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International Capital Flows and U.S. Interest Rates Francis Warnock and Veronica Warnock Discussion by Aart Kraay The World Bank International Monetary Fund 7th Jacques Polak Annual Research Conference November 9, 2006 The views expressed in this paper are those of the author(s) only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the paper. WW on Foreign Flows and US Interest Rates • Do foreign purchases of US debt significantly affect US interest rates? – tighter short-term interest rates since 2003 have not led to much higher long-term interest rates • Estimate an IS/LM motivated empirical specification for US long-term interest rates (10-yr Treasuries) – foreign (official) purchases have large effects on US interest rates (90 basis points!) • Unspoken implication: what will happen when foreigners stop bailing out Uncle Sam? Discussion • Nice paper on an interesting question! – surely captures an important driver of interest rates given large foreign participation in US bond markets • Large foreign flows during the 2000s consistent with low interest rates despite large budget deficits – but can they explain the second half of the 1990s? – is the stock market boom/bubble the missing ingredient? • How exogenous are foreign official purchases of US Treasuries? – are they a pure demand shock? – possible correlations with shocks to supply? Budget Deficits and Interest Rates • There has been a dramatic weakening of the relationship between budget deficits and interest rates • 1981-1995: High deficits, high r • 1996-2000: Low deficits, high r • 2001-2005: High deficits, low r • WW story (large foreign capital inflows keep rates low) surely helps to explain part of last period • But why were interest rates relatively high 1996-2000 despite: – low budget deficits (and even small surpluses)? – significant foreign capital inflows? Budget Deficits and Interest Rates 5.0% 9 4.5% 8 4.0% 7 6 3.0% 5 2.5% 4 2.0% 3 1.5% 1.0% 2 0.5% 1 0.0% 0 1981-85 1986-90 1991-95 1996-00 Budget Deficit/GDP (Left Axis) Ex-Post Real 1-Yr Treasury Bill Rate (Right Axis) 2001-05 Percent Percent of GDP 3.5% Foreign Official Holdings of US Treasuries (BEA) /Total Public Debt (CBO) Foreign Holdings of US Public Debt 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 1975 1980 1985 1990 1995 2000 2005 Simple Alternative/Complementary Story • Stock market booms (or bubbles?) in second half of 1990s – public debt has to offer a higher return in order to induce investors to hold it • Stock market crashes (or bursts?) in first half of 2000s – public debt no longer has to offer such a high return in order to induce investors to hold it • Kraay and Ventura (2005) “The Dot-Com Bubble...” provide a model with dynamic inefficiencies in which this operates – 1990s: stock market bubble eliminates inefficient investments and raises welfare – 2000s: bubble bursts but expanding public debt enhances welfare in same way – stock market bubble and public debt compete for saving U.S. Stock Market Boom and Bust 600 Share Price Index (1990=100) 500 400 300 200 100 0 1980 1985 1990 1995 2000 2005 Do Growth Expectations Capture This? Are Foreign Official Purchases Exogenous? • WW identification strategy hinges on interpreting foreign official purchases as pure shocks to demand for US Treasuries – not implausible – after all, who knows what motivates foreign central bankers? – hard to assess precisely because of data limitations, and confidentiality of foreign central bank holdings • “benchmark consistent flows” more accurate measure of total foreign (not just foreign official) purchases • “TIC-reported foreign official flows” a lower bound on even foreign official flows • purchases by individual central banks confidential • What if shocks to demand for US Treasuries correlated with shocks to supply? Exogenous Foreign Official Purchases (1)? • Recycling of petrodollars? – shock is high oil prices – revenues from high oil prices reinvested in US Treasuries (outward shift in demand) – what if high oil prices also slow US economic activity leading to higher budget deficits (outward shift in supply)? – observed fall in interest rates understates effect of foreign purchases Exogenous Foreign Official Purchases (2)? • Dooley, Folkerts-Landau, and Garber story of the new Bretton Woods system (a.k.a. “The Giant Communist-Capitalist Conspiracy”) – Chinese Central Bank buys US Treasuries to “bribe” US for access to export markets – Cyclical implications not spelled out by DFG, but presumably value of access to US markets is higher when US in boom • higher bribe value (outward shift in demand) • lower budget deficits (inward shift in supply) • overstate effect of foreign purchases on interest rates Conclusion • Again, nice paper on an interesting question, that surely is picking up an important effect of foreign bond purchases on US interest rates • Hard to think about portfolio considerations in IS/LM framework, possibly shocks to other asset returns explain low interest rates • Finding exogenous shocks to foreign purchases is hard, even foreign official purchases may not be sufficiently exogenous, although direction of bias is unclear