How can the U.S. have a surplus in investment income and be the “world’s largest debtor nation?” How does this relate to “dark matter”?
Historically, U.S. overseas investments have generated higher returns than foreign investments in the U.S., resulting in a surplus in investment income.
“Dark matter” is the latest attempt to explain the longstanding surplus in investment income for the “world’s largest net debtor nation.” It suggests that the higher returns on U.S. companies’ overseas investments largely reflect advantages in technology and management that should be included in U.S. exports (thereby lowering the trade deficit) and added to the value of the U.S. direct investment position (thereby lowering the U.S. net debt position).
Are U.S. companies’ rates of return on their overseas investments abnormally high?
No. Over the last several decades the rate of return on U.S. direct investment abroad has averaged only about 1 percentage point more than the rate of return for all non-financial corporations in the United States. The somewhat higher return on U.S. direct investment abroad partly reflects the higher risks associated with overseas investments.
Are foreign companies’ rates of return on their U.S. investments abnormally low?
While the rate of return on foreign direct investment in the U.S. is lower than the overall rate of return for all domestic non-financial corporations, there are a number of possible reasons why this may occur, including:
- Profitability is positively correlated with market share and BEA research indicates that in many industries, market shares for foreign-owned U.S. companies are relatively small.
- Much of the financing for foreign direct investment in the U.S. reflects foreign funds, and long-term interest rates in major foreign direct investor countries have, on average, been lower than those in the U.S. for an extended period. Some key investor countries, particularly Japan, have had especially low long-term interest rates.
- The economies of scale associated with access to the large U.S. market through sales and distribution affiliates may result in increases in home country rates of return, and in overall returns, that more than compensate direct investors for the relatively low rates of return of their U.S. sales and distribution affiliates.
- Transactions between foreign direct investors and their U.S. affiliates may occur at prices (“transfer prices”) that result in the U.S. affiliates recording low profits. Earnings on foreign direct investments, while still relatively low, have grown briskly over the last few years.
Is the rate of return for foreign direct investment in the U.S. artificially low because foreign direct investors understate their U.S. profits through transfer pricing?
- Some researchers have argued that transfer pricing explains why the rate of return that foreign investors earn on their direct investments in the U.S. is lower than what U.S. investors earn on their direct investments abroad.
- However, the question of whether transfer pricing distorts profits in the U.S. or abroad has been long studied and researchers have not yet reached a consensus.
- The U.S. is neither an especially high tax nor low tax country when compared with its major trading partners. Average effective corporate tax rates in the U.S. are lower than those in Italy and Japan, and are higher than those in the Netherlands, Mexico, United Kingdom, and France. Effective rates in the U.S. are close to those in Canada and Germany.
- BEA’s estimates of direct investment earnings are based on company-reported information compiled using U.S. financial reporting rules, as adjusted to BEA economic account concepts.
How does “dark matter” relate to the U.S. international investment position?
- As noted above, “dark matter” has been variously described as an indication that U.S. rates of return are too high and measured exports too low, or that the measured value of U.S. investments abroad is too low.
- Some have suggested that if both U.S. investments abroad and foreign investments in the United States were valued at a common rate of return, the United States would not be a net debtor nation.
- One study suggested using an arbitrary rate of 5% to capitalize income from U.S. direct investment abroad and from foreign direct investment in the U.S. Because the rate of return on U.S. direct investment abroad consistently exceeds 5%, and the return on foreign direct investment in the U.S. usually is lower than 5%, the value of U.S. assets abroad would be revised higher, and the value of foreign direct investments in the U.S. would usually be revised lower, than the estimates now included in the International Investment Position Accounts.
- As the steward of the U.S. Balance of Payments and International Investment Position Accounts, BEA – like statistical agencies in other countries that follow the International Monetary Fund’s Balance of Payments Manual – values financial flows and positions based on market values, not on inferred values based on theoretical hypotheses of how markets might value an income stream.
- BEA’s estimates of components of the international investment position are based on readily observable market prices when these prices are available. That is, stocks, bonds, deposits, currency, gold, etc. are regularly traded or are listed on public markets and their market values are known. Similarly, BEA’s -- and other countries’ -- estimates of exports and imports are based on observable market transactions.
- The primary exception involves the market values of direct investment equity interests, which are not directly observable. As a result, BEA revalues book values to current-period prices using two indicator series: stock market equity indexes and the replacement value of tangible assets.
What would be the impact if BEA reclassified receipts of direct investment income to exports of services?
- It has often been argued the U.S. receipts of income on direct investment abroad include a “premium” arising from superior U.S. management services or intellectual property rights. However, a simple reclassification of receipts from income on direct investment abroad to U.S. exports of services would result in offsetting changes within the current account. The balance on the current account would therefore be unaffected.
There have been a number of recent news articles and working papers about the current account balance being either understated or overstated. What’s the issue and who’s right?
- BEA’s balance of payments account estimates are based on international statistical standards.
- A number of recent news articles and working papers have suggested alternate ways of measuring the U.S. current account. Dark matter proponents argue that U.S. exports are understated because they exclude implicit transfers of knowledge by U.S. direct investors to their foreign affiliates for which there is no charge. Others have recently argued that U.S. receipts of income included in the current account are overstated, due to the inclusion of reinvested earnings in direct investment income.
- It is important to note that these alternate views of the U.S. current account are not consistent with existing or proposed new international statistical standards, they each raise a number of conceptual problems, and some of them contain inaccurate statements about BEA’s methodologies or international statistical standards. For example:
- Some have suggested a possible double-counting in BEA’s methodology for revaluing direct investment at book value to market value. They suggest that double-counting arises because stock market indexes are used to revalue direct investment equity positions. Both the stock index and direct investment equity positions include reinvested earnings, and so, if the change in the index is multiplied by the equity portion of the position, reinvested earnings will be double-counted.
- However, BEA has examined its methodology and has concluded that there is no double counting. BEA’s methodology removes reinvested earnings before calculating the change in the stock market index, applies the adjusted change in the index to the equity portion of the position excluding reinvested earnings, and then revalues reinvested earnings to reflect end-of-year prices rather than average prices.
- It has also been suggested that the year-to-year change in the international investment position is conceptually equivalent to the current account balance. This is incorrect, as valuation adjustments (such as those arising from price changes or from changes in foreign currency exchange rates) can significantly affect the value of the investment position. Under international statistical standards that virtually all countries follow, valuation adjustments are excluded from the current account and from the overall international transactions accounts. However, BEA does calculate valuation adjustments and includes them in its calculation of the change in the international investment position.
For additional discussion of “dark matter,” see the BEA paper "Statistical Issues Related to Global Economic Imbalances: Perspectives on 'Dark Matter'."