The broad appreciation of the US dollar, the stability of the euro and the overall downward trend of the yen were salient developments in foreign exchange markets over most of 2005. Starting in early December 2005, however, the upward trend of the US dollar reversed. As in previous years, three main factors underpinned exchange rate developments during the period under review: interest rate differentials, the current account deficit and rising net international liabilities of the United States, and continuing reserve accumulation in China limiting the dollar's depreciation against the renminbi. In contrast to earlier years, reserves grew more slowly in other emerging market countries in Asia. The change in China's exchange rate policy introduced in July 2005 received much attention, but by mid-May 2006 had only had a modest impact on foreign exchange markets.
A special section explores trends and determinants of net income in the United States and other industrial countries and the possible implications for the sustainability of external imbalances. The United States has typically reported a positive net income balance, despite a deteriorating net foreign asset position. This is partly because a higher proportion of its assets are in high-yielding asset classes, such as foreign direct investment, and partly because it earns a higher yield on its direct investment abroad than foreigners earn on their direct investment in the United States. Simple sensitivity analysis highlights the importance of an improvement in the trade balance for the sustainability of the net foreign asset position. Moreover, valuation effects can have significant, albeit one-off, effects on the external balance. Changes in relative yields have an important effect on net income, but only a second-order one on net foreign assets.