Financial globalization and Financial globalization and real exchange ratesreal exchange rates

Philip R. Lane Philip R. Lane IIIS, Trinity College DublinIIIS, Trinity College Dublin

Gian Maria Milesi-FerrettiGian Maria Milesi-FerrettiInternational Monetary FundInternational Monetary Fund

What the paper doesWhat the paper does

Provides stylized facts on international Provides stylized facts on international financial integration for financial integration for – Industrial countriesIndustrial countries– and emerging marketsand emerging markets

Discusses implications of financial Discusses implications of financial integration for the role of the exchange integration for the role of the exchange rate in international financial adjustmentrate in international financial adjustment

Motivation of the paperMotivation of the paper

With limited international financial integration, With limited international financial integration, – The exchange rate’s primary role is through the The exchange rate’s primary role is through the

traditional expenditure-switching channeltraditional expenditure-switching channel

With large stocks of external assets and With large stocks of external assets and liabilities, denominated in different currencies,liabilities, denominated in different currencies,– Exchange rate changes also have potentially large Exchange rate changes also have potentially large

balance-sheet effectsbalance-sheet effects

A simple example: the USA simple example: the US

What is the US$ depreciation that would trigger What is the US$ depreciation that would trigger a reversal in the US trade balance sufficient to a reversal in the US trade balance sufficient to stabilize the NFA to GDP ratio?stabilize the NFA to GDP ratio?

Traditional response: Traditional response:

need to reduce the CA deficit to 1.3 percent (5% need to reduce the CA deficit to 1.3 percent (5% nom. GDP growth times NFA ratio of 25%)nom. GDP growth times NFA ratio of 25%)

1 1t t t tb b ca b

A simple example (cont’d)A simple example (cont’d)

This implies a “large” depreciation (over This implies a “large” depreciation (over 30%?) 30%?)

However...However...

Balance-sheet effect: a 30% depreciation of Balance-sheet effect: a 30% depreciation of the US$ will improve the US NFA position by the US$ will improve the US NFA position by over $1 trn (10% of GDP)! over $1 trn (10% of GDP)!

It increases the $ value of US for.-currency It increases the $ value of US for.-currency assets (primarily portfolio equity and FDI)assets (primarily portfolio equity and FDI)

Emerging marketsEmerging markets

For emerg. markets with foreign-currency-For emerg. markets with foreign-currency-denominated liabilities, a depreciation will denominated liabilities, a depreciation will have have negativenegative balance-sheet effects. balance-sheet effects.

A simple graphical example:A simple graphical example:

Rates of return and real exchange ratesRates of return and real exchange ratesemerging markets, 1997emerging markets, 1997

TUR

SAF

ARG

BRA

CHI

COL

MEX VENISR

TAI

IND

IDN

KOR

MAL

PHI

THA

CHNCZE HUN

POL

-20%

0%

20%

40%

60%

80%

100%

-50% -40% -30% -20% -10% 0% 10% 20% 30% 40%

Perc. change in real eff. exch. rate

Rea

l dom

. cur

r. r

ate

of r

etur

n on

ext

. lia

bs.

Stylized facts on financial Stylized facts on financial integration: industrial countriesintegration: industrial countries

Increased dispersion of NFAIncreased dispersion of NFA

Remarkable increase in size of gross Remarkable increase in size of gross external assets and liabilitiesexternal assets and liabilities

Increased “equity integration” (FDI and Increased “equity integration” (FDI and portfolio equity)portfolio equity)

Net foreign assets and GDP per capitaNet foreign assets and GDP per capita

NZE

AUS

SPA

PRT

IRE

ICE

GRE

FIN

JPN

CAN

SWI

SWE

NOR

NET

ITA

GERFRA

DEN

BEL

AUT

UK

US

y = 0.04x - 1.1

R2 = 0.31

-100%

-50%

0%

50%

100%

150%

200%

11 16 21 26 31 36 41

GDP per capita (in thousands of current US$)

Net

for

eign

ass

ets

/ GD

P

Composition of international portfoliosComposition of international portfolios

0

0.5

1

1.5

2

2.5

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Equity FDI Debt

Emerging marketsEmerging markets

Reduction in net external liabilitiesReduction in net external liabilities

Increase in gross assets and liabilities Increase in gross assets and liabilities (less pronounced than in industrial co.)(less pronounced than in industrial co.)

Increased role of FDI and portfolio equity Increased role of FDI and portfolio equity

Current account and net foreign assetsCurrent account and net foreign assets

Current account (left axis)

Net foreign assets(right axis)

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

-40%

-35%

-30%

-25%

-20%

A

Net foreign assets and GDP per capitaNet foreign assets and GDP per capita

TUR

SAF

ARG

BRA

CHI

COL

MEX

VEN

ISR

TAI

IND

IDN

KOR

MAL

PHI

THA

RUS

CHN

CZE

HUN

POL

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

0 2000 4000 6000 8000 10000 12000 14000 16000 18000

GDP per capita, current US$

Net

for

eign

ass

ets/

GD

P

Table 4. Indicators of Int. Fin. Integration, Table 4. Indicators of Int. Fin. Integration, Emerging Markets (ratios of GDP)Emerging Markets (ratios of GDP)

1982 1992 2002

Average net external position -26.7% -21.1% -20.6% Average external assets 16.6% 26.5% 61.1% of which: foreign exchange reserves 5.1% 11.1% 19.4% FDI + portfolio equity 0.5% 2.0% 9.3% Average external liabilities 43.3% 49.9% 81.7% of which: FDI + portfolio equity 5.1% 9.6% 34.5%

Source: authors’ calculations based on Lane and Milesi-Ferretti (2001) and IFS.

Exchange rates and net foreign assetsExchange rates and net foreign assets

1 1 1( ) ( )L A Lt t t t t t t t tb b bgs r g b r r a

b= net foreign assets/GDPb= net foreign assets/GDP

bgs=balance of goods, services, and transfersbgs=balance of goods, services, and transfers

r(a, l)=real rate of return on assets (liabilities)r(a, l)=real rate of return on assets (liabilities)

g = growth rateg = growth rate

a= external assetsa= external assets

Evidence on RER and rates of returnEvidence on RER and rates of return

Industrial countries:Industrial countries:– High correlation between rate of return on High correlation between rate of return on

foreign assets and RER changes (around -0.8 foreign assets and RER changes (around -0.8 in a panel regression)in a panel regression)

– High correlation between rate of return on High correlation between rate of return on foreign liabs and RER changes (around -0.7 foreign liabs and RER changes (around -0.7 in a panel) but...in a panel) but...

– No correlation for returns on FDI liabilitiesNo correlation for returns on FDI liabilities

Evidence on rates of return and RER Evidence on rates of return and RER (emerging mkts)(emerging mkts)

Rates of return play a key role in explaining Rates of return play a key role in explaining the dynamics of external position (Tbl 6)the dynamics of external position (Tbl 6)

Correlation between rates of return on Correlation between rates of return on liabilities and RER changes higher than for liabilities and RER changes higher than for industrial countries [see 1997 graph!]industrial countries [see 1997 graph!]

Higher volatility of rates of return Higher volatility of rates of return

Policy implications (emerging mkts)Policy implications (emerging mkts)

Devaluations raise dom.-currency payouts on Devaluations raise dom.-currency payouts on foreign liabilities—foreign liabilities—balance-sheet effectsbalance-sheet effects!!

Improve risk-sharing: FDI and equity promote closer Improve risk-sharing: FDI and equity promote closer link between dom. econ. performance and rates of link between dom. econ. performance and rates of returnreturn

(more speculative) Alternative forms of debt? (more speculative) Alternative forms of debt? – Domestic-currency bond marketDomestic-currency bond market– GDP-indexed bondsGDP-indexed bonds

ConclusionsConclusions

Financial integration increasing:Financial integration increasing:– More portfolio diversificationMore portfolio diversification– Net borrowing and lending?Net borrowing and lending?

Exchange-rate effects on rates of return Exchange-rate effects on rates of return increasingly importantincreasingly important

Modeling work needs to catch up with Modeling work needs to catch up with evidenceevidence

More data needed!More data needed!