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Financial globalization and real exchange rates Philip R. Lane IIIS, Trinity College Dublin Gian Maria Milesi-Ferretti International Monetary Fund What the paper does Provides stylized facts on international financial integration for – Industrial countries – and emerging markets Discusses implications of financial integration for the role of the exchange rate in international financial adjustment Motivation of the paper With limited international financial integration, – The exchange rate’s primary role is through the traditional expenditure-switching channel With large stocks of external assets and liabilities, denominated in different currencies, – Exchange rate changes also have potentially large balance-sheet effects A simple example: the US What is the US$ depreciation that would trigger a reversal in the US trade balance sufficient to stabilize the NFA to GDP ratio? Traditional response: bt bt 1 cat bt 1 need to reduce the CA deficit to 1.3 percent (5% nom. GDP growth times NFA ratio of 25%) A simple example (cont’d) This implies a “large” depreciation (over 30%?) However... Balance-sheet effect: a 30% depreciation of the US$ will improve the US NFA position by over $1 trn (10% of GDP)! It increases the $ value of US for.-currency assets (primarily portfolio equity and FDI) Emerging markets For emerg. markets with foreign-currencydenominated liabilities, a depreciation will have negative balance-sheet effects. A simple graphical example: Rates of return and real exchange rates emerging markets, 1997 100% Real dom. curr. rate of return on ext. liabs. KOR 80% IDN THA 60% MAL PHI 40% TAI BRA COL HUN CZE ARG CHN ISR IND CHITUR POL MEX 20% 0% VEN SAF -20% -50% -40% -30% -20% -10% 0% 10% Perc. change in real eff. exch. rate 20% 30% 40% Stylized facts on financial integration: industrial countries Increased dispersion of NFA Remarkable increase in size of gross external assets and liabilities Increased “equity integration” (FDI and portfolio equity) Net foreign assets and GDP per capita 200% SWI Net foreign assets / GDP 150% 100% y = 0.04x - 1.1 R2 = 0.31 50% BEL NOR JPN FRA GER 0% ITA CAN SPA -50% PRT GRE SWE UK AUT NET FIN DEN US IRE AUS ICE NZE -100% 11 16 21 26 31 GDP per capita (in thousands of current US$) 36 41 Composition of international portfolios 2.5 2 Equity FDI Debt 1.5 1 0.5 0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Emerging markets Reduction in net external liabilities Increase in gross assets and liabilities (less pronounced than in industrial co.) Increased role of FDI and portfolio equity Current account and net foreign assets 3% -20% 2% Net foreign assets (right axis) 1% -25% 0% -1% -30% A Current account (left axis) -2% -3% -35% -4% -5% -40% 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 Net foreign assets and GDP per capita 100% TAI 80% Net foreign assets/GDP 60% 40% 20% RUS VEN 0% KOR CHN SAF IND CZE -20% ISR COL THA ARG -40% PHI -60% MAL CHI POL MEX BRA TUR IDN HUN -80% 0 2000 4000 6000 8000 10000 GDP per capita, current US$ 12000 14000 16000 18000 Table 4. Indicators of Int. Fin. Integration, Emerging Markets (ratios of GDP) 1982 1992 2002 Average net external position -26.7% -21.1% -20.6% Average external assets of which: foreign exchange reserves FDI + portfolio equity 16.6% 26.5% 61.1% 5.1% 0.5% 11.1% 2.0% 19.4% 9.3% Average external liabilities of which: FDI + portfolio equity 43.3% 49.9% 81.7% 5.1% 9.6% 34.5% Source: authors’ calculations based on Lane and Milesi-Ferretti (2001) and IFS. Exchange rates and net foreign assets bt bt 1 bgst (rt gt ) bt 1 (rt rt )at 1 L A L b= net foreign assets/GDP bgs=balance of goods, services, and transfers r(a, l)=real rate of return on assets (liabilities) g = growth rate a= external assets Evidence on RER and rates of return Industrial countries: – High correlation between rate of return on foreign assets and RER changes (around -0.8 in a panel regression) – High correlation between rate of return on foreign liabs and RER changes (around -0.7 in a panel) but... – No correlation for returns on FDI liabilities Evidence on rates of return and RER (emerging mkts) Rates of return play a key role in explaining the dynamics of external position (Tbl 6) Correlation between rates of return on liabilities and RER changes higher than for industrial countries [see 1997 graph!] Higher volatility of rates of return Policy implications (emerging mkts) Devaluations raise dom.-currency payouts on foreign liabilities—balance-sheet effects! Improve risk-sharing: FDI and equity promote closer link between dom. econ. performance and rates of return (more speculative) Alternative forms of debt? – Domestic-currency bond market – GDP-indexed bonds Conclusions Financial integration increasing: – More portfolio diversification – Net borrowing and lending? Exchange-rate effects on rates of return increasingly important Modeling work needs to catch up with evidence More data needed!