Portfolio capital flows and the US dollar exchange rate: Viewed from the lens of time and frequency dynamics of connectedness

This study uses proprietary data on daily net non-resident portfolio flows to emerging markets to analyse the interconnectedness of non-resident debt and equity portfolio flows under different market conditions. We find that there is less interconnectedness during normal times but increased interconnectedness during periods of uncertainty and stress, suggesting an asymmetry in the spillovers of these portfolio flows. Importantly, we find that shocks in the broad EM US dollar exchange rate are a net transmitter of shocks to debt and equity portfolio flows of EM economies. Our analysis, based on the net directional spillover index, shows that this effect is most pronounced during the COVID-19 pandemic. Furthermore, using a frequency domain approach to connectedness, we find that the broad EM US dollar exchange rate is a net transmitter of shocks to the EM economies’ debt and equity flows, with the impact hitting portfolio capital flows within at least a week to 100 days. Our results suggest that pre-emptive macroprudential policy measures and better risk monitoring can improve the resilience of borrowers and investors in EM economies during times of global shocks, particularly during US dollar appreciations when portfolio flows tend to reverse.     

Adjustment patterns to commodity terms of trade shocks: The role of exchange rate and international reserves policies

We analyze the way in which Latin American countries have adjusted to commodity terms of trade (CTOT) shocks in the 1970–2007 period. Specifically, we investigate the degree to which the active management of international reserves and exchange rates impacted the transmission of international price shocks to real exchange rates. We find that active reserve management not only lowers the short run impact of CTOT shocks significantly, but also affects the long run adjustment of REER, effectively lowering its volatility. We also show that relatively small increases in the average holdings of reserves by Latin American economies (to levels still well below other emerging regions current averages) would provide a policy tool as effective as a fixed exchange rate regime in insulating the economy from CTOT shocks. Reserve management could be an effective alternative to fiscal or currency policies for relatively trade closed countries and economies with relatively poor institutions or high government debt. Finally, we analyze the effects of active use of reserve accumulation aimed at smoothing REERs. The result support the view that “leaning against the wind” is potent, but more effective when intervening to support weak currencies rather than intervening to slow down the pace of real appreciation. The active reserve management reduces substantially REER volatility.     

External shocks, U.S. monetary policy and macroeconomic fluctuations in emerging markets

Estimated structural VARs show that external shocks are an important source of macroeconomic fluctuations in emerging markets. Furthermore, U.S. monetary policy shocks affect interest rates and the exchange rate in a typical emerging market quickly and strongly. The price level and real output in a typical emerging market respond to U.S. monetary policy shocks by more than the price level and real output in the U.S. itself. These findings are consistent with the idea that “when the U.S. sneezes, emerging markets catch a cold.” At the same time, U.S. monetary policy shocks are not important for emerging markets relative to other kinds of external shocks.     

Default, insurance, and debt over the life-cycle

The widespread use of debt and default suggests that unsecured credit markets play an important role in consumption smoothing. In this paper, I address two previously unanswered questions. First, how does policy towards debt default affect the evolution of consumption and net worth over the life-cycle? Second, how does debt default policy interact with social insurance over the life-cycle? The findings are as follows. First, US default policy appears “lax”, in the sense that it creates severe credit constraints, especially for the young. Second, eliminating default will lower consumption inequality among the young, but will increase it among the old. Third, social insurance alters default risk and, in turn, loan pricing, and therefore matters for purely intertemporal smoothing.     

Subsidiary debt,capital structure and internal capital markets

I study external debt issued by operating subsidiaries of diversified firms. Consistent with Kahn and Winton's [2004. Moral hazard and optimal subsidiary structure for financial institutions. Journal of Finance 59, 2537–2575] model, where subsidiary debt mitigates asset substitution, I find firms are more likely to use subsidiary debt when their divisions vary more in risk. Consistent with subsidiary debt mitigating the free cash flow problem, I find that subsidiaries are more likely to have their own external debt when they have fewer growth options and higher cash flow than the rest of the firm. Finally, I find that subsidiary debt mitigates the “corporate socialism” and “poaching” problems modeled in theories of internal capital markets.     

A present value test of habits and the current account

Forecasts derived from standard intertemporal current account (ICA) models generally fail to match the volatility of actual current accounts. This paper offers a solution to the “excess volatility” problem of standard ICA models by incorporating consumption habits into the standard model. The model, as developed in the paper, shows that significant habit formation implies increased current account volatility, as sluggishness is introduced into the consumption adjustment process that follows income shocks. A theory-consistent measure of the degree of habit formation is estimated using GMM. The estimated habit parameter is found to be statistically significant in six of eight quarterly samples.     

Should corporate debt include a rating trigger?

Recent corporate debt offerings have included a covenant specifying a pre-determined payment to debtholders when the debt is downgraded. We examine the incentive for equityholders to increase firm risk (and the associated costs) when debt includes a “rating trigger.” Equityholders of firms with a low-risk profile and operating flexibility choose debt with a trigger, while equityholders of firms with a high-risk profile and less flexibility choose regular debt. A trigger that requires an equity infusion better mitigates conflicts between equityholders and debtholders than a trigger paid by liquidating assets. A trigger that increases the coupon rate is not optimal.     

Analyzing determinants of bond yield spreads with Bayesian Model Averaging

This paper analyzes determinants of country default risk in emerging markets, reflected by sovereign yield spreads. The results reported so far in the literature are heterogeneous with respect to significant explanatory variables. This could indicate a high degree of uncertainty about the “true” regression model. We use Bayesian Model Averaging as the model selection method in order to find the variables which are most likely to determine credit risk. We document that total debt, history of recent default, currency depreciation, and growth rate of foreign currency reserves as well as market sentiments are the key drivers of yield spreads.     

The Great Recession: US dynamics and spillovers to the world economy

This paper provides an empirical investigation of both the within-US and international channels of transmission of macroeconomic and financial shocks by means of a 50-country macroeconometric model (estimated over the 1980-2009 period), including measures of excess liquidity and financial fragility, specifically designed in order to evaluate the relevance of the boom-bust credit cycle view put forward as an interpretation of the recent “Great Recession” episode. We find that such a view is consistent with the empirical evidence. Moreover, concerning the real effects of financial shocks within the US, we detect stronger evidence of an asset prices channel, rather than a liquidity channel. Concerning the spillovers to the world economy, we find that while financial disturbances are transmitted to foreign countries through US house and stock price dynamics, as well as excess liquidity creation, the trade channel is the key trasmission mechanism of real shocks.     

Financing decisions when managers are risk averse

Leverage raises stock volatility, driving a wedge between the cost of debt to shareholders and the cost to undiversified, risk-averse managers. I quantify these “volatility costs” of debt and examine their impact on financing decisions. I find that: (1) the volatility costs of debt can be large for executives exposed to firm-specific risk; (2) for a range of empirically relevant parameters, higher option ownership tends to increase, not decrease, the volatility costs of debt; and (3) for managers with stock options, a stock price increase typically raises volatility costs. For a large sample of US firms, I find evidence that volatility costs affect both the level of and short-term changes in debt, and that volatility costs help explain a firm's choice between debt and equity.     

“Black Swans” before the “Black Swan” evidence from international LIBOR–OIS spreads

The LIBOR–OIS spread is a closely monitored indicator of the financial health of economy. Previous research has used this spread to identify and anticipate abrupt changes in financial markets. Taylor and Williams (2009) refer to the drastic increase in the US LIBOR–OIS spread on August 7th, 2007 as a “Black Swan” in the money market. In this paper, rather than rely on visual observations of “Black Swans” we estimate them using Bai and Perron’s (1998) procedure. We estimate structural breaks, Granger causality tests, and innovation accounting in international LIBOR–OIS spreads and a CDS index to better understand their dynamics during the recent crisis. Our results reveal that “Black Swans” appeared in smaller economies prior to that in large ones during the financial crisis. In addition, we find that only shocks to the US LIBOR–OIS spread has any statistically significant effects after 30 days.     

International income risk-sharing and the global financial crisis of 2008–2009

We examine the impact of the global financial crisis on the degree of international income and consumption risk-sharing among industrial economies using returns on cross-border portfolio holdings (e.g., debt, equity, FDI). We split the returns from the net foreign holdings as receipts (inflows) and payments (outflows) to investigate which of the two sides exhibited the greater resilience for income risk-sharing during the recent crisis. First, we find that debt delivered better risk-sharing than equity, mainly reflecting the deficit deterioration in EMU countries during the post-crisis period. FDI, by contrast, did not correspond to noticeable risk diversification. Second, separating output shocks into positive and negative components reveals that debt holding receipts (equity liability payments) performed better under negative (positive) realizations of the shock variable. Third, the unwinding of capital flows resulted in a sharp fall in income dis-smoothing via the debt liability channel in the new EU countries.     

Neither a borrower nor a lender: Does China's zero net foreign asset position make economic sense?

China in the past few years has emerged as a net foreign creditor on the international scene with net foreign assets (NFAs) slightly greater than 0% of wealth. This is surprising given that China is a relatively poor country with a capital-labor ratio about one-fifth the world average and one-tenth the US level. We ask whether it makes economic sense for China to be a net creditor and what China's NFA position might be in 20 years. We calibrate a theoretical model of international capital flows featuring diminishing returns, production risk, and sovereign risk. Our calibrations for China yield a predicted NFA position of −17% of China's wealth. We also estimate non-structural cross-country regressions of determinants of NFAs in which China is always a significant outlier with around 9% points more of NFAs relative to wealth than is predicted by its characteristics. We speculate that a variety of domestic distortions account for these deviations from the theory and cross-country empirics. We calibrate and predict different—and necessarily speculative—scenarios out to 2025, assuming that China's NFA position eventually conforms with the theoretical and cross-country regularities. Our scenarios suggest a future negative NFA position between 3% and 9% of wealth. Starting from China's zero NFA position, it would take current account deficits in the range of 2-5% of GDP to reach any of these future NFA positions. These are not unreasonable deficits, but they would require a large adjustment from the present 6% of GDP current account surplus.     

Optimal leverage strategy: Capital structure in real estate investments

This article examines the optimal leverage strategy for real estate investors who are investing in income-producing properties. Within a discounted cash-flow context, the investment objective for the equity investor is to maximize the contribution to net present value of using mortgage financing. Utilizing more debt decreases the required equity investment and increases the size of the tax shelter. On the other hand, as the loan-to-value ratio increases, the interest rate charged by the lender increases, which indicates a higher cost of debt. This article goes beyond the simple conventional wisdom that debt financing should be used when financial leverage is positive by developing an equation that allows one to determine the optimal level of debt financing to use when positive leverage is possible. The optimal loan-to-value ratio is found to be a function of the investor's characteristics. Several hypotheses about the relationships between such an optimal loan-to-value ratio and the investor's characteristics are derived.     

What lies beneath: Foreign exchange rate exposure,hedging and cash flows

This paper presents results from an in-depth analysis of the foreign exchange rate exposure of a large nonfinancial firm based on proprietary internal data including cash flows, derivatives and foreign currency debt, as well as external capital market data. While the operations of the multinational firm have significant exposure to foreign exchange rate risk due to foreign currency-based activities and international competition, corporate hedging mitigates this gross exposure. The analysis illustrates that the insignificance of foreign exchange rate exposures of comprehensive performance measures such as total cash flow can be explained by hedging at the firm level. Thus, the residual net exposure is economically and statistically small, even if the operating cash flows of the firm are significantly exposed to exchange rate risk. The results of the paper suggest that managers of nonfinancial firms with operations exposed to foreign exchange rate risk take savvy actions to reduce exposure to a level too low to allow its detection empirically.     

Estimating exchange rate responsiveness to shocks

The goal of this paper is to examine the importance of permanent and transitory shocks using a more efficient trend-cycle decomposition of the real exchange rate series. Our main contribution is that in measuring the impact of shocks, we not only impose common trend restrictions but also common cycle restrictions. We later confirm, through a post sample forecasting exercise, the efficiency gains from imposing common cycle restrictions. Our results indicate that permanent shocks are responsible for the bulk of the real exchange rate variations for Japan, Italy, Germany, France, and the UK vis-à-vis the US dollar over short horizons. For Canada, however, transitory shocks are dominant over the short horizon. In sum, while for Japan, France, and Italy, around 15% of the variation in real exchange rate is due to transitory shocks, for Canada, Germany and the UK, over 25% of the variations over the short horizon are due to transitory shocks. Thus, we claim that the role of transitory shocks should not be ignored.     

Measuring financial market integration over the long run: Is there a U-shape?

Using long time series for sovereign bond markets of fifteen industrialized economies from 1875 to 2009, I find that financial market integration by the end of the 20th century was higher than in earlier periods and exhibited a J-shaped trend with a trough in the 1920s. The main reason for the higher financial integration seen today is the recent extensive globalization. Around the turn of the 20th century, countries frequently drifted apart. Conversely, in recent years, the bond markets of most countries have moved together. Both policy variables and the global market environment play a role in explaining the time variation in integration, while “unexplained” changes in the overall level of country risk are also empirically important. My methodology, based on principal components analysis, is immune to outliers and accounts for global and country-specific shocks and, hence, can capture trends in financial integration more accurately than standard techniques such as simple correlations.     

Do mortgage rates vary based on household default characteristics? Evidence on rate sorting and credit rationing

Credit screening models suggest that lenders vary loan rates and debt ceilings across applicants on the basis of credit risk. We argue that regulatory constraints such as Fair Lending Laws may preclude rate sorting while increasing lender use of debt ceilings to adjust for applicant credit risk. Using household data from the 1983 SCF, we find that mortgage rates do not vary with applicant credit risk whereas related studies find that debt ceilings vary with borrower risk attributes. Together, these findings support arguments that regulatory constraints reduce rate sorting while increasing the use of non-price terms in the mortgage contract.     

The interbank market after the financial turmoil: Squeezing liquidity in a “lemons market” or asking liquidity “on tap”

After August 2007 the plumbing system that supplied banks with wholesale funding, the interbank market, failed because toxic assets obstructed the pipes. Banks were forced to squeeze liquidity in a “lemons market” or to ask for liquidity “on tap” from central banks. This paper disentangles the two components of the 3-month Euribor–Eonia swap spread, credit and liquidity risk and then evaluates the decomposition. The main finding is that credit risk increased before the key events of the crisis, while liquidity risk was mainly responsible for the subsequent increases in the Euribor spread and then reacted to the systemic responses of the central banks, especially in October 2008. Moreover, the level of the spread between May 2009 and February 2010 was influenced mainly by credit risk, suggesting that European banks were still in a “lemons market” and relied on liquidity “on tap” even before sovereign debt crisis unfolded in Europe.     

Supersanctions and sovereign debt repayment

What might happen if a third-party entity had the power to implement fiscal reforms and/or punish sovereign debt defaulters? In contrast to recent history, extreme sanctions such as gunboat diplomacy and “fiscal house arrest” were used to punish debt defaulters during the period 1870–1913. We find that, after a “supersanction” was imposed, a country improved its fiscal discipline. As a result, ex ante default probabilities on new issues fell dramatically and the country spent no additional time in default. Our results suggest some type of external fiscal or monetary control may be effective in imposing discipline on serial debt defaulters.