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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!