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1. International Financial Spillovers to Emerging Market Economies: How Important Are Economic Fundamentals?

Author:
Shaghil Ahmed, Brahima Coulibaly, and Andrei Zlate
Publication Date:
05-2015
Content Type:
Commentary and Analysis
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We assess the importance of economic fundamentals in the transmission of international shocks to financial markets in various emerging market economies (EMEs). Our analysis covers the so-called taper-tantrum episode of 2013 and six earlier episodes of severe EME-wide financial stress since the mid-1990s. Cross-country regressions lead us to the following results: (1) EMEs with relatively better economic fundamentals suffered less deterioration in financial markets during the 2013 taper-tantrum episode. (2) Differentiation among EMEs set in quite early and persisted throughout this episode. (3) Controlling for economic fundamentals, we also find that, during the taper tantrum, financial conditions deteriorated more in those EMEs that had earlier experienced larger private capital inflows and greater exchange rate appreciation. (4) For earlier episodes, we find little evidence of investor differentiation across EMEs being explained by differences in their relative vulnerabilities during EME crises of the 1990s and early 2000s. (5) That said, differentiation across EMEs based on fundamentals does not appear to be unique to the 2013 episode. Differences in economic fundamentals played a role in explaining the heterogeneous EME financial market responses during the global financial crisis of 2008, and the role of fundamentals appeared to progressively increase through the European crisis in 2011 and subsequently the 2013 taper tantrum.
Topic:
Economics, Emerging Markets, Markets, Exchange Rate Policy, Fiscal Policy, and Economic Crisis
Political Geography:
Global Focus

2. U.S. Unconventional Monetary Policy and Transmission to Emerging Market Economies

Author:
David Bowman, Juan M. Londono, and Horacio Sapriza
Publication Date:
06-2014
Content Type:
Commentary and Analysis
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We investigate the effects of U.S. unconventional monetary policies on sovereign yields, foreign exchange rates, and stock prices in emerging market economies (EMEs), and we analyze how these effects depend on country-specifc characteristics. We find that, although EME asset prices, mainly those of sovereign bonds, responded strongly to unconventional monetary policy announcements, these responses were not outsized with respect to a model that takes into account each country's time-varying vulnerability to U.S. interest rates affected by monetary policy shocks.
Topic:
Economics, Emerging Markets, Foreign Exchange, Markets, Monetary Policy, Exchange Rate Policy, Interest Rates, and Stock Markets
Political Geography:
North America and United States of America

3. Estimating U.S. Cross-Border Securities Positions: New Data and New Methods

Author:
Carol C. Bertaut
Publication Date:
08-2014
Content Type:
Commentary and Analysis
Institution:
Board of Governors of the Federal Reserve System
Abstract:
The role of capital flows in the buildup to the global financial crisis and the potential vulnerabilities posed by capital flows to emerging market economies highlight the importance of reliable and timely measures of cross-border investment activity to better monitor developments as they unfold. We present new monthly estimates of U.S. cross-border securities investment, combining information from detailed annual Treasury International Capital (TIC) surveys with new information from the TIC form SLT. We also show how changes in the new monthly data can be decomposed into flows, estimated valuation changes, and a residual "gap". These decompositions can provide a richer and timelier view of developments in both foreign portfolio investment in the U.S. and U.S. portfolio investment abroad than available from transactions data or survey data alone. Data on cross-border holdings through December 2013, by country, are available for download; we also provide advice on how to construct estimates going forward. These data can be combined with the existing Bertaut-Tryon monthly estimates of securities holdings (now updated through 2011) to generate consistent monthly time series of positions.
Topic:
Emerging Markets, Markets, Global Financial Crisis, Capital Flows, and Investment
Political Geography:
Global Focus

4. A Theory of Rollover Risk, Sudden Stops, and Foreign Reserves

Author:
Sewon Hur and Illenin O. Kondo
Publication Date:
02-2013
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Emerging economies, unlike advanced economies, have accumulated large foreign reserve holdings. We argue that this policy is an optimal response to an increase in foreign debt rollover risk. In our model, reserves play a key role in reducing debt rollover crises ("sudden stops"), akin to the role of bank reserves in preventing bank runs. We find that a small, unexpected, and permanent increase in rollover risk accounts for the outburst of sudden stops in the late 1990s, the subsequent increase in foreign reserves holdings, and the salient resilience of emerging economies to sudden stops ever since. Finally, we show that a policy of pooling reserves can substantially reduce the reserves needed by emerging economies.
Topic:
Economics, Emerging Markets, Risk, and Foreign Reserves
Political Geography:
Global Focus

5. Capital Flows to Emerging Market Economies: A Brave New World?

Author:
Shaghil Ahmed and Andrei Zlate
Publication Date:
06-2013
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We examine the determinants of net private capital inflows to emerging market economies. These inflows are computed from quarterly balance-of-payments data from 2002:Q1 to 2012:Q2. Our main findings are: First, growth and interest rate differentials between EMEs and advanced economies and global risk appetite are statistically and economically important determinants of net private capital inflows. Second, there have been significant changes in the behavior of net inflows from the period before the recent global financial crisis to the post-crisis period, especially for portfolio inflows, partly explained by the greater sensitivity of such .flows to interest rate differentials and risk aversion. Third, capital control measures introduced in recent years do appear to have discouraged both total and portfolio inflows. Fourth, in the pre-crisis period, there is some evidence that greater foreign exchange intervention to curb currency appreciation pressures brought more capital inflows down the line, but we cannot identify such an effect in the post-crisis period. Finally, we do not find statistically significant positive effects of unconventional U.S. monetary expansion on total net EME inflows, although there does seem to be a change in composition toward portfolio flows. Even for portfolio flows, U.S. unconventional policy is only one among several important factors.
Topic:
Emerging Markets, Monetary Policy, Economic Growth, Interest Rates, and Capital
Political Geography:
North America and United States of America

6. Global Financial Conditions, Country Spreads and Macroeconomic Fluctuations in Emerging Countries

Author:
Ozge Akinci
Publication Date:
08-2013
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper uses a panel structural vector autoregressive (VAR) model to investigate the extent to which global financial conditions, i.e., a global risk-free interest rate and global financial risk, and country spreads contribute to macroeconomic fluctuations in emerging countries. The main findings are: (1) Global financial risk shocks explain about 20 percent of movements both in the country spread and in the aggregate activity in emerging economies. (2) The contribution of global risk-free interest rate shocks to macroeconomic fluctuations in emerging economies is negligible. Its role, which was emphasized in the literature, is taken up by global financial risk shocks. (3) Country spread shocks explain about 15 percent of the business cycles in emerging economies. (4) Interdependence between economic activity and the country spread is a key mechanism through which global financial shocks are transmitted to emerging economies.
Topic:
Development, Emerging Markets, International Cooperation, Financial Crisis, and Global Financial Crisis
Political Geography:
Global Focus

7. Monetary Policy in Emerging Market Economies: What Lessons From the Global Financial Crisis?

Author:
Brahima Coulibaly
Publication Date:
02-2012
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
During the 2008-2009 global financial crisis, emerging market economies (EMEs) loosened monetary policy considerably to cushion the shock. In previous crises episodes, by contrast, EMEs generally had to tighten monetary policy to defend the value of their currencies, to contain capital flight, and to bolster policy credibility. Our study aims to understand the factors that enabled this remarkable shift in monetary policy, and also to assess whether this marks a new era in which EMEs can now conduct countercyclical policy, more in line with advanced economies. The results indicate statistically significant linkages between some characteristics of the economies and their ability to conduct countercyclical monetary policy. We find that macroeconomic fundamentals and lower vulnerabilities, openness to trade, and international capital flows, financial reforms, and the adoption of inflation targeting all facilitated the conduct of countercyclical policy. Of these factors, the most important have been the financial reforms achieved over the past decades and the adoption of inflation targeting. As long as EMEs maintain these strong economic fundamentals, continue to reform their financial sector, and adopt credible and transparent monetary policy frameworks such as inflation targeting, the conduct of countercyclical monetary policy will likely be sustainable.
Topic:
Economics, Emerging Markets, Monetary Policy, and Global Financial Crisis
Political Geography:
Global Focus

8. The Impact of Macroeconomic Announcements on Real Time Foreign Exchange Rates in Emerging Markets

Author:
Fang Cai and Hyunsoo Joo
Publication Date:
05-2009
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper utilizes a unique high-frequency database to measure how exchange rates in nine emerging markets react to macroeconomic news in the U.S. and domestic economies from 2000 to 2006. We find that major U.S. macroeconomic news have a strong impact on the returns and volatilities of emerging market exchange rates, but many domestic news do not. Emerging market currencies have become more sensitive to U.S. news in recent years. We also find that market sentiment could sway the impact of news on these currencies systematically, as good (bad) news seems to matter more when optimism (pessimism) prevails. Market uncertainty also interacts with macroeconomic news in a statistically significant way, but its role varies across currencies and news.
Topic:
Emerging Markets, Exchange Rate Policy, and Macroeconomics
Political Geography:
North America and United States of America

9. Labor Market Search in Emerging Economies

Author:
Emine Boz, Ceyhun Bora Durdu, and Nan Li
Publication Date:
12-2009
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper shows that labor markets of emerging economies are characterized by large fluctuations in wages while employment fluctuations are subdued. We find that a real business cycle model of a small open economy that embeds a Mortensen-Pissarides type of search-matching frictions can account for these aforementioned regularities. Moreover, the joint interaction of countercyclical interest rates and search-matching frictions can go a long way in accounting for higher consumption variability relative to output and countercyclical current account observed in emerging markets. Extending this baseline model to incorporate procyclical variations in the technical efficiency at which matches are generated, the model can match the unemployment variability observed in the data.
Topic:
Economics, Emerging Markets, and Labor Issues
Political Geography:
Global Focus

10. Emerging Market Business Cycles Revisited: Learning about the Trend

Author:
Emine Boz, Christian Daude, and Ceyhun Bora Durdu
Publication Date:
04-2008
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
The data reveal that emerging markets do not differ from developed countries with regards to the variance of permanent TFP shocks relative to transitory. They do differ, however, in the degree of uncertainty agents face when formulating expectations. Based on these observations, we build an equilibrium business cycle model in which the agents cannot perfectly distinguish between the permanent and transitory components of TFP shocks. When formulating expectations, they assign some probability to TFP shocks being permanent even when they are purely transitory. This is sufficient for the model to produce "permanent-like" effects in response to transitory shocks. The imperfect information model calibrated to Mexico predicts a higher variability of consumption relative to output and a strongly negative correlation between the trade balance and output, without the predominance of trend shocks. The same model assuming perfect information and calibrated to Canada accounts for developed country business cycle regularities. The estimated relative variance of trend shocks in these two models is similar.
Topic:
Economics, Emerging Markets, and Markets
Political Geography:
Canada and Mexico

11. An Anatomy of Credit Booms: Evidence From Macro Aggregates and Micro Data

Author:
Enrique G. Mendoza and Marco E. Terrones
Publication Date:
07-2008
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper proposes a methodology for measuring credit booms and uses it to identify credit booms in emerging and industrial economies over the past four decades. In addition, we use event study methods to identify the key empirical regularities of credit booms in macroeconomic aggregates and micro-level data. Macro data show a systematic relationship between credit booms and economic expansions, rising asset prices, real appreciations, widening external deficits and managed exchange rates. Micro data show a strong association between credit booms and firm-level measures of leverage, firm values, and external financing, and bank-level indicators of banking fragility. Credit booms in industrial and emerging economies show three major differences: (1) credit booms and the macro and micro fluctuations associated with them are larger in emerging economies, particularly in the nontradables sector; (2) not all credit booms end in financial crises, but most emerging markets crises were associated with credit booms; and (3) credit booms in emerging economies are often preceded by large capital inflows but not by financial reforms or productivity gains.
Topic:
Economics, Emerging Markets, International Trade and Finance, and Markets

12. The Asian Financial Crisis, Uphill Flow of Capital, and Global Imbalances: Evidence from A Micro Study

Author:
Brahima Coulibaly and Jonathan Millar
Publication Date:
08-2008
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This study assesses the role of the Asian Önancial crisis of the late 1990s in the emergence and persistence of the large current account surpluses across non-China emerging Asia, which have been a signiÖcant counterpart to the U.S. current account deÖcit. Using panel data encompassing nearly 3,750 Örms, we trace the current account surpluses to a marked and broad-based decline in corporate expenditures on Öxed investment in the aftermath of the crisis that cuts across a wide spectrum of countries, industries, and Örms. The lower corporate spending in turn depressed aggregate investment rates, widened the saving-investment gap, and allowed the region to turn into a net exporter of capital. We then consider the factors behind this reduction in postcrisis corporate investment. While weaker Örm-level fundamentals in the postcrisis period seem to explain part of the drop in investment rates, ongoing re-structuring owing to large debts accumulated and excess investment undertaken in the run-up to the crisis has been the main source of restraint postcrisis corporate investment. The results suggest that even after a decade, the e§ect of the Önancial crisis is still a§ecting corporate investment decisions in emerging Asia, and that as the restructuring completes its course, investment rates will likely rise to contribute to a gradual reduction in the regionís current account surpluses.
Topic:
Emerging Markets, Financial Crisis, Economic Inequality, and Investment
Political Geography:
Asia

13. Some Simple Tests of the Globalization and Inflation Hypothesis

Author:
Steven B. Kamin, Jaime Marquez, Jane Ihrig, and Deborah Lindner
Publication Date:
04-2007
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper evaluates the hypothesis that globalization has increased the role of international factors and decreased the role of domestic factors in the inflation process in industrial economies. Toward that end, we estimate standard Phillips curve inflation equations for 11 industrial countries and use these estimates to test several predictions of the globalization and inflation hypothesis. Our results provide little support for that hypothesis. First, the estimated effect of foreign output gaps on domestic consumer price inflation is generally insignificant and often of the wrong sign. Second, we find no evidence that the trend decline in the sensitivity of inflation to the domestic output gap observed in many countries owes to globalization. Finally, and most surprisingly, our econometric results indicate no increase over time in the responsiveness of inflation to import prices for most countries. However, even though we find no evidence that globalization is affecting the parameters of the inflation process, globalization may be helping to stabilize real GDP and hence inflation. Over time, the volatility of real GDP growth has declined by more than the volatility of domestic demand, suggesting that net exports increasingly are acting to buffer output from fluctuations in domestic demand.
Topic:
Economics, Emerging Markets, Globalization, International Trade and Finance, and Markets

14. Quantity Discounts from Risk Averse Sellers

Author:
Patrick J. DeGraba
Publication Date:
05-2005
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
It is widely believed that larger customers in a market can secure lower prices than smaller customers. This paper presents conditions under which risk averse sellers, who can distinguish larger customers from smaller customers, but who cannot observe customers' valuations, have an incentive to offer lower prices to larger customers. The intuition is that a single customer that demands a specific quantity represents a riskier profit source than multiple customers with independent valuations whose demands sum to that same quantity. Sellers respond to the riskier profit source by offering a lower price to reduce some of the risk.
Topic:
Economics, Emerging Markets, Industrial Policy, and International Trade and Finance

15. A Variance Screen for Collusion

Author:
Rosa M. Abrantes-Metz, Luke M. Froeb, John F. Geweke, and Charles T. Taylor
Publication Date:
03-2005
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
In this paper, we examine price movements over time around the collapse of a bid-rigging conspiracy. While the mean decreased by sixteen percent, the standard deviation increased by over two hundred percent. We hypothesize that conspiracies in other industries would exhibit similar characteristics and search for "pockets" of low price variation as indicators of collusion in the retail gasoline industry in Louisville. We observe no such areas around Louisville in 1996-2002.
Topic:
Economics, Emerging Markets, Industrial Policy, and International Trade and Finance

16. Optimal Inflation Persistence: Ramsey Taxation with Capital and Habits

Author:
Sanjay Chugh
Publication Date:
03-2005
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Ramsey models of fiscal and monetary policy with perfectly-competitive product markets and a fixed supply of capital predict highly volatile inflation with no serial correlation. In this paper, we show that an otherwise-standard Ramsey model that incorporates capital accumulation and habit persistence predicts highly persistent inflation. The result depends on increases in either the ability to smooth consumption or the preference for doing so. The effect operates through the Fisher relationship: a smoother profile of consumption implies a more persistent real interest rate, which in turn implies persistent optimal inflation. Our work complements a recent strand of the Ramsey literature based on models with nominal rigidities. In these models, inflation volatility is lower but continues to exhibit very little persistence. We quantify the effects of habit and capital on inflation persistence and also relate our findings to recent work on optimal fiscal policy with incomplete markets.
Topic:
Economics, Emerging Markets, Industrial Policy, and International Trade and Finance

17. Investment-Specific and Multifactor Productivity in Multi-Sector Open Economies: Data and Analysis

Author:
Luca Guerrieri, Dale W. Henderson, and Jinill Kim
Publication Date:
02-2005
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
In the last half of the 1990s, labor productivity growth rose in the U.S. and fell almost everywhere in Europe. We document changes in both capital deepening and multifactor productivity (MFP) growth in both the information and communication technology (ICT) and non-ICT sectors. We view MFP growth in the ICT sector as investment-specific productivity (ISP) growth. We perform simulations suggested by the data using a two-country DGE model with traded and nontraded goods. For ISP, we consider level increases and persistent growth rate increases that are symmetric across countries and allow for costs of adjusting capital-labor ratios that are higher in one country because of structural differences. ISP increases generate investment booms unless adjustment costs are too high. For MFP, we consider persistent growth rate shocks that are asymmetric. When such MFP shocks affect only traded goods (as often assumed), movements in 'international' variables are qualitatively similar to those in the data. However, when they also affect nontraded goods (as suggested by the data), movements in some of the variables are not. To obtain plausible results for the growth rate shocks, it is necessary to assume slow recognition.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States and Europe

18. The High-Frequency Effects of U.S. Macroeconomic Data Releases on Prices and Trading Activity in the Global Interdealer Foreign Exchange Market

Author:
Jonathan H. Wright, Alain P. Chaboud, Edward Howorka, David Liu, Sergey Chernenko, and Raj S. Krishnasami Iyer
Publication Date:
11-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We introduce a new high-frequency foreign exchange dataset from EBS (Electronic Broking Service) that includes trading volume in the global interdealer spot market, data not previously available to researchers. The data also gives live transactable quotes, rather than the indicative quotes that have been used in most previous high frequency foreign exchange analysis. We describe intraday volume and volatility patterns in euro-dollar and dollar-yen trading. We study the effects of scheduled U.S. macroeconomic data releases, first confirming the finding of recent literature that the conditional mean of the exchange rate responds very quickly to the unexpected component of data releases. We next study the effects of data releases on trading volumes. News releases cause volume to rise, and to remain elevated for a longer period. However, in contrast to the result for the level of the exchange rate, even if the data release is entirely in line with expectations, we find that there is still typically a large pickup in trading volume.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

19. Growth-Led Exports: Is Variety the Spice of Trade?

Author:
Joseph E. Gagnon
Publication Date:
11-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Fast-growing countries tend to experience rapid export growth with little secular change in their terms of trade. This contradicts the standard Armington trade model, which predicts that fast-growing countries can experience rapid export growth only to the extent that they accept declining terms of trade. This paper generalizes the monopolistic competition trade model of Helpman and Krugman (1985), providing a basis for growth-led exports without declining terms of trade. The key mechanism behind this result is that fast-growing countries are able to develop new varieties of products that can be exported without pushing down the prices of existing products. There is strong support for the new model in long-run export growth of many countries in the post-war era.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

20. The Value of Financial Intermediaries: Empirical Evidence from Syndicated Loans to Emerging Market Borrowers

Author:
Gregory P. Nini
Publication Date:
09-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Empirical estimates of the benefit of financial intermediation are constructed by examining the role played by local banks in facilitating syndicated loans to borrowers in emerging market countries. Assuming that local banks possess a superior monitoring ability, the market is ideal for studying the value of intermediation since cross-border lending into emerging markets is plagued by particularly high information and agency costs and the supply of local bank capital is in limited short run supply. Using variation in the propensity of local banks to participate in foreign arranged syndicates, there are two economically important results. First, local banks are much more likely to participate in unconditionally riskier loans. Second, after controlling for borrower characteristics, loan characteristics, and the endogeneity of the local bank lending decision, loans with local bank participation have spreads that are 10 percent lower (29 basis points) than otherwise similar loans. Combined, the results support the conclusion that local banks, a particularly special type of financial intermediary, provide value by considerably reducing financing costs, especially for riskier borrowers.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

21. What Makes Investors Over or Underweight? Explaining International Appetites for Foreign Equities

Author:
Carol C. Bertaut and Linda S. Kole
Publication Date:
09-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Using data from the IMF Coordinated Portfolio Investment Surveys conducted in 2001, we analyze the determinants of 31 countries' international equity holdings. We show that investors in all countries underweight U.S. equities in their portfolios, many by more than they underweight foreign equities in general. Such behavior is surprising given the common perception of the United States as a desirable investment destination due to its well-developed legal and regulatory environment. Instead we find that investors in some countries are overweight in equities from other countries with which they have close regional or political ties. Such ties, along with distance, trade, issuance of U.S. ADRs or cross-listing on the London Stock exchange, market concentration, and estimated betas help explain patterns of diversification. However, even when all these variables are included, we find significant fixed effects for most countries, suggesting that a considerable amount of cross-country variation in investment positions and in home bias remains to be explained. Our work confirms previous findings and extends results most completely documented for the United States to other major investor countries. But it also suggests caution should be used when interpreting results derived from studies of one or a few countries.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States and London

22. The Information Content of Forward and Futures Prices: Market Expectations and the Price of Risk

Author:
Jonathan H. Wright, Sergey V. Chernenko, and Krista B. Schwarz
Publication Date:
06-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Forward and futures rates are frequently used as measures of market expectations. In this paper we apply standard forecast efficiency tests, and some newer exact sign and rank tests, to a wide range of forward and futures rates, and in this way test whether these are in fact rational expectations of future actual prices. The forward and futures rates that we study under a common methodology include foreign exchange forward rates, U.S. and foreign interest rate futures and forward rates, oil futures and natural gas futures. For most, but not all, of these instruments, we find that we can reject the hypothesis that the forward or futures rates are rational expectations of actual future prices. It is well known that foreign exchange forward rates give less accurate forecasts than a random walk, but we show that this is also true for some interest rate futures and forward rates. We conclude that forward and futures prices are not generally pure measures of market expectations: they are also heavily affected by the market price of risk.
Topic:
Security, Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

23. Is Inflation Targeting Best-Practice Monetary Policy?

Author:
Jon Faust and Dale W. Henderson
Publication Date:
05-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We describe the inflation targeting framework (ITF) and compare it against hypothetical bestpractice based on optimization. The core requirements of the ITF are an explicit long-run inflation goal and a commitment to transparency in policymaking. Advocates and practitioners of the ITF have made many contributions to clear goal setting and communication by central banks. However, we contend that ITF communication policies both as advocated and practiced often have some elements that either obfuscate or, in some cases, explicitly contradict the dictates of optimization in a stabilization-policy paradigm. In this paradigm, the central bank has an objective function that places weight on both inflation and output-gap stabilization and faces a conventional (exploitable) Phillips-curve trade-off. We point out some problems that the ITF communication policy may generate in this setting. Our analysis leads us to make four suggestions for communication policy intended to help central banks avoid these problems.
Topic:
Security, Economics, Emerging Markets, and International Trade and Finance

24. Foreign Participation in Local-Currency Bond Markets

Author:
Francis E. Warnock and John D. Burger
Publication Date:
02-2004
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We analyze the development of, and foreign participation in, 49 local bond markets. Countries with stable inflation rates and strong creditor rights have more developed local bond markets and rely less on foreign-currency-denominated bonds. Less developed bond markets have returns characterized by high variance and negative skewness, factors eschewed by U.S. investors. Results based on a three-moment CAPM indicate, however, that it is diversifiable idiosyncratic risk that U.S. investors appear to shun. Taken as a whole our results hint at a virtuous cycle of bond market development: Creditor friendly policies and laws can spark local bond market development that enables the development of derivatives markets and, in turn, attracts foreign participation.
Topic:
Development, Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

25. China and Emerging Asia: Comrades or Competitors?

Author:
John W. Schindler, John G. Fernald, Prakash Loungani, and Alan J. Ahearne
Publication Date:
12-2003
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Do increases in China's exports reduce exports of other emerging Asian economies? We find that correlations between Chinese export growth and that of other emerging Asian economies are actually positive (though usually not significant), even after controlling for trading-partner income growth and real effective exchange rates. We also present results from a VAR estimation of aggregate trade equations on the relative importance of foreign income and exchange rates in determining Asian export growth. Although exchange rates do matter for export performance, the income growth of trading partners matters even more. In addition, we examine specific products and find evidence that a considerable shifting of trade patterns is taking place, consistent with a 'flying geese' pattern in which China and ASEAN-4 move into the product space vacated by the NIEs. Our results suggest that China and emerging Asia are both comrades (overall) and competitors (in specific products).
Topic:
Economics and Emerging Markets
Political Geography:
China and Asia

26. Precautionary Savings and the Wealth Distribution with Illiquid Durables

Author:
Joseph W. Gruber and Robert F. Martin
Publication Date:
09-2003
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We study the role an illiquid durable consumption good plays in determining the level of precautionary savings and the distribution of wealth in a standard Aiyagari model (i.e. a model with heterogeneous agents, idiosyncratic uncertainty, and borrowing constraints). Transactions costs induce an inaction region over which the durable stock and the associated user cost are not adjusted in response to changes in income, increasing, on average, the volatility of non-durable consumption. The volatility of total consumption is then a function of the share of the durable good in the utility function and the width of the inaction region. We are particularly interested in parameterizations which increase the precautionary motive for saving through an increase in "committed expenditure risk." We find, for an empirically relevant share of durable consumption and for all transaction costs below an upper threshold, that the level of precautionary savings is increasing in the transaction costs. Transaction costs have only a modest impact on the degree of wealth dispersion, as measured by the Gini index, as the associated increase in savings is close to linear in wealth. While we are unable to match the dispersion of wealth in the data, we increase the dispersion over a single asset model (Gini index of .71 for financial assets and .37 for total wealth) and we are able to match the relative dispersion of financial to durable assets, i.e. we find financial assets much more unequal than durable assets. We also match the ratio of housing wealth to total wealth for the median agent. We calibrate the model to data from the PSID, the CES, and the SCF.
Topic:
Economics, Emerging Markets, International Trade and Finance, and Science and Technology

27. Loans to Japanese Borrowers

Author:
David C. Smith
Publication Date:
07-2003
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper examines the characteristics of loans to Japanese borrowers using a relatively unexplored, contract-specific data set. I find that Japanese banks charge less on loans to Japanese borrowers than do foreign banks, holding constant many of the risk characteristics of the borrower. Moreover, Japanese banks vary pricing less across these risks than do foreign banks, suggesting that Japanese banks tend not to distinguish good risks from bad. Taken together, the results suggest that problems at Japanese banks stem from the behavior of the banks themselves, not simply from poor economic conditions. I also document a significant shortening in the maturity structure of Japanese loans in the late 1990s.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
Japan and Israel

28. U.S. Investors' Emerging Market Equity Portfolios: A Security-Level Analysis

Author:
Francis E. Warnock and Hali J. Edison
Publication Date:
07-2003
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We analyze a unique data set and uncover a remarkable result that casts a new light on the home bias phenomenon. The data are comprehensive, security-level holdings of emerging market equities by U.S. investors. We document, as expected, that at a point in time U.S. portfolios are tilted towards firms that are large, have fewer restrictions on foreign ownership, or are cross-listed on a U.S. exchange. The size of the cross-listing effect is striking. In contrast to the well-documented underweighting of foreign stocks, emerging market equities that are cross-listed on a U.S. exchange are incorporated into U.S. portfolios at full international CAPM weights. Our results suggest that information asymmetries play an important role in equity home bias and that the benefits of international risk sharing are limited to select firms.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

29. Cross-Border Listings, Capital Controls, and Equity Flows to Emerging Markets

Author:
Francis E. Warnock and Hali J. Edison
Publication Date:
07-2003
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We analyze capital flows to emerging markets in a framework that incorporates two quantitative measures of financial integration, the intensity of capital controls and the extent of cross-border listings, while controlling for traditional global (push) and country-specific (pull) factors. Two important results emerge. First, the cross-listing of an emerging market firm on a U.S. exchange is an important but short-lived capital flows event, suggesting that the cross-listed stock is in effect a new security that U.S. investors quickly bring into their portfolios. Second, the effect of financial liberalization on capital flows is more nuanced than is suggested by event studies: A reduction in capital controls results in increased inflows only when the controls were binding. Among the standard push and pull factors, global factors are important—slack U.S. economic activity is associated with increased flows to emerging markets—and U.S. investors appear to chase expected, but not past, returns.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

30. Was There Front Running During the LTCM Crisis?

Author:
Fang Cai
Publication Date:
02-2003
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper uses a unique dataset of audit trail transactions to examine the trading behavior of market makers in the Treasury bond futures market when Long-Term Capital Management (LTCM) faced binding margin constraints in 1998. Although identities are concealed in the dataset, I find strong evidence that during the crisis market makers in the aggregate engaged in front running against customer orders from a particular clearing firm (coded “PI7”) that closely match various features of LTCM's trades through Bear Stearns. That is, market makers traded on their own accounts in the same direction as PI7 customers did, but one or two minutes beforehand. Furthermore, a significant percentage of market makers made abnormal profits on most of the trading days during the crisis. Their aggregate abnormal profits, however, were more than offset by abnormal losses realized after the private sector recapitalization of LTCM. Moreover, I show that before the rescue, a market maker's cumulative abnormal profit was positively correlated both to her tie as contra party with PI7 and to the intensity of her front running, but these relationships turned negative after the rescue. The overall evidence suggests that the recapitalization plan effectively relaxed LTCM's binding constraints and therefore reversed the profitability of front running.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

31. Sticky Prices, No Menu Costs

Author:
David Bowman
Publication Date:
12-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
A model that contains no costs to changing prices but in which prices do not respond to nominal shocks is presented. In models that do not feature superneutrality of money flexible price equilibria will allow certain types of monetary shocks to affect the real economy. Sticky price behavior may in fact be better at protecting the real economy from the effects of monetary shocks in such environments. This point is demonstrated in a standard monetary model with liquidity effects. An equilibrium in which sticky prices are supported without menu costs is then constructed. In equilibrium firms choose to keep prices fixed in response to nominal shocks because doing so provides a service to their customers, increasing profits by expanding the customer base.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

32. The Road to Adopting the Euro: Monetary Policy and Exchange Rate Regimes in EU Candidate Countries

Author:
Fabio M. Natalucci and Federico Ravenna
Publication Date:
12-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper examines the choice of exchange rate regime in EU candidate countries during the process of accession to the European Monetary Union (EMU). In the presence of real exchange rate appreciation due to the Balassa-Samuelson effect, candidate countries face a trade-off between trend appreciation of the nominal exchange rate and high inflation rates. In a general equilibrium model of an emerging market economy, we show that under a fixed or heavily managed exchange rate the Balassa-Samuelson effect might prevent compliance with the Maastricht inflation criterion, unless a contractionary policy is adopted. We then discuss how the real exchange rate appreciation shifts the output gap/inflation variance trade-off, increasing the cost of managing or fixing the exchange rate. As a consequence, the requirement of membership in the Exchange Rate Mechanism (ERM-II) and the Maastricht inflation criterion constrain the policy choice while providing no additional benefit to countries credibly committed to joining the Euro. Finally, we show that relaxing either the exchange rate requirement or the inflation criterion has sharply different business cycle implications for the accession countries.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
Europe

33. Identifying the Effects of Monetary Policy Shocks on Exchange Rates Using High Frequency Data

Author:
John H. Rogers, Jonathan H. Wright, Jon Faust, and Eric Swanson
Publication Date:
10-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper proposes a new approach to identifying the effects of monetary policy shocks in an international vector autoregression. Using high-frequency data on the prices of Fed Funds futures contracts, we measure the impact of the surprise component of the FOMC-day Federal Reserve policy decision on financial variables, such as the exchange rate and the foreign interest rate. We show how this information can be used to achieve identification without having to make the usual strong assumption of a recursive ordering.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

34. Are Depreciations as Contractionary as Devaluations? A Comparison of Selected Emerging and Industrial Economies

Author:
Steven B. Kamin, Shaghil Ahmed, Christopher J. Gust, and Jonathan Huntley
Publication Date:
09-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
According to conventional models, flexible exchange rates play an equilibrating role in open economies, depreciating in response to adverse shocks, boosting net exports, and stimulating aggregate demand. However, critics argue that, at least in developing countries, devaluations are more contractionary and more inflationary than conventional theories would predict. Yet, it is not clear whether devaluations per se have led to adverse outcomes, or rather the disruptive abandonments of pegged exchange-rate regimes associated with devaluations. To explore this hypothesis, we estimate VAR models to compare the responses to devaluation of developing economies and two types of industrial economies: those that have consistently floated, and those that have sustained fixed exchange-rate regimes as well. We find that both of these types of industrial economies exhibit conventional (i.e., expansionary) responses to devaluation shocks, compared with the contractionary responses exhibited by developing countries. This finding suggests that exchange rate movements may be more destabilizing in developing countries than in industrial countries, regardless of exchange rate regime.
Topic:
Economics, Emerging Markets, Industrial Policy, and International Trade and Finance

35. Identifying the Role of Moral Hazard in International Financial Markets

Author:
Steven B. Kamin
Publication Date:
09-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Considerable attention has been paid to the possibility that large-scale IMF-led financing packages may have distorted incentives in international financial markets, leading private investors to provide more credit to emerging market countries, and at lower interest rates, than might otherwise have been the case. Yet, prior attempts to identify such distortions have yielded mixed evidence, at best. This paper makes three contributions to our ability to assess the empirical importance of moral hazard in international financial markets. First, it is argued that because large international "bailouts" did not commence until the 1995 Mexican crisis, financial indicators prior to that time could not have reflected a significant degree of this type of moral hazard. Therefore, one test for the existence of moral hazard is that the access of emerging markets to international credit is significantly easier than it was prior to 1995. Second, the paper argues that because private investors expect large-scale IMF-led packages to be extended primarily to economically or geo-politically important countries, moral hazard, if it exists, should lead these countries to have easier terms of access to credit than smaller, non-systemically important countries. Finally, in addition to looking at bond spreads, the focus of earlier empirical analyses of moral hazard, the paper also examines trends in capital flows to gauge the access of emerging market countries to external finance. Looking at the evidence in light of these considerations, the paper concludes that there is little support for the view that moral hazard is significantly distorting international capital markets at the present time.
Topic:
International Relations, Economics, Emerging Markets, and International Trade and Finance

36. On the Fragility of Gains from Trade under Continuously Differentiated Bertrand Competition

Author:
Mario Marazzi
Publication Date:
09-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
One of the most widely accepted principles of economics is the existence of gains from trade for every nation under certain conditions including perfect competition. In the last twenty years, trade economists have revolutionized the field by firmly establishing the possibility of modeling imperfectly competitive international markets. Despite this development, most still agree there are good reasons to believe that gains from trade are still present. However, we show that in the absence of international redistributions the presence of a positive profit sector in a general equilibrium model can lead to a situation in which some nations may lose from the reduction of international trade barriers.
Topic:
International Relations, Economics, Emerging Markets, and International Trade and Finance

37. A Theory of the Currency Denomination of International Trade

Author:
Philippe Bacchetta and Eric van Wincoop
Publication Date:
07-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Nominal rigidities due to menu costs have become a standard element in closed economy macroeconomic modeling. The "New Open Economy Macroeconomics" literature has investigated the implications of nominal rigidities in an open economy context and found that the currency in which prices are set has significant macroeconomic and policy implications. In this paper we solve for the optimal invoicing choice by integrating this microeconomic decision at the firm level into a general equilibrium open economy model. Strategic interactions between firms play a critical role in the analysis. We find that the less competition firms face in foreign markets, as reflected in market share and product differentiation, the more likely they will price in their own currency. We also show that when a set of countries forms a monetary union, the new currency is likely to be used more extensively in trade than the sum of the currencies it replaces.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

38. Macroeconomics of International Price Discrimination

Author:
Giancarlo Corsetti and Luca Dedola
Publication Date:
07-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This paper builds a baseline two-country model of real and monetary transmission under optimal international price discrimination. Distributing traded goods to consumers requires nontradables; because of distributive trade, the price elasticity of export demand depends on the exchange rate. Profit-maximizing monopolistic firms drive a wedge between wholesale and retail prices across countries. This entails possibly large deviations from the law of one price and incomplete pass-through on import prices. Yet, consistent with expenditure-switching effects, a nominal depreciation generally worsens the terms of trade. Moreover, the exchange rate and the terms of trade can be more volatile than fundamentals. For plausible ranges of the distribution margin, there can be multiple steady states, whereas large differences in nominal and real exchange rates across equilibria translate into small differences in consumption, employment and the price level. Finally, we show that with competitive goods markets international policy cooperation is redundant even under financial autarky.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

39. Identifying VARs Based on High Frequency Futures Data

Author:
Jonathan H. Wright, Jon Faust, and Eric Swanson
Publication Date:
02-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Using the prices of federal funds futures contracts, we measure the impact of the surprise component of Federal Reserve policy decisions on the expected future trajectory of interest rates. We show how this information can be used to identify the effects of a monetary policy shock in a standard monetary policy VAR. This constitutes an alternative approach to identification that is quite different, and, we would argue, more plausible, than the conventional short-run restrictions. We find that the usual recursive identification of the model is rejected, but we nevertheless agree with the literature's conclusion that only a small fraction of the variance of output can be attributed to monetary policy shocks.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

40. Inflation Targeting and Nominal Income Growth Targeting: When and Why Are They Suboptimal?

Author:
Dale W. Henderson and Jinill Kim
Publication Date:
02-2002
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
We derive optimal monetary stabilization rules and compare them to simple rules under both full and partial information. The nominal interest rate is the instrument of monetary policy. Special attention is devoted to inflation targeting and nominal-income-growth targeting. We use an optimizing-agent model of a closed economy which features monopolistic competition in both product and labor markets. A stabilization problem exists because there are one-period nominal contracts, either for wages alone or for both wages and prices, and three shocks that are unknown when contracts are signed. In order to highlight basic theoretical results, we deliberately keep our model simple enough that we can obtain exact solutions. Optimal rules maximize the expected utility of the representative agent subject to the information set of the policymaker. A key result, possibly surprising at first, is that even with monopolistic competition, the optimal full information policy makes the economy mimic the hypothetical equilibrium with flexible prices and wages. We explain why strict versions of inflation targeting, nominal income growth targeting, and other such simple rules are suboptimal under both full and partial information and derive flexible versions that are optimal under certain partial information assumptions. Nominal income growth targeting dominates inflation targeting for plausible parameter values.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

41. The Use of Cyclical Indicators in Estimating the Output Gap in Japan

Author:
Jane Haltmaier
Publication Date:
04-2001
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
The paper uses capital and labor utilization rates to derive estimates of the Japanese output gap and potential output. Two techniques are used. The first uses the cyclical indicators to adjust potential output estimates derived from a Hodrick-Prescott filter over the most recent period when such estimates are generally considered to be unreliable. The second estimates equilibrium levels of the cyclical indicators and uses an Okun's Law-type relationship to derive output gaps and potential output. The second method is also applied to the components of potential output to derive a third estimate. These methods suggest that the current Japanese output gap is considerably larger than a simple Hodrick-Prescott filter would suggest.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States and Japan

42. Home Bias and High Turnover Reconsidered

Author:
Francis E. Warnock
Publication Date:
04-2001
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
The Tesar and Werner (1995) finding of very high turnover rates on foreign equity portfolios is based on an underestimation of cross-border equity positions. Foreign turnover rates calculated using information from comprehensive benchmark surveys on cross-border holdings are much lower than previously reported and comparable to domestic turnover rates. However, the basic intuition from the Tesar-Werner study, that transaction costs do not help explain the observed home bias, is confirmed using data on transaction costs in 41 markets.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

43. A Retrospective on J. Denis Sargan and His Contributions to Econometrics

Author:
Neil R. Ericsson, Esfandiar Maasoumi, and Grayham E. Mizon
Publication Date:
03-2001
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
This retrospective provides a biographical history of Denis Sargan's career and reviews his contributions to econometrics, emphasizing the breadth of his work in both theoretical and applied econometrics. We include a complete bibliography for Denis and a list of PhD theses that he supervised--students were a substantive facet of his professional life. Finally, two of Denis's previously unpublished manuscripts on model building now appear in print.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States

44. Border Effects within the NAFTA Countries

Author:
John H. Rogers and Hayden P. Smith
Publication Date:
03-2001
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
Using consumer price indexes from cities in the U.S., Canada and Mexico, we estimate the "border effect" on U.S.-Mexican relative prices and find that it is nearly an order of magnitude larger than for U.S.-Canadian prices. However, during a very stable sub-period in Mexico (May 1988 to November 1994), the "width" of the U.S.-Mexican border falls dramatically and becomes approximately equal to the U.S.-Canadian border. We then show that when consideration is limited to cities lying geographically very close to the U.S.-Mexican border--San Diego, Los Angeles, Houston, Dallas, Tijuana, Mexicali, Juarez, and Matamoros--the border width falls compared to that estimated with the full sample of U.S. and Mexican cities, but falls only very slightly. We also present evidence that the border effect in U.S.-Mexican prices is not primarily due to the border effect in U.S.-Mexican wages. Finally, using the prices of 276 highly dis-aggregated goods and services, we estimate the variability of relative prices of different items within Mexican cities. This measure of relative price variability declines during the stable peso sub-period, but by less than the decline in nominal and real (i.e., CPI-based) exchange rate variability. Our results are strong evidence of a "nominal border effect" in relative prices within NAFTA, but also indicate that real side influences are important.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
United States, Canada, North America, and Mexico

45. Price Level Convergence, Relative Prices, and Inflation in Europe

Author:
John H. Rogers
Publication Date:
03-2001
Content Type:
Working Paper
Institution:
Board of Governors of the Federal Reserve System
Abstract:
If price levels are initially different across the euro area, convergence to a common level of prices would imply that inflation will be higher in countries where prices are initially low. Price level convergence thus provides a potential explanation for recent cross-country differences in European inflation, a worrisome development under the ECBs "one-size-fits-all" monetary policy. I present direct evidence on price level convergence in Europe, using a unique data set, and then investigate how much of the recent divergence of national inflation rates can be explained by price level convergence. I show that between 1990 and 1999 prices did become less dispersed in the euro area. Convergence is especially evident for traded goods, and more in the first half of the 1990s than the second half. By some measures, traded goods price dispersion across the euro area is now close to that across U.S. cities. Despite an on-going process of convergence, deviations from the law of one price are large. Finally, I find a statistically-significant and robust negative relationship between the 1999 price level and 2000 inflation rate in Europe, and that the contribution of price level convergence to explaining inflation differentials is often quite important economically. Still, factors other than price convergence explain most of the cross-country inflation differences.
Topic:
Economics, Emerging Markets, and International Trade and Finance
Political Geography:
Europe