The
Analysis of International Capital Markets:
Understanding Europe's Role in the Global Economy
Research
Training Network
Research
Microfoundations
of International Financial Markets and Level and Composition of Capital
Flows
Together
with Milesi-Ferretti (IMF), Lane (TCD)
has studied long-term trends in international capital flows. To do so,
they have a developed a comprehensive new database on the foreign assets
and liabilities held by a large number of industrial and developing
countries. They find that three variables (relative GDP per capita; public
debt stocks; and demographic composition) do a good job in explaining the
evolution of net foreign asset positions for a panel of 66 countries. In
addition, they show that net foreign asset positions matter for real
exchange rate behavior: debtor countries tend to experience real
depreciation. Importantly, this connection is very much influenced by
patterns of rate of return and output growth. If a country earns a high
return on its foreign assets and pays out a low return on its liabilities,
then it can run a bigger trade deficit all else equal. Similarly, fast
output growth reduces the relative burden of repaying a given stock of
external debt. The recent experience of the US matches these findings: it
has managed to earn a positive net return on its international balance
sheet and rapid growth in the late 1990s also helped delay/reduce any
required adjustment in the US dollar. These authors have also been
studying the determinants of the composition of international balance
sheets: for instance, developing countries tend to have much higher
debt/equity ratios than their industrial nation counterparts.
Lane
has also investigated whether international trade improves the credit
rating of developing countries. Another paper examines whether investment
income on foreign investments is correlated with the domestic business
cycle.
Hoffmann
(Young Researcher, TCD)
conducted an empirical study of the relation between domestic
infrastructural investments and international capital inflows. There is
clear evidence of a positive relation: however, high co-linearity between
the various infrastructural indicators makes it difficult to identify
which specific infrastructural investments have the biggest impact.
Gross
(CFS) investigated into the
role of the trade channel as important determinant of a country's current
account position and the degree of business cycle synchronisation with the
rest of the world by comparing the predictions of two types of DGE models.
It is shown that the behaviour of a country's external balance and the
international transmission of shocks depends amongst other things on two
factors: i) the magnitude of trade interdependence, ii) the degree of
substitutability between importable and domestically produced goods. Using
time series data on bilateral trade flows, he has estimated the magnitude
of trade interdependence and the elasticity of substitution between
importable and domestic goods for the G7 countries. Given these estimates,
idiosyncratic supply shocks potentially induce changes in the current
account and foreign output that vary in direction and magnitude across G7
countries. The relationship between the magnitude of foreign trade and the
import substitutability with various correlation measures was examined
empirically in a cross-sectional dimension. Lane also worked on the
relation between business cycle shocks and the current account.
Assaf
Razin and Efraim Sadka (both Tel
Aviv) developed a model in which foreign direct investors are better
equipped and experienced in skimming the "good" firms than their
domestic counterparts. Employing
this technology, the foreign direct investors are able to outbid domestic
and foreign portfolio investors for the good firms.
They emphasised a second feature of FDI which is hands-on
management standards that enable them to react in real time to a changing
business environment. This
feature allows foreign direct investor to recover the cost of the skimming
technology.
They
were able to establish a pecking order among capital flows:
high-productivity firms are acquired by foreign direct investors;
medium-high-productivity firms attract debt flows; and low-productivity
firms attract portfolio equity flows.
In this context, we are able to establish the clear existence of
gains from FDI to the host economy. Nevertheless,
it is impossible to determine whether the FDI flows are efficient, or
whether they are inadequate of excessive.
Razin
(with Prakash Loungani, IMF) looked critically at the advantages of FDI
inflows to emerging markets. Both economic theory and recent empirical
evidence suggest a beneficial impact of FDI on developing host countries.
But recent work also points to some sources of potential risks and
excesses: FDI can be reversed through financial transactions; there can be
a FDI bias in the composition of capital inflows, owing to adverse
selection and fire sales. A large coefficient of FDI in investment
regression equations, that are derived from an international cross-country
data is likely to be the result of an endogeneity bias, and of heavy
reliance by multinationals on borrowings from domestic lenders. The high
share of FDI in a country's total capital inflows may reflect its
capital-market institutions' weakness rather than their strength. Though
the empirical relevance of some of these sources remains to be
demonstrated, they do appear to make a case for taking a nuanced view of
the likely effects of FDI.
Helga
Kristiansdottir (Young Researcher,
EPRU) worked on an empirical
study of foreign direct investment. She used a gravity model to analyse
the determinants of FDI, using Iceland as a case. Kräussl (Young
Researcher at Tel Aviv) and Beck (CFS)
focused on the empirical analysis of currency crises. Kräussl
analysed sovereign ratings and their impact on recent financial crises. In
a related work, Beck (2000a) showed that emerging market eurobond spreads
after the Asian crisis can be largely explained by market expectations
about macroeconomic fundamentals and international interest rates.
Elhanan
Helpman with Marc Melitz and Steven Yeapple (all Tel
Aviv) examined a multi-country general equilibrium model that explains
the decision of heterogeneous firms to serve foreign markets either
through exports or local subsidiary sales (FDI). These modes of market
access involve different relative costs, some of which are sunk (in both
cases) while others vary with sales volume (such as transport costs and
tariffs). Relative to investment in a subsidiary (FDI), exporting involves
lower sunk costs but higher per-unit costs. In equilibrium, only the more
productive firms choose to serve the foreign markets (the others only
serve their domestic market or exit the industry) - and the most
productive among this group will further choose to serve the overseas
market via FDI. The paper then explores several implications of the
individual firms' decisions for aggregate export and FDI sales relative to
the domestic and foreign market sizes. In particular, it is shown that
firm level heterogeneity is an important determinant of relative export
and FDI flows: dispersion of productivity levels across firms in an
industry strongly affects the extent to which firms substitute local for
domestic production (and exporting). Empirical testing confirmed the
importance and significance of this result.
Although
exports and subsidiary sales are substitutes at the firm level, the
measured aggregate sales for both activities across firms in an industry
may not necessarily exhibit the same property. The paper identifies the
characteristics of industries that lead the aggregated flows to move
either in similar or opposite directions (relative to the overall size of
the industry). The paper also shows how the home market effect translates
into a condition on the ownership of firms operating in a market (based on
that market's size) rather than one based on the production location of
firms.
Finally,
they used the model to derive testable empirical predictions on the
relative aggregate export and FDI sales in a given country for a given
sector based both on relative costs and the extent of firm level
heterogeneity in that sector. These predictions are tested on a panel data
of US affiliate sales and US exports in 30 different countries and 52
sectors (at roughly the 3 digit SIC level). The comparative statics based
on relative costs are very similar to those tested by Brainard (AER 1997)
and are confirmed in our data: sector/country specific transport costs and
tariffs have a strong negative effect on export sales relative to FDI.
More importantly, our new predictions for the effects of firm-level
heterogeneity on the relative export and FDI sales are also strongly
supported by the data: more heterogeneity leads to significantly more FDI
sales relative to export sales (after controlling for the relative and
fixed country-level costs).
Helene
Rey and Harald Hau (both CEPR) worked on the microeconomics of the day-to-day relation
between capital flows and exchange rates. In work presented to the London
network conference, they showed how equity traders influence the market
microstructure of the exchange rate market.
Such a study is very relevant for the
determinants of the euro dollar exchange rate since it has been argued,
especially in the press, that the decline of the value of the euro has
been driven by European investments in the US stock markets. Hau and Rey
found that the empirical correlations between exchange rate, order flows
on the foreign exchange market and equity prices can be reconciled only in
a model where the exchange rate is determined by trade in assets rather
than trade in good and where equity traders do not hedge against currency
fluctuations. Finally they emphasised the importance of heterogeneous
beliefs to understand the data.
Rey
also worked with Philippe Martin (Lille/CEPR)
on the links between market size, stock market capitalisation and asset
prices. In “Financial Super-Markets: Size Matters for Asset Trade”,
they showed that large financial area (like the Euro area) enjoy lower
cost of capital for firms, a higher market capitalisation per capita and
better risk sharing. In “Financial Integration and Asset Returns”,
they used their model to discuss the changing geographical location of
financial centres as cost of transacting in financial markets declines and
harmonisation of standards across stock exchanges take place. These two
studies are especially relevant for the euro area where trading costs are
declining due to the elimination of exchange rate uncertainty and European
wide harmonisation measures. Finally in a new project (“Financial
Globalisation and Emerging Markets: With or Without Crash?”), Martin and
Rey studied the impact of global financial integration on financial
stability. They show that international capital market integration
enhances welfare in good times, but also potentially increases the
likelihood of self-fulfilling financial crashes for countries in
intermediate range of the income distribution and at an intermediate level
of capital market liberalisation.
The
LBS team has also done related work in this area. Ravn has worked on two
projects. The first projects examined the link between capital flows and
goods market integration among OECD countries including the countries
within the EU area. In the other project, Ravn examines how imperfect
competition in the goods market affect national and international business
cycles. Scott has worked on the structure of government debt.
Macroeconomic
Interdependence and International Financial Markets
Lane
(Network Co-ordinator, TCD)
finalised an overall survey on the contribution of the “new open economy
macroeconomics”. Together with Michael Devereux (CEPR,
2001), he worked on incorporating roles for credit constraints and
foreign-currency debt in determining macroeconomic behaviour in emerging
market economies. They find that such features serve to magnify business
cycle fluctuations and actually reinforce the need for exchange rate
flexibility to cope with real shocks. In addition, they show that the
properties of alternative monetary and exchange rate policies are very
sensitive to the degree of pass through from exchange rates to consumer
prices. However, in work in progress, they find that an exchange rate peg
may in fact be superior if imported intermediates are important in
production and these are financed by trade
credits.
Giancarlo
Corsetti (Roma III) has analysed a baseline general-equilibrium model of
Optimal Monetary Policy among independent economies with monopolistic
firms that set prices one period in advance. Strict adherence to
inward-looking policy objectives such as the stabilization of domestic
output cannot be optimal when firms’ mark-ups are exposed to currency
fluctuations. Such policies induce excessive volatility in exchange rates
and foreign sales revenue, leading exporters to set higher prices in
response to higher profit risk. In general, optimal rules trade off a
larger domestic output gap against lower import prices. Monetary rules in
a world Nash equilibrium lead to less exchange rate volatility relative to
both inward-looking rules and discretionary policies, even when the latter
do not suffer from any inflationary (or deflationary) bias. He found that
gains from international monetary cooperation are related in a
non-monotonic way to the degree of exchange rate pass-through. In International
Dimensions of Optimal Monetary Policies, Corsetti and Pesenti (Federal
Reserve Bank of New York) provide a baseline general-equilibrium model of
optimal monetary policy among interdependent economies, with monopolistic
firms that set prices one period in advance. The paper analyses the
optimal response of a central bank of a large area, such as the Euro area,
to the international cycle and policy stance.
Giancarlo
Corsetti together with Mackowiak (Young
Researcher, Roma III) in their paper proposed a new framework for
interpreting a currency crisis associated with a fiscal imbalance, that
they found appropriate for the analysis of contemporary economies with
outstanding public debt. The paper developed an innovative analysis of
currency and financial instability in the presence of nominal liabilities.
The analysis is especially relevant to the design of stabilisation
policies in the countries that are candidates for joining the EU and/or
the Euro Zone.
In “Self-validating Optimum Currency Areas”, Corsetti and Pesenti (New York Federal Reserve) showed that a currency area can be a self-validating optimal policy regime, even when monetary unification does not foster real economic integration and intra-industry trade. In their model, exporters choose the degree of exchange rate pass-through onto export prices given monetary policy rules, and monetary authorities choose optimal policy rules taking firms' pass-through as given. There exist two equilibria, which define two self-validating currency regimes. In the first, firms pre-set prices in domestic currency only, and let foreign-currency prices to be determined by the law of one price. Optimal policy rules then target the domestic output gap and floating exchange rates support the flex-price allocation. In the second equilibrium firms optimally preset prices in local currency, and a monetary union is the optimal policy choice for all countries. Although business cycles are more synchronized with a common currency, flexible exchange rates are superior in terms of welfare.
What economic forces lie at the root of global links? How is international transmission affected by the growth of trade in manufacturing, foreign direct investment and the growth of cross-border mergers and acquisition? To answer these questions, Corsetti and Luca Dedola (Bank of Italy) developed a model of the international economy with vertical integration among firms located in different markets. The elasticity of demand for Home goods becomes market specific (so that there is price discrimination, deviation from the law of one price and imperfect pass-through) and non-linear in the exchange rate. The latter property implies multiple equilibria. When the Marshall Lerner condition does not hold, there are different steady states. The nominal and real exchange rate varies markedly across these steady states, yet the difference in price levels, consumption and employment are quite small. The possibility of multiple equilibria raises new issues in the design of optimal policy, and in the desirability of international policy coordination. It offers an explanation to large swings in the value of the exchange rate across countries.
Together
with Sylvain Leduc at the Federal Reserve of Pennsylvania, Corsetti and
Dedola provided a calibrated version of the model addressing the so-called
Backus and Smith Puzzle. The standard open economy models predict that
relative consumption in two countries be perfectly or high correlated with
the real exchange rate. In the data, such correlation is zero or negative.
The model by Corsetti and Dedola is the first that can account for this
stylised fact. The intuition is the effect on consumption of terms of
trade movements that transmit domestic productivity shocks abroad.
Bacchetta
and Devereux (both CEPR) also
developed a number of models in the new open macro school. Both authors
(in collaboration with van Wincoop and Engel respectively) made progress
on the key question of the determination of the currency denomination of
prices: what determines whether a firm will set prices in euro or dollars?
In part, there is a spillover effect: the more competitors set in euro,
the more likely a given firm will also price in euro.
The clear prediction is that EMU will induce more and more firms to
set prices in euro rather than in dollars: in turn, this will increase
price stability in the eurozone, by increasing insulation from exchange
rate fluctuations. Sutherland (CEPR)
also made important contributions to the new open macro literature. In
particular, his work has highlighted how the existence of uncertainty
affects the welfare gains to alternative exchange rate systems: if an
exchange rate regime reduces uncertainty, it will typically reduce risk
premia and expand economic activity.
Andersen
(EPRU) used the new
open-economy macro approach to study the need and potential for active
stabilization policies in open economies. He also studied the need for
international policy coordination, focusing on interdependencies in fiscal
policy via trade channels and via a common monetary policy for members of
the EMU. Ganelli (Young Researcher,
TCD) also used such an approach to study open-economy fiscal policies.
He looked at the role of substitutability between public and private goods
in deriving the welfare gains to various fiscal policies. He also examined
the impact of government debt if households are finite-lived: the novelty
is in building this assumption into a sticky-price new open macro model.
Together with Roberto Perotti (EUI/CEPR),
Lane (TCD) empirically examined the impact of various items of government
expenditure in an open economy. They find that the impact of fiscal policy
on private sector variables
(profitability, employment) depends on (a) the exchange rate regime: fixed
or flexible; and (b) composition: government wage consumption has stronger
distortionary effects than non-wage items of government consumption.
The
increasing integration of international goods and capital markets is
driven by a decline of natural and political barriers to trade. This is
unambiguously true for international capital markets; trading and
communication costs have been dramatically reduced by the development of
modern communication technologies and in addition restrictions on
international flows of capital have been abandoned or at least
considerably reduced for many capital markets. For international commodity
markets, however, the question of increasing integration is not so
obvious. Although a considerable decrease in transportation and
information costs and an increasing opening of national markets can be
observed, the empirical (and theoretical) literature on this subject still
reveals strong evidence of insufficient integration.
In
their seminal study of the North American goods markets, Engel and Rogers
(1996) - using disaggregated price data for 14 US and 9 Canadian cities -
show that price dispersion within countries is significantly lower than
that across countries. They interpret the strong impact of the border
variable on the dispersion of international prices as evidence of strong
segmentation of the US and the Canadian commodity markets. Successive
studies have confirmed these results. Parsley and Wei (2000) and Beck and
Weber (CFS, 2001a) show for the US and Japan that markets across these two
countries are even more segmented.
A
recent CFS study by Beck and
Weber (2001b) obtained similar results about goods market segmentation for
the European Union countries based on price data from 81 European cities
in six European countries prior and during EMU (see map below for our
regional coverage).
Beck
and Weber showed that EMU has reduced price dispersion in Europe by
roughly 80 percent within the first two years of EMU. Thus, monetary
unification has contributed significantly to a decline in good market
segmentation within Europe. But markets are far from being perfectly
integrated yet. Beck and Weber (2001b) also confirmed for Europe the
finding of Cecchetti, Mark and Sonora (1999), who discovered a large
degree of persistence in inflation differentials across US cities. Owing
to such inflation differentials, national governments in the Euro zone
face differential real interest rates (under equalised nominal interest
rates) and therefore will have differential real tax liabilities in the
servicing of the respective national debts. This may cause problems for
the policy of the ECB since it will result in different national demands
concerning monetary policy (Does One Size Fit All?).
Whilst
for the US many of the issues discussed above are analysed as part of a
large NBER project, research
with European data is still in its infancy. The CFS
research project briefly described here aims at pushing this research
forward. After completing an extensive data gathering exercise, a number
of research papers are now in the process of being written. Two such
papers, already referred to above, will be appearing as CFS Discussion
Papers shortly.
After
completing this initial set of CFS studies outlined above, the next step
will be to make the spatial price data bank available on the Internet and
to involve other researchers from outside CFS in these projects. Also,
gathering additional European regional data on prices, interest rates,
wages, output, employment and fiscal data will enable us to extend our
research to studying the regional impact of monetary and fiscal policy in
Europe in more detail than national data typically allow.
Weber
and Beck used consumer price data for 205 cities/regions in 21 countries
to study deviations from the law-of-one-price before, during and after the
major currency crises of the 1990s. They combined data from industrialised
nations in North America (United States, Canada, Mexico), Europe (Germany,
Italy, Spain and Portugal) and Asia (Japan, Korea, New Zealand, Australia)
with corresponding data from emerging market economies in South America
(Argentina, Bolivia, Brazil, Columbia) and Asia (India, Indonesia,
Malaysia, Philippines, Taiwan, Thailand). They confirmed previous results
indicating that both distance and border explain a significant amount of
relative price variation across different locations. In addition, they
found that currency attacks have had major disintegration effects by
significantly increasing these border effects, and by raising
within-country relative price dispersion in emerging market economies.
These effects are found to be quite persistent since relative price
volatility across emerging markets today is still significantly larger
than a decade ago.
Beck
extended the approach above by investigating how price dispersion between
EU-members and the major non-EU trading partners Canada and the U.S. has
developed before and after January 1999. Using regional price data (taken
from SPATDATã,
a database compiled by CFS-Frankfurt), he investigated how intra-national (within European
and North American countries), intra-continental (within European and
North American countries) and intercontinental (between European and North
American countries) price dispersion has developed over the last 10 years.
The key results are the following:
1.
EMU has drastically reduced inter-European price dispersion, i.e.
results of previous study (Beck and Weber, 2001) are confirmed
2.
however:
even
in EMU borders still matter for relative price dispersion
3.
inter-continental price dispersion: some reduction, however very
small
4.
NAFTA
has no measurable impact on price dispersion (previous results in
literature still hold for recent period.
Industrial
production in G7 countries is assumed to be driven by two exogenous
disturbances. Those disturbances are identified in a VAR model so they can
be interpreted as country-specific and global supply shocks. The dynamic
properties of the model are analyzed and the relative importance of each
shock is measured. It is shown that the VAR model matches most of the
theoretical predictions of standard intertemporal open-economy models. The
identified structural disturbances are analyzed with regard to their
impact on the current account and investment.
Natalie
Chen (post-doctoral Young
Researcher, LBS) also carried out research into the behavior of
relative prices within Europe. Andrew Scott (LBS)
examined the properties of debt and deficit fluctuations. Morten O. Ravn (LBS)
looked at how financial markets affect consumption and how fluctuations
spread across countries. Thygesen
(EPRU) finished a study on the
relationship between the euro and the dollar, involving estimations of the
economic fundamentals determining the long run equilibrium exchange rate.
Central
banks spend a lot of effort on making forecasts about the economy.
Although it is debatable whether central banks produce better forecasts
than private sector analysts, central bank’s forecasts are inputs for
monetary-policy making. Therefore, publication of the central bank’s
forecasts influences people’s expectations in a different way than other
forecasts. In his paper, “The Credibility of Central Bank
Announcements”, Marco Hoeberichts (Young
Researcher, CFS) wanted to investigate the incentives and
possibilities that a central bank faces when it publishes its private
forecast of supply and demand shocks and how this interacts with the
interest-rate instrument.
In
addition, Hoeberichts (Young
Researcher), produced a paper on “Learning and Disinflation” (with
Eric Schaling, Rand Afrikaans University, Johannesburg). Central bankers
generally prefer to reduce inflation gradually. They showed that a central
bank may try to convince the private sector of its commitment to price
stability by choosing to reduce inflation quickly ehich they refer to as
"teaching by doing". They found that allowing for "teaching
by doing" effects always speeds up the disinflation. As a
consequence, they attempted to clarify why "speed" in the
disinflation process does not necessarily "kill" in the sense of
creating large output losses.
Stability
of the International Financial System
Richard
Portes (LBS) carried out
research into the European role in providing financial stability and into
the role of the Euro in the international financial system. Together with
Aghion and Banerjee, Bacchetta (CEPR)
studied the origins of financial and currency crises in emerging market
economies. In particular, they demonstrated the conditions under which a
crisis can be self-fulfilling: pessimism about economic prospects leads to
exchange rate depreciation which in turn raises the burden of
foreign-currency debt, adding to the economic downturn. Hutchison
(EPRU) studied episodes of
banking distress in Europe and discussed their implications for
institutional and macroeconomic risks in the EMU. Another part of Hutchison's research analysed whether foreign
exchange market intervention in the euro area could be an effective policy
instrument for the European Central Bank. In addition, he carried out
empirical research on the output costs of 'sudden stops' in international
capital flows.
Alex
Cukierman has been involved together with Itay Goldstein and Yossi Spiegel
(all Tel Aviv) in the
investigation of the choice of exchange rate regimes in the presence of
potential speculative attacks. This effort is summarized in the joint
paper: "The choice of exchange rate regime and speculative
attacks". In this paper they develop a framework for studying
the choice of exchange rate regime in an open economy where the local
currency is vulnerable to speculative attacks. The optimal regime is
determined by a policymaker who trades off the loss from nominal exchange
rate uncertainty, against the cost of maintaining a given regime. This
cost is affected in turn by the likelihood of a speculative attack.
Searching
for the optimal regime within the class of exchange rate bands, we show
that the optimal regime is either a peg (a zero-width band), a free float
(an infinite-width band), or a non degenerate finite width band. In the
latter case, the exchange rate is allowed to move freely only within a
band set around some central rate. We examine the determinants of the
optimal band width and show, among other things, that, ceteris
paribus, lower costs of moving across currencies induce policymakers
to set more flexible exchange rate systems. This lowers, in turn, the
likelihood of financial crises. More generally the framework of the paper
can be used to shed new light on the recent worldwide trend towards a
bipolar system of exchange rate arrangements.
Eran
Yashiv (Tel Aviv) studied the behaviour of fundamentals, central bank
intervention and the resulting exchange rate behavior using a structural
optimization model and a unique data-set. This is Israeli data of almost
1000 daily observations on a directly-observed fundamental, the amount of
central bank intervention and exchange rates at the opening and closing of
trading. He characterised the behaviour of fundamentals and intervention
using various descriptive statistics, proposed a model of optimal central
bank intervention, and structurally estimated the model. The results
showed that the behaviour of daily exchange rates is relatively well
captured by the model and that intervention policy can be structurally
characterised in an optimization model.
Taxation
and the International Financial System
In
collaboration with Huizinga (Tilburg),
Nielsen (EPRU) completed a
research project on the coordination of capital income and profit taxation
with cross-ownership of firms, and another one studying the effects of
withholding taxes versus information exchange in the taxation of
international interest income flows. Nielsen also started up joint work
with Raimondos-Moeller (EPRU) on the taxation of multinational firms,
focussing on the issue of transfer pricing.
Eggert (EPRU) and Sorensen (EPRU) also studied the national and international capital market effects of international information exchange to secure enforcement of taxes on foreign source capital income. Sorensen also developed an applied general equilibrium model for the OECD economy to illustrate and quantify the international spillover effects of national tax policies. He used the model to study the domestic and international capital market effects of the recent German tax reform. In addition, Sorensen finished a study on the need for tax coordination in the EU, allowing for the effect of EU policies on capital flows between the EU and the rest of the world.
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Research