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on International Finance |
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Issue of 2010‒03‒28
sixteen papers chosen by Ajay Shah National Institute of Public Finance and Policy |
| By: | Sarno, Lucio; Schneider, Paul; Wagner, Christian |
| Abstract: | We study the properties of foreign exchange risk premia that can explain the forward bias puzzle - the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premia arise endogenously from imposing the no-arbitrage condition on the relation between the term structure of interest rates and exchange rates, and they compensate for both currency risk and interest rate risk. In our empirical analysis, we estimate risk premia using an affine multi-currency term structure model and find that model-implied risk premia yield unbiased predictions for exchange rate excess returns. While interest rate risk affects the level of risk premia, the time-variation in excess returns is almost entirely driven by currency risk. Furthermore, risk premia are (i) closely related to global risk aversion, (ii) countercyclical to the state of the economy, and (iii) tightly linked to traditional exchange rate fundamentals. |
| Keywords: | term structure; exchange rates; forward bias; predictability |
| JEL: | E43 F31 G10 |
| Date: | 2010–01 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:21302&r=ifn |
| By: | Kaizoji, Taisei |
| Abstract: | Recent many empirical studies have argued that currency carry trade have been a driving force behind exchange rate movements, and have explained the latest financial crisis of 2007-2009 in terms of a sudden, massive reversal of carry trade positions. The aim of this paper is to provide one potential theoretical explanation for questions why currency carry trade becomes profitable, and why a sudden unwinding of carry trade is caused. We propose a new behavioral model of currency bubbles and crashes. We consider that investors trade two currencies: the domestic currency, and the foreign currency. Investors are divided into two groups, the rational investors and the carry traders. The rational investors maximize their expected utility of their wealth in the next period. Carry traders maximize their random utility of binary choice: investing the domestic currency or investing the foreign currency. We demonstrate that carry-traders’ herd behavior, which follows the behavior getting a majority, gives cause to a currency bubble, and their carry trading prolongs bubble. However, depreciation of funding currency slows down as the carry-trader’s behavior approaches to a stationary state, so that the return on carry trade predicted by carry traders begins to decrease in the second half of bubble. We demonstrate that decreasing the return on carry trade predicted by carry traders lead to currency crash. Our model also gives a plausible explanation on the forward premium puzzle. |
| Keywords: | Carry trade; forward premium puzzle; currency crisis; behavioral finance |
| JEL: | F31 |
| Date: | 2010–03–10 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:21432&r=ifn |
| By: | Charalambos G. Tsangarides; Mahvash Saeed Qureshi |
| Abstract: | This paper examines the impact of exchange rate regimes on bilateral trade while differentiating the effects of "words" and "deeds". Our findings-based on an extended database for de jure and de facto exchange rate classifications-show that while fixed exchange rate regimes increase trade, there is no systematic difference in the effects of policy announcements versus actions to maintain exchange rate stability. The trade generating effect of more stable exchange rate regimes is however more pronounced when words and actions are aligned, both in the short and long-run. Policy credibility therefore plays an important role in determining the effects of de jure and de facto exchange rate arrangements such that deviations between the two could be costly. In addition, we find evidence that (i) the impact of hard pegs such as currency unions is broadly similar to that of conventional pegs; (ii) the currency union and direct peg effects evolve over time; and (iii) the effects of more stable regimes are heterogeneous across country groups. |
| Keywords: | Bilateral trade , Currency pegs , Economic models , Exchange rate regimes , Exchange rate variability , International trade , Monetary unions , |
| Date: | 2010–02–25 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:10/48&r=ifn |
| By: | Willem Thorbecke (Asian Development Bank Institute) |
| Abstract: | Many argue that the yuan needs to appreciate to rebalance the People’s Republic of China’s trade. However, empirical evidence on the effects of a CNY appreciation on the People’s Republic of China’s exports has been mixed for the largest category of exports, processed exports. Since much of the value-added of these goods comes from parts and components produced in Japan, the Republic of Korea, and other East Asian supply chain countries, it is important to control for exchange rate changes in these countries. Employing dynamic ordinary least squares, or DOLS, techniques and quarterly data, this paper finds that exchange rate appreciations across supply chain countries would cause a much larger drop in processed exports than a unilateral appreciation of the yuan. |
| Keywords: | China, exchange rate policy, exchange rate appreciations, trade |
| JEL: | F32 F41 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:eab:financ:2171&r=ifn |
| By: | Masahiro Nozaki |
| Abstract: | The answer seems affirmative. We compare currency carry trades with an investment strategy based on currency fundamentals: taking a long (short) position in undervalued (overvalued) currencies. Carry trades have high risk-adjusted returns, but are subject to "crash risk." In contrast, the fundamental strategy has lower risk-adjusted returns, but is less prone to crash risk, because the realization of crash risk coincides with corrections towards fundamentals. In particular, the fundamental strategy outperformed carry trades during the recent global financial crisis. Building on these results, we present early warning indicators for potential turbulence in the currency market. |
| Keywords: | Asset management , Currencies , Economic models , Exchange rate assessments , Investment , Real effective exchange rates , Terms of trade , |
| Date: | 2010–02–19 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:10/39&r=ifn |
| By: | Leandro Medina; Jordi Prat; Alun H. Thomas |
| Abstract: | This paper uses a modified version of the methodology used by the IMF's Consultative Group on Exchange Rate Issues (CGER) to calculate equilibrium current account balances (or ?norms?) for a sample of 33 emerging market economies. We find that the fundamental determinants of the equilibrium current account balances are similar to those identified by the CGER using a sample that also comprises advanced economies. However, the fiscal balance has a considerably stronger impact on current account norms for emerging markets. This paper also offers estimates for the equilibrium current account balances of eleven smaller emerging market economies that are not currently included in the country sample used by the CGER. |
| Keywords: | Cross country analysis , Current account balances , Economic models , Emerging markets , Real effective exchange rates , |
| Date: | 2010–02–22 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:10/43&r=ifn |
| By: | Carlos Urrutia; Felipe Meza |
| Abstract: | We account for the appreciation of the real exchange rate in Mexico between 1988 and 2002 using a two sector dynamic general equilibrium model of a small open economy with two driving forces: (i) differential productivity growth across sectors and (ii) a decline in the cost of borrowing in foreign markets. These two mechanisms account for 60 percent of the decline in the relative price of tradable goods and explain a large fraction of the reallocation of labor across sectors. We do not find a significant role for migration remittances, foreign reserves accumulation, government spending, terms of trade, or import tariffs. |
| Date: | 2010–03–15 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:10/63&r=ifn |
| By: | Céline Gimet (GATE Lyon Saint-Etienne - Groupe d'analyse et de théorie économique - CNRS : UMR5824 - Université Lumière - Lyon II - Ecole Normale Supérieure Lettres et Sciences Humaines) |
| Abstract: | This article focuses on the reaction of Asean economies to international financial shocks. The crises in emerging markets at the end of the last century underlined the vulnerability of emerging Asean economies to international financial fluctuations and a lack of sustainability in their exchange rate regime. A Structural VAR model is used to analyze the efficiency of the measures adopted by these countries, after this crisis episode, to protect their economies against speculative attacks. The results reveal that the impact of the current subprime crisis on emerging Asean countries is less significant than that observed in industrialized ones. |
| Keywords: | Asean countries, international financial fluctuations, macroeconomic impact, regional integration, SVAR Model |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:halshs-00464216_v1&r=ifn |
| By: | Hiroshi Fujiki (Associate Director-General and Senior Monetary Affairs Department, Bank of Japan (E-mail: hiroshi.fujiki @boj.or.jp)) |
| Abstract: | During the recent global financial crisis, some central banks introduced two innovative cross-border operations to deal with the problems of foreign currency liquidity shortages: domestic liquidity operations using cross-border collaterals and operations for supplying foreign currency based on standing swap lines among central banks. We show theoretically that central banks improve the efficiency of equilibrium under foreign currency liquidity shortages by those two innovative temporary policy measures. |
| Keywords: | Standing swap lines, Operations supplying US dollar funds outside the US, Cross-border collateral arrangements |
| JEL: | E58 F31 F33 |
| Date: | 2010–03 |
| URL: | http://d.repec.org/n?u=RePEc:ime:imedps:10-e-04&r=ifn |
| By: | Li L. Ong; Bergljot Barkbu |
| Abstract: | The proliferation of foreign exchange (FX) swaps as a source of funding and as a hedging tool has focused attention on the role of the FX swap market in the recent crisis. The turbulence in international money markets spilled over into the FX swap market in the second-half of 2007 and into 2008, giving rise to concerns over the ability of banks to roll over their funding requirements and manage their liquidity risk. The turmoil also raised questions about banks' ability to continue their supply of credit to the local economy, as well as the external financing gap it could create. In this paper, we examine the channels through which FX swap transactions could affect a country's financial and economic stability, and highlight the strategies central banks can employ to mitigate market pressures. While not offering any judgment on the instrument itself, we show that the use of FX swaps for funding and hedging purposes is not infallible, especially during periods of market stress. |
| Keywords: | Balance of payments , Banks , Capital , Central bank role , Credit demand , Credit risk , Currency swaps , Economic stabilization , Exchange rates , Financial institutions , Financial stability , Liquidity management , Reserves , Stabilization measures , |
| Date: | 2010–03–08 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:10/55&r=ifn |
| By: | Michael G. Plummer (Asian Development Bank Institute) |
| Abstract: | The ongoing global economic crisis has punished Asian economies severely, despite the fact that its origins derive from outside the region. The global economic crisis was transmitted through real and financial channels, underscoring how vulnerable the region is to external shocks. This paper explores the microeconomic origins of the financial crisis and endeavors to ascertain how crises might be mitigated in the future through better regulation, supervision, and institution-building. Moreover, it makes the case for closer economic cooperation in order to internalize key externalities associated with modern global finance. This cooperation, in turn, should take place at the appropriate level, with incentives for cooperation at the global, regional, and subregional levels. It explores the potential for the creation of an Asian Financial Stability Board and deepening other initiatives in Association of Southeast Asian Nations (ASEAN)+3 and ASEAN forums. However, it stresses that the most important financial reforms in Asia will need to take place at the national level. |
| Keywords: | global financial crisis, Asia, microeconomics, financial regulation, financial externalities, ASEAN |
| JEL: | G28 F36 F33 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:eab:financ:2170&r=ifn |
| By: | Joshua Aizenman (Asian Development Bank Institute) |
| Abstract: | In this paper I review the use of precautionary measures aimed at mitigating emerging markets’ exposure to fragility associated with financial integration. The discussion draws possible lessons from the ongoing global liquidity crisis. The fear of losing international reserves (IR) constrained most emerging markets more than the fear of floating. The fear of using IR during a crisis suggests that emerging markets (EMs) opt to revisit the gains from financial globalization. High levels of IR may be required for the self insurance offered by those reserves to be effective. Under such circumstances, countries may benefit by supplementing the hoarding of IR with Pigovian tax-cum-subsidy policies. These policies would reduce external borrowing, and would fund the marginal hoarding of IR. The fear of losing IR also suggests a greater demand for regional pooling arrangements and swap lines as well as possible new roles for international financial institutions (IFI). |
| Keywords: | Financial Integration, International Reserves, Emerging Markets, Pigovian Tax |
| JEL: | F15 F21 F32 F36 G15 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:eab:financ:2160&r=ifn |
| By: | Yoshifumi Kon (Asian Development Bank Institute) |
| Abstract: | Recently, a dramatic accumulation in foreign exchange reserves has been widely observed in developing countries. This paper explores the possible long-run impacts of this trend on macroeconomic variables in developing countries. We analyze a simple open economy model where increased foreign exchange reserves reduce the costs of liquidity risk. Given the amount of foreign exchange reserves, utility-maximizing representative agents decide consumption, capital stock, and labor input, as well as the amounts of liquid and illiquid external debt. The equilibrium values of these variables depend on the amount of foreign exchange reserves. A rise in foreign exchange reserves increases both liquid and total debt, while shortening debt maturity. To the extent that interest rates of foreign exchange reserves are low, an increase in foreign reserves also leads to a permanent decline in consumption. However, when the tradable sector is capital intensive, the increase may enhance investment and economic growth. We provide empirical support for our theoretical analysis using panel data from the Penn World Table. The cross-country evidence shows that an increase in foreign exchange reserves raises external debt outstanding and shortens debt maturity. The results also imply that increased foreign exchange reserves may lead to a decline in consumption, but can also enhance investment and economic growth. The positive impact on economic growth, however, disappears when we control the impact through investment. |
| Keywords: | foreign exhange reserves, developing countries, consumption, investment, economic growth |
| JEL: | F21 F32 F34 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:eab:macroe:2164&r=ifn |
| By: | Ashoka Mody; Sonja Keller |
| Abstract: | We examine risk spreads charged on corporate bonds placed by emerging market borrowers on international exchanges. While global developments have an important effect on spreads, changes in firm-level default risk also matter significantly in a way consistent with theory and experience in mature markets. In contrast, except during periods of financial crisis, country factors play a limited role. These findings go against the supposition that limited information on emerging market firms or significant agency problems prevent firm-level credit discrimination by international investors. The firm-level information capitalization into spreads possibly reflects protection afforded by the exchange listing on international markets. |
| Keywords: | Asset prices , Bond markets , Bonds , Corporate sector , Credit risk , Emerging markets , External borrowing , International capital markets , Investment , Risk premium , |
| Date: | 2010–01–29 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:10/26&r=ifn |
| By: | Gian Maria Milesi-Ferretti; Philip R. Lane |
| Abstract: | This note documents and assesses the role of small financial centers in the international financial system using a newly-assembled dataset. It presents estimates of the foreign asset and liability positions for a number of the most important small financial centers, and places these into context by calculating the importance of these locations in the global aggregate of cross-border investment positions. It also reports some information on bilateral cross-border investment patterns, highlighting which countries engage in financial trade with small financial centers. |
| Keywords: | Asset management , Banking , Capital flows , Cross country analysis , Financial institutions , Foreign direct investment , International financial system , |
| Date: | 2010–02–18 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:10/38&r=ifn |
| By: | Anita Tuladhar; Alexander W. Hoffmaister; Jorge Roldos |
| Abstract: | This paper applies the models used to study yield curve dynamics and spillovers in the U.S. and other countries to Central and Eastern European countries (CEE countries). Using the Diebold, Rudebusch, and Aruoba (2006) dynamic version of the Nelson-Siegel representation of the yield curve, the paper finds that the two-way relationship between macroeconomic and financial variables in the CEE countries is similar to the one in mature economies. However, inflation shocks have very little persistence in the CEE countries, owing to the strong convergence trends in these countries-which tend to re-anchor expectations faster. Increased convergence in policies and market integration over time are associated with a stronger correlation between the levels of the yield curves, while the curves slopes are more driven by idiosyncratic factors. Shifts in the euro yield curve are transmitted both to interest rates and inflation expectations in the CEE countries-and transmission is stronger after 2004. |
| Keywords: | Central and Eastern Europe , Cross country analysis , Economic integration , Economic models , International bond markets , Regional shocks , Spillovers , |
| Date: | 2010–02–26 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:10/51&r=ifn |