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Sunday, February 27, 2011

Gross or Net Capital flows to use in economic analysis?

In the financial world, the issue of which figure to use(gross or net) is quite important in several contexts
  1. Revenue recognition:- Accounting rules have strict conditions for when to use gross/net values
  2. Regulatory restrictions:- The stock exchanges margin requirements(for derivatives trading) permit netting out only in certain defined situations
  3. Disclosures:- Where there are rights of setoff etc, the reporting institution(bank/FI) may want to netout the exposures and disclose only the net asset/liability on its balance sheet.
But it is in the area of investment policy and monetary management that this distinction is of most significance. Proponents of a gross approach(add inflows+outflows)  feel that(as mentioned in Dr Shyamala Gopinath's address to FEDAI in Feb-11 here)
  • Gross capital flows contribute immensely to diffusion of technology and international knowledge flows. This is also why gross trade flows(imports +exports)  are considered while comparing the extent of 'openness' of economies
  • It is gross flows that determine risk exposures and are therefore important for financial stability
  • Netting of cross-temporal flows does not capture the real impact of gross capital flows on exchange rate as well as asset price impacts.  
 While proponents of the net approach(take the difference of inflows/outflows) feel that the reserves change only to the extent of the net flows, so that value only should be taken.

Before the subprime crisis, the net approach was widely considered but now the gross approach is also considered to be more representative. Still, for currency analysis, the net approach may probably work better
Bottom Line:- Depending on the purpose you want to analyze capital flows more, select the appropriate indicator(gross/net)

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