Composition of International Assets and the Long‐run Current Account

We document the role of capital gains and losses for the current account that a country can sustain along a balanced growth path. While it is well know that growth allows a country to run a current account deficit and still keep its external debt stable as a share of GDP, the sensitivity of the current account to the composition of external assets and liabilities has received little attention. We show that this composition matters because several assets, such as equity or FDI, earn substantial capital gains that are not reflected in the current account. A country that is a net creditor in such assets can then sustain a larger current account deficit. Using a broad sample, we show that this aspect substantially tilts estimates of the long‐run current account towards a deficit among industrialized economies, with the opposite situation for emerging markets. We also show that industrialized economies are likely to benefit from predictable capital gains in the future.     

Reducing large net foreign liabilities

In light of persistently large net foreign liability (NFL) positions in several euro area countries, we analyze 138 episodes of sizeable NFL reductions for a broad sample of advanced and emerging economies. We provide stylized facts on the channels through which NFLs were reduced and estimate factors that make episodes “stable”, that is, sustained over the medium term. Our findings show that while GDP growth and valuation effects contribute most to NFL reductions overall, stable reduction episodes also require positive transaction effects (i.e., current account surpluses), in particular in advanced economies. Considering the different components of a country's external balance sheet, we observe that reduction episodes were almost exclusively driven by a decline in gross external liabilities in emerging economies, while in advanced economies also gross external asset accumulation contributed significantly, in particular in stable episodes. Our econometric analysis shows that NFL reductions are more likely to be sustained if a country records strong average real GDP growth during an episode and exits the episode with a larger current account surplus that consists of a combination of relatively high exports, low imports and low net factor income payments. Moreover, we find evidence that nominal effective exchange rate depreciation during an episode is helpful for achieving episode stability in the short run, while IMF programs and sovereign debt restructurings also contribute to longer term stability.     

How international financial flows affect stock markets?

Relying on the IMF Coordinated Portfolio Investment Survey, which reports countries’ bilateral investments in financial assets at end-2001 to end-2015, this article shows that a country’s stock market growth is not only spatially correlated with those of nearby countries, but also positively associated with the magnitude of connectedness of the country’s international investments in debt within a dynamic financial investment flow network. The positive relation arises because debts have become an increasingly important source of capital for developing countries.     

External liabilities,domestic institutions and banking crises in developing economies

We investigate the impact of foreign equity and debt on the occurrence of banking crises in 61 lower income and middle income economies during the 1984 to 2010 period. We also focus on the effects of domestic institutions on banking crises and whether they mitigate or exacerbate the impact of the external liabilities. We find that FDI liabilities lower the probability of a crisis, while debt liabilities increase their incidence. However, institutions that lower financial or political risk partially offset the impact of debt liabilities, as does government stability. A decrease in investment risk directly reduces the incidence of banking crises.     

Where Do Australians Invest?

In this article, we analyse the geography of Australia's international portfolio investment using the International Monetary Fund's Co‐ordinated Portfolio Investment Survey dataset. Preliminary results suggest that Australia's external holdings of equity and debt as a percentage of national income almost doubled between 1997 and 2001. However, Australia's international investment position as a percentage of national income is one of the lowest amongst the major OECD countries. In 2001 approximately two‐thirds of Australia's total investments were in the United States and the United Kingdom. By contrast Australia's trade share (exports plus imports as a percentage of Australia's total world trade) with these countries was approximately 20 per cent in the same year. The major determinants of Australia's geographical allocation of portfolio investment indicate a broad correspondence between stock market capitalisation of destination countries and the allocation of Australian financial investments but with some deviations from that baseline, where the deviations are correlated with Australian trade patterns.     

Credit risk and sustainable debt: a model and estimations of why the Euro is stable in the long-run

Sustainable debt has become the key issue in rating of private as well as sovereign debtors. The problem of how to estimate sustainable debt has also been at the center of the debate over the Asian 1997–1998 financial crisis. If the external value of the currency depends on the external debt of a country, it is necessary to estimate the creditworthiness of the country. This paper studies credit risk and sustainable debt in the context of a dynamic model. For a dynamic growth model with an additional equation for the evolution of debt, we demonstrate of how to compute sustainable debt and creditworthiness. The model is estimated by employing time series data for the core countries of the Euro-area. The computations show that the Euro-area has large external assets. Using time series methods, the sustainability of external debt (assets) is estimated for those core countries of the Euro-area. Those estimations show that the Euro will be a stable currency in the long-run.     

Financial Globalization,Financial Crises,and the External Portfolio Structure of Emerging Markets*

We study the transitional dynamics of financial integration in emerging economies using a two‐sector model with a collateral constraint on external debt and trading costs incurred by foreign investors. The probability of a financial crisis displays overshooting; it rises sharply initially and then falls sharply, but remains non‐zero in the long run. While equity holdings fall permanently, bond holdings initially fall, but rise after the probability of a crisis peaks. Conversely, asset returns and asset prices first rise and then fall. These results are in line with the post‐globalization dynamics observed in emerging markets, and the higher frequency of crises that they display.     

A simple model of emerging market portfolio structure

Many emerging market economies have experienced large buildups of foreign exchange rate reserves over the last decade. Much of the contemporary discussion of this phenomenon has focused on this reserve growth as the consequence of exchange rate policies which have maintained fixed pegs to the US dollar. By contrast, this paper focuses on emerging market reserve choice as a consequence of portfolio diversification, applied to the experience of Asian economies. While Asian economies have become significant gross creditors in bonds and other fixed income assets, their liability position in equity and FDI assets has also grown significantly. This suggests that a full understanding of the reserve growth episode must be seen as part of an overall model of portfolio choice. The paper constructs a model of the interaction between an emerging market and an advanced economy in which an optimal general equilibrium portfolio structure implies that emerging market economies simultaneously build up a stock of foreign exchange rate reserves while receiving FDI flows from the advanced economy. The model can provide a reasonable quantitative account of the recent Asian experience.     

Currency internationalization and valuation effects: based on the threshold model

ABSTRACT

Based on the three functions of currency internationalization, including exchange medium, pricing currency and foreign reserve, this paper explores how the degree of currency internationalization affects the impact of the exchange rate and the asset price on valuation effects. Using samples of 161 countries or regions from 2001 to 2016 and the threshold regression method, we find that, firstly, there is a threshold effect of the exchange rate on valuation effects due to currency internationalization. The higher the comprehensive level of currency internationalization is, the greater the positive impact of the exchange rate on valuation effects will be. Secondly, the threshold effect of the asset price on valuation effects due to currency internationalization is not significant because of the high stickiness of asset price. Besides, compared with developed countries, currency internationalization is more important to increase valuation effects through exchange rate channel and asset price channel in developing countries or regions. Finally, there are some differences in the three types of currency internationalization functions. The promotion of exchange medium function will lead to a greater positive impact of the exchange rate on valuation effects, as well as pricing currency function. However, the foreign reserve function has no such effect.     

Evidence of cross-asset contagion in U.S. markets

This study examines evidence of cross-asset contagion among REIT, money, stock, bond, and currency markets in the US from 2006 to 2012, which covers the subprime and European sovereign debt crisis. We apply the Granger causality test and a vector auto-regression to examine the change of causality structure. Our results show that contagion exists from medium-term bond markets to equity markets; REIT, money markets and short-term bond markets show little evidence of cross-asset contagion with other markets; and the currency market shows high co-movement and contagion with equity markets. Our findings provide more rewarding asset reallocating strategies for the investors who invest in both bond and equity markets before a crisis to consider reallocating their portfolio into REIT and money markets to benefit from diversification during a crisis period.     

The OECD's new global model

This paper provides a summary of the OECD's new global macroeconometric model, including an overview of model structure and a selection of simulations illustrating its main properties. Compared with its predecessors, the new model is more compact and regionally aggregated, but gives more weight to the focus of policy interests in global trade and financial linkages. The country model structures typically combine short-term Keynesian-type dynamics with a consistent long-run neo-classical supply-side. While retaining a conventional treatment of international trade and payments linkages, the model has a greater degree of stock-flow consistency, with explicit modelling of domestic and international assets, liabilities and associated income streams. Account is also taken of the influence of financial and housing market developments on asset valuation and domestic expenditures via house and equity prices, interest rates and exchange rates. As a result, the model gives more prominence to wealth and wealth effects in determining longer-term outcomes and the role of asset prices in the transmission of international shocks both to goods and financial markets.     

Capital Market Integration and National Wealth

This article examines the effects of increased capital market integration on Australia's external liabilities, total assets and national wealth using an inter-temporal approach. Stylised national balance sheets-then provide summary statements of how these aggregates changed following the unprecedented international financial liberalisation of the 1980s. Though the level of international debt was relatively high at the end of the 1980s compared to the 1970s, it was easily exceeded by growth in asset values, resulting in a sharp rise in wealth per head.     

The 2014–15 Financial Crisis in Russia and the Foundations of Weak Monetary Power Autonomy in the International Political Economy

ABSTRACT

This article contributes to international political economy debates about the monetary power autonomy (MPA) of emerging market and developing countries (EMDs). The 2014–15 Russian financial crisis is used as a case study to explore why an accumulation of large international reserves does not provide protection against currency crises and macroeconomic adjustments in EMDs. The analysis centres on the interplay between two dimensions of MPA: the Power to Delay and the Power to Deflect adjustment costs. Two structural factors condition Russia’s low MPA. First, the country’s subordinated integration in global financial markets increases its financial vulnerability. The composition of external assets and liabilities, combined with cross-border capital flows, restrict the use of international reserves to delay currency crises. Second, the choice of a particular macroeconomic policy regime embraced the financialisation of the – mainly state-owned – Russian banking sector, thus making it difficult to transform liquidity inflows into credits for enterprises. Russia’s main comparative advantage, hydrocarbon export revenues, is not exploited. The type of economy created due to the post-Communist transition means that provided ‘excessive’ liquidity remains in the financial system and is channelled into currency arbitrage. This factor increases exchange rate vulnerability and undermines Russia’s MPA.     

Investment under Uncertainty, Debt and Taxes

It is common practice in financial derivative valuation to use a discount factor based on the riskless debt rate. But, to what extent is this discount factor appropriate for cash flows emerging in capital budgeting? To answer this question, we introduce a framework for real asset valuation that considers both personal and corporate taxation. We first discuss broad circumstances under which personal taxes do not affect valuation. We show that the appropriate discount rate for equity‐financed flows in a risk‐neutral setting is an equity rate that differs from the riskless debt rate by a tax wedge due to the presence of personal taxation. We extend this result to the valuation of the interest tax shield for exogenous debt policy with default risk. Interest tax shields, which accrue at a net rate corresponding to the difference between the corporate tax rate and a tax rate related to the personal tax rates, can have either positive or negative values. We also provide an illustrative real options application of our valuation approach to the case of an option to delay investment in a project, showing that the application of Black and Scholes formula may be incorrect in presence of personal taxes.     

Determinants of capital flows to emerging and advanced economies between 1990 and 2011

The previous and latest crises confirmed that stability of external financing of the economy is determined not only by the volume of capital inflow but also by its structure. It is established that a bias in gross external liabilities towards debt, especially short-term, may rise vulnerability to financial crises. Greater share of equity capital, mainly direct investment is not found to bear such financial risk. The results of Bayesian Model Averaging (BMA) show that influence of variables inherent in macroeconomic and portfolio approaches varies depending on the type of capital inflow and the group of countries. We also find some arguments that equity investment is a more desirable form of foreign capital because debt inflows are more responsive to global factors and therefore more volatile. As a word of caution, we highlight the need for diversification and careful monitoring of external financing sources and forms.     

Taxi,Takeoff and Landing: Behavioural Patterns of Capital Flows to Emerging Markets

This paper analyses volatility, persistence, predictability, correlation, comovement (or contagion risk) and sudden stop (reversibility) of capital flows (foreign direct investment (FDI), foreign portfolio equity investment, long-term and short-term debt flows) using time series econometric techniques for 24 emerging economies over 1970–2014. This is informative on the pattern and relationship between capital inflows, with implications for accommodating macroeconomic policies in countries receiving inflows. The paper also addresses the predictions of conventional theory, that differences are associated with the maturity of the capital (long-term vs. short-term), with the information-based trade-off model of Goldstein and Razin [(2006). An information-based trade off between foreign direct investment and foreign portfolio investment. Journal of International Economics, 70(1), 271–295], that differences are associated with the structure of the capital (equity vs. debt). In line with the latter, equity flows (FDI and portfolio) are less volatile and persistent, more predictable and less susceptible to sudden stops than debt flows. Contrary to conventional theory, short-term flows are not more volatile, but there is evidence that correlations and risks of contagion are strong within all capital flow components.     

Are valuation effects desirable from a global perspective?

Recent studies have emphasized the role of valuation effects due to exchange rate movements in easing the process of adjustment of the external balance of a country. This paper asks to what extent valuation effects are desirable from a global perspective as a mean to achieve an efficient allocation of resources. In a frictionless world, it is desirable to have large movements in prices and exchange rates. But once a small degree of price rigidity is introduced not only should prices be stabilized but also the response of the exchange rate should be muted. There is a minor role for valuation effects that depends both on the size and composition of assets and liabilities.     

OPTIMAL INTERNATIONAL ASSET ALLOCATION WITH TIME-VARYING RISK

This paper examines the optimal allocation each period of an internationally diversified portfolio from the different points of view of a UK and a US investor. We find that investor location affects optimal asset allocation. The presence of exchange rate risk causes the markets to appear not fully integrated and creates a preference for home assets. Domestic equity is the dominant asset in the optimal portfolio for both investors, but the US investor bears less risk than the UK investor, and holds less foreign equity – 20% compared with 25%. Survey evidence indicates actual shares are 6% and 18%, respectively, making the home‐bias puzzle more acute for US than UK investors. There would seem to be more potential gains from increased international diversification for the US than the UK investor.     

VEHICLE CURRENCY*

Historically, the world economy has been dominated by a single currency accepted in the exchange of goods and assets among countries. In recent decades, the U.S. dollar has played this role. The dollar acts as a “vehicle currency” in the sense that agents in nondollar economies will generally engage in currency trade indirectly using the U.S. dollar instead of using direct bilateral trade among their own currencies. A vehicle currency is desirable when there are transactions costs of exchange. This article constructs a dynamic general equilibrium model of a vehicle currency. We explore the nature of the efficiency gains arising from a vehicle currency and show how it depends on the total number of currencies in existence, the size of the vehicle currency economy, and the monetary policy followed by the vehicle currency’s government. We find that there can be significant welfare gains to a vehicle currency in a system of many independent currencies. But these gains are asymmetrically weighted toward the residents of the vehicle currency country. The survival of a vehicle currency places natural limits on the monetary policy of the vehicle currency country.     

EXTERNAL BALANCE SHEETS: CONCEPTS AND EMPIRICAL APPROXIMATION*

International financial relationships should be interpreted in the context of a comprehensive conceptual framework; this paper advocates the use of concepts developed to measure and analyze balance of payments flows. Broad-based, empirical estimates of the international wealth of most countries of the western world are presented on the basis of cumulating balance of payments flows over a lengthy period. Among the more interesting aspects of the results are: the importance of intra-industrial country capital flows in a global context; the propensity of debtors to regard a larger share of their aggregate external debt as long term than do their creditors; the overwhelming importance of banks located in the industrial countries in global external asset and liability positions, and the preponderance of short-term positions taken by those banks; and the tendency for balance of payments records to report more direct investment assets than liabilities. The paper also contains some observations, based on the cumulations of balance of payments capital flows, concerning the nature and size of certain deficiencies in alternative sources–particularly the World Bank's Debtor Reporting System, and the Bank for International Settlements' banking data–of information on outstanding external debt positions.