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Berlin
GAM Fonds Marketing GmbH
Friedrichstrasse 154, 10117 Berlin, Germany
Tel: +49 (0) 30 22 65 60 Fax: +49 (0) 30 22 65 6566
Bermuda
GAM Limited
Wessex House, 45 Reid Street, Hamilton HM12, Bermuda
Tel: +1 441 295 5825 Fax: +1 441 292 9824
Dubai
GAM (Dubai) Limited
Dubai International Financial Centre, Office 39, Level 15,
The Gate P.O. Box 125115, Dubai, United Arab Emirates
Tel: +971 4 365 0160 Fax: +971 4 365 0162
GAM Gilbert de Botton
Award Lecture
Dublin
GAM Fund Management Limited
George’s Court, 54–62 Townsend Street, Dublin 2, Ireland
Tel: +353 (0) 1 6093900 Fax: +353 (0) 1 6702088
Hong Kong
GAM Hong Kong Limited
16th Floor, Two Exchange Square, Central, Hong Kong
Tel: +852 2978 8566 Fax: +852 2868 1432
London
GAM London Limited
12 St James’s Place, London SW1A 1NX, England
Tel: +44 (0) 20 7493 9990 Fax: +44 (0) 20 7493 0715
Incorporating the
5th GAM Gilbert de Botton Award
in Finance Research
New York
GAM USA Inc
330 Madison Avenue, New York
NY 10017, USA
Tel: +1 212 407 4600 Fax: +1 212 407 4684
Tokyo
GAM Japan Limited
Tokyo Ginko Kyokai Building, 3–1 Marunouchi 1-chome, Chiyoda-ku,
Tokyo 100–0005, Japan
Tel: +81 (0) 3 52198800 Fax: +81 (0) 3 52198808
Zurich
GAM (Schweiz) AG
Klausstrasse 10, 8034 Zurich, Switzerland
Tel: +41 (0) 44 388 30 30 Fax: +41 (0) 44 388 30 31
www.gam.com
Email enquiries – [email protected]
JN1478
6 November 2007
Somerset House, London
JN1478 Gdb mini speech book COVER.qxp
07-11-15
10:45
Page 1
Berlin
GAM Fonds Marketing GmbH
Friedrichstrasse 154, 10117 Berlin, Germany
Tel: +49 (0) 30 22 65 60 Fax: +49 (0) 30 22 65 6566
Bermuda
GAM Limited
Wessex House, 45 Reid Street, Hamilton HM12, Bermuda
Tel: +1 441 295 5825 Fax: +1 441 292 9824
Dubai
GAM (Dubai) Limited
Dubai International Financial Centre, Office 39, Level 15,
The Gate P.O. Box 125115, Dubai, United Arab Emirates
Tel: +971 4 365 0160 Fax: +971 4 365 0162
GAM Gilbert de Botton
Award Lecture
Dublin
GAM Fund Management Limited
George’s Court, 54–62 Townsend Street, Dublin 2, Ireland
Tel: +353 (0) 1 6093900 Fax: +353 (0) 1 6702088
Hong Kong
GAM Hong Kong Limited
16th Floor, Two Exchange Square, Central, Hong Kong
Tel: +852 2978 8566 Fax: +852 2868 1432
London
GAM London Limited
12 St James’s Place, London SW1A 1NX, England
Tel: +44 (0) 20 7493 9990 Fax: +44 (0) 20 7493 0715
Incorporating the
5th GAM Gilbert de Botton Award
in Finance Research
New York
GAM USA Inc
330 Madison Avenue, New York
NY 10017, USA
Tel: +1 212 407 4600 Fax: +1 212 407 4684
Tokyo
GAM Japan Limited
Tokyo Ginko Kyokai Building, 3–1 Marunouchi 1-chome, Chiyoda-ku,
Tokyo 100–0005, Japan
Tel: +81 (0) 3 52198800 Fax: +81 (0) 3 52198808
Zurich
GAM (Schweiz) AG
Klausstrasse 10, 8034 Zurich, Switzerland
Tel: +41 (0) 44 388 30 30 Fax: +41 (0) 44 388 30 31
www.gam.com
Email enquiries – [email protected]
JN1478
6 November 2007
Somerset House, London
JN1478 Gdb mini speech book.qxp
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GAM Gilbert de Botton Award Lecture
Contents
GAM Gilbert de Botton Award Lecture
Governments, Markets and Climate Change............................................................................
1
Sir Nicholas Stern – IG Patel Professor of Economics and Government at LSE
GAM Gilbert de Botton Award in Finance Research..............................................................
Interest Rate and Business Cycles in a Credit Constrained Small Open Economy.....................
Sarquis JB Sarquis
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1
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1. Sir Nicholas Stern
IG Patel Professor of Economics
and Government at LSE
2. Jeremy Smouha,
Director, GAM
3. Sarquis Sarquis
4. The Hon Mrs Janet de Botton
and Sarquis Sarquis
4
Left to right: Jan Bena, Christian Reusch, Miel de Botton Aynsley, Professor David Webb,
Jose Mauricio Bustani, Sarquis Sarquis, Sir Nicholas Stern, the Hon Mrs Janet de Botton.
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Governments, Markets and Climate Change
Sir Nicholas Stern
IG Patel Professor of Economics and Government at LSE
Today I would like to discuss the scale of the problem posed by climate change, the scale of the response, and
the way in which this response will depend upon the kinds of instruments we choose. Among these instruments,
market instruments are going to take centre stage.
I would also like to emphasise that this is a global problem, and unless there is a global solution we are
not going to tackle it seriously. I imagine I will be going beyond the Stern Review Report on the Economics of
Climate Change in my speech today. Since it was published just over a year ago, I have been intensively involved
with the discussions of how we can put a global deal together, so some of my comments will be based upon
these discussions.
The scale of the problem
Since the industrial revolution took hold in around 1850, the earth has been experiencing climate changes. This
is because human activities cause the formation of a stock of greenhouse gasses that are released into the
atmosphere. This is called a flow stock process. The stock of gasses causes irreversible problems as it catches
infrared energy and stops it escaping from the atmosphere, making the earth warmer than it would otherwise
have been. This in turn leads to climate change.
Climate changes manifest themselves in a number of ways, including storms, droughts, floods, sea level
rises, shortening of growing periods in agriculture, as well as heat stress. For example, in India another 5-10
degree centigrade rise in temperature could prove fatal for a sizeable section of the population. However, the
main problem is water - too much or too little at the wrong time. This was demonstrated recently by the massive
floods in Ethiopia or, on a smaller scale, the floods in England earlier this year.
The increase in temperature relative to pre-industrial days is around 0.8 degrees centigrade. From even
this small increase we are witnessing events that might have occurred once in 100 years every 30 years or so,
or experiencing new catastrophes that might never have occurred at all. In short, we are seeing extremes that
are changing the way we view risk.
Action is crucial
The flow stock process is crucial to the way in which we need to shape policy and, as the effects of global warming are irreversible, immediate action to prevent further damage is needed. If we decide not to act and let the
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flow stock process continues throughout this century, levels of greenhouse gasses will double from where we
are now. We measure greenhouse gasses in the atmosphere in terms of parts per million of carbon dioxide
(CO2). Current levels are around 430 parts per million of CO2. If the problem goes unchecked, this could rise
to around 800 by the end of the century. That would give us a roughly 50/50 chance of temperatures being
either side of 5 degrees centigrade higher than in pre-industrial times.
This is an enormous change. 5 degrees centigrade below current levels was the temperature during the
last ice age 12,000 years ago, when most of the human population lived around the equator. Another 5 degrees
centigrade move upwards from today’s temperatures would mean massive population movements away from
the lower latitudes towards the poles. Essentially, large parts of the lower latitudes of the earth would become
uninhabitable and the rest of the world would see extremes of weather, largely through water, of a kind that
would be extremely difficult to cope with.
In essence, we are gambling with the planet. The good news is that if we act sensibly, we could reduce
these risks substantially, giving ourselves a better than 50/50 chance of keeping temperature increases below
2.5 or 3 degrees centigrade. But to achieve this we need to hold the level of greenhouse gasses as stocks in
the atmosphere somewhere in the range of 500 to 550 parts per million. We are adding around 2.5 parts per
million a year to the current level of just below 430, a figure that is growing very rapidly. In fact, if we did very
little to stop this growth over the next 30 years, we would almost certainly be close to the top of the 500-550
range. At that point it would be too late to halt the momentum.
The scale of the action
The flow stock process, our current position and where we need to be should explain the great urgency of the
situation and the importance of acting quickly. The question is, what should the scale of the response be? If we
link the stock target of 500 to 550 to the kind of flows we should be aiming for, we should be looking to cut global emissions by around half between now and 2050.
We are currently emitting the equivalent of around 40 to 45 gigatons of CO2 a year, with a world
population of about six billion people. This means that the average person is generating 7 tons. The US currently
generates just over 20 tons per capita, Europe about 10 to 15, China 4 to 5 and India 1. If we are to cut
emissions by half by 2050, this average figure of seven tons needs to come down to around 2 or 3 tons per
person, taking into account that the population by then will be around nine billion.
The magnitude of the challenge is clear, but people are now starting to talk seriously about an effective
response. The halving of emissions by 2050 was the target set at the G8 summit in June 2007; world leaders
are starting to realise just how big the change will have to be. If we do succeed in halving emissions, then we
would actually have a good chance of keeping temperature increases below 2.5 or 3 degrees centigrade.
What measures have already been taken?
The Kyoto Protocol, agreed in December 1997, expires in 2012. People generally realise that this is an important deadline for the credibility of the new markets. The Kyoto Protocol was significant as it brought countries
together in a common understanding of what could be done. It also gave us institutional structures of trading
mechanisms, such as the clean development mechanism. I believe that if nothing happens by 2012, confidence in these market structures will start to erode and that would undermine the very mechanism that is needed to drive through change.
If you look at the way in which things have moved in the past year, this gives hope for agreement on
overall targets at the United Nations Climate Change Conference in Indonesia in December 2007, as well as
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some understanding of how we are going to build the post-Kyoto mechanisms. In addition, by 2009, when the
United Nations Climate Change Conference will be held in Copenhagen, a new American president would have
been in office for nearly a year, something that could be significant.
The differences between rich and poor countries
There is an enormous inequity in this whole story. This is because of the fact that rich countries are mainly
responsible for the emissions, particularly of the past emissions that have put us where we are now, while poor
countries are the ones that will be hit the earliest and hardest. We have to remember that all countries will be
affected though. For example, London will have wetter winters and dryer summers, which will test its infrastructure. In fact there would have to be large investments in London’s infrastructure simply to cope with the 2-2.5
degree increase that is likely to happen anyway. These large changes will occur in a city that is not the worst
affected in the world. There will, of course, be much greater adjustment costs in other places.
It is an uncomfortable fact that poor countries, which are the least responsible for the problem, are going
to be the most affected. This is why an appropriate target for rich countries is to cut emissions by around 75% by
2050. In other words, the 10 to 15 tons of emissions per capita in Europe would be brought down to 2 or 3 tons.
Financial and economic implications
So far I have discussed this issue largely in terms of the dangers, the physics and the geography of the situation. Now I would like to link it to economics and finance.
What I have spoken about is a classic externality, in an economic sense, in that our actions as individual
consumers or producers affect the possibilities of other people in their consumption and production. That is an
aspect of our economic behaviour for which we do not pay, so the standard economic response would be that,
if people are causing a cost to others that they do not pay for, we need to put a price on the damage to
incentivise the right behaviour. Another approach is to stop people doing something because we think their
actions are wrong. For example, London stopped people emitting smoky fuel because its citizens were dying
from related diseases such as bronchitis and heart disease.
So, we can seek to control the problem through prices or through direct controls. The problem with these
standard economic mechanisms is that this is a very different kind of problem - it is on a much bigger scale
than anything we have seen in the past. The problem is global because a ton of CO2 emitted in Sydney, London,
Los Angeles, Delhi or Beijing has exactly the same effect.
This issue is surrounded by much uncertainty. It is also a long-term concern as we do not actually see
the problem immediately. It is not like the smog in London that killed people as recently as the 20th century, or
the congestion we can see slowing us down. While we can use economics to try and form a solution, we have
to recognise that this is a very different externality from those we are used to dealing with. We cannot respond
simply by banning smoky fuel or instigating a congestion charge. Instead we have to formulate a global response
on a global scale.
Solutions through market mechanisms
How do we put together a solution that can use market instruments to get us where we need to be? Trading in
carbon is a very powerful instrument. The targets for emissions set for rich countries and the world generally
will create a large demand for carbon reduction. Rich countries need to reduce carbon emissions by 75%, some
of which can be achieved in developing countries. This means that a company with a very strong reduction target will be able to buy down some of those reductions in a poorer country.
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This is an efficient market solution; companies will be achieving reductions where it is the cheapest for
them. At the same time, they will be providing a flow of finance to developing countries to allow them to make
the technological changes they need to move on to a low carbon growth path.
So the overall physics of where we need to go can be translated into a market phenomenon and a set of
market structures that is both equitable, if the rich countries’ targets are high enough, and efficient in achieving
carbon reductions in the cheapest possible way. This demonstrates how a market mechanism quickly arises
from the basic economics of what is a physical externality problem.
The issue of risk
Businesses will need to adjust to the new risks that they face. Insurance markets will have to be transformed
by a recognition that examining sequences of events and probabilities looking backwards to determine risk is
probably going to be a bad guide to the kind of events that may occur in the future.
There are many kinds of volatilities that are going to occur in key markets. For example, the price of
wheat has doubled over the past year, in part due to the droughts in Australia. The volatility that we see in the
world as a result of climate change is going to have a direct effect on markets and, again, business is going to
have to factor this carefully into its story.
Businesses will need to be concerned with their reputations; just as some people might find it
uncomfortable to work for weapons or tobacco manufacturers, some may also be reluctant to work for firms that
they think are pursuing irresponsible policies on climate change. This may also be true of customers, as well as
some shareholders. What may happen, and what is already happening with some companies such as Tesco,
Marks & Spencer, HSBC, Shell and BP in the UK, is that many firms will strive for zero carbon emissions
wherever possible. In the case of Tesco, the company has pledged to label its products with carbon content in
a move that has been partly driven by consumer awareness of green issues.
The changes that have already been made are the result of companies analysing risk, including risk to
their reputations.
New opportunities
There will also be tremendous opportunities in carbon reduction technologies and carbon reduction finance.
Carbon as an asset is already appearing strongly in financial markets and, given the scale of the trading, the
financial side of this story is going to be very important too.
Numerous financial packages will be put together on the theme of energy saving. For example,
something that is already happening in Holland is that specialist firms visit private houses and advise their
owners on how to cut back on energy use, as well as arranging and undertaking all necessary work. These
combinations of technology and finance are going to be very important in finding solutions. In addition, new jobs
created from the development of low carbon technologies will be a big part of the solution.
Whether we look at the carbon markets themselves, the adjustments that individuals and companies are
going to have to make, the opportunities that will arise in financing the reduction of energy use, or technological
innovations, it is clear that the business world is going to be central to this whole process.
How will businesses adapt?
We are facing a physical problem with an economic solution, and finance and business are at the heart of this.
The business community understands the kinds of incentives that are going to be necessary in order for them
to be able to invest in reducing emissions. We sometimes hear that businesses need signals that are ‘loud, long
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and legal’ in order to act. However, what they really need is clear, credible and long-term guidance and incentives. Without these in place, businesses will not be able to make the big changes that are needed. This is the
reason that we now see firms pushing governments strongly to get this kind of apparatus in place. It is often
said that markets cannot function without governments and vice versa, and it is very true here.
The cost of the solution
It would only cost around 1% of world GDP per annum to reach the targets, provided we follow good policies
and take the cheapest options. By looking at the technologies and the costs of cutting back on carbon, we can
make a good estimate of the price that carbon is going to have to be if we are to achieve the results we need.
Carbon needs to be around USD 30 or USD 40 per ton of CO2, which can be translated into an extra USD 10
or USD 15 on a barrel of oil.
Why do we need that sort of price? Unless carbon capture and storage for coal is financially viable, we
are simply not going to get reductions on the scale that we require.
Taking action
We have seen that climate change is a very big problem but we can actually reduce the risks substantially if we
pursue the methods I have discussed. The question is, why are we not doing this already?
The solution means that energy is going to be more expensive, which will slow growth. We may have to
change our lifestyles or pay more tax, something that many people are reluctant to do. It is easy to justify not
changing our behaviour by saying, for example, that buying a more fuel-efficient car will not help if new power
stations are opening up in China every week. Also, the economic cycle can play a role in making people more
defensive. In a recession, the idea of a trading mechanism which would allow funds to flow from rich countries
to China or India might be more difficult to introduce. With these in mind, it is not difficult to understand the
short-term political objections.
We need to bring governments together to understand the scale of the problem and the solution. From
an economic point of view, it is always better to wait for someone else to act, which means that no-one will do
anything until everyone is committed. What is remarkable is that more and more countries and regions are
making changes or committing themselves to change without a full global deal being put in place. California has
committed itself to 80% reductions by 2050, France has agreed to 75% reductions by 2050, while the UK has
committed itself to 60% reductions by 2050, which may soon rise to 75%.
This makes me reasonably optimistic that we will achieve some of our goals. I am not fully optimistic all
of them will be met, which why I am worried about the dangers that could leave us with.
The need for a global deal
Nothing is going to work unless it involves the US and China. What we need to do in putting a global deal together is to build the markets in Europe, open them up to other countries, and then show others how these trades
can work on an international level. This means that when the US and China are ready to participate, there is
actually a working model already in place.
This approach is already reaping rewards. The Governor of California, Arnold Schwarzenegger, is talking
to the EU about how California can link up with the European Union Emissions Trading Scheme, which already
covers half of the European Union’s emissions. In addition, in Australia the Prime Minister John Howard was
initially sceptical about the whole issue but now seems to have changed his stance. This turnaround is an
indication of how, in the face of a drought and an imminent election, leaders start to see the advantages of
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taking climate change seriously. Similarly, George Bush changed his views; before January 2007 he was
dismissive about the phenomenon of climate change. However, in September he held a meeting of major
economies and explained to the participants that the US was now a leader in the fight against climate change
through the investments it was making in technology.
These attitude changes are extraordinary. In many countries politicians are determining what people
want and responding to that. There is also leadership-driven change, but in many cases it is a response to
popular demand.
China
China has set out its own plans for climate change. On the positive side, the country is reforesting not deforesting, and deforestation is a big issue. In addition, you cannot sell a car from the US in China as it will not meet
emissions standards, while China has also imposed an export tax on energy intensive goods in December 2006.
The 11th five-year plan in China started a year ago and has only two headline targets: increasing the growth rate
and cutting the energy output ratio by 20%.
However, China is still opening two coal-fired power stations every week. It matters a great deal that
China, as well as India, is relying largely on coal. On average, China generates about four tons of CO2 per capita.
Given that its population is just over a billion, we are talking about 6 billion tons as a nation. If China keeps to
its growth rate targets, using coal for 80% or 90% of its power, then we will probably see emissions growing at
around the same rate as GDP growth. So if China grows at 9% per annum over the next 20 or 30 years,
emissions will probably grow by around 7%. By 2050, emissions could have grown by as much as 24%,
meaning that China alone would be producing all the emissions that the world is able to cope with.
What is important though is that China takes this problem seriously. This is because it knows that the
country is vulnerable to the retreat of the ice from the Himalayas - something that is already happening - which
is the source of its major rivers.
Given this situation, the rest of the world needs to help China by producing and sharing new technologies
and through carbon finance. With help, China can move to a technological structure enabling it to capture and
store carbon in the period 2015 and 2035 or so. This is also why we need a sufficiently high price for C02. By
2035, China should have moved to a range of other sources of power generation, such as nuclear, solar or wind,
which will take it closer to zero carbon emissions in its electricity generation.
Indonesia
While it is difficult to provide any accurate numbers for Indonesia, on some calculations it is the third largest polluter because of deforestation and peat fires. The country has very strong legislation on deforestation, illegal logging etc, but this does not seem to make a difference. This is partly due to a lack of resources for policing and prosecution. Non-compliance with existing legislation is a real issue. Institutions such as the World Bank and others
can help to put governance and observation structures in place that would ensure existing laws are adhered to.
At the same time, in order to expand the margin of agriculture we need to help countries such as
Indonesia find more productive uses for their land other than logging. Even if help with governance and
observation and forestry is forthcoming, as well as assistance with agricultural development, there would still
need to be incentives for preserving the forests. I believe much of this is perfectly feasible.
The current Indonesian government is very interested in making the changes. Unusually for the country,
the present government is an elected one. In December 2007 Indonesia is hosting the United Nations Climate
Change Conference, and I hope that deforestation will be a big part of the discussions.
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Alternative fuels
I have briefly mentioned alternative fuels, such as nuclear, wind and solar power, and particularly carbon capture and storage for coal. I also emphasised that we will be using hydrocarbons for electricity generation for
some time to come. On the subject of biofuels I have mixed feelings, and I say this as someone who has worked
a great deal on agriculture in regions such as India and Africa over the past 40 years.
There has been talk about supplying some of the demand for liquid fuels through grain and sugar, both
of which are land and water intensive. In the eastern part of Brazil, there are large areas of rain-fed sugar that
can be used for fuel, probably without putting too much pressure on other crops. But in other areas, such as
North India where sugar is grown quite intensively, it competes directly with wheat and rice for water and land.
We have to ask ourselves how big a contribution sugar could make to the overall liquid energy that is going to
be needed for transport.
In my view, the potential for sugar, as well as corn ethanol, in relation to the overall structure of world
energy demand, is actually quite small. It may have a role to play but I am far more optimistic about so-called
second-generation biofuels; crops that make diesel and can be grown on semi-arid land such as that found
around the Sahara, Central Asia, Western Brazil and Southern Africa. This biofuel would put much less pressure
on world food markets, indeed could actually prevent the advances of deserts in some cases. That is already
being invested in and grown, although we have yet to see whether that activity could be scaled upwards.
Conclusion
Country by country, there is an increasing focus on the problem of climate change and an increasing commitment to real measures. I am far more optimistic than I was at the time the Stern Review was published in
October 2006 that we can put a global agreement of the kind I have described in place. One of the reasons for
my optimism is not simply changes at a political level, it is the way in which change has been happening and
the role that the business and finance community has played. Many members of that community have been
real drivers of change, partly because they are responsible citizens, but partly because they believe that they
can benefit from doing good. I believe both of these motivations are perfectly acceptable.
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GAM Gilbert de Botton Awards Lecture
The 2007 GAM Gilbert de Botton Award in Finance Research
The fifth GAM Gilbert de Botton Award in Finance Research was won by Sarquis JB Sarquis for his paper
“Interest Rate and Business Cycles in a Credit Constrained Small Open Economy”.
Launched in 2003 with the London School of Economics and Political Science (LSE), in honour of GAM’s
founder, Gilbert de Botton (1935-2000), the annual award recognises academic excellence in the area of
finance and assists PhD or graduate students to pursue a PhD at the LSE’s internationally renowned Financial
Markets Group (FMG).
Jeremy Smouha and The Hon Mrs Janet de Botton presented the prizes following the GAM Gilbert de Botton
Award Lecture. The 2007 winners were:
First Place:
Sarquis JB Sarquis
Interest Rate and Business Cycles in a Credit Constrained Small Open Economy
Second Place:
Christian Reusch
Self-Exciting CAViaR Models with Endogenous Thresholds
Third Place:
Jan Bena
Which Firms Benefit More from Financial Development?
Runners-up:
Christian Fons-Rosen
Start-up Costs, External Finance and Improvements in Financial Development
Nikolaj Schmidt
Foreign Bank Entry and Credit Market Segmentation
Ashley Taylor
Productivity Implications of Financial Sector Reforms: a Heterogeneous Firm Approach
From left to right: Ashley Taylor, Nikolaj Schmidt, Miel de Botton Aynsley, Sarquis Sarquis, Christian Fons-Rosen,
Jeremy Smouha, Professor David Webb, the Hon Mrs Janet de Botton, Christian Reusch, Jan Bena.
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Interest Rate and Business Cycles in a
Credit Constrained Small Open Economy
Sarquis JB Sarquis
Executive Summary
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GAM Gilbert de Botton Awards Lecture
In the last two decades emerging economies have intrigued both macroeconomists and financial economists
with two phenomena. On the one hand, they have faced real interest rates in international financial markets
(measured for instance by the country’s nominal rate of borrowing in US dollars minus a corresponding expected inflation) that are higher and more volatile in absolute terms than those observed in advanced economies.
On the other hand, over the same period emerging economies have registered greater real aggregate volatility
than advanced economies.
Motivated by such phenomena, this paper supports both empirically and theoretically the hypothesis
that, as long as the real interest rate can be treated as exogenously determined, movements in the rate can
explain a considerable share of macroeconomic fluctuations in emerging economies. It has been argued that
international financial variables – exogenous to the economy – can conform to a large extent the overall lending
and borrowing conditions affecting the emerging economy – or a group of similar economies – in global financial
markets (e.g. Calvo et al. 1996). Changes in these conditions are reflected in the real interest rate. The latter
could therefore be mainly determined by exogenous and foreign factors rather than by endogenous and
domestic variables. Moreover, by powerful credit propagation mechanisms, it can be a key driver of business
cycles in emerging economies.
A very distinguishing feature of the paper is precisely that it abstracts from an explicit role of monetary
policy and from nominal aspects. Credit frictions are at the core of the propagation mechanism and, therefore,
can reconcile the evidence of interest rate and business cycles in emerging economies.
The goal of the paper is two-folded:
(a) to organize and understand the empirical regularities related to the interest rate and, mainly, to its
macroeconomic effects in emerging economy business cycles; and
(b) to offer a model – of Credit Constrained Small Open Economy – that is able to rationalize these
regularities in an integrated and comprehensive way, while at the same time overcoming difficulties
and anomalies revealed by standard small open economy models when confronted with the same task.
In order to revisit and to clarify the evidence on the role of real interest rate shocks in emerging
economies, as well as to give an empirical benchmark for the proposed model, the paper contains empirical
analysis of the Brazilian experience from 1994 to 2005, with quarterly data. Brazil is one of the major developing
economies, being one of the key countries associated to emerging markets. The period of analysis covers most
of its experience of closer integration with global financial markets, which is similar and concurrent with
experiences of many other emerging economies, particularly in Latin America.
The standard deviation ‘of Brazil’s GDP series (in log and detrended by the Hodrick-Prescott filter) is
1.78 higher than the US counterpart, while the volatility of Brazil’s real interest rate is about 2.01 greater than
the US rate. The former exceeds the latter roughly by Brazil’s premium in international markets, such as proxied
by an EMBI index. Granger causality and variance decompositions, under Vector Autoregressions (VAR)
analysis, indicate a strong degree of exogeneity for Brazil’s interest rate, whereas the reverse causality is not
found at all. Furthermore, interest rate innovations affect significantly Brazil’s economic activity, explaining
around 30% of the variability of output and investment, besides 40% of consumption’s.
The empirical findings are overall in agreement with the cross-country evidence on the role of interest
rate in business cycles of emerging economies (e.g. AgEmor and Prasad 2000, Kydland and Saragoza 1997,
Neumeyer and Perri 2005, Sarquis 2006 and Uribe and Vue 2006). Moreover it clarifies the fact that emerging
economies reveal strong negative growth persistence to interest rate shocks in recession. Such a fact is
consistent with all suggested regularities and can be seen as an essential one, which should underlie a
framework to explain them.
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Elucidated by the Brazilian case, the paper argues that the interest rate and business cycles in emerging
economies suggests the following stylised facts:
(a) shocks to the real interest rate can be predominantly exogenous;
(b) the real interest rate can be therefore non neutral at business cycle frequencies;
(c) the interest rate is countercyclical and leads macroeconomic cycles;
(d) innovations to the interest rate leads to inverted hump-shaped responses in output, consumption
and investment;
(e) such innovations are behind excessive volatility in general activity
(f) consumption reacts relatively more than output to interest rate shocks; (g) correlation between
output and lagged interest rate can be increasingly negative during recession; and
(h) current account can be at least as counter-cyclical as in advanced economies.
These regularities contrast qualitatively and quantitatively with those found in advanced economies and
cannot be explained by available small open economy models. Although widely recognized as a potentially
important mechanism for transmitting international shocks, the real interest rate has traditionally had a limited
role in standard business cycle models of Small Open Economies.
These models have weak propagation mechanisms and can badly match these regularities. Their
limitations result intrinsically from a poor intertemporal substitution mechanism, in particular to international
interest rate shocks. They have lead researchers to posit and explore a variety of ad hoc assumptions that could
improve the models performance.
The alterations proposed in the standard models have been ad hoc or unsatisfactory, relying on an
excessive volatility of interest rates and a negative correlation between the latter and productivity. It has been
shown that by reversing standard Real Business Cycle methodology, typically associated with these models,
about one-third of output volatility would be explained by interest rate shocks (Blankenau, Kose and Yi 2001).
Nevertheless, their volatility would be badly unrealistic, at about 8 times the volatility of total factor productivity
shocks. Some authors (e.g. Neumeyer and Perri 2005, Uribe and Yue 2006) incorporate, besides other features
(e.g. time to build), a working capital constraint and explicitly a country-spread as a component of the real
interest rate. Their models perform relatively well with regard respectively to the negative correlation between
output and lagged interest rate and to the responses to interest rate shocks. However, their key findings depend
unsatisfactorily on a negative correlation between productivity and interest rate. Merely incorporating a working
capital constraint would not suffice.
To address the identified empirical regularities in an integrated and comprehensive basis, it appears that
a model must have at least two key features:
(a) non-neutral real interest rate shocks, preferably with strong effects on consumption’s intertemporal
substitution; and
(b) propagation mechanisms that lead to negative growth persistence.
The Credit Constrained Small Open Economy model, proposed in the paper, reveals such features, in
sharp contrast with standard Small Open Economy models. It performs better than the standard framework, in
particular when assessing it against the empirical benchmark on the following grounds:
(a) matching of standard second moments of data statistics, with a clear nonneutral role for interest
rates, which contributes to greater aggregate variability and potentially to a more realistic co movement of the
series and their relative volatilities, as in the case of a relatively high consumption variability vis-a.-vis output’s;
(b) ability to generate inverted hump-shaped responses of output, consumption and investment to
interest rate shocks, consistent with negative (positive) growth persistence observed in recessions (recoveries);
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(c) replication of the dynamic pattern of serial correlations between output and lagged interest rate,
compatible with the latter variable being countercyclical and leading cycles.
The Credit Constrained Small Open Economy (CCSOE) model is built as a dynamic, general equilibrium
(infinite horizon) model. It assumes the representative agent is relatively impatient vis-a-vis the rest of the world
and faces a credit collateral constraint on net foreign liabilities. The constraint imposes an endogenous
relationship between capital as collateral and foreign net liabilities. Due to the impatience effect, the agent is
permanently keeping its net liabilities to the limit, and thus the constraint is permanently binding. The
impatience and the constraint are the main departures from standard models. As a logical consequence of
these departures, stationarity of the system is assured without recourse to one of the typical ad hoc assumptions
required to close small open economy models (Schmitt-Grohe 2003). Other ingredients of the model that only
have minor quantitative effects are a general setting of preferences that account realistically for wealth effects
in labour supply and standard adjustment costs to control for excessive variability of investment and labour – a
common feature of small open economy models.
The model captures by an impatience hypothesis and by the implication of a permanently binding
collateral constraint two aspects of the economy’s financial integration with world economy. On the one hand, it
stresses the inability of some emerging economies, namely in Latin America, to generate financial deepening
and/or domestic savings and therefore their dependence on foreign credit. On the other hand, it underlines
frictions in international financial markets, which by the means of collateral provide foreign creditors and
investors with some control or discipline over the country’s international exposure, measured by the stock of
international liabilities.
The paper is not necessarily the first to consider a collateral credit constraint – following Kiyotaki and
Moore (1997) – in a small open economy model (Arellano and Mendoza 2002, Chari et al 2005 and
Kocherlakota 2000). It is however unique in deriving the full implications of a permanently binding constraint
of this sort with endogenous collateral and endogenous net liabilities. Its uniqueness allows for endogenous
interactions between an accumulating collateral in the form of a variable stock of capital – rather than simply
an asset with fixed aggregate supply – and accumulating net foreign liabilities. Such interactions change
qualitatively and quantitatively the propagation of shocks in a small open economy, especially when facing
external shocks.
The model reveals considerable propagation of interest rate shocks, namely of innovations to an
independent interest rate process. It is the mechanics brought about by the inter-temporal consumption
substitution, implicit in the inter-play of the Euler equations governing capital and consumption growth, that
assures the envisaged properties. The constraint imposes frictions that work in tadem in foreign borrowing and
capital accumulation. These frictions mediate the adjustment process on both demand and supply sides.
The the Credit Constrained Small Open Economy model is solved around the steady state and calibrated
with parameters and data from the Brazilian economy. It is simulated and tested successfully against the
empirical (VAR) benchmark on all proposed grounds – second moments, impulse responses and serial
correlations of output with lagged real interest rate. Its properties are first revealed for an independent process of
interest rate. In sharp contrast with standard models, it is robust to the adding of realistic productivity shocks.
The model’s performance is improved by the consideration of richer specifications of exogenous processes. Such
specifications include variations in which positive changes in interest rate might affect negatively productivity
and/or collateral formation. In all specifications, the model is consistent with the evidence that interest rate shocks
can determine a high proportion (over 20%) of output volatility at business cycle frequencies. The through of the
responses (during recessions) are realistically around 3 quarters after the shock.
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Thanks to its strong mechanism of propagation, the model also overcomes anomalies manifested in
standard models (Mendoza 1991, Schmitt-Grohe 2003), namely: a little correlation between output and the net
export ratio to GDP; and a lack of serial auto-correlation in investment. Moreover, it nests, on its opposite
extremes, the standard small open economies and closed-economy real business cycle models in various
dimensions. It enhances within a small open economy framework the intertemporal properties of the latter, with
regard to productivity shocks, and extend these properties, in an even more powerful way, with regard to the
propagation of external shocks.
Coincidentally, the model attains properties that have so far been restricted to closed-economy monetary
models that assume nominal rigidities. In the latter, these rigidities are responsible for the propagation
mechanism and negative growth persistence in recessions (Christiano et al. 2005). The paper points out that
the propagation of shocks in a small open economy framework could be strengthened by the complementary
roles of collateral credit constraints and nominal rigidities.
0.5
0.3
0.1
-0.1
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-4
-3
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-1
0
1
2
3
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5
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Figure. Serial correlations between GDP an interest rates, corr(rt+j;yt). The correlations are in (orange) lines
marked with crosses for a pure interest rate, in (green) lines marked with circles for interest rate shock and
induced collateral, in (brown) lines marked with squares for interest rate shock induced productivity, and in
(blue) lines marked with triangles for interest rate shock and induced collateral and productivity. The vertical
axis represent correlations and the horizontal axis j quarters.
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