Download Gains from Financial Globalization

Gains from Financial Globalization
First, we study factors that limit international borrowing and lending. Second, we
see how a nation’s ability to use international financial markets allows it to
accomplish three different goals:
1. Consumption smoothing (keeping consumption steady as income fluctuates)
2. Efficient investment (borrowing to invest in productive capital)
1. Diversification of risk (trading of financial assets between countries)
Limits on Borrowing from Abroad: the long-run budget constraint
• The ability to borrow in times of need and lend in times of prosperity
has profound effects on a country’s well-being.
• We first derive the long-run budget constraint (LRBC) - the constraint
that limits a country’s foreign borrowing in the long run.
• The LRBC shows precisely how and why a country must, in the long
run, “live within its means.” use changes in an open economy’s
external wealth to derive
The long-run budget constraint
• A household borrows $100,000 at 10% annually. The household can deal with its
debt in different ways, for example:
• Case 1 The debt is serviced. The borrower pays the interest but never needs
to repay any principal.
• Case 2 The debt is not serviced. The borrower pays neither interest nor
principal. The debt grows by 10% every year.
• Case 2 is not sustainable. This is often called a rollover scheme, a pyramid
scheme, or a Ponzi game. This case illustrates the limits on the use of borrowing.
• In the long run, lenders will simply not allow the debt to grow beyond a certain
point. This requirement is the essence of the long-run budget constraint.
The Long-Run Budget Constraint For a Country
What we assume:
1. Prices are perfectly flexible. All analysis can be conducted in terms
of real variables, so that monetary aspects of the economy can be
ignored.
2. The country is a small open economy. The country cannot influence
prices in world markets for goods and services.
3. All debt carries a real interest rate r*, the world real interest rate,
which is constant. The country can lend or borrow an unlimited
amount at this interest rate.
The Long-Run Budget Constraint For a Country
More assumptions we make:
4. The country pays a real interest rate r* on its start-of-period debt
liabilities L and is paid the same interest rate r* on its start-ofperiod debt assets A.
Net interest income payments equal to r*A minus r*L, or r*W,
where W is external wealth (A − L) at the start of the period.
5. There are no unilateral transfers (NUT = 0), no capital transfers
(KA = 0), and no capital gains on external wealth.
Under these assumptions, there are only two nonzero items in
the current account: the trade balance and net factor income
from abroad, r*W.
Calculating the Change in Wealth Each Period
WN 
WN  WN –1

 TBN

Change in external wealth
this period

Trade balance
this period
*
r WN –1

Interest paid/received
on last period's external wealth
Calculating Future Wealth
WN

External wealth at
the end of this period
 TBN

Trade balance
this period

(1  r ) WN –1

*
Last period's external wealth
plus interest paid/received
The Budget Constraint in a Two-Period Example
At the end of year 0, W 0  (1  r* )W 1  TB0
Assume that all debts owed or owing must be paid off, and the country
must end that year with zero external wealth.
 of year 1
At the end
W1  0  (1  r * )W0  TB1
Substituting, we get
W1  0  (1  r * ) 2W1  (1  r * )TB0  TB1
The two-period budget constraint is
(1  r* ) 2 W 1  (1  r* )TB0  TB1
A two-period example
Let W-1 = - $110 million, and r = 10%
• To pay off $110 million at the end of period 1, the country must have
a present value of future trade balances of +$110 million.
• The country could run a trade surplus of $110 million in period 0, or it
could wait to pay off the debt until the end of period 1, and run a
trade surplus of $121 million in period 1.
• Or it could use any other combination of trade balances in periods 0
and 1 that allow it to pay off the debt with the accumulated
interested so that external wealth at the end of period 1 is zero.
The long-run budget constraint in general
We let N go to infinity to get the equation of the LRBC:
 (1  r )W1

*
Minus the present value of
wealth from last period
TB3
TB1
TB2
TB4
 TB0 




*
* 2
* 3
* 4
(1  r ) (1  r ) (1  r ) (1  r )

Present value of all present and future trade balances
• A debtor (surplus) country must have future trade balances that are
offsetting and positive (negative) in present value terms.
A Long-Run Example: The Perpetual Loan
• The formula below helps us compute PV(X) for any stream of constant
payments:
X
X
X
X
PV ( X ) 


  *
*
* 2
* 3
(1  r ) (1  r ) (1  r )
r
• For example, the present value of a stream of payments on a
perpetual loan, with X = 100 and r*=0.05, equals 2,000:
100
100
100



2
3
(1  0.05) (1  0.05)
(1  0.05)

100
 2,000
0.05
Implications of the LRBC for GNE and GDP
• The LRBC tells us that in the long run, a country’s national expenditure
(GNE) is limited by how much it produces (GDP). To see this, we use the
equation for the LRBC and the fact that
TB  GDP  GNE
GDP1
GDP2
GNE1
GNE2
(1  r )W1  GDP0 

   GNE0 


*
*
2
*
*
2

(1  r ) (1  r )
(1 r ) (1  r )
PV of wealth
 
*
from last period
PV of current and future GDP
PV of current and future GNE
• The left side of this equation is the present value of resources of the
country in the long run: the present value of any inherited wealth plus
the present value of present and future product.
• The right side is the present value of all present and future spending
(C + I + G), measured by GNE.
The Limits on Borrowing
• The long-run budget constraint says that in the long run, in present
value terms, a country’s expenditures (GNE) must equal its production
(GDP) plus any initial wealth.
• The LRBC therefore shows quite precisely how an economy must live
within its means in the long run.
The U.S LRBC and Exorbitant Privilege
• Since the 1980s, the United States has been a net debtor, W = A − L < 0.
Negative external wealth would lead to a deficit on net factor income from
abroad: r*W= r* (A − L) < 0. But we learned that U.S. net factor income
from abroad has been positive for decades. How can this be?
• The only way a net debtor can earn positive net interest income is by
receiving a higher rate of interest on its assets than it pays on its liabilities.
• In the 1960s, Charles de Gaulle, complained about the United States’
“exorbitant privilege” of being able to borrow cheaply while earning higher
returns on U.S. external assets.
The U.S LRBC: more benefits
• The U.S. has long received positive capital gains, KG, on its external
wealth.
• These large capital gains on external assets and the smaller capital
losses on external liabilities are not the result of price or exchange
rate effects. They are gains that cannot be otherwise measured. As a
result, some skeptics call these capital gains “statistical manna from
heaven.”
• This financial gain for the U.S. is a loss for the rest of the world. As a
result, some economists describe the United States as more like a
“venture capitalist to the world” than a “banker to the world.”
The U.S LRBC
• Adding the 2% capital gain differential to the 1.5% interest
differential, we end up with a U.S. total return differential (interest
plus capital gains) of about 3.5% per year since the 1980s. In the
same period, the total return differential was about zero in every
other G7 country.
• Adding these additional effects to the budget constraint for the U.S.,
we get
WN 
WN  WN –1

Change in external wealth
this period
 TBN


Trade balance
this period
r *WN –1

Interest paid/received
on last period’s external wealth

(r *  r 0 ) L


Income due
to interest rate differenti al

KG

Capital gains
on external wealth




 
Conventional effects
Additionaleffects
External Wealth of the United States: Favorable Interest Rates and Capital
Gains
Emerging Markets
• The United States borrows low and lends high. For most poorer
countries, the opposite is true. Because of country risk, investors
typically expect a risk premium before they will buy any assets issued
by these countries, whether government debt, private equity, or FDI
profits.
Public debt and bond
ratings
Problems for Emerging Market Borrowers
In a sudden stop, a borrower country sees its financial account surplus rapidly
shrink.
The math of the long-run budget constraint
• Begin with the standard identity for the change in external wealth:
WN  WN  WN –1  CAN  KAN  KG N
• The change in a country’s external wealth equals the sum of the CA
and KA plus capital gains on external wealth, KG .
• Replacing the current account with its components leads to
WN  WN  WN –1  TBN  r WN –1  NUTN  KAN  KG N
*
• Next, we can rearrange this to write external wealth at the end of
year N as


WN  1  r WN –1  TBN  NUTN  KAN  KG N
*
The math of the long-run budget constraint
• To keep the algebra simple, for the time being, we will assume that
NUTN  KAN  KG N  0
• We find a relationship between external wealth this year and future
year’s trade balances, TB, by repeatedly adding equations like this to
get


WN  1  r * WN –1  TBN
WN 1
TBN 1
 WN 
*
*
1 r
1 r
WN  2
1  r 
* 2
WN 1 TBN  2


2
*
*
1 r
1 r


The math of the long-run budget constraint
Adding these three identities leads to


WN 1
WN  2
WN 1
TBN 1 TBN  2
*
WN 

 1  r WN –1  WN 
 TBN 

2
2
*
*
*
*
*
1 r
1 r
1 r
1 r
1 r



Cancelling terms that appear on both sides of the equation gives us
WN  2
1  r 
* 2


TBN 1 TBN  2
 1  r WN –1  TBN 

*
* 2
1 r
1 r
*



The math of the long-run budget constraint
Extrapolating leads to our equation,


TBN 1 TBN  2
TBN 3
0  1  r WN –1  TBN 


 ...
2
3
*
*
*
1 r
1 r
1 r
If
WN T
1  r 
* T
*

 

0
This means that WN T does not grow as 1 r
some country’s debt is growing explosively.

* T
or faster. If it did,
The math of the long-run budget constraint
• The LRBC is


TBN 1 TBN  2
TBN 3
 1  r WN –1  TBN 


 ...
2
3
*
*
*
1 r
1 r
1 r
*

 

• If NUT  KA  KG is not zero, TB is replaced by TB  NUT  KA  KG
• For the U.S., we will also need to include r *  r0  LN 1
1. The Gains from Consumption Smoothing
Some additional assumptions:
• GDP is denoted Q. Output is produced using only labor. Production of
GDP may be subject to shocks.
• Think of a country as a collection of households. Households prefer
consumption C that is constant over time, or smooth.
• The country must satisfy the long-run budget constraint.
Gains from Consumption Smoothing
• For now, assume investment I and government spending G are zero.
In this case, GNE equals C.
• At time 0, the country has zero initial wealth, W−1 =0.
• Assume the country is small and the rest of the world (ROW) is large,
and the prevailing world real interest rate is constant equal to r.
Gains from Consumption Smoothing
These assumptions give us a special case of the LRBC that requires the
present value of current and future trade balances to equal zero
(because initial wealth is zero):
W-1 = 0 = Present value of TB =
Present value of Q - Present value of C
That is,
Present value of GDP = Present value of GNE
Closed Versus Open Economy: No Shocks
A Closed or Open Economy with No Shocks Output equals consumption.
Trade balance is zero. Consumption is smooth.
Closed versus Open Economy: Shocks
A Closed Economy with Temporary Shocks Output equals consumption.
Trade balance is zero. Consumption is volatile.
Closed versus Open Economy: Shocks
An Open Economy with Temporary Shocks A trade deficit is run when output
is temporarily low. Consumption is smooth. When output fluctuates, a
closed economy cannot smooth consumption, but an open one can.
Gains from Consumption Smoothing
• Suppose output Q and consumption C are initially constant, equal (Q
= C), and external wealth is zero. The LRBC is satisfied.
• If output falls in year 0 by ΔQ, for just one year and then returns to its
level for all future periods, then the present value of output
decreases by ΔQ.
• To meet the LRBC, a closed economy reduces its consumption by the
whole ΔQ in year 0.
• An open economy can smooth its consumption by reducing C every
year by a smaller amount, so that ΔC < ΔQ.
Gains from Consumption Smoothing
• A loan of ΔQ − ΔC in year 0 requires interest payments of r*(ΔQ − ΔC)
in future years. Beginning in year 1, trade surpluses of ΔC equal these
interest payments. The change in ΔC is chosen so that C is constant.
r ´ (DQ - DC) = DC
*
• Rearranging,
r*
C 
Q
*
1 r
Smoothing Consumption when a Shock Is Permanent
• With a permanent shock, output falls by ΔQ forever, so the only way
either a closed or open economy can satisfy the LRBC and smooth
consumption is to cut consumption by ΔC= ΔQ every year.
• Comparing the results for a temporary shock and a permanent shock:
consumers can smooth out temporary shocks, but they must adjust
completely to permanent shocks.
Summary
• Financial openness allows countries to “save for a rainy day.” Without
financial institutions to lend or borrow, you have to spend what you
earn each period.
• Using financial transactions to smooth consumption fluctuations
makes a household and/or country better off.
• In an open economy, consumption can be smoothed by running a
trade deficit in bad times and a trade surplus in good times.
• Deficits and surpluses can be used to finance emergency spending.
Consumption smoothing and war
Japan’s gross saving and investment during the RussoJapanese War, 1904-1905
Year
Saving/GDP
Investment/GDP
1903
0.131
0.136
1904
0.074
0.120
1905
0.058
0.168
1906
0.153
0.164
Wars and U.K. Current Account and Government Deficits
Consumption Volatility and Financial Openness
• Does the evidence show that countries avoid consumption volatility
by embracing financial globalization?
• The ratio of a country’s consumption volatility to its output volatility
should fall if openness fosters consumption smoothing.
• Since not all shocks are global, countries ought to be able to achieve
some reduction in consumption volatility through external finance.
Consumption Volatility and Financial Openness
• The lack of evidence suggests that some of the relatively high consumption
volatility must be unrelated to financial openness.
• Consumption-smoothing gains in emerging markets require improving poor
governance and weak institutions, developing their financial systems, and
limited financial integration.
Precautionary Saving, Reserves, and Sovereign Wealth Funds
• Countries may engage in precautionary saving: the government
accumulates a buffer of external assets.
• Two forms of precautionary saving by governments:
(1) Foreign reserves held by central banks;
(2) Sovereign wealth funds - state-owned asset management
companies invest some of the government savings.
2. Gains from Efficient Investment
• On the investment side, financial openness can improve a country’s
ability to increase capital and take advantage of new production
opportunities.
• Assume that production requires both labor and capital. Capital is
created over time through investment. The LRBC must be modified to
include investment I as a component of GNE. We still assume that G is
zero.
• When initial wealth is 0 , the LRBC is:
0 = Present value of TB
Gains from Efficient Investment
• Because Present value of TB = 0,
Present value of Q = Present value of C + Present value of I
• A closed economy, external borrowing and lending are not possible,
and the trade balance is zero in all periods.
• An open economy, borrowing and lending are possible, the trade
balance can be more or less than zero, and the LRBC must be
satisfied.
Efficient Investment: A numerical example
Q = 100, C = 100, I = 0, TB = 0, and W = 0.
A shock in year 0 arrives as a new investment opportunity requiring an
expenditure of 16 units. This will pay off in future years, increasing the
country’s output by 5 units in year 1 and all subsequent years (but not
in year 0).
With investment, output is 100 today and 105 in every subsequent
year. The present value of this output is 100 + 105/0.05 = 2,200. The
present value of consumption must equal Q – I = 2,200 – 16 = 2,184.
Efficient Investment: A numerical example
Efficient Investment
• A new investment opportunity requires ΔK units of output in year 0.
This investment will lead to ΔQ more units of output every year
starting in year 1.
• The rise in PV(Q) comes from extra output in every year but year 0:
Change in present value of output
Q
Q
Q




*
* 2
* 3
(1  r )
(1  r )
(1  r )
Q
 *
r
• The change in PV(I) is ΔK. Investment will increase the present value
of consumption if and only if ΔQ/r* ≥ ΔK.
Efficient Investment
• Rearranging, the investment should be made if
Q  r  K
*
• Dividing by ΔK,
Q
 r*
K
• Firms invest if the MPK, is at least as great as the real interest rate.
Gains from Efficient Investment
• In an open economy, firms borrow and repay to make investments
that maximizes the PV of output.
• An open economy should investment until its MPK equals the world
real rate of interest.
• Financial openness allows countries to increase investment and
smooth consumption at the same time.
• In a closed economy, the consumption cost of investment cannot be
smoothed.
Example: North Sea oil boom and Norwegian investment
Gains from Efficient Investment
• These imply that capital should flow to higher MPK countries from
lower MPK countries.
• Since poor countries have low ratios of capital to labor, the MPK of
capital should be higher in poorer countries than in rich (all else
equal).
Using the Production Function: output per worker, q = Q/L, is a function
of capital per worker, k = K/L, and productivity A.
Gains from Efficient Investment
• A standard and widely used production function is written
q  
A  k
Productivity Capital
Output
per
worker
level

per
worker
• where 𝜃 is a number between 0 and 1 that measures the contribution
of capital to production. 𝜃 is the elasticity of capital with respect to
output and is about 1/3. The productivity level A is set at a reference
level of 1. Then:
q  k 1/ 3
• MPK is the slope of the production function, is given by
q
q
 1
 Ak   
MPK 
k
k
• Mexico’s output per
worker is about 43%
of that for the U.S.
• If the level of
productivity, A, is the
same, then k for
Mexico is 43% of k for
the U.S.
• Investment in Mexico
should increase k and
output per worker
until they are the
same as in the U.S.
Why Doesn’t Capital Flow to Poor Countries?
• This doesn’t happen in reality. Poor and rich countries have different
levels of productivity. MPK may not be much higher in poor countries
than it is in rich countries.
• Instead, output is proportional to A given capital per worker:
q  A k
If MPK is the same between the two countries, output per worker and
capital per worker are lower in the country with a lower A.
q
MPK   
k
• The poorer country
(Mexico) is now at C
and not at B.
Investment increases k
only until MPK is the
same as in the U.S. at
point D.
• Capital per worker k
and output per worker
q do not converge to
the levels seen in the
rich country.
Why Doesn’t Capital Flow to Poor Countries?
This is called the Lucas paradox from Nobel laureate Robert Lucas’
article “Why Doesn’t Capital Flow from Rich to Poor Countries?”
Lucas noted that if international financial markets are open to free
movements of resources, then investment goods should flow from rich
to poor countries and investment should be very low in wealthy
countries.
What if Countries Have Different Productivity Levels?
• Suppose that
AUS  AMEX
and output is produced in each country using the technologies
qUS  AUS kUS

qMEX  AMEX k MEX

The MPKs are related as
MPK MEX
[qMEX / k MEX ] qMEX / qUS


MPKUS
[qUS / kUS ]
k MEX / kUS
What if Countries Have Different Productivity Levels?
If
then
MPK MEX  MPKUS  r *
qMEX AMEX

qUS
AUS
 k MEX

 kUS




Capital per worker in Mexico is about 1/3 of the ratio of capital per
worker in the U.S.. If Mexico has the same productivity as the U.S., then
Mexico’s output per worker should be about is about 69% of U.S.
1
output per worker. That is,

Instead, it is 43% as much.
 k MEX
qMEX
 
qUS
 kUS

1 3

     0.69
3

What if Countries Have Different Productivity Levels?
If the MPK is equal between Mexico and the U.S., we can estimate the
difference between productivity levels in Mexico and the U.S. using this
equation,
qMEX AMEX

qUS
AUS
 k MEX

 kUS


AMEX
 
AUS

1
3
1
  .
3
If the MPK’s are equal, then Mexico’s productivity level should be 63%
of the U.S. productivity level.
Comparing A and k
as sources of output differences
Comparing A and k
as sources of output differences
Comparing A and k as sources of output differences
• Differences in A could reflect a country’s technical efficiency,
construed narrowly as a function of its technology and management
capabilities.
• Many economists believe that the level of A may primarily reflect a
country’s social efficiency, construed broadly to include institutions,
public policies, and cultural differences.
• Indeed, some evidence that, among poorer countries, more capital
does tend to flow to the countries with better institutions.
Comparing A and k as sources of output differences
Other factors may also explain the lack of convergence.
• Differences in MPK could be due to the cost of risk investing in an
emerging market (e.g., risks of regulatory changes, tax changes,
expropriation, and other political risks).
• Risk premiums can be substantial in practice: for example, before the
global financial crisis, the risk premium for Argentina was 25%, but for
Mexico, it was 3%.
Risk Premiums in Emerging Markets
The risk premium
measures the difference
between the interest rate
on the country’s long-term
government debt and the
interest rate on long-term
U.S. government debt.
The larger the risk
premium, the more
compensation investors
require, given their
concerns about the
uncertainty of repayment.
Gains for Diversification of Risk
• Diversification can help smooth shocks by promoting risk sharing.
With diversification, countries may be able to reduce the volatility of
their incomes (and hence their consumption levels) without any net
lending or borrowing.
• An example: Two countries, A and B, with outputs that fluctuate
asymmetrically.
Two possible “states of the world,” with equal probability of
occurring. State 1 is a bad state for A and a good state for B; state 2 is
good for A and bad for B.
We assume that all output is consumed (there is no investment or
government spending). Output is divided 60-40 between labor income
and capital income.
Gains for Diversification of Risk - example
• No diversification means that each country owns 100% of its capital.
Output is the same as income.
Suppose that in state 1, A’s output is 90, of which 54 units are
payments to labor and 36 units are payments to capital
In state 2, A’s output rises to 110, and factor payments rise to 66 for
labor and 44 units for capital.
The opposite is true in B: in state 1, B’s output is higher than it is in
state 2.
The variation of GNI about its mean of 100 is plus or minus 10 in
each country. Because households prefer smooth consumption, this
variation is undesirable.
Example without diversification
Gains for Diversification of Risk - example
• Diversification allows the two countries to partially smooth national
income by holding portfolios of capital assets in each country.
For example, each country could own half of the domestic capital
stock, and half of the other country’s capital stock. Indeed, this is what
standard portfolio theory says that investors should try to do.
For our example, capital income is smoothed at 40 units for each
country (same in each state 1 or 2). Total capital income is 80 in each
state, so each country receives a constant share of 40.
Because labor income is not shared, each country’s GNI still
fluctuates around a mean of 60 by plus or minus 6.
Example with diversification
Gains for Diversification of Risk - example
• What happens if each country owns 100 percent of other country’s
capital stock?
• In state 1 (bad for Country A), A’s labor income is 54. Capital income
in country B belongs to country A and equals 44. GNI for Country A is
now 54 + 44 = 98.
• In state 2 (good for Country A), A’s labor income is 66 and its income
from capital (in Country B) is 36. GNI for Country A equals 102.
• GNI fluctuates around a mean of 100 plus or minus only 2 in each
country.
Example with more diversification
Gains for Diversification of Risk and the Balance of Payments
• Consider country A. In state 1 (bad for A, good for B), A’s income or
GNI exceeds A’s output. The extra income is net factor income from
abroad, which is the difference between the income earned on A’s
external assets and the income paid on A’s external liabilities. With
that net factor income, country A runs a negative trade balance,
which means that A can consume more than it produces.
• Adding the trade balance of –4 to net factor income from abroad of
+4 means that the current account is 0, and there is still no need for
any net borrowing or lending.
• These flows are reversed in state 2 (good for A, bad for B).
Capital income smoothing
• Each country’s payments to capital are volatile. A portfolio of 100%
country A’s capital or 100% of country B’s capital has capital income
that varies by plus or minus 4 (between 36 and 44). But a 50-50 mix
of the two leaves the investor with a portfolio of minimum, zero
volatility (it always pays 40).
• In general, there will be some common shocks, which are identical
shocks experienced by both countries. In this case, there is no way to
avoid this shock by portfolio diversification.
• But as long as some shocks are asymmetric, the two countries can
take advantage of gains from the diversification of risk.
Return Correlations and Gains from Diversification The charts plot the volatility of capital income against the share of the
portfolio devoted to foreign capital. The two countries are identical in size and experience shocks of similar amplitude. In panel
(a), shocks are perfectly asymmetric (correlation = −1), capital income in the two countries is perfectly negatively correlated.
Risk can be eliminated by holding the world portfolio, and there are large gains from diversification.
Return Correlations and Gains from Diversification (continued)
In panel (b), shocks are perfectly symmetric (correlation = +1), capital income in the two countries is perfectly positively
correlated. Risk cannot be reduced, and there are no gains from diversification.
In panel (c), when both types of shock are present, the correlation is neither perfectly negative nor positive. Risk can be
partially eliminated by holding the world portfolio, and there are still some gains from diversification.
Limits to Diversification: Capital versus Labor Income
• Labor income risk (and hence GDP risk) may not be diversifiable
through the trading of claims to labor assets or GDP.
• But capital and labor income in each country are perfectly correlated,
and shocks to production tend to raise and lower incomes of capital
and labor simultaneously. This means that, as a risk-sharing device,
trading claims to capital income can substitute for trading claims to
labor income.
The Home Bias Puzzle
• In practice, we do not observe countries owning foreign-biased
portfolios or even the world portfolio.
• Countries tend to own portfolios that suffer from a strong home bias,
a tendency of investors to devote a disproportionate fraction of their
wealth to assets from their own home country, when a more globally
diversified portfolio might protect them better from risk.
The Home Bias Puzzle
Portfolio Diversification in the United States
The figure shows the return (mean of monthly return) and risk (standard deviation of monthly return) for a
hypothetical portfolio made up from a mix of a pure home U.S. portfolio (the S&P 500) and a pure foreign
portfolio (the Morgan Stanley EAFE) using data from the period 1970 to 1996.
The Home Bias Puzzle
The Globalization of Cross-Border Finance
Gains from Diversification of Risk: Summary
• If countries could borrow and lend without limit or restrictions in an
efficient global capital market, they should be able to cope quite well
with the array of possible shocks, in order to smooth consumption.
• In reality, as the evidence shows, countries are not able to fully
borrow and choose not to lend so freely.
• In theory, if countries were able to pool their income streams and
take shares from that common pool of income, all country-specific
shocks would be averaged out.
Countries would be exposed only to common global shocks to
income. Global shocks are systemic (shocks to the entire system)
and are never diversifiable.
Gains from Diversification of Risk: “Don’t put all your eggs in one
basket.”
• Financial openness allows countries, like households, to follow this
adage.
• In practice, risk sharing through asset trade is limited. First, the
number of assets is limited. The market for claims to capital income is
incomplete because not all capital assets are traded (e.g., many firms
are privately held and are not listed on stock markets), and trade in
labor assets is legally prohibited.
• Even so, investors have tended to include foreign assets in their
wealth portfolios much less than they could. This appears to be
changing slowly in the presence of ongoing financial globalization.
The gains from financial globalization: summary
Financial markets allow:
• households to save and borrow to smooth consumption over shocks
to their income.
• firms to borrow in order to invest efficiently and permit investors to
diversify their holdings across a wide range of assets.
• International financial markets should allow the same gains subject to
the long-run budget constraint. Countries face national income
shocks, new investment opportunities and country-specific risks.
The gains from financial globalization: Summary
These Gains are Elusive:
• In poorer countries, we do not see consumption smoothing gains, and
there is little scope for development based on external finance until
productivity levels are improved.
• Financial globalization hasn’t really been fully tried yet. Many emerging
markets still have large barriers to full financial liberalization.
• Institutional weaknesses in these countries most likely inhibit gains from
financial integration and might turn financial liberalization to a detriment
rather than benefit. It is possible that financial openness stimulates
competition, transparency, and accountability.
• The benefits of financial globalization are likely to be much smaller for
these countries, and they must also be weighed against potential offsetting
costs, such as the risk of crises.