influence of various factors on the net assets when all other factors are held constant. This analysis can be taken as a rule of thumb to predict the immediate effect on Denmark's net assets. Chart 4 shows the impact on Denmark's net assets of changes in share and bond prices and in the dollar exchange rate. The steeper the curve, the more sensitive the net assets are to changes in the variable.

Chart 4 shows that a general drop in share prices by 5 per cent that is assumed to affect direct investment, SPE^[5] and portfolio shares symmetrically on both the assets and liabilities sides will reduce Denmark's net assets by kr. 15 billion. In the same way, a general increase in bond prices by 5 per cent will reduce the net assets by kr. 17 billion. A fall in the dollar by 5 per cent against all other currencies will reduce residents' net external assets by kr. 11 billion. If all three scenarios occur simultaneously, the total impact will be kr. 43 billion. On the other hand, share price increases, bond price decreases and dollar rate increases will have a positive impact on Denmark's international investment position.

It should be noted that the sensitivity analysis can only be used to calculate the immediate effects because the analysis is partial. Many investors hedge their investments, and in Denmark this applies particularly to pension funds' hedging of interest-rate risks. When interest rates fall, bond prices rise, but the value of guaranteed returns to policyholders also rises. To counter this risk, the pension companies enter into interest-rate swap contracts, typically with non-resident counterparties, whereby they pay interest at a floating rate and receive interest at a fixed rate. When interest rates fell in 2005, the gains on the pension funds' derivatives clearly exceeded the total price increases on Danish bonds held by non-residents. As a result, Denmark's total net assets increased, rather than decreasing. Share and bond prices and exchange-rate risks can also be hedged directly, and all other things being equal, the result will be that the overall effect on Denmark's net assets is not as great as shown in Chart 4.

Despite the reservations made, the above examples illustrate that even minor price fluctuations can have a great impact on Denmark's net assets. Therefore, Denmark will not necessarily be able to maintain its creditor status in the short term, notwithstanding the sound current-account surpluses. For example, in the first three quarters of 2006, there were negative valuation adjustments amounting to kr. 42 billion, mainly attributable to the falling share prices and dollar rate.^[6] This means that at the end of the 3rd quarter, Denmark's external liabilities again
exceeded its external assets. The largest valuation adjustments so far on an annual basis were seen in connection with the dotcom bubble, when valuation gains totalled kr. 102 billion in 1999 and valuation losses amounted to kr. 84 billion in 2000.

RETURNS ON DENMARK'S ASSETS AND LIABILITIES

The investment income in the current account of the balance of payments is closely related to movements in Denmark's external assets and liabilities, cf. Box 1 and Chart 5. In general, Denmark's interest burden increased in the period when the net external debt was accumulated, but since then the investment income has improved as the net external liabilities have been settled. In 2005, Denmark recorded positive net investment income from abroad for the first time since 1963.

Despite the clear long-term relation between the development in Denmark's international investment position and investment income, the correlation is not perfect. In the period 1985-88, Denmark increased its external debt as a ratio of GDP, but nonetheless its investment income improved. In contrast, the investment income deteriorated in the following three years, even though Denmark's net external liabilities were diminishing. This shows that changes in the returns on Denmark's assets and liabilities can be asymmetrical.

Chart 6 shows the returns on Denmark's assets and liabilities in the period 1992-2005. It is seen that the return on liabilities exceeds the return on assets throughout the period up to 2003. The spread between the returns narrows gradually, however, and in 2004 and 2005, the return on assets exceeded the return on liabilities. Asymmetrical changes in returns on assets and liabilities can be due to several factors such as changes in the breakdown of assets and liabilities by instrument, and changes in credit standing, interest-rate spread, maturity and currency structure.

Returns at instrument level
The returns on Denmark's external assets and liabilities have fluctuated considerably in recent years, cf. Table 2. Especially returns on SPE vary strongly from year to year. However, this is a special group of enterprises that is currently being wound down and is dominated by individual enterprises' large transactions. Moreover, the general reservation should be made that the return is calculated as the investment income divided by the average of the holdings at the beginning and end of the year. If there is very strong fluctuation in the holdings during the year, the results from this calculation method can vary.

The profit on direct investment has also proved to be volatile, which is attributable to cyclical fluctuations, among other factors. Even though the changes in both assets and liabilities have been in the same direction to a certain degree, in several years there are significant differences in the extent of the changes. The arithmetic average return on Danish outward direct investment was 7.0 per cent in the period 1999-2005, while inward direct investment yielded an average return of 8.2 per cent. With regard to portfolio shares, the equivalent returns are 1.7 and 1.8 per cent. Returns on direct investment may be overestimated since unlisted shares are included in the holdings at book value rather than estimated market value, which can generally be expected to exceed the book value. Nonetheless, the differing rates of return illustrate that the non-recording of reinvested earnings on portfolio shares clearly distorts the compilation of investment income, cf. Box 1.

The average bond yields in the period were 5.8 and 4.1 per cent for respectively assets and liabilities. The return appears to be high compared to the return on shares. Basic financing theory prescribes a significantly higher return on shares than on bonds over a long period since share yields are more volatile, and therefore investors require a higher risk premium on these assets.^[7] It is important to note that, in contrast to enterprises' financial statements, reinvested earnings and revaluations are not included as investment income on portfolio shares in the balance of payments. In addition, Table 2 relates to a brief period of dampened global economic growth at the start of the new millennium.

The return on intercompany debt, etc. is low throughout the period, but increases sharply in 2005. This is related among other things to many enterprises' reporting of netted interest in the payments-based system used to compile the balance of payments up to and including 2004. The low returns on other assets and liabilities should be viewed in the light of the large proportion of bank deposits and other liquid, short-term outstandings for which interest rates are normally low.

In overall terms, as previously stated, returns on Denmark's liabilities exceeded the returns on its assets in the period 1992-2003, while the situation reversed in 2004 and 2005. Countries such as the USA and the UK have for a number of years seen how returns on assets have clearly exceeded returns on liabilities, resulting in positive investment income, notwithstanding their considerable external debt, cf. Box 2.

SENSITIVITY ANALYSIS OF INVESTMENT INCOME

Denmark's investment income for 2005 was kr. 4.4 billion, a positive figure for the first time since 1963. It is relevant to investigate the robustness of the switch from negative to positive investment income. In this section, static analyses are constructed to show the significance of various scenarios to investment income, given the average holdings of assets and liabilities in 2005.^[8]

Chart 7 illustrates the impact on investment income in the event of changes in the level of interest rates, the profit on direct investment and the dollar exchange rate. The steeper the curve, the greater the effect of any change. It is seen that a rising level of interest rates will result in lower investment income. This is because Denmark's liabilities that are exposed to fluctuations in interest rates, defined as intercompany debt, bonds and other liabilities, exceed its equivalently exposed assets. Given the assumptions on which the analysis is based, an increase in interest rates by 1 percentage point will reduce Denmark's investment income by kr. 3.3 billion.^[9]

Chart 7 also shows that an increase of 1 percentage point in the profit on inward direct investment in Denmark will negatively affect investment income by kr. 3.7 billion. On a decrease of 1 percentage point in the profit on Denmark's outward direct investment, the investment income decreases by kr. 4.4 billion and is thus zero. If the return on direct investment falls by 1 percentage point for both assets and liabilities, the investment income will decrease by kr. 0.7 billion, and a symmetrical change in the return will have only a minor net effect.

Often the return on direct investment fluctuates in the same direction for both assets and liabilities, but in 2000, the profit on outward direct investment fell against 1999, while the profit on inward direct investment rose. Based on the 2005 figures, a repetition of this scenario would lead to an overall decrease in investment income of kr. 17.2 billion. In other words, this would result in investment income of kr. -12.8 billion, instead of kr. 4.4 billion. If the scenario from 2003 is repeated, with increasing returns on outward direct investment and falling returns on inward direct investment, Denmark's investment income would, on the other hand, improve by kr. 15.2 billion to kr. 19.6 billion. Asymmetrical changes in the profit on direct investment, which have previously occurred, will thus have a strong impact on the investment income and can change the preceding sign.

In contrast to the effect on Denmark's net assets, changes in the dollar exchange rate will have only a limited effect on the investment income. In 2005, Denmark's investment income receipts in dollars were equivalent to kr. 18.2 billion, compared to expenditure equivalent to kr. 7.8 billion. A decline in the dollar exchange rate by 1 per cent will therefore have an immediate downward impact of only kr. 0.1 billion on the investment income.

The overall conclusion to the sensitivity analysis is thus that asymmetrical changes in the profit on direct investment, and general changes in the level of interest rates, will have a significant impact on the investment income. If the compilation principle for investment income on portfolio shares were to be harmonised with the principle for compilation of direct investment, the effect on the overall investment income would likewise be assumed to be significant, cf. Box 3. Investment income is not particularly sensitive to changes in the dollar exchange rate.

LITERATURE

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Brealey, Richard A., Stewart C. Myers and Franklin Allen (2005), Corporate Finance, 8th edition, McGraw-Hill.

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Hansen, Frank Øland and Lill Thanning Hansen (2000), Interest and Dividend on Denmark's External Debt, Danmarks Nationalbank, Monetary Review, 1st Quarter.

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