nep-opm New Economics Papers
on Open Economy Macroeconomic
Issue of 2014‒03‒15
thirteen papers chosen by
Martin Berka
Victoria University of Wellington

  1. Uncovered Equity Parity and Rebalancing in International Portfolios By Stephanie E. Curcuru; Charles P. Thomas; Francis E. Warnock; Jon Wongswan
  2. Determinants of the Trilemma Policy Combination By Hiro Ito; Masahiro Kawai
  3. Capital controls as an instrument of monetary policy By Davis, Scott; Presno, Ignacio
  4. Is There Really a Renminbi Bloc in Asia? By Kawai, Masahiro; Pontines, Victor
  5. The People’s Republic of China’s Growth, Stability, and Use of International Reserves By Joshua Aizenman; Yothin Jinjarak; Nancy P. Marion
  6. Measuring the Impact of Exchange Rate Movements on Domestic Prices: A Cointegrated VAR Analysis By Nidhaleddine Ben Cheikh; Waël Louhichi
  7. Emerging Economies’ Supply Shocks and Japan’s Price Deflation : International Transmissions in a Three-Country DSGE Model By Naohisa Hirakata; Yuto Iwasaki; Masahiro Kawai
  8. Exchange Rate Regime, Fiscal Foresight and the Effectiveness of Fiscal Policy in a Small Open Economy By Virkola, Tuomo
  9. Lucas paradox and allocation puzzle: Is the euro area different? By Herrmann, Sabine; Kleinert, Jörn
  10. A contribution to the empirics of convergence in real GDP growth: The role of financial crises and exchange-rate regimes By Amalia Morales-Zumaquero; Simón Sosvilla-Rivero
  11. Nonlinear Econometric Approaches in Testing PPP of SADC Economies towards Monetary Union By Mulatu F. Zerihun, Marthinus C. Breitenbach and Francis Kemegue
  12. Issues for Renminbi Internationalization : An Overview By Barry Eichengreen; Masahiro Kawai
  13. Modeling the Transition Towards Renminbi's Full Convertibility: Implications for China’s Growth By Bonatti, Luigi; Fracasso, Andrea

  1. By: Stephanie E. Curcuru; Charles P. Thomas; Francis E. Warnock; Jon Wongswan
    Abstract: Portfolio rebalancing is a key driver of the Uncovered Equity Parity (UEP) condition. According to UEP, when foreign equity holdings outperform domestic holdings, domestic investors are exposed to higher exchange rate exposure and hence repatriate some of the foreign equity to decrease their exchange rate risk. By doing so, foreign currency is sold, leading to foreign currency depreciation. We examine the relationship between U.S. investors’ portfolio reallocations and returns and find some evidence consistent with UEP: Portfolio shifts are related to past returns in the underlying equity markets. But we argue that a motive other than reducing currency risk exposure is likely behind this rebalancing. In particular, U.S. investors may be exploiting mean reversion in underlying equity markets, rebalancing away from equity markets that recently performed well and moving into equity markets market just prior to relatively strong performance. Such behavior suggests tactical reallocations to increase returns rather than reduce risk.
    JEL: F21 F31 G11
    Date: 2014–03
  2. By: Hiro Ito (Asian Development Bank Institute (ADBI)); Masahiro Kawai
    Abstract: We present a theoretical framework for policy making based on the “impossible trinity†or the “trilemma†hypothesis. A simple optimization model shows that placing more weight in terms of preference for each of the three open macroeconomic policies—exchange rate stability, financial market openness, and monetary policy independence—contributes to a higher level of achievement in that particular policy. We then develop the first empirical framework in the literature to investigate the joint determination of the triad open macroeconomic policies based on the trilemma hypothesis. Specifically, we estimate the three policy indexes under the trilemma constraint that they must add up to a constant. By applying the seemingly unrelated regression (SUR) estimation method and employing other robustness checks, we demonstrate that simple economic and structural fundamentals determine the trilemma policy combinations. Last, we examine how deviations from the “optimal†trilemma policy combinations evolve around the time of a financial crisis. Policy combinations seem to violate the trilemma constraint when a currency, banking, or debt crisis breaks out. These findings suggest that deviations from the trilemma hypothesis would create policy stress, which would have to manifest itself in a crisis unless policy makers adjust the policy combination in a way consistent with the trilemma constraint.
    Keywords: impossible trinity, trilemma hypothesis, exchange rate stability, financial market openness, monetary policy independence, trilemma policy combination, trilemma constraint
    JEL: F15 F21 F31 F36 F41 O24
    Date: 2014–01
  3. By: Davis, Scott (Federal Reserve Bank of Dallas); Presno, Ignacio (Federal Reserve Bank of Dallas)
    Abstract: Large swings in capital flows into and out of emerging markets can potentially lead to excessive volatility in asset prices and credit supply. In order to lessen the impact of capital flows on financial instability, a number of researchers and policy markers have recently proposed the use of capital controls. This paper considers the benefit of adding capital controls as a potential instrument of monetary policy in a small open economy. In a DSGE framework, we find that when domestic agents are subject to collateral constraints and the value of collateral is subject to fluctuations driven by foreign capital inflows and outflows, the adoption of temporary capital controls can lead to a significant welfare improvement. The benefits of capital controls are present even when monetary policy is determined optimally, implying that there may be a role for capital controls to exist side-by-side with conventional monetary tools as an instrument of monetary policy.
    JEL: E32 E52 F32 F41
    Date: 2014–02–01
  4. By: Kawai, Masahiro (Asian Development Bank Institute); Pontines, Victor (Asian Development Bank Institute)
    Abstract: This paper examines whether the renminbi (RMB) has supplanted the US dollar as the major anchor currency in the currency baskets of East Asian economies. It systematically demonstrates that existing techniques to address the problem of severe multicollinearity in estimations of the Frankel¬–Wei regression model, with the movements in both the RMB and the US dollar included on the right-hand side of the equation, remain limited in providing stable and robust results. The paper proposes a simple modification of the Frankel–Wei regression model to estimate the RMB weight in an economy’s currency basket. Using this new approach, findings show there is not yet an RMB bloc in East Asia, contrary to claims made by some recent studies, with the US dollar continuing to be the dominant anchor currency in the region. The RMB has taken on some importance in the currency baskets of many East Asian economies in recent years and this appears to have occurred at the expense of the yen. In short, despite the rising importance of the RMB, it has not eclipsed the US dollar as the dominant anchor currency in East Asia.
    Keywords: RMB; renminbi bloc; Frankel–Wei regression model; anchor currency; East Asia; currency baskets
    JEL: F15 F31 F36 F41 O24
    Date: 2014–03–07
  5. By: Joshua Aizenman (Asian Development Bank Institute (ADBI)); Yothin Jinjarak; Nancy P. Marion
    Abstract: In the run-up to the financial crisis, the world economy was characterized by large and growing current account imbalances. Since the onset of the crisis, the People’s Republic of China and the United States have rebalanced. As a share of gross domestic product, their current account imbalances are now less than half their pre-crisis levels. For the People’s Republic of China, the reduction in its current account surplus post-crisis suggests a structural change. Panel regressions for a sample of almost 100 economies over the thirty-year period, 1983–2013, confirm that the relationship between current account balances and economic variables such as performance, structure, wealth, and the exchange rate, changed in important ways after the financial crisis.
    Keywords: current account imbalances, financial crisis, China, PRC
    JEL: F32 O57
    Date: 2014–01
  6. By: Nidhaleddine Ben Cheikh; Waël Louhichi
    Abstract: This paper measures the pass-through of exchange rate changes into domestic inflation within a cointegrated VAR (CVAR) framework. This issue is of particular interest for the euro area (EA) as Member Sates cede their national currencies and no longer have options of using monetary policy to respond to local conditions. In fact, a common exchange rate shock, in the absence of a national monetary policy, may have differential impact on EA countries, leading notably to possible divergence in inflation levels. Using quarterly data for 12 EA covering 1980:1 to 2010:4, we report a large degree of heterogeneity in the rates of pass-through across our sample, especially, between "peripheral" and "core" EA economies. For instance, prices rise by 84% in Portugal following one percent depreciation of exchange rate, while for the German economy the extent of pass-through is not exceeding 0.20%. This outcome would have important implications for the general risk perceived by foreign firms and investors regarding the inflationary environment within each EA country.
    Keywords: Exchange Rate, Domestic prices, Cointegration, Euro area
    JEL: C32 E31 F31
    Date: 2014–03
  7. By: Naohisa Hirakata (Asian Development Bank Institute (ADBI)); Yuto Iwasaki; Masahiro Kawai
    Abstract: This paper examines the international transmission effects that a positive supply shock in emerging economies may have on inflation in developed economies. We construct a dynamic stochastic general equilibrium (DSGE) model for three countries and analyze the impact of a supply shock in an emerging economy, the People’s Republic of China (PRC), on inflation rates in two developed economies, the United States (US) and Japan. We demonstrate that the assumed asymmetric trade structures among the three countries and the PRC’s choice of exchange rate regime influence the international transmission of a supply shock in the PRC. Specifically, Japan is under a greater deflationary pressure than the US because of its vertical trade specialization vis-à-vis the PRC and the PRC’s USdollar- pegged regime. This outcome suggests that, even though Japan and the US may face common positive supply shocks from emerging economies, the deflationary impact of the shock is greater for Japan.
    Keywords: emerging economies, supply shock, price deflation, dynamic stochastic general equilibrium (DSGE) model, PRC, China, Japan, US, international transmission effects, exchange rate regime
    JEL: F32 F41 F44 F47
    Date: 2014–02
  8. By: Virkola, Tuomo
    Abstract: This paper studies the effects of discretionary fiscal policy shocks under different exchange rate regimes within a structural vector autoregressive (SVAR) model. We first suggest that by estimating the effects of fiscal policy shocks in two structurally similar small open economies that have opted for different monetary policy regimes (Finland and Sweden), we may control for the economic environment and study the effect of exchange rate regime on fiscal policy transmission. Second, we propose to augment the baseline model with quarterly fiscal forecasts and study fiscal policy shocks under fiscal foresight, i.e., when economic agents may anticipate and respond to fiscal policy measures prior to their implementation. Our findings suggests that discretionary fiscal policy is more effective under a fixed exchange rate regime than under a floating exchange rate regime. This is consistent with the conventional wisdom inherited from the Mundell-Fleming framework and with recent evidence that suggests the effectiveness of fiscal policy depends on the degree of monetary policy accommodation. We also find evidence that unanticipated (as opposed to standard SVAR) fiscal policy shocks have a larger expansionary effect on output than in the baseline.
    Keywords: fiscal policy, exchange rate regime, fiscal foresight
    JEL: E62 E63 F41 H30
    Date: 2014–03–03
  9. By: Herrmann, Sabine; Kleinert, Jörn
    Abstract: This paper examines the Lucas Paradox and the Allocation Puzzle of international capital flows referring to a panel data set of EMU countries and major industrialized and emerging economies. Overall, the results do not provide evidence in favour of the Lucas Paradox and the Allocation Puzzle. Rather, in line with neoclassical expectations, net capital flows are allocated according to income and growth differentials. The 'downhill' flow of capital from rich to poor economies was particularly pronounced in intra-euro area capital flows and after the introduction of the common currency. If we control for the fact that the assumptions of the neoclassical model are not perfectly given in emerging markets, the Lucas Paradox and the Allocation Puzzle can be dismissed for these countries too. However, in periods of financial stress, the neoclassical behaviour of financial flows is to some extent dampened. --
    Keywords: Financial integration,International Capital Flows,European Monetary Union
    JEL: E22 F21 F36 O16 O
    Date: 2014
  10. By: Amalia Morales-Zumaquero (Departamento de Teoría e Historia Económica, Facultad de Ciencias Económicas y Empresariales, Universidad de Málaga); Simón Sosvilla-Rivero (Department of Quantitative Economics, Universidad Complutense de Madrid)
    Abstract: This paper investigates the convergence in real Gross Domestic Product (GDP) growth focusing on the impact of financial crises (i.e. banking crises, currency crises and debt crises) and nominal exchange rate regimes (i.e. fixed, intermediate and flexible) on convergence. To that end, we compute four convergence indicators (s-convergence, g- convergence, absolute b-convergence and conditional b-convergence), for 163 countries classified into four income groups during the 1970-2011 period. Results suggest that: (i) There is evidence in favor of -convergence and -convergence only for high income countries; (ii) absolute and conditional -convergence are presented in each of the four income groups of countries under study; (iii) exchange-rate regimes seem to play some role in upper-middle and lower-middle income countries; and (iv) financial crises have a negative and significant impact on GDP growth independently of the level of income of countries.
    Keywords: Convergence indicators, financial crises, nominal exchange-rate regimes
    JEL: O47 G15 F33
    Date: 2014–02
  11. By: Mulatu F. Zerihun, Marthinus C. Breitenbach and Francis Kemegue
    Abstract: The theory of purchasing power parity implies that real exchange rate series should be stationary. However, conventional unit root tests on the Southern African Development community (SADC) real exchange rates confirm the existence of a unit root. Such deficiencies in the investigation of the dynamics of real exchange rates in the region calls for nonlinear methods like the method used in this study to be pursued, which may better explain the dynamics of real exchange rates in SADC. In this paper two nonlinearity tests are employed: the nonparametric test developed by Brock, Dechert, and Scheinkman - known as the BDS test and the Fourier stationarity test. The BDS test detects the independent and identically distribute (iid) assumption of the time series used in the analysis while the Fourier approximation mimics a wide variety of breaks and other types of nonlinearities. Both tests confirm the non-linear nature of real exchange series in SADC. The result from the Fourier stationarity test further provides strong evidence of an OCA among the 11 SADC countries included in the study
    Keywords: Optimal Currency Area (OCA), Purchasing Power Parity (PPP), Real Exchange Rate, Fourier Stationarity Test, BDS Test
    JEL: C22 C32 F31
    Date: 2014
  12. By: Barry Eichengreen (Asian Development Bank Institute (ADBI)); Masahiro Kawai
    Abstract: The growing weight of the People’s Republic of China (PRC) in the world economy, measured by gross domestic product (GDP) and trade volume, has intensified debate on the potential international role of its currency—the renminbi (RMB). This paper provides an overview of RMB internationalization issues. Reviewing the current state of RMB internationalization, the paper finds that much progress has been made on RMB settlements for trade involving the PRC and on RMB-denominated bond issuance in Hong Kong, China, but that RMB internationalization is still limited due to capital account controls. The paper argues that a high degree of RMB internationalization requires significant capital account liberalization—supported by financial market liberalization including market-determined interest rates, and by effective financial regulation and supervision—which in turn would call for greater exchange rate flexibility so that the People’s Bank of China (PBOC) can enjoy monetary policy autonomy. This, however, would pose a challenge for PRC authorities as hasty capital account liberalization could expose PRC financial markets to the risk of crisis. The paper also emphasizes the importance of institutional reforms—such as making the PBOC independent from political processes, improving the judicial system to implement rule of law, raising transparency and accountability of policy making, and democratizing the political regime—to make the RMB a truly international reserve currency. Finally, the paper explores the implications of RMB internationalization for the international monetary system.
    Keywords: renminbi (RMB), internationalization, PRC, China, capital account internationalization, financial market liberalization, monetary policy autonomy
    JEL: F31 F32 F33 F41
    Date: 2014–01
  13. By: Bonatti, Luigi; Fracasso, Andrea
    Abstract: There is a widespread consensus that China’s growth paradigm needs a rebalancing away from investment and external demand and towards consumption and domestic demand. This rebalancing process is supposed to be accompanied by the transition towards Renminbi’s full convertibility. In contrast, it is controversial to what extent this adjustment will accelerate the slowdown of China’s growth, which will likely occur because of other structural factors. We address these issues by means of a two-country two-stage (before and after Renminbi’s full convertibility) model, which reproduces some qualitative features of China’s growth pattern and its relationship with the US. We analyze to what extent altering the Chinese exchange rate policy, as well as other structural and policy variables, may have (short-, medium- and long-term) effects on the evolution of the Chinese economy. The paper shows that by lifting the controls on the capital account and letting the currency float, the Chinese authorities will not only expose the economy to the risks of free capital mobility, but will also renounce to important policy instruments for controlling the dynamics of China’s economy and the allocation of the national resources.
    Keywords: Growth rebalancing; global imbalances; currency convertibility; Chinese economy
    JEL: E42 F33 F41 F43 O41
    Date: 2014–01

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