nep-ifn New Economics Papers
on International Finance
Issue of 2011‒03‒19
four papers chosen by
Ajay Shah
National Institute of Public Finance and Policy

  1. Carry Trades and Global Foreign Exchange Volatility By Menkhoff, Lukas; Sarno, Lucio; Schmeling, Maik
  2. The Capital Inflow “Problem” Revisited By Reinhart, Carmen; Reinhart, Vincent
  3. India's FDI Inflows: Trends and Concepts By K, S Chalapati Rao; Dhar, Biswajit
  4. Volatility and correlations for stock markets in the emerging economies By David E Allen; Anna Golab; Robert Powell

  1. By: Menkhoff, Lukas; Sarno, Lucio; Schmeling, Maik
    Abstract: We investigate the relation between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from popular strategies that borrow in low interest rate currencies and invest in high-interest rate currencies, so-called 'carry trades'. We find that high interest rate currencies are negatively related to innovations in global FX volatility and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Our proxy for global FX volatility risk captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. In turn, these results provide evidence that there is an economically meaningful risk-return relation in the FX market. Further analysis shows that liquidity risk also matters for expected FX returns, but to a lesser degree than volatility risk. Finally, exposure to our volatility risk proxy also performs well for pricing returns of other cross sections in foreign exchange, U.S. equity, and corporate bond markets.
    Keywords: carry trade; forward premium puzzle; liquidity; volatility
    JEL: F31 G12 G15
    Date: 2011–03
  2. By: Reinhart, Carmen; Reinhart, Vincent
    Abstract: Capital inflows can be a mixed blessing, especially in economies with thin domestic financial markets and when driven by investors with a short-term focus. Many levers of policy can be applied to resist the effects of the inflows. One that has been widely relied upon has been currency intervention. Key to that appears to be keeping their bilateral exchange rate stable vis-à-vis the U.S. dollar. But this requires them to resist currency appreciation and accumulate dollar reserves when the anchor country is mired in financial problems and keeps monetary policy accommodative in an unprecedented manner. The willingness of emerging market economies to limit exchange rate fluctuations will be tested as monetary policy in advanced economies remains geared toward domestic considerations. Meanwhile, some advanced economies will be looking to finance large deficits and to roll over large debts. In that environment, prior reticence toward capital controls and other restrictions on finance may well lift. For emerging markets, this insulates them from monetary policy in advanced economies that may be inappropriate for domestic circumstances. For advanced economies, this limits the competition for the debt they dearly have to sell. In such a world, the policy tools we discussed will be increasingly relied upon.
    Keywords: capital flows; reserves; exchange rates;capital controls
    JEL: F40 F30
    Date: 2011–02
  3. By: K, S Chalapati Rao; Dhar, Biswajit
    Abstract: India’s inward investment regime went through a series of changes since economic reforms were ushered in two decades back. The expectation of the policy makers was that an “investor friendly” regime will help India establish itself as a preferred destination of foreign investors. These expectations remained largely unfulfilled despite the consistent attempts by the policy makers to increase the attractiveness of India by further changes in policies that included opening up of individual sectors, raising the hitherto existing caps on foreign holding and improving investment procedures. But after 2005‐06, official statistics started reporting steep increases in FDI inflows. This paper is an attempt to explain this divergence from the earlier trend. At the outset, the paper dwells on the ambiguities surrounding the definition and the non‐adherence of international norms in measuring the FDI inflows. The study finds that portfolio investors and round-tripping investments have been important contributors to India’s reported FDI inflows thus blurring the distinction between direct and portfolio investors on one hand and foreign and domestic investors on the other. These investors were also the ones which have exploited the tax haven route most. These observations acquire added significance in the context of the substantial fall in the inflows seen during 2010‐11. In most countries, particularly those that have faced chronic current account deficits, obtaining stable long term FDI flows was preferred over volatile portfolio investments. This distinction between long term FDI and the volatile portfolio investments has now been removed in the accepted official definition of FDI. From an analytical point of view, the blurring of the lines between long term FDI and the volatile portfolio investments has meant that the essential characteristics of FDI, especially the positive spill‐overs that the long term FDI was seen to result in, are being overlooked. FDI that is dominated by financial investments, though a little more stable than the portfolio investments through the stock market, cannot deliver the perceived advantages of FDI. The net result is that while much of the FDI cannot enhance India’s ability to earn foreign exchange through exports of goods and services and thus cover the current account gap on its own strength, large inflows of portfolio capital causes currency appreciation and erodes the competitiveness of domestic players. The falling share of manufacturing and even of IT and ITES means that there is less likelihood of FDI directly contributing to export earnings. India seems to have been caught in a trap wherein large inflows are regularly required in order to finance the current account deficit. To keep FDI flowing in, the investment regime has to be liberalised further and M&As are allowed freely. Even at the global level, the developmental impact of FDI is being given lesser importance notwithstanding the repeated assertions to the contrary in some fora. International data on FDI and its impact has never been unambiguous. If FDI has to deliver, it has to be defined precisely and chosen with care instead of treating it as generic capital flow. India should strengthen its information base that will allow a proper assessment of the impact that FDI can make on its development aspirations.
    Keywords: FDI; portfolio capital; foreign direct investment; round-tripping; India; benchmark definition; tax havens; private equity; manufacturing
    JEL: P33 P45 F21 G24
    Date: 2011–02–24
  4. By: David E Allen (School of Accounting Finance & Economics, Edith Cowan University); Anna Golab (School of Accounting Finance & Economics, Edith Cowan University); Robert Powell (School of Accounting Finance & Economics, Edith Cowan University)
    Abstract: This paper examines the European investment implications of the recent European Union (EU) expansion to encompass former Eastern bloc economies. What are the risk and return characteristics of these markets pre- and post-EU? What are the implications for investors within the Euro zone? Should investors diversify outside the Central and Eastern Europe (CEE)? The former Eastern bloc economies constitute emerging markets which typically offer attractive risk-adjusted returns for international investors. In this paper, we explore a number of aspects of this important issue and their implications for CEE based investors, culminating in a Markowitz efficient frontier analysis of these markets pre- and post-EU expansion.
    Keywords: Emerging Markets; European Union; Portfolio investment
    Date: 2010–06

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