Financial Globalization Lecture 5 PDF

Economic Environment Analysis Lecture 5 Last weeks 1. Globalization: facts about trade. 2. How productivity and natural resources shape trade patters and gains. 3. Trade Policies. This week 1. Financial Globalization. 2. Current Account: from domestic to open economy. 3. Balance...

Economic Environment Analysis Lecture 5 Last weeks 1. Globalization: facts about trade. 2. How productivity and natural resources shape trade patters and gains. 3. Trade Policies. This week 1. Financial Globalization. 2. Current Account: from domestic to open economy. 3. Balance of Payment. Financial Globalization Financial globalization Financial globalization: the phenomenon of rising global linkages created through cross-border financial flows. Financial globalization ≠ Trade globalization. Measures of trade openness / trade globalization : Integration and economic vulnerability: (Exports + Imports)/GDP. What are the restrictions to trade? Measure of financial globalization: extent of the openness in cross-border financial transactions. Financial globalization: which assets? Characteristics of financial assets = mean of transferring purchasing power across periods. Portfolio investment: equity or debt; Foreign direct investment (> 10% ownership); Other investments: bank loans, trade credit; Derivatives (futures, options…); Reserves (Central Banks). Financial globalization: De Jure vs. De Facto Measure of financial globalization: extent of the openness in cross-border financial transactions. De Jure: what are the restrictions to international capital movements? Focus on legal and regulatory frameworks governing financial openness. Indicate the official policies on capital account restrictions, foreign exchange regulations, and other controls on cross-border financial transactions. Useful for understanding how permissive or restrictive a country’s financial system is according to law. Financial globalization: De Jure vs. De Facto Measure of financial globalization: extent of the openness in cross-border financial transactions. De Facto: how much international trade in financial assets? Reflect the actual flow of capital across borders, irrespective of regulations. Focus on how much financial integration is occurring in practice through trade in financial assets, FDI, and portfolio investments. Capture the real-world outcomes of financial liberalization, including both legal and illegal flows. Financial globalization: the Chinn-Ito Index Let’s start with a de jure measure: the Chinn-Ito index! Created by Menzie Chinn and Hiro Ito, it quantifies the degree of capital account openness using IMF data on legal restrictions in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). Covers over 180 countries from 1970 onward, providing long-term data. Simple yet broad: Collapses complex regulatory information into a single index, allowing for easier comparison across countries and over time. Reflects key legal factors: Incorporates restrictions on exchange rates, current and capital account transactions, and export proceeds. Financial globalization: the Chinn-Ito Index Financial globalization (De Jure) Chinn-Ito index based on IMF information on restrictions to capital movements. Index takes value between -2.5 (closed capital market) and 2.5 (fully opened). Financial globalization How do we measure financial assets: 1. Flows: the value of assets traded for a given year: 𝑎𝑡. 2. Stock: the value of assets held for a given year: 𝐴𝑡 = 𝐴𝑡−1 + 𝑎𝑡. Stocks are cumulative flows. Financial globalization Examples: 1. Equity bonds In 2023, a company issues bonds worth €100 million. This represents the flow of financial assets for that year (the value of bonds traded). The company's total outstanding bonds at the end of 2022 were €500 million. At the end of 2023, after issuing new bonds, the stock of bonds is: 𝐴𝑡 = 𝐴𝑡−1 + 𝑎𝑡 = €500 million + €100 million = €600 million. Financial globalization Examples: 2. Sovereign Debt In 2023, Spain issued approximately €70 billion in new sovereign debt, slightly below the amount issued in 2022. At the end of 2022, Spain’s total outstanding sovereign debt was about €1.5 trillion, which represented 113% of GDP. After issuing the new debt in 2023, the total stock of debt is: 𝐴𝑡 = 𝐴𝑡−1 + 𝑎𝑡 = €1.5 trillion + €70 billion = €1.57 trillion. Financial globalization De facto measures of financial globalization: 1. Stocks: International Financial Integration = (domestic assets held by foreigner + foreign assets held by domestic investors)/ GDP. 2. Flows: inflows/GDP or outflows/GDP. Inflows: net purchases of domestic assets by foreign investors (for example, a loan by a foreign bank to a domestic firm). Outflows: net purchases of foreign assets by domestic investors (for example, a domestic household buying a bond issued by a foreign government).  Financial globalization (De Facto) International Financial Integration, 1970–2015 (Domestic assets held by foreigners + Foreign assets held by domestic agents)/ GDP Large increase in international assets held in both groups. But much more so in developed countries. Data source: Lane and Milesi-Ferretti (2018)  Financial globalization (De Facto) International Capital Flows (% of world GDP) Flows more volatile than stocks. Total collapse of international flows in the 2008 crisis. Financial globalization: History « What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! … The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. ». John Maynard Keynes, Chapter II Europe Before the War, in The Economic Consequences of the Peace (1920). Financial globalization: History World capital markets very integrated at the end of the 19 th century. Share of British wealth invested overseas: 17% in 1870 and 33% in 1913 (larger than most country today). Similar in France, Germany. Capital outflows from UK (purchase of foreign assets): mostly to the « New World » with natural resources: Canada + Australia (28%), US (15%), Latin America (24%) Source: Taylor and Williamson (1994) What form? Portfolio investment (equity and bonds to invest in railroads, harbors…) Financial globalization: History 1. Gold Standard era (1880-1914) 2. World Wars (1915-1945) 3. Bretton Woods era (1945-1971) 4. Floating-rate era Financial globalization: the Beginning Causes of first financial globalization: Transportation and communication (telegraph): information Global UK banks. Basic theory: Solow growth model. Capital scarce countries should have high returns to capital. End of 19th century = first globalization Capital flows from capital abundant countries (say Europe or UK) to capital scarce ones (say US). European capital chased European labor (and vice versa): both migrated to New World where returns are high. Financial globalization: the Beginning A quick sketch of theory. Output 𝑦𝑡 is produced using inputs (capital 𝑘𝑡 ) efficiently. α Production function: 𝑦𝑡 = f 𝐴𝑡 , 𝑘𝑡 = 𝐴𝑡 𝑘𝑡. 𝐴𝑡 is an efficiency parameter, think of technology. Also called total factor productivity (TFP). Output (𝑦𝑡 ) is increasing in productivity (𝐴𝑡 ) and capital (𝑘𝑡 ). 0 < 𝛼 < 1, meaning that the marginal productivity of capital is decreasing. Financial globalization: the Beginning The graphs shows for given capital how much output we have. It’s curved (concave) because of the decreasing marginal productivity. Remember the H-O model? What does this mean? Financial globalization: the Beginning The marginal productivity of capital (MPK) measures the amount of output created with an additional unit of capital. Equals to the returns to capital! Assumptions about MPK are purely technological. With more technologies, we might need more assumptions. We assume decreasing returns (0 < 𝛼 < 1) 𝜕𝑦 𝑀𝑃𝐾 = = 𝛼𝐴𝑡 𝐾𝑡𝛼−1 𝜕𝑘 Returns to capital fall when capital increases. Financial globalization: the Beginning Financial globalization: the Beginning Financial globalization Washington Consensus: collection of loosely articulated ideas in the beginning of the 1990s aimed at modernizing, reforming, deregulating and opening economies. Consequence: many emerging markets opened up their capital markets in the early 1990s (while most developed markets were already opened since the 1980s). Important to note that restrictions on capital mobility are still more stringent for developing countries. Financial globalization: Expected Gains Intertemporal trade gains! Capital should flow from capital rich (low return due to decreasing returns) country to capital poor country (high return). Allows increased investment in capital poor country. Positive effect on growth = faster transition to steady state. Financial globalization: Expected Gains Financial globalization: Expected Gains Event studies on sample of emerging markets (Henry (2007), Bekaert et al. (2005)). Pick up financial integration dates. Compare outcomes before and after financial integration. Find at most a 1% increase in real GDP growth after financial integration. Mostly through capital accumulation and falling cost of capital (small effects on TFP growth). Limits Temporary effect. No evidence that financial globalization has long term impact on growth Is the date random? Is it financial integration or just financial development? Upper bound of the effect? Financial globalization: The Lucas Puzzle Despite low capital/labor ratios, capital flows to developing countries are small and often in the “wrong” direction. Many emerging markets lending to rich countries. Main explanations Differences in TFP Institutional quality (Alfaro et al., 2008). Capital market imperfections (sovereign risk, asymmetric information…) Financial globalization: Uphill Capital Flows Financial globalization: Uphill Capital Flows Financial globalization: Expected Gains International risk sharing (= risk diversification) Risk aversion: other things equal, people dislike risk. If investors are risk averse, diversification of country-specific risk through diversified portfolio. Incentives to diversify abroad. From portfolio theory, better diversification opportunities allow investors to reduce the risk of their portfolio (for the same expected returns). Are global financial markets integrated? International asset holdings are large and have grown substantially. But “portfolio home bias” remains large and puzzling. Portfolios not very diversified internationally. Looking at the internationally diversified part of their portfolio, investors tend to hold a larger share of assets geographically close to their own market. Effect of distance on asset trade comparable to its effect on real trade. Reasons? Are global financial markets integrated? National Income Accounts The National Income Accounts Records the value of national income that results from production and expenditure. Producers earn income from buyers who spend money on goods and services. The amount of expenditure by buyers = the amount of income for sellers = the value of production. National income is often defined to be the income earned by a nation’s factors of production. The National Income Accounts Gross national product (GNP) is the value of all final goods and services produced by a nation’s factors of production in a given time period. What are factors of production? Factors that are used to produce goods and services: workers (labor services), physical capital (such as buildings and equipment), natural resources, and others. The value of final goods and services produced by U.S.-owned factors of production are counted as U.S. GNP. The National Income Accounts Gross national product (GNP) is calculated by adding the value of expenditure on final goods and services produced: 1. Consumption: expenditure by domestic consumers. 2. Investment: expenditure by firms on buildings and equipment. 3. Government purchases: expenditure by governments on goods and services. 4. Current account balance (exports minus imports): net expenditure by foreigners on domestic goods and services. US’ GNP and Its Components The figure shows 2020:QI GNP and its components at an annual rate, seasonally adjusted. Source: U.S. Department of Commerce, Bureau of Economic Analysis. The National Income Accounts To have a more precise measure of national income GNP can be adjusted for: 1. Depreciation of physical capital resulting in a loss of income to capital owners. The amount of depreciation is subtracted from GNP. 2. Unilateral transfers to and from other countries can change national income: payments of expatriate workers sent to their home countries, foreign aid, and pension payments sent to expatriate retirees. The National Income Accounts Gross Domestic Product (GDP) is another measure of national income: Gross domestic product measures the final value of all goods and services that are produced within a country in a given time period. GDP = GNP – payments from foreign countries for factors of production + payments to foreign countries for factor of production. National Income Accounts for an Open Economy The national income identity for an open economy is: Y = C + I + G + EX − IM = C + I + G + CA where C + I + G are the expenditures by domestic individuals and institutions and CA represents the net expenditures by foreign individuals and institutions National Income Accounts for an Open Economy CA = EX − IM = Y − (C + I + G) When production > domestic expenditure exports > imports current account > 0 and trade balance > 0 when a country exports more than it imports, it earns more income from exports than it spends on imports net foreign wealth is increasing National Income Accounts for an Open Economy CA = EX − IM = Y − (C + I + G) When production < domestic expenditure exports < imports current account < 0 and trade balance < 0 when a country exports less than it imports, it earns less income from exports than it spends on imports net foreign wealth is decreasing National Income Accounts for an Open Economy An example with an imaginary country, Agraria, producing 100 units of wheat: Production is divided as follows: 55 are consumed by residents 25 are invested 10 are purchased by government 10 are exported Agraria is also importing 40 units of milk at the price of 0.5 per unit. GN P = Consumption + Investment + Government + Exports mi n us Imports (total output) purchases 100 = 75 75totheapo wer + 25 + 10 + 10 mi n us 20 20tothebpo wer Consumption = 55 wheat + 0.5*40 units of milk Imports = 0.5*40 units of milk National Income Accounts for an Open Economy Agraria is producing 100 units and consuming 110 units. This would be impossible in a closed economy. Those 10 units will need to be repaid in the future. The CA captures also intertemporal trade. A country with a current account deficit is importing present consumption and exporting future consumption. A country with a current account surplus is importing future consumption and exporting present consumption. National Income Accounts for an Open Economy A string of current account deficits starting in the early 1980s reduced America’s net foreign wealth until, by the early 21st century, the country had accumulated a substantial net foreign debt. Saving and the Current Account National saving (S) = national income (Y) that is not spent on consumption (C) or government purchases (G). S = Y −C −G An open economy can save by building up its capital stock or by acquiring foreign wealth. S = I + CA Crucial difference with closed-economy accounting! Private and Government Saving Private saving is the part of disposable income (national income, Y, minus taxes, T) that is saved rather than consumed: S P = Y −T − C Government saving is net tax revenue, T, minus government purchases, G: Sg = T −G Private and government saving add up to national saving. S = (Y −T − C ) + (T − G ) = S P + S g Current Account and Savings Let’s take a look at the current account: 𝐶𝐴 = 𝐸𝑋 − 𝐼𝑀 =𝑌 −𝐶 −𝐼 −𝐺 =𝑌 −𝐶 −𝐼 −𝑇+𝑇 −𝐺 = 𝑆 𝑃 + 𝑆𝑔 − 𝐼 Accounting identity (no behaviour, no theory here). A country whose savings exceed national investment runs a current account surplus: the country is lending to the rest of the world. A theory of current accounts is a theory of saving and investment. A current account deficit can reflect Small private saving (high consumption). High investment A large fiscal deficit (‘twin deficit’ hypothesis) Current Account and Savings in the U.S. Understanding Current Accounts Consumption smoothing = intertemporal approach Countries borrow and lend to smooth income shocks. Higher income tomorrow (e.g. faster growth) should lead to a current account deficit. I > S. Fast growth implies high returns to capital, high I. Borrow against future consumption (low S). Demographics Aging countries should be saving more (rising life expectancy). Low expected growth in the future if low fertility and rising old dependency ratios. S > I. Aging countries should run current account surpluses. To the opposite, countries expected to stay young should import capital. An Aging Population Understanding Current Accounts No obvious normative judgment on sign (or size) of current accounts. Often capital flows do not reflect an efficient allocation of capital. Domestic Distortions “Too” high private saving : lack of social insurance, lack of financial development, financial repression, … “Too” low private saving : asset bubbles (real estate), excessive leverage, … “Excessive” public borrowing Systemic Distortions After Asian crisis (1997-98), emerging markets ran large current account surpluses and accumulated large foreign exchange reserves. Partly insurance (precautionary saving) against speculative attacks. Individually rational but globally may lead to excessive imbalances. Understanding Current Accounts Spain: Construction and current account deficit. Source: The Spanish hangover by Gros and Alcidi (2012). Multinationals’ Profit Shifting and Ireland’s Volatile GDP Ireland’s GDP rose by a whopping 26.3% between 2014 and 2015, an outlier compared to growth rates since 1999. No massive increase in factors of production such as employment occurred. In large part, was an accounting phenomenon reflecting tax avoidance by large multinationals from other countries. Ireland’s comparatively low corporate tax rate of 12.5% leads to multinationals allocating their intellectual property (IP) assets to Ireland (and other low-tax havens such as Bermuda). GDP has shortcomings as a measure of economic welfare. Ireland’s GDP The figure shows the Real GDP Growth in Ireland Since 1999 The huge jump in Ireland’s 2015 real GDP was mostly an artifact of creative accounting. Source: International Monetary Fund, World Economic Outlook database, April 2019. Data point for 2020 is a projection Balance of Payment Balance of Payments Accounts A country’s balance of payments accounts for its payments to and its receipts from foreigners. An international transaction involves two parties, and each transaction enters the accounts twice: once as a credit (+) and once as a debit (-). The balance of payments accounts are separated into three broad accounts: 1. current account: accounts for flows of goods and services (imports and exports). 2. financial account: accounts for flows of financial assets (financial capital). 3. capital account: flows of special categories of assets (capital): typically non-market, non-produced, or intangible assets such as debt forgiveness, copyrights, and trademarks. Examples of Balance of Payments Accounting You import a fax machine from Olivetti. Olivetti deposits your check in a U.S. bank. Fax machine purchase (Current account, U.S. good import) -$1000 Sale of bank deposit (Financial account, U.S. asset sale) +$1000 Examples of Balance of Payments Accounting You buy lunch in France and pay by credit card. French restaurant receives payment from your credit card company. Meal purchase (Current account, U.S. service import) -$200 Sale of credit card claim (Financial account, U.S. asset sale) +$200 Examples of Balance of Payments Accounting You buy a share of British Petroleum. British Petroleum deposits the money in a U.S. bank. Stock purchase (Financial account, U.S. asset purchase) -$95 Bank deposit (Financial account, U.S. asset sale) +$95 Examples of Balance of Payments Accounting U.S. banks forgive a $5,000 debt owed by the government of Bygonia through debt restructuring. U.S. banks who hold the debt thereby reduce the debt by crediting Bygonia’s bank accounts. U.S. banks debt forgiveness (capital account, U.S. transfer -$5,000 payment) Reduction in bank’s claims on Bygonia (financial account, +$5,000 U.S. asset sale) Balance of Payments Accounts How do the Balance of Payments Accounts balance? Due to the double entry of each transaction, the balance of payments accounts will balance by the following equation: current account + financial account + capital account = 0 Essentially an accounting trick - every credit needs to be matched by a debit. The current account shows overall situation in transactions of goods and services. The capital and financial account shows how this is financed. Balance of Payments Accounts Current account: imports and exports 1. merchandise (goods like DVDs) 2. services (payments for legal services, shipping services, tourist meals, etc.) 3. income receipts (interest and dividend payments, earnings of firms and workers operating in foreign countries) Balance of Payments Accounts Current account: net unilateral transfers gifts (transfers) across countries that do not purchase a good or service nor serve as income for goods and services produced Capital account: records special transfers of assets, but this is a minor account for the United States Balance of Payments Accounts Financial account: the difference between sales of domestic assets to foreigners and purchases of foreign assets by domestic citizens. Financial inflow Foreigners loan to domestic citizens by buying domestic assets. Domestic assets sold to foreigners are a credit (+) because the domestic economy acquires money during the transaction. Financial outflow Domestic citizens loan to foreigners by buying foreign assets. Foreign assets purchased by domestic citizens are a debit (-) because the domestic economy gives up money during the transaction. Balance of Payments Accounts Financial account: has at least three subcategories: 1. Official (international) reserve assets 2. All other assets 3. Statistical discrepancy Balance of Payments Accounts Statistical discrepancy Data from a transaction may come from different sources that differ in coverage, accuracy, and timing. The balance of payments accounts therefore seldom balance in practice. The statistical discrepancy is the account added to or subtracted from the financial account to make it balance with the current account and capital account. US Balance of Payment Accounts, 2019 Current Account (1) Exports and current transfer receipts 3,805.94 Of which: Goods 1,652.44 Services 875.83 Income receipts (primary income) 1,135.69 Current transfer receipts (secondary income) 141.98 (2) Imports and current transfer payments 4,286.16 Of which: Goods 2,516.77 Services 588.36 Income receipts (primary income) 899.35 Current transfer receipts (secondary income) 281.69 Balance on current account [(1) – (2)] - 480.22 (3) Capital Account - 6.24 Source: U.S. Department of Commerce, Bureau of Economic Analysis. Totals may differ from sums because of rounding. US Balance of Payment Accounts, 2019 Financial Account (4) Net U.S. acquisition of financial assets, excluding 440.75 financial derivatives Of which: Official reserve assets 4.66 Other assets 436.09 (5) Net U.S. incurrence of liabilities, excluding financial 797.96 derivatives Of which: Official reserve assets 61.63 Other assets 736.33 (6) Financial derivatives, other than reserves, net - 38.34 Net financial flows [(4) – (5) – (6)] - 395.54 Statistical Discrepancy 90.92 [Net financial flows less sum of current and capital accounts] Source: U.S. Department of Commerce, Bureau of Economic Analysis. Totals may differ from sums because of rounding. The Mystery of the Missing Deficit Because each country’s exports are other countries’ imports, the world’s current account balances must add up to zero. But they don’t. In all but one year between 1980 and 2003, the sum of global current accounts was negative. Partly due to incomplete reporting of international investment income? Since 2004, the measured global current account has been positive. Partly due to growing international trade in services? The Mystery of the Missing Deficit The figure shows the global current account discrepancy since 1980. Once big and negative, implying missing current account credits, the world’s current account balance has become big and positive, implying missing current account debits. More on: Export to Mars. The Economist. Source: International Monetary Fund, World Economic Outlook database, October 2019. Balance of Payments Accounts An economy’s central bank is the institution responsible for managing the supply of money. In the United States, the central bank is the Federal Reserve. In Europe, the European Central Bank (ECB). Central banks often buy or sell international reserves in private asset markets to affect macroeconomic conditions in their economies. Official transactions of this type are called official foreign exchange intervention. One reason why foreign exchange intervention can alter macroeconomic conditions is that it is a way for the central bank to inject money into the economy or withdraw it from circulation Balance of Payments Accounts Official (international) reserve assets: foreign assets held by central banks to cushion against financial instability. Assets include government bonds, currency, gold, and accounts at the International Monetary Fund. Official reserve assets owned by (sold to) foreign central banks are a credit (+) because the domestic central bank can spend more money to cushion against instability. Official reserve assets owned by (purchased by) the domestic central bank are a debit (-) because the domestic central bank can spend less money to cushion against instability. Balance of Payments Accounts The negative value of the official reserve assets is called the official settlements balance or “balance of payments.” It is the sum of the current account, the capital account, the non-reserve portion of the financial account, and the statistical discrepancy. A negative official settlements balance may indicate that a country is depleting its official international reserve assets, or may be incurring large debts to foreign central banks so that the domestic central bank can spend a lot to protect against financial instability. Balance of Payment and Net Foreign Assets U.S. Balance of Payments Accounts The United States has the most negative net foreign wealth in the world, and so is therefore the world’s largest debtor nation. Its current account deficit in 2012 was $440 billion dollars, so that net foreign wealth continues to decrease. The value of foreign assets held by the United States has grown since 1980, but liabilities of the United States (debt held by foreigners) have grown faster. US Net Foreign Weath The figure shows the U.S. Gross Foreign Assets and Liabilities, 1976– 2019. Since 1976, both the foreign assets and the liabilities of the United States have increased sharply. But liabilities have risen more quickly, leaving the United States with a substantial net foreign debt. Source: U.S. Department of Commerce, Bureau of Economic Analysis. Current accounts and net foreign assets Accumulating CA deficits leads to a negative net foreign assets position (NFA) with the ROW (or Net International Investment Position, NIIP) Accounting (forget capital gains and losses for now): 𝐶𝐴𝑡 = 𝑁𝐹𝐴𝑡 − 𝑁𝐹𝐴𝑡−1 (flow) Net external position (NFA) in t is NFA in t-1 + CA value 𝑁𝐹𝐴𝑡 = 𝐶𝐴𝑡 + 𝑁𝐹𝐴𝑡−1 (stock) If 𝑁𝐹𝐴𝑡 < 0, the country is a debtor: the value of foreign assets held by domestic residents is lower than the value of domestic assets held by foreigners.  Net Foreign Assets (% of World GDP) Source: World Economic Outlook and IMF staff calculations. Valuation effects on external positions Back to reality: CA deficits only one factor of the evolution of the NFA position. 𝑁𝐹𝐴𝑡 − 𝑁𝐹𝐴𝑡−1 = 𝐶𝐴𝑡 + capital gains (looses) on external assets and liabilities. Changes in exchange rate and/or market value of stocks/bonds affect value of both foreign assets held by domestic agents (assets) and domestic assets held by foreign agents (liabilities). Valuation effects have become large due to financial globalization and the increase in gross positions (assets and liabilities).  Valuation effects on external positions US Annual real returns (%) on foreign assets and liabilities. Capital gains on NFA extremely volatile. Source: Gourinchas and Rey (2005) Understanding valuation effects Application: US current account imbalances in the early 2000s. Growing divergence between accumulation of CA deficits and NFA in US. Period 2002-2006 in the US: large CA deficits (about 5% of GDP), NFA position (measures the difference between the value of foreign assets held by US agents and US assets held by foreigners) barely changed. Cumulative of CA deficits around $3.4 trillions ⇒ should have raised US net external liabilities to about $5.5 trillions (40% of GDP). The NFA deterioration was only $400 billions. As a ratio of GDP it actually improved. Where did those other $3 trillions of US net borrowing go? US Net Foreign Assets, % of GDP Understanding valuation effects How can that be? Capital gains on NFA: foreign assets held by Americans (mostly denominated in foreign currency) increased in value much more than foreign-held assets in the US (mostly denominated in $) $ depreciation over 2002-2007. Foreign stocks did better than US stocks. If repeated: can suggest that due to dollar role (US debt in dollar) foreigners get a weak return on American assets = exorbitant privilege The US Net foreign asset positions Currency denomination of US assets and liabilities in the 2000s (Tille, 2008) Exorbitant privilege Gourinchas and Rey (2005): From world banker to world venture capitalist: US external adjustment and the ‘exorbitant privilege’ Total return on US assets held by foreigners (US debt) < Return on foreign assets held abroad by US investors US borrow at 3.6% and lend or invest at 5.7% 2.1%! = (large) exorbitant privilege Both a composition effect (assets are riskier and less liquid than liabilities) and a return effect (excess return within class of assets). Even larger privilege (3.5%) post Bretton-Woods (post 1973). Exorbitant privilege Return effect: returns are not equalized even within classes could be that assets and liabilities of US of different maturities role of dollar as reserve currency + liquidity of US financial markets: foreigners are willing to hold underperforming US assets because more liquid (exorbitant privilege of $) Composition effect: assets are in risky/high return (equity/FDI), liabilities are in low returns bonds: plays a less important role (but more important through time) Exorbitant privilege: US Net Foreign Asset Position, % of GDP Source: Gourinchas et al. (2017) Exorbitant privilege and exorbitant duty Consequence of exorbitant privilege: US external constraint relaxed. CA deficits without worsening of external position. Gourinchas, Rey and Govillot (2017) Find large exorbitant privilege in normal times. Financial crisis → dramatic worsening of US NFA (19% of GDP) : dramatic valuation adjustment (price of US holdings abroad contracted more than foreign holdings in US): exorbitant duty during disasters (insurance) U.S. Balance of Payments Accounts About 70% of foreign assets held by the United States are denominated in foreign currencies and almost all of U.S. liabilities are denominated in USD. Changes in the exchange rate influence value of net foreign wealth. Appreciation of foreign currencies makes foreign assets more valuable, but does not change the dollar value of dollar-denominated debt. To give an idea (an extract from the revision at the end of the year of the U.S. Net International Investment Position ($ billions)) External Adjustment Adjustment mechanisms to close a current account deficit. Countries need to payback their net external debt. Two channels of external adjustment: Trade channel Consume less than what is produced. Run trade surpluses. Financial channel (valuation effects) Capital gains on net external positions. Higher returns on foreign assets than liabilities. Default. External Adjustment and Exchange Rates Exchange rates changes essential for external adjustment: Trade channel Depreciation helps exports and decreases imports. Financial channel (valuation effects) A depreciation facilitates the adjustment if debts are in local currency and assets are in foreign currency (e.g. the US) In emerging markets, a currency depreciation (against the $) makes the adjustment more difficult because external debts are in $ (‘original sin’) External Adjustment and Exchange Rates Pre-2008 financial crisis, current account imbalances within the Eurozone. Deficits in South Europe and surpluses in the North. Post 2008, external adjustment to close imbalances. Post crisis, Southern countries need to reduce spending and run trade surpluses. Costly in period of recession. Nominal exchange rate cannot depreciate (common currency). Valuation effects limited. Competitiveness restored through very low inflation (deflation). A Glimpse of The Euroarea Heterogeneity Average current account balances % of GDP (2002-2007) Summary Summary Financial globalization has been increasing significantly over the last decades, even though the recent crises have led to a drop in international capital flows. Financial globalization should provide (small) intertemporal gains by fostering the transition to steady-state of capital scarce countries and risk- sharing gains. A few accounting definitions, GNP, GDP, … Countries whose investment exceed savings run current account deficits and import capital. The balance of payments records transactions with the rest of the world. It is balanced since current account deficits must be financed by capital inflows. Summary Global imbalances have emerged, with the US running persistent current account deficits financed by borrowing to some industrialized countries (e.g. Japan and Germany), oil producers but more surprisingly some fast growing emerging markets (China). Current account deficits cumulate into negative net foreign asset positions. Adjustment of current account imbalances requires trade surplus or capital gains on net foreign assets. The US earn higher returns on their external assets than what they pay on their liabilities (‘exorbitant privilege’). This relaxes their external constraint.