International Capital Flows and U.S. Interest Rates

Transcription

1 IIIS Discussion Papr No.3/Dcmbr 2005 Inrnaional Capial Flows and U.S. Inrs Ras Francis E. Warnock Global Economis and Marks Group Dardn Businss School Univrsiy of Virginia Vronica C. Warnock Dparmn of Urban and Environmnal Planning School of Archicur Univrsiy of Virginia

2 IIIS Discussion Papr No. 3 Inrnaional Capial Flows and U.S. Inrs Ras Francis E. Warnock Vronica C. Warnock Disclaimr Any opinions xprssd hr ar hos of h auhor(s) and no hos of h IIIS. All works posd hr ar ownd and copyrighd by h auhor(s). Paprs may only b downloadd for prsonal us only.

3 Board of Govrnors of h Fdral Rsrv Sysm Inrnaional Financ Discussion Paprs Numbr 840 Spmbr 2005 Inrnaional Capial Flows and U.S. Inrs Ras Francis E. Warnock Vronica Cacdac Warnock NOTE: Inrnaional Financ Discussion Paprs ar prliminary marials circulad o simula discussion and criical commn. Rfrncs in publicaions o Inrnaional Financ Discussion Paprs (ohr han an acknowldgmn ha h wrir has had accss o unpublishd marial) should b clard wih h auhor or auhors. Rcn IFDPs ar availabl on h Wb a This papr can b downloadd wihou charg from Social Scinc Rsarch Nwork lcronic library a hp://

4 Inrnaional Capial Flows and U.S. Inrs Ras Francis E. Warnock Vronica Cacdac Warnock Absrac: Forign flows hav an conomically larg and saisically significan impac on longrm inrs ras. Conrolling for various macroconomic facors w sima ha had hr bn no forign flows ino U.S. bonds ovr h pas yar, h -yar Trasury yild would currnly b 50 basis poins highr; vn a sp-down o avrag inflows would imply an incras of 5 basis poins. Th impac of h hadlin-making forign official flows a rlaivly small subs of oal forign accumulaion of U.S. bonds is also significan bu markdly smallr. Our rsuls ar robus o a numbr of alrnaiv spcificaions. Kywords: bond yilds, Japan, China JEL Cods: E43, E44, F2 * Th auhors ar a h Univrsiy of Virginia. V. Warnock is in h Dparmn of Urban and Environmnal Planning in h School of Archicur. F. Warnock is in h Global Economis and Marks (GEM) Group in h Dardn Businss School; much of his work on his projc occurrd whn h was a Snior Economis a h Board of Govrnors. Th viws in his papr ar solly h rsponsibiliy of h auhors and should no b inrprd as rflcing h viws of h Board of Govrnors of h Fdral Rsrv Sysm or of any ohr prson associad wih h Fdral Rsrv Sysm. Th auhors ar indbd o Brian Sack of Macroconomic Advisrs for numrous discussions, hlpful commns, and assisanc wih daa. W also hank Jo Gagnon, Grac Wong, and paricipans a h 2005 Inrnaional AREUEA confrnc in Los Cabos for hlpful commns. addrsss for h auhors ar warnockf@dardn.virginia.du and vwarnock@virginia.du.

5 I. Inroducion Thr is a burgoning liraur on h impac of inrnaional capial flows on mrging mark conomis. For xampl, w hav larnd in rcn yars ha in mrging marks forign flows can rsul in a rducion in sysmaic risk (Chari and Hnry (2004)) and an incras in boh physical invsmn (Hnry (2000, 2003)) and conomic growh (Bkar, Harvy, and Lundblad (2005)). Ths posiiv aspcs of capial flows ar mprd by h rol of forign flows in sprading criss (Boyr, Kumagai, and Yuan (2005)). In comparison, w know vry lil abou h rol of forign flows in larg dvlopd conomis. W aim o fill his gap by xamining h impac of inrnaional capial flows on wha is arguably h mos imporan pric in h U.S. conomy and possibly h world ha of h n-yar Trasury bond. Spcifically, w ask o wha xn forign flows ino U.S. bond marks can xplain movmns in long-rm Trasury yilds. W addrss his issu a an imporan im. Two yars ago, in h summr of 2003, shor-rm inrs ras wr vry low and inflaion was undr conrol. Mos modls would hav prdicd vry poor rurns for U.S. bonds ovr h subsqun yar or wo. And, ovr h cours of 2004, as inflaion pickd up, h Fdral Rsrv bgan a ighning cycl ha raisd shor ras, and conomic growh srnghnd, many mark obsrvrs prdicd an incras in long-rm U.S. inrs ras ha would rsul in subsanial losss on bond posiions (s, for xampl, Roach (2005)). Long-rm inrs ras hav, howvr, rmaind qui low, and h bond mark has hld up a a S, for xampl, Bakr, Grnwood, and Wurglr (2003). Ohr imporan work on h prdicabiliy of bond rurns includs Frson and Harvy (99, 993), Kim and Sambaugh (986), Fama and Frnch (989), and Campbll and Shillr (99).

6 im whn many prdicd subpar prformanc. Th subbornly low long ras hav puzzld no only mark paricipans and financial conomiss, bu also policymakrs. Migh forign flows hlp xplain his puzzling bhavior? W addrss his qusion using daa on h flows of wo ss of forign invsors. Our firs masur uilizs informaion on h purchass of Trasury scuriis by socalld forign official insiuions prominn forign insiuions such as h Bank of Japan and h Popl s Bank of China. Bu w viw a focus on forign official flows as incompl, in par bcaus h bhavior of forign govrnmns ovr h pas fw yars could b characrizd as spping up purchass of U.S. bonds a ims whn priva dmand falrd (Dooly, Folkrs-Landau, and Garbr, 2004). Our scond masur of forign flows combins forign official purchass wih hos of priva forign invsors. 2 Priva forign invsors h main acors in narly vry sudy of inrnaional capial flows ar in aggrga much largr han h hadlin-grabbing forign official insiuions (Figur ). To b sur, forign official purchass of U.S. Trasury bonds skyrockd in 2003 and 2004, bu hs wr only a small subs of forign flows ino all yps of U.S. bonds Trasury, corpora, and agncy bonds. A hir pak in h summr of 2004, forign official inflows amound o 2.5 prcn of GDP, far blow h ovrall forign purchass of U.S. bonds of 7 prcn. To drmin h impac forign buying of U.S. bonds has on U.S. Trasury yilds and U.S. inrs ras in gnral, w uiliz a rducd-form modl, similar in spiri 2 Daa on priva forign invsor flows is publicly availabl bu a h sam im is no radily accssibl o rsarchrs; on of our conribuions is o show how hs daa can b uilizd afr hy ar corrcd for known problms. 2

7 o ha dvlopd in Sack (2004). 3 Th mhodology conrols for svral macroconomic facors inflaion and growh xpcaions, h budg dfici, h fdral funds ra, and a risk prmium ha normally provid a rasonabl accouning of Trasury yilds. As Figur 2 shows, rcnly hs macroconomic variabls hav no fard as wll for longrm inrs ras, as -yar Trasury yilds ar subsanially lowr han can b xplaind by macroconomic condiions. W add o h modl a bary of carfully consrucd capial flows sris h forign official purchass ha arac h mos anion, bu also all forign purchass of Trasuris and, alrnaly, of all U.S. bonds. W find ha hs capial flows variabls hav diffrn impacs, bu ach hlps xplain h surprisingly low U.S. inrs ras. 4 Spcifically, w find in our sampl spanning January 984 o May 2005 ha forign inflows ino U.S. bonds rduc h -yar Trasury yild by an conomically (and saisically) significan amoun. For xampl, if forignrs did no accumula U.S. bonds ovr h wlv monhs nding May 2005, our modl suggss ha h -yar Trasury yild would currnly b 50 basis poins highr. No forign accumulaion, or zro inflows ovr h cours of a full yar, migh sm farfchd (alhough no in a balancd currn accoun scnario). Bu vn if h Unid Sas xprincd only avrag inflows of 2 prcn of GDP, our poin sima suggss ha U.S. ras would b 95 basis poins highr. Ohr capial flows masurs yild similar or vn largr poin 3 Th Sack (2004) mimo and much of h mark commnary uilizs only h radily availabl daa on forign official inflows ino Trasury scuriis, and finds mods rsuls. Myr and Sack (2004), which also focuss on forign official flows, updas h original mimo and finds ffcs as larg as 50 basis poins. 4 Our work can b sn as a forign rlaiv of a variy of paprs ha hav focusd on domsic facors. For xampl, Dibold, Piazzsi, and Rudbusch (2005) and Piazzsi (2005) xamin h impac of domsic macroconomic facors on h yild curv. Brand and Kavajcz (2004) and Grn (2004), in h spiri of Evans (2002) and Evans and Lyons (2002), xamin h impac of ordr flow on Trasury yilds. S Brnank, Rinhar, and Sack (2004) for a high frquncy sudy of h vry shor-run impac of forign official purchass. 3

8 simas in our rgrssions, bu bcaus h flows ar smallr, h ovrall impac is mor mud. For xampl, had forign official flows bn zro ovr h las wlv monhs, long ras would currnly b 60 basis poins highr. 5 Our rsuls ar robus o many alrnaiv spcificaions. In robusnss chcks, w modl ral long ras; forign flows significanly affc ral ras. To limina h impac of shor-run businss cycl variaions, w modl fuur xpcd ral ras (h ral 5-yar forward ra fiv yars hnc); h main rsuls hold. W prsn vidnc ha a viw currnly circulaing in praciionr circls ha h puzzl of low ras is solvd by incorporaing a masur of corpora savings (JP Morgan, 2005) dos no impac our rsuls (nor dos i appar o hlp xplain h bhavior of long ras). Our final robusnss chck involvs rolling rgrssions. W prsn h voluion of h cofficin simas hrough im; ovrall inflows hav significanly impacd U.S. long ras for ovr a dcad. Our finding ha forign flows hlp xplain h bhavior of U.S. inrs ras lavs unanswrd on ponially inrsing qusion: Ar w, on avrag, capuring a swiching ffc, as global invsors shif allocaions bwn U.S. and forign bonds, or a supply ffc in which a global savings glu lavs global invsors wih mor funds availabl? W ar agnosic on his qusion in larg par bcaus w bliv ha ovr im boh ffcs ar a work, prhaps wih varying innsiis and rlaiv imporanc bu mak som amp a addrssing i in ordr o provid h radr wih guidanc ha migh will aid in h inrpraion our rsuls. In fac, w prsn vidnc ha srongly suggss h formr h swiching ffc is mor prvaln. In paricular, if w 5 This is consisn wih h samn in Grnspan (2005) of a mods impac of official flows, lar o b dfind as probably lss han 50 basis poins. 4

9 includ a variabl ha masurs h sprad of forign inrs ras ovr U.S. ras, i nrs ino our rgrssions wih a ngaiv and significan cofficin. Tha is, whn forign ras ris rlaiv o U.S. ras, U.S. ras fall, suggsing ha invsors ar swiching from forign o U.S. bonds. Finally, w also sima modls for a variy of U.S. inrs ras shorr rm Trasury yilds (2-yar), high and lowr qualiy corpora db (Aaa and Baa), and longrm fixd and shor-rm adjusabl morgag ras. Th impac of forign inflows diffrs across hs insrumns, bu i is always saisically significan and ofn conomically larg. Th impac on corpora bond ras and long-rm (30-yar) fixd morgag ras is vry similar o ha on h -yar Trasury yild. Shor-rm ras ar in gnral lss affcd by forign flows, prhaps bcaus as our modls show hy ar mor closly linkd o h fdral funds ra. Th diffrnial ffc on h wo- and nyar Trasury yilds implis ha forign flows hav fland h yild curv by abou 75 basis poins. Our papr is as follows. In h nx scion, bcaus hr is considrabl confusion abou h diffrn sourcs of capial flows daa, w bgin wih a shor dscripion of h various capial flows daa; show why w canno us "off-h-shlf" flows daa; and prsn capial flows sris ha ar rsad o limina known daa problms. In Scion III w prsn our main rgrssion rsuls of -yar Trasury yilds, as wll as various robusnss chcks. Scion IV addrsss h inrpraion of our rsuls, in paricular whhr hy appar o rflc a porfolio-swiching ffc or a supply ffc associad wih a global savings glu. Scion V prsns vidnc on ohr long- and shor-rm inrs ras. Scion VI concluds. 5

10 II. U.S. Daa on Inrnaional Capial Flows Thr ar many inrrlad sourcs of daa on U.S. capial flows. In his scion w discuss, in urn, wkly daa from h Fdral Rsrv Bank of Nw York (FRBNY), monhly daa from h Trasury Inrnaional Capial Rporing Sysm (TIC), and monhly flows implid from infrqun bnchmark survys of posiions (which w call bnchmark-consisn flows). 6 Bcaus of limiaions of h monhly TIC daa, discussd blow, our prfrrd masur uilizs h bnchmark-consisn flows h rsad flows ha incorpora informaion from bnchmark survys. FRBNY Wkly Daa on Forign Official Holdings of Trasury Scuriis Th wkly FRBNY cusodial daa ar h mos imly daa availabl for h holdings of U.S. Trasury scuriis by forign official insiuions (cnral banks and financ minisris). Thy ar asily obaind 7 and of high qualiy; misaks in FRBNY daa ar similar o a bank rcording h wrong amoun for an accoun balanc, infrqun and likly quickly corrcd. Alhough h FRBNY is jus on of many cusodians, i is h U.S. cusodian of choic for many of h world's cnral banks and financ minisris; a h nd of Jun 2003, 88 prcn of forign official holdings of long-rm Trasury scuriis wr hld in cusody a h FRBNY. 8 6 Anohr imporan sourc, quarrly balanc of paymns (BOP) daa from h Burau of Economic Analysis (BEA), will b mniond only brifly. 7 A mmo im a h boom of h firs pag of h H.4. rlas ( shows forign official holdings a h FRBNY. Th Trasury and FRBNY daa ar no dircly comparabl for a numbr of rasons; s qusion C on Trasury's FAQ si ( 8 From Tabl of Trasury al (2004) and h hisorical Major Forign Holdrs abl (availabl a forign official holdings a all U.S. cusodians oald $864 billion ($653 billion in long-rm Trasury scuriis and anohr $2 billion in shor-rm Trasury bills), of which $757 billion wr hld in cusody a FRBNY. 6

11 Th wkly FRBNY daa ar h bs sourc of forign official flows ino U.S. scuriis. Howvr, forign official purchass ar ofn dwarfd by inflows from priva forignr invsors. For priva flows, w mus uiliz daa from h monhly TIC rpors. Monhly TIC Daa Th TIC sysm rpors monhly daa on h purchass and sals of all yps of long-rm scuriis (quiis as wll as corpora, agncy, and Trasury bonds) by all forignrs (ha is, forign officials and priva invsors). 9 As such, h TIC daa givs a much fullr picur of inrnaional flows ino U.S. scuriis. I is, howvr, lss imly han h FRBNY daa, bing rlasd six wks afr monh s nd. Whil h TIC sysm is mor comprhnsiv han FRBNY s cusodial rpors, for a las wo rasons TIC daa ar no as accssibl o mos daa usrs. Firs, h daa prsnaion is much mor complicad; FRBNY publishs a singl holdings numbr pr wk, whras h TIC sysm publishs a myriad of im sris ach monh. Scond, h TIC ransacions daa ar by dsign lss accura han FRBNY s cusodial daa. Rahr han dircly accssing invsors accouns o collc ransacions daa, h TIC sysm rlis on mark paricipans primarily banks and brokr dalrs o nr on rporing forms h amoun of gross purchass and gross sals bwn U.S. and forign rsidns. Th aggrga naur of h TIC ransacions daa dos no allow for h daild diing and chcking ha is possibl wih scuriy- or accoun-lvl daa. This, coupld wih h 9 Th TIC daa also includ daa on shor-rm insrumns and on U.S. invsors rading in forign scuriis. W do no focus on hs daa in his papr. 7

12 vr-incrasing complxiy of inrnaional financial sysms, maks mainaining high qualiy daa no small fa. Tha said, w hav no dirc way of knowing whhr h TIC capial flows daa ar accura, in par bcaus bnchmark survys of capial flows do no xis. Howvr, high qualiy scuriy-lvl bnchmark survys of forignrs' holdings of U.S. scuriis survys ha rcnly hav bn conducd annually can b usd o gaug whhr rcordd capial flows daa ar rasonably accura. Spcifically, on can form flowsbasd holdings simas and compar hm wih known holdings from h bnchmark survys. Th comparison is no prfc, bcaus unknown valuaion adjusmns ar incorporad ino h markd-o-mark posiions daa, bu larg discrpancis bwn holdings givn by h comprhnsiv bnchmark survys and holdings implid from capial flows daa would indica a problm wih h flows daa. Figur 3 shows flows-basd holdings simas (h solid lins) and bnchmark amouns (h dos) for forignrs posiions in Trasury, corpora, and agncy bonds; compl dails on h mhodology for forming h flows-basd holdings simas ar prsnd in h appndix. For Trasury bonds, rpord TIC flows appar o hav bn running a bi high in h la 990s; h March 2000 sima of $,063 billion is almos $200 billion highr han h amoun collcd hrough h bnchmark survy. Sinc hn, howvr, hr is no vidnc ha TIC flows for Trasury bonds ar inaccura, as simad holdings ar righ in lin wih bnchmark amouns. For corpora bonds, flows appar o hav bn slighly ovrsad a ims, bu h discrpancis ar no grgious. 8

13 Agncy bonds ar anohr sory: Th TIC sysm consisnly ovrsimas forignrs purchass of agncy bonds. Th discrpancy bwn flows implid from high-qualiy bnchmark survys and TIC rpord flows maks i difficul for mark paricipans o inrpr and us h TIC ransacions daa. W prsn a soluion in h appndix. Brifly, w can uiliz h bnchmark survy daa o guid a rsamn of monhly TIC flows. Th rsuling sris, which w call bnchmark-consisn flows, will b qui similar o rpord TIC flows whn TIC flows ar in lin wih h survys. Bu whr hr is a wid discrpancy bwn TIC flows and bnchmark survys--as wih agncy bonds--our bnchmarkconsisn flows will diffr subsanially from rpord TIC flows. Bcaus h TIC daa appar o ovrsa forign flows ino U.S. bonds (Figur 3), our adjusmns will gnrally rduc rpord flows. This is spcially ru for agncy bonds. For xampl, in h 2-monh priod from July 200 o Jun 2002, h TIC sysm rpord ha forignrs purchasd on n $206 billion in agncy bonds, whras our monhly bnchmark-consisn flows oald only $68 billion for h sam priod. In h mpirical work ha follows, w uiliz bnchmark-consisn flows. III. Th Impac of Forign Inflows on U.S. Long-Trm Inrs Ras Our basic approach follows Sack (2004): Esima a rducd-form modl of longrm nominal inrs ras ha includs sandard (bu wll hough-ou) macroconomic This ows o an inabiliy of h TIC sysm o cos-ffcivly collc daa on h priodic principal paymns on morgag-backd scuriis which should b rcordd as capial ouflows. Th TIC wb si ( dscribs h issu and provids adjusmns; howvr, hos adjusmns appar o b far oo small o limina h discrpancy. Th BEA also publishs inrnaional flows daa in hir quarrly BOP rlas. For long-rm scuriis, h quarrly BOP daa is formd ssnially by summing h monhly TIC daa. Howvr, BEA adjuss rpord TIC daa if hy fl i is warrand. BEA's drmins whhr TIC flows daa should b alrd by consuling h infrqun bnchmark posiions daa, so hir adjusmn is similar in spiri o ours. 9

14 variabls, show ha h modl prforms rasonably wll in normal ims bu lss so rcnly, and hn augmn h modl using various masurs of forign inflows ino U.S. bonds. W focus on h -yar Trasury yild. In Scion V w also analyz ohr long ras (Aaa and Baa corpora bond yilds and 30-yar fixd morgag ras) as wll as wo shor ras (2-yar Trasury yild and on-yar adjusabl morgag ras). III.A. Domsic Modl of -yar Trasury Yilds Th fac ha in 2004 and h firs half of 2005 long-rm Trasury yilds hav rmaind so low is considrd puzzling, largly bcaus convnional modls hav prdicd far highr ras. In his subscion w lay ou an xampl of a ypical rducdform modl. Th modl is rlaivly sandard, conrolling for h influnc of macroconomic condiions and h monary policy sing on Trasury yilds. Bcaus h Trasury yild is a forward-looking ass pric, w ry o rly on variabls ha ncompass forward-looking xpcaions. Spcifically, w assum ha h -yar Trasury yild is a funcion of xpcd growh, xpcd inflaion, a risk prmium, and monary and fiscal policy. W brifly discuss ach variabl. () Expcd Growh and Expcd Inflaion Nominal long-rm inrs ras ar, from h Fishr Equaion, a funcion of ral inrs ras and xpcd inflaion. For xpcd inflaion, w us boh a long-rm π + (-yar) masur, dnod, and a shorr-rm (on-yar) on ha w xprss

15 rlaiv o long-rm xpcaions ( π + π + ). 2 Expcd GDP growh ovr h subsqun yar (dnod (2) Risk Prmium y + ) hlps capur facors ha impac ral inrs ras. Invsors mus b compnsad for baring risk. Whil U.S. Trasury bonds h world s risk-fr ra should b fr of dfaul risk, invsors ar nvrhlss subjc o inrs ra risk. As inrs ras ris and fall, invsors holdings of xising Trasury bonds bcom lss (or mor) valuabl. To proxy for an inrs ra risk prmium ( rp ), w us h volailiy of long-rm inrs ras, calculad as h rolling 36-monh sandard dviaion of changs in long ras. (3) Monary and Fiscal Policy Currn monary policy, capurd by h arg fdral funds ra ( ff ), has a dirc impac on h shor nd of h yild curv and hus, basd on h xpcaions hory of h rm srucur, also impacs long ras. Fiscal policy, which should impac ral ras, is a bi rickir o capur. Bcaus long ras ar forward looking, bs for our purposs would b o follow Laubach (2003) and uiliz h long-dad budg projcions of h Congrssional Budg Offic (CBO) or Offic of Managmn and Budg (OMB). Howvr, hs projcions ar availabl only infrqunly. Insad, w us a radily availabl masur, h srucural budg dfici ( dfici ) xprssd as a prcn of laggd GDP. Our masur has on hing in common wih h long- 2 Ang, Bkar, and Wi (2005) show ha survys forcas inflaion qui wll.

16 dad projcions; bing srucural, i absracs from currn businss cycl condiions. 3 Th variabls includd ar inndd o provid an ffciv summary of conomic and policy condiions ha migh influnc Trasury yilds hrough hir implicaions for policy xpcaions and rm prmiums. Many of h rgrssors ar basd on survy daa rahr han ralizd oucoms, sinc xpcaions of fuur dvlopmns should b h primary drivr of Trasury yilds. 4 Two conomric issus aris in simaing his rgrssion; boh ar addrssd in robusnss chcks prsnd in a lar subscion. Th firs issu is h ponial ndogniy of h rgrssors. W ar assuming ha h righ-hand sid variabls do no rspond conmporanously o innovaions o h inrs ra. This assumpion sms rasonabl (and is widly usd) wih rgard o macroconomic variabls, which nd o b sluggish. Th assumpion is somwha lss convincing, bu is sill mainaind, wih rgard o survy xpcaions of macroconomic variabls and h currn fdral funds ra. As a robusnss chck, prsnd lar in his scion, w allvia his concrn by modling long-dad forward ras using only longr-rm xplanaory variabls; our main rsuls hold. Th scond conomric issu concrns h saionariy of h dpndn variabl. Ovr h pas wny yars, U.S. inrs ras and inflaion xpcaions hav drifd lowr, wih no apparn ndncy o rvr o som sabl avrag lvl. Tha is, hy 3 Morovr, as w will show, our simas of h impac of budg dficis on inrs ras ar no dissimilar from hos in Laubach (2003) or, by xnsion, Engn and Hubbard (2004). 4 Shor-rm GDP growh and inflaion xpcaions ar from h Blu Chip survy; long-rm inflaion xpcaions ar from h Philadlphia Fd s Survy of Profssional Forcasrs and ar inrpolad o monhly figurs. 2

17 appar o b nonsaionary. If hy ar indd nonsaionary and coingrad, an unrsricd rgrssion would pick up only h long-rm rlaionship and no h shorrrm dynamics ha w ar inrsd in. Thus, o accuraly sima h impac of ohr rgrssors, w impos an assumpion abou h long-run rlaionship bwn inrs ras and inflaion xpcaions ha is consisn wih h work of Mhra (998). In paricular, w assum ha Trasury yilds ar non-saionary and ar coingrad wih h fdral funds ra and xpcd inflaion by imposing ha h cofficins on hos wo variabls sum o on. 5 As a robusnss chck, w avoid his issu by modling ral inrs ras, which ar saionary. Our main rsuls hold (and hos rgrssions provid addiional analysis of h impac of flows on ral ras). Tabl prsns rgrssion rsuls using only domsic xplanaory variabls for h nominal -yar Trasury yild simad using monh-avrag daa from January 984 o May In his spcificaion, h mos significan drivrs of long-rm Trasury yilds ar xpcd long-run inflaion, h risk prmium, h siz of h budg dfici, and h lvl of h fdral funds ra. Dclining inrs ra volailiy lowrs long ras, and, in lin wih h rsuls in Laubach (2003), a on-prcnag-poin incras in h dfici-o-gdp raio incrass long ras by 24 basis poins. A onprcnag-poin incras in long-rm inflaion xpcaions nds o incras nominal long ras by 57 basis poins, and on prcnag poin of Fd ighning rsuls in a 43 basis poin incras. Th usual rlaionship bwn Fd ighning and h long ra is 5 This rsricion assums ha ral inrs ras ar saionary. I can b shown ha imposing his rsricion is idnical o simaing h rgrssion on h yild curv slop, wih on of h rgrssors qual o h dviaion of h fdral funds ra from h long-run inflaion ra. On could argu ha all of h variabls from his alrnaiv rgrssion ar saionary. Morovr, if his rsricion wr no imposd, h impac of long-run inflaion xpcaions would bcom implausibly larg. 3

18 shown clarly in Figur 4: Evry im h Fd mbarkd on a ighning cycls long-rm ras incrasd subsanially. Unil rcnly, ha is. Th fi of h quaions is gnrally good, wih an adjusd R 2 of abou Figur 2 shows h fi, bu also apparn is h puzzl: Givn currn macro and policy condiions, h domsic modl prdics ha h long ra should b roughly 0 basis poins highr han i currnly is. III.B. Forign Inflows and Long-rm Trasury Yilds Whhr h rcn larg forign inflows ar bhind h lowr han xpcd longrm Trasury yilds is a opn qusion. Morovr, o our knowldg, lil if any acadmic work has bn don on his opic, prhaps bcaus capial flows daa ar no asily inrprabl. 6 In his scion w prsn our rgrssion modl, which uss (alrnaly) hr masurs of capial flows ha ar inndd o capur any sysmaic ffcs of inflows on Trasury yilds. Th firs masur is h hadlin-grabbing forign official purchass of Trasury scuriis, which, as w hav shown, is jus on componn of h rcn larg inflows. Th scond and hird masurs mor broadly capur h forign flows ino U.S. fixd-incom marks. Th scond, lik h forign official flows, focuss on h Trasury mark: ovrall (ha is, boh forign official and priva forign) purchass of Trasury bonds. 7 Th hird is h broads masur of forign flows ino U.S. bonds: our bnchmark-consisn sris of ovrall forign purchass of all yps of U.S. bonds 6 Chinn and Frankl (2005) spcula ha rcn capial flows migh b diluing radiional inrs ra rlaionships. 7 Bnchmark-consisn flows for h componn of ovrall bond inflows ar no availabl prior o 994, so for his scond masur w uiliz rpord TIC daa. Figur 3 showd ha for Trasuris rpord daa ar rahr accura. 4

19 (agncy, corpora, and Trasury). In ach cas, h forign flow variabl is consrucd as wlv-monh flows scald by laggd GDP. 8 Rgrssion rsuls for h global modl of -yar yild ha includs forign flows ar prsnd in Tabl 2. As in h domsic modl, h cofficins on xpcd inflaion, h risk prmium, h siz of h budg dfici, and h lvl of h fdral funds ra ar highly significan. In addiion, xpcd growh bcoms significan in hs modls. Bcaus h cofficins on ( π + π + ) and π + ar of similar magniuds, in hs spcificaions shor-rm inflaion xpcaions appar o b subsanial drivrs of nominal long ras (prhaps bcaus hy adjus mor rapidly). Noably, all hr forign flow variabls xhibi a significan ngaiv impac on long ras. Jus as imporanly, a comparison of Figur 5 wih Figur 2 indicas ha including a forign flow variabl liminas h puzzl. Th global modl racks long-run ras wll, and rcn long-rm ras ar righ in lin wih fundamnals. Forign flows ar no only significan in a saisical sns, bu hir impac is also conomically imporan. Figur 6 shows h impac on h -yar yild of oal bond inflows and forign official inflows. No ha h graph is consrucd o show how much lowr U.S. ras ar in comparison wih h cas of zro inflows. Zro inflows ovr h cours of an nir yar ar common nough for forign official flows (s Figur ), bu ar infrqun vns for ovrall bond inflows. Tha said, had h las wlv monhs sn zro forign purchass of forign bonds, our simas suggs ha U.S. long ras would b 50 basis poins highr. Forign official accumulaion, a is 8 Forign official is acually h 2-monh chang in posiions, which ar masurd by FRBNY a fac valu (i.., hy do no includ valuaion adjusmns). W do no us changs in posiions for our ohr flow variabls bcaus in hos cass posiions ar markd-o-mark vry monh. Doing so would incorpora valuaion changs ino h flow variabl and, bcaus hs valuaion changs ow o inrs ra movmns, would hardwir rsuls. Our flows variabls do no suffr from his faur. 5

20 summr 2004 pak, dprssd U.S. long ras by 0 basis poins. For ovrall flows, a rurn o avrag inflows is prhaps a br bnchmark; had h U.S. aracd only avrag ovrall bond inflows (2 prcn of GDP) long ras would b 5 basis poins highr. A firs glanc, our rsuls appar o b larg; in no way can 50 basis poins b considrd a small ffc. Bu rcall ha forignrs ar major paricipans in U.S. bond marks. Thy ar mos conspicuous in h Trasury mark, whr as of Jun 2004 hy hld 50 prcn of ousanding radabl bonds, bu hy ar also imporan playrs in all U.S. marks, holding 20 prcn of h ovrall U.S. bond mark (Trasury al., 2005). Th U.S. bond mark is xpanding by roughly $2 rillion pr yar. On way o gaug h siz of our simas is o ask h following: If 20 prcn of h mark sa on h sidlins whil $2 rillion in nw bonds wr issud, is a 50-basis-poin incras implausibly larg? Anohr way o pu our rsuls in prspciv is o compar hm o ohr sudis of inrs ras. For xampl, Laubach (2003) found ha a on-prcnag-poin incras in h budg dfici would incras long ras by 25 basis poins. Ovr h cours of 2002 and 2003 h budg dfici incrasd from nar zro o 4 prcn of GDP, which, according o h Laubach simas, would imply a 0-basis-poin impac on long ras. If w winssd a similarly dramaic movmn in forign flows, our rsuls would imply a similar impac on long ras. Finally, h finding of a rlaivly larg forign official ffc on long-rm Trasuris may sm puzzling, considring ha forign official insiuions hav radiionally prfrrd scuriis wih shor mauriis. Howvr, indirc bidding aciviy 6

21 from Trasury aucions suggss ha hs insiuions hav movd fairly aggrssivly ino longr mauriis. This is corroborad by vidnc from bnchmark survy daa, which indicas ha as of mid-2004 mor han on-hird of forign official holdings had a rmaining mauriy of mor han four yars (Trasury al., 2005). In addiion, dollar for dollar, hr may b grar scop for pric ffcs on longr-rm insrumns; ffcs in h dpr marks for shorr mauriis may b limid bcaus hr ar larg amouns of priva asss availabl as subsius and bcaus prics of hos scuriis ar mor srongly anchord by monary policy insrumns (as shown blow). III. C. Robusnss Chcks In his subscion w prsn a numbr of robusnss chcks. To addrss any ponial concrns abou h non-saionariy of nominal inrs ras ovr our sampl and abou h impac of shor-run dynamics and businss cycl flucuaions on our rgrssions, w analyz ral ras and long-dad forward ras. W sima rolling rgrssions ha dpic h voluion of cofficin simas ovr im o ascrain whhr h significan ffc of forign flows on U.S. inrs ras ows solly o h rcn priod of rcord inflows. Finally, w bring corpora savings ino h modl o s if i, rahr han forign flows, is driving inrs ra movmns. Modling Ral Ras W bliv our main modl is wll spcifid, bu rcogniz ha in small sampls issus of non-saionariy ar difficul o convincingly addrss. Bu ral inrs ras ar clarly non-saionary, so w nx xamin ral long-rm inrs ras ( i π + ). As 7

22 Panl A of Tabl 3 shows, our main rsuls hold. Compard o h simas in Tabl 2, h cofficin simas on h forign flows variabls ar smallr, bu forign flows significanly impac ral long-rm ras. Eliminaing Effc of Shor-run Businss Cycl Variaions Any minor vn ha changs xpcaions should immdialy impac h long ra; on canno b crain ha w accound for vry shor-run variabl ha can impac Trasury yilds. To limina h impac of shor-run businss cycl flucuaions, w modl an xpcd fuur ral long ra, h ral 5-5 forward ra (i.., h fiv-yar ra fiv yars hnc), using only long-rm variabls. 9 Th rsuls ar prsnd in Panl B of Tabl 3. Absracing from businss cycl considraions, ral long-rm forward ras ar lowr whn risk prmiums dcras and budg dficis ar smallr. Morovr, h cofficin simas on h forign flows variabls ar consisn wih our main rsuls. Evn absracing from h ponially confounding ffcs of businss cycl flucuaions, forign flows hav a saisically and conomically significan impac on U.S. inrs ras. In all, Tabl 3 shows ha non-saionariy and businss cycl flucuaions ar unlikly o advrsly affc our main rgrssions of Tabl 2. Do h Rsuls Ow Solly o h Mos Rcn Priod? To drmin whhr our rsuls ow solly o h mos rcn priod of vry larg forign inflows, w sima rolling rgrssions of h -yar yild. Spcifically, w r-sima h rgrssions in Tabl 2 wih h firs r-simaion nding a January 9 Bcaus daa on 5-5 forward ras do no xnd back o January 984, w form hs ras using h sandard chniqu of Shillr, Campbll, and Schonholz (983). 8

23 994 and ach subsqun rgrssion xnding h sampl by on monh; h sar da is always lockd a January 984. Th voluion of h cofficins on h forign flows variabls ar prsnd in Figur 7. Th figur indicas ha for Toal Bond Inflows (Fig. 7(a)), h sima on h flow cofficin has bn ngaiv and significan for ovr a dcad. For h ohr yps of flows, h currn priod has indd playd an imporan rol. Prior o h surg in inflows ovr h pas fw yars, h cofficins on forign official and flows ino Trasuris wr no significanly diffrn from zro, alhough prior o h la 990s hs wr ngaiv and significan. Do Corpora Savings Solv h Puzzl? JPMorgan (2005) is a wll-publicizd pic ha claims o solv h puzzl of low long ras by including a masur of corpora savings. 20 Th logic is ha as h corpora scor movd from a n borrowr in 2000 (wih a financing gap of abou 3 prcn of GDP) o a n savr by 2004 (a slighly ngaiv financing gap), hir rducd dmand for capial should hav pu downward prssur on inrs ras. To s whhr corpora savings, rahr han forign flows, hlps xplain h puzzl, w includ a masur of h corpora financing gap (scald by GDP). Bcaus h financing gap is availabl only quarrly, for his s w uiliz a quarrly modl. Th rsuls ar prsnd in Tabl 4. W find no vidnc ha h incrasd corpora savings has pu downward prssur on U.S. inrs ras; indd, h sign on h 20 S h wri up in h July 9, 2005 Economis aricl, Th corpora savings glu. 9

24 (insignifican) cofficin would suggs h opposi. As in prvious abls, in all hr modls forign flows ar conomically and saisically imporan. 2 IV. Inrpraion of Our Main Rsuls Th finding ha h larg forign flows ino U.S bonds has kp U.S. inrs ras low lavs an inrsing qusion unanswrd. Do forign purchass rprsn a porfolio shif from forign o U.S. bonds? Or is h forign accumulaion par of a global savings glu in which bonds of all counris ar bing purchasd a lvad amouns? W suspc ha ovr im boh ffcs ar a work, prhaps wih varying innsiis and rlaiv imporanc. Unforunaly, a rigorous xaminaion is hamprd in par by lack of daa, as sufficin im sris of capial flows ar availabl for surprisingly fw counris. For xampl, Warnock (2003) and Tsar and Wrnr (995) wr abl o loca rasonabl capial flows daa for only a fw counris. W can, howvr, rly on pric daa o shd som ligh on his qusion. In paricular, if h dclin in U.S. inrs ras is bing drivn by a global rnd, w should s vidnc ha U.S. ras ar bing draggd down by forign ras. Tha is, in our framwork, a forign sprad variabl, calculad as forign ras lss U.S. ras, should b posiivly rlad o U.S. long ras if a global savings glu is driving forign and U.S. ras lowr. In conras, if h larg capial flows ino U.S. bonds rprsn h shifing of global porfolios from forign 2 W wr surprisd o find rsuls ha diffrd so graly from hos in JPMorgan (2005), so w invsigad furhr. W uilizd, as hy did, daa on non-financial firms financing gap from h Fdral Rsrv s Flow of Funds Accouns (Tabl F.2 lin 59). JPMorgan appnds a masur for financial firms, alhough no such masur xiss. Bu hir appndd sris is oo similar o h rpord on o xplain h diffrnc in rsuls, which appars o ow o h sampl; hir sampl xnds back o 959, and h fw-yar priod nding 984:Q xprincd vry high inrs ras and a vry high financing gap. 20

25 bonds ino U.S. bonds, h forign sprad variabl should b ngaivly rlad o U.S. ras whn forign ras ris rlaiv o U.S ras, U.S. ras fall. Tabl 5 provids vidnc suggsiv of h porfolio swiching ffc. Th forign sprad variabl is no posiiv, bu rahr is ngaiv and significan. Whn forign ras ris rlaiv o U.S ras, U.S. ras ar falling, suggsing ha h inflows ar h rsul of porfolio-swiching by global bond invsors. Our inn is no o us h rgrssions prsnd in his subscion o rul ou h global savings glu sory, bu o provid furhr vidnc o guid h inrpraion of our rsuls. In fac, i is likly ha a ims xcss global savings pushs down U.S. ras. Howvr, h long-rm vidnc is mor supporiv of a swiching ffc. V. Th Impac of Forign Inflows on Ohr U.S. Inrs Ras Whil h focus of our papr is on long-rm Trasury yilds, for furhr invsigaion w prsn rsuls for ohr long-rm inrs ras as wll as shor-rm ras. Our rgrssion spcificaions ar as in h prvious scion, alhough w includ on xra variabl, cycl, a ral-im indicaor of h sa of h businss cycl. 22 Th businss cycl variabl plays wo rols in wha follows. Whn mploymn growh is vry wak, risk prmiums on som of h riskir bonds w considr blow migh widn, so Cycl may capur a risk prmium ffc (spara from h inrs ra risk prmium). Also, whn w urn o shorr ras ha adjus vry quickly, hr is a chanc 22 Using ral-im daa from h Philadlphia Fd, w compu cycl as h dviaion of currn ral-im mploymn growh from is 36-monh avrag. Thr is a ponial rol for cycl in our main rgrssions, as Gurkaynak, Sack, and Swanson (2005) show ha long-rm ras adjus o mploymn rpors. Bu including cycl in our rgrssions for h -yar Trasury yild would no alr our rsuls, prhaps bcaus Gurkaynak al. argu ha surpriss from mploymn rpors impac long ras hrough changs in inflaion xpcaions (for which w conrol). 2

26 ha our xpcaions daa ar sluggish. If so, h ral-im businss cycl variabl could pick up insananous adjusmns in xpcaions. V. A. Rsuls for Ohr Long-Trm Ras To s if our rsuls also hold for a broadr s of U.S. long-rm inrs ras, w r-sima h rgrssions for corpora bond yilds (for boh Moody's Aaa and Baa) as wll as a 30-yar fixd morgag ra. 23 Th rsuls ar prsnd in Tabl 6. Whil h cofficin simas for som variabls diffr somwha from hos in our bnchmark rgrssions, h drivrs ar similar. In paricular, hs ohr long ras nd o b drivn by inflaion and growh xpcaions as wll as risk prmiums and policy variabls. Morovr, forign flows xhibi a subsanial impac on hs marks. V. B. Rsuls for Shor-Trm Ras Shor-rm inrs ras ar mor closly id o h fdral funds ra, so w xpc h impac of forign flows o b mor mud. Tabl 7 confirms his for boh h 2-yar Trasury yild and h -yar adjusabl ra morgag (ARM). For boh, h cofficin on h forign flows variabl is abou half hos in prvious abls, whil h cofficin on h fdral funds ra has incrasd subsanially. No oo ha h cofficin on h businss cycl indicaor plays diffrn rols in hs rgrssions. For ARMs, cyclical waknss is associad wih highr ras, prhaps his ows o grar dmand for h lowr ras of ARMs whn unmploymn is mporarily high. In 23 Th corpora bond ra daa is from h Fdral Rsrv Board H.5 saisical rlas ( Morgag ra daa ar from Frddi Mac's Primary Morgag Mark Survy ( 22

27 conras, for shor-rm Trasury yilds, h cofficin on h businss cycl indicaor is posiiv; cyclical waknss is associad wih a dcras in shor ras. A comparison of h cofficins on h forign flows variabls in Tabl 7A and Tabl 2 suggss ha forign flows can xplain a las som of h rcn flaning of h yild curv. In h las yar and a half of our sampl, h -yar minus 2-yar sprad dcrasd by 85 basis poins. Our rgrssions suggs ha h diffrnial impacs of forign flows on hs ras ar associad wih 75 basis poin of his flaning. VI. Conclusion This papr rprsns a firs amp a analyzing h impac of forign flows on a larg dvlopd conomy. Pas work has augh us much abou h rol of forign invsors in mrging mark. W can now add our rsuls o his liraur: Forign flows hav an conomically larg and saisically significan impac on long-rm U.S. inrs ras. Our work also appars o limina a currn puzzl. Long ras ar indd low, bu no surprisingly so. Th rsuls in his papr suggs ha larg forign purchass of U.S. bonds hav conribud imporanly o h low lvls of U.S. inrs ras obsrvd ovr h pas wo yars. W prsn a rang of simas of h impacs of forign flows, dpnding on diffrn assumpions of wha h normal lvl of flows is. Th mos xrm comparison is wih h hypohical cas of zro forign accumulaion of U.S. bonds ovr h cours of an nir yar, which w show would lav long ras 50 basis poins highr. 23

28 W cauion ha alhough w prsn a muliud of robusnss ss, i is possibl ha our rsuls ovrsa h ffcs of forign flows. On migh suspc ha ohr facors no complly capurd by h rgrssors wr puing downward prssur on inrs ras ovr his priod. Thos ohr facors includ FOMC samns suggsing ha policy accommodaion would b rmovd only slowly, worris abou h risk of dflaion, or a gnrally mor bnign oulook for inflaion han suggsd by h Philadlphia Fd s survys (which hav long-run inflaion xpcaions as ssnially fla sinc h middl of 998). Sill, h facs w prsn ar suggsiv of sizabl ffcs: Inrs ras appar o b somwha low, our rgrssions aribu a subsanial porion of his bhavior o forign purchass, and h fi of our global modl racks acual Trasury yilds qui wll. Forign buying of U.S. bonds has clar bnfis for h U.S. conomy. For xampl, by hlping o kp inrs ras rlaivly low, forign buying has lowrd borrowing coss and spurrd conomic aciviy. Consumrs bnfi bcaus, for xampl, h monhly morgag paymn on a 30-yar fixd morgag is $58 lss a a 6 prcn ra compard o h zro-inflow cas of 7.2 prcn ra. Fuur work migh provid a mor daild xploraion of h implicaions of forign flows for h ral sid of h U.S. conomy. Th radr migh ask whhr a rra of forign invsors from U.S. bond marks is likly imminn. No ncssarily. To b sur, as w showd in Figur, forign official inflows ar currnly slowing, as hy hav many ims in h pas. Eas Asian counris' xchang ra managmn has bn on major sourc of h rcn official dmand (Dooly, Folkrs-Landau, and Garbr (2004)), and whhr hs 24

29 counris will coninu o acquir larg amouns of U.S. scuriis is in qusion. Th fuur dmand from forign officials is difficul o prdic wih any crainy i is saf o say ha hir objciv funcions ar sufficinly complx and includ much mor han jus a dsir for high risk-adjusd porfolio rurns. Bu wih U.S. bonds comprising roughly half h global bond mark, ohr inrnaional invsors b hy spculaors or insiuions such as pnsion funds ar no likly o complly abandon h U.S. mark. Indd, zro n inflows ino U.S. bonds ovr a susaind priod has no occurrd in a las 20 yars. Evn during h rcssion, whn h U.S. currn accoun was mporarily balancd (and hus n capial inflows wr no rquird), annual forign purchass of U.S. bonds sill oald abou on prcn of GDP (compard o h currn rcord annual bond inflows of roughly 6 prcn of GDP). This is no o say ha a rra could no occur, jus ha a compl and susaind rra is unlikly. 25

30 Rfrncs Ang, A., G. Bkar, and M. Wi, Do Macro Variabls, Ass Marks or Survys Forcas Inflaion Br? Mimo. Bakr, M., R. Grnwood, and J. Wurglr, Th Mauriy of Db Issus and Prdicabl Variaion in Bond Rurns. Journal of Financial Economics 70: Bkar, G., Harvy, C., and C. Lundblad, Dos Financial Libralizaion Spur Growh. Journal of Financial Economics 77: Brnank, B., V. Rinhar, and B. Sack, Monary Policy Alrnaivs a h Zro Bound: An Empirical Assssmn. Financ and Economics Discussion Papr # , Board of Govrnors of h Fdral Rsrv Sysm. Brand, M., and K. Kavajcz, Pric Discovry in h U.S. Trasury Mark: Th Impac of Ordrflow and Liquidiy on h Yild Curvr. Journal of Financ 59(6): Chari, A., and P. Hnry, Risk Sharing and Ass Prics: Evidnc from a Naural Exprimn. Journal of Financ 59(3): Chinn, M., and J. Frankl, Th Euro Ara and World Inrs Ras. Wisconsin and Harvard mimo. Dibold, F., M. Piazzsi, and G. Rudbusch, Modling Bond Yilds in Financ and Macroconomics. Amrican Economic Rviw Paprs and Procdings (forhcoming). Dooly, M., D. Folkrs-Landau, and P. Garbr, Th Rvisd Bron Woods Sysm: Th Effcs of Priphry Inrvnion and Rsrvs Managmn on Inrs Ras and Exchang Ras in h Cnr. NBER Working Papr 332. Engn, E., and R.G. Hubbard, Fdral Govrnmn Db and Inrs Ras. NBER Working Papr No. 68. Evans, M., FX Trading and Exchang Ra Dynamics. Journal of Financ 57: Evans, M., and R. Lyons, Ordrflow and xchang ra dynamics. Journal of Poliical Economy : Fama, E., and K. Frnch, 989. Businss Condiions and Expcd Rurns on Socks and Bonds. Journal of Financial Economics 25:

31 Frson, W., and C. Harvy, 99. Th Variaion of Economic Risk Prmiums. Journal of Poliical Economy 99: Frson, W., and C. Harvy, 993. Explaining h Prdicabiliy in Ass Rurns. Rsarch in Financ : Grn, C., Economic Nws and h Impac of Trading on Bond Prics. Journal of Financ 59: Grnspan, A., Rmarks o h Inrnaional Monary Confrnc, Bijing, Popl s Rpublic of China (via salli), Jun 6, Gurkaynak, R., B. Sack, and E. Swanson, Th Snsiiviy of Long-Trm Inrs Ras o Economic Nws: Evidnc and Implicaions for Macroconomic Modls. Amrican Economic Rviw 95(): Hnry, P., Do Sock Mark Libralizaions Caus Invsmn Booms? Journal of Financial Economics 58: Hnry, P., Capial Accoun Libralizaion, h Cos of Capial, and Economic Growh. Amrican Economic Rviw 93(2): JPMorgan, Corporas Asr Driving h Global Saving Glu. Kim, D., and R. Sambaugh, 986. Prdicing Rurns in h Sock and Bond Marks. Journal of Financial Economics 7: Laubach, T., Nw Evidnc on h Inrs Ra Effcs of Budg Dficis and Db. Financ and Economics Discussion Papr #2003-2, Board of Govrnors of h Fdral Rsrv Sysm. Mhra, Y., 998. Th Bond Ra and Acual Fuur Inflaion. Economic Quarrly, Fdral Rsrv Bank of Richmond (Spring). Myr, L., and B. Sack, Forign Official Purchass and Trasury Yilds. Monary Policy Insighs, Macroconomic Advisrs (Dcmbr). Piazzsi, M., Bond Yilds and h Fdral Rsrv. Journal of Poliical Economy 3(2): Roach, S., Lssons from Morgan Sanly. Sack, B., Rgrssion Evidnc on h Effcs of Forign Official Purchass of U.S. Trasury Scuriis. mimo, Board of Govrnors of h Fdral Rsrv Sysm. 27

32 Shillr, R., J. Campbll, and K. Shonholz, 983. Forward Ras and Fuur Policy: Inrpring h Trm Srucur of Inrs Ras. Brookings Paprs on Economic Aciviy, Thomas, C., F. Warnock, and J. Wongswan, Th Prformanc of Inrnaional Porfolios. Inrnaional Financ Discussion Papr #87, Board of Govrnors of h Fdral Rsrv Sysm. Trasury Dparmn, Fdral Rsrv Bank of Nw York, and Board of Govrnors of h Fdral Rsrv Sysm, Rpor on Forign Holdings of U.S. Scuriis as of Jun 30, Warnock, F., and C. Clavr, Financial Cnrs and h Gography of Capial Flows. Inrnaional Financ 6():

33 Appndix. Craing Bnchmark-Consisn Capial Flows Daa To cra bnchmark-consisn capial flows daa, w rsa monhly TIC flows so ha flowsbasd holdings simas ar consisn wih holdings rpord in priodic bnchmark survys. Daa Rquirmns Bilaral capial flows. Forignrs ransacions in U.S. scuriis ar rpord monhly o h TIC Sysm, mainly by brokrs and dalrs. For U.S. long-rm db scuriis (wih original mauriy grar han on yar), hs mandaory rpors conain informaion on gross purchass and gross sals (a mark valu) and h counry of h forign counrpary o h ransacion. Th TIC daa ar availabl a Bnchmark liabiliis survys. Daa on forign holdings of U.S. scuriis, availabl a ar collcd in daild bu infrqun scuriy-lvl bnchmark liabiliis survys conducd in Dcmbr of 978, 984, 989, and 994; March 2000; and Jun of 2002, 2003, and Rporing o h survys is mandaory, wih pnalis for noncomplianc, and h daa rcivd ar subjcd o xnsiv analysis and diing. For liabiliis survys (of forign holdings of U.S. scuriis), h rporrs consis primarily of larg cusodians (banks and brokr-dalrs). U.S. firms ha issu scuriis ar also includd in h survy, bu hy ypically hav lil informaion abou h acual ownrs of hir scuriis bcaus U.S. scuriis ar ypically rgisrd on hir books in sr nam ha is, in h nam of h cusodian, no of h ulima invsor. Valuaion adjusmns. W uiliz hr Lhman Brohrs indxs: Lhman Brohrs US Trasury Indx, Lhman Brohrs US Agncy Indx, and Lhman Brohrs US Corpora Invsmn Grad Indx. Transacion coss. Th TIC daa ar rpord gross a cos including commissions and axs, so o compu h valu of scuriis bough or sold, an adjusmn for ransacion coss mus b mad. For round-rip ransacion coss in U.S. db scuriis, w rly on rough simas of bidask sprads providd by mark paricipans of 5 basis poins on US Trasury db, basis poins on US agncy db, and 25 basis poins on US corpora db. Mhodology To form bnchmark-consisn capial flows daa, w firs form monhly bnchmark-consisn holdings. Th rsad flows consisn wih hos holdings simas ar our bnchmarkconsisn flows. W form spara simas for agncy, corpora, and Trasury bonds. All ha follows is for a paricular yp i of long-rm db scuriy (i=agncy, corpora, Trasury); w omi h subscrip i in h quaions blow. W bgin by forming naiv baslin simas. End-of-monh holdings ar formd by adjusing h prvious monh s holdings for simad pric changs and adding h currn monh s (ransacion cos-adjusd) n purchass. Spcifically, w us h following formula o form naiv simas of forign invsors holdings of U.S. db scuriis a h nd of priod : 24 Dails of h 2004 liabiliis survy, including findings and mhodology, ar discussd in Trasury Dparmn al. (2005). Grivr, L, and Warnock (200) is a primr on h survys. Th rcn annual survys ar mini survys ha srv o supplmn h quinqunnial full bnchmarks. 29

34 nh = nh ( + r ) + gp ( c) gs ( + c) (A) whr nh r gp gs c naiv simas of forign holdings of U.S. bonds a h nd of monh rurns from priod - o, compud from appropria pric indics forignrs gross purchass of U.S. bonds during monh forignrs gross sals of U.S. bonds during monh a consan adjusmn facor for ransacion coss W hn combin h naiv baslin simas wih holdings from h infrqun bnchmark survys (conducd a im T) o form bnchmark-consisn holdings simas. For xampl, o form simas for h January March 2000 inr-survy priod, w sar from h Dcmbr 994 bnchmark survy amoun and apply quaion (A) o form simas o March Doing so rsuls in a naiv sima of holdings as of March 2000 (nh T) ha diffrs from holdings as givn by h bnchmark survy (bh T ) by an amoun, gap T : gap T = bh nh (A2) T T On possibl caus for h gap is rrors in h capial flows daa. Assuming ha such rrors ar largr in monhs wih grar rading aciviy, w add o ach inr-survy monh an amoun ha is a funcion of h gap and h proporion of inr-survy rading aciviy ha occurrd in ha monh. Tha is, w add o monh s n purchass of U.S. bonds an adjusmn givn by: adj gp + gs * adjfacor * (A3) gp + gs = gapt T k = k k whr priods and T span h nir inr-survy priod. For ach inr-survy priod, vryhing on h righ sid of (A3) is givn xcp adjfacor, which w choos o minimiz h disanc a im T bwn bnchmark holdings and our adjusd holdings simas: min bht h T (A4) whr our adjusd holdings simas, h, volv according o h = h ( + r ) + gp ( c) gs ( + c) + adj (A5) and, for all, w impos a non-ngaiviy consrain on our holdings simas: h 0 (A6) Bcaus h adjusmn for any priod mus b par of h rvaluaion ha producs priod + holdings (and so on), his is no a simpl linar problm and, accordingly, w mploy a gridsarch mhod o solv for h adjusmn facor. Onc h adjusmn facor is drmind and applid o (A3), our bnchmark-consisn flows, or n purchass (np ), ar givn by np = gp ( c) gs ( + c) + adj (A7) 30

35 No hr faurs of our adjusmn facor. Firs, adjfacor can diffr across inr-survy priods. Scond, adjfacor is consan wihin an inr-survy priod, bu h adjusmn islf, adj, is im-varying. Third, for h priod afr h las survy w canno form adjusmn facors and so apply adjfacor from h prvious inr-survy priod. To h xn ha h rlaionship bwn TIC-rpord flows and bnchmark survys will chang in h fuur, our simas ha pos-da h mos rcn survy should b considrd prliminary. 3