Foreign Currency Flows and Real Exchange Rae Volatility. By Alejandro Micco

Transcription

1 Foreign Currency Flows and Real Exchange Rae Volatility By Alejandro Micco Abstract In this paper we study the effect of foreign flows on the RER. We consider not only capital flows but also current account flows. The Balance of Payments is opened in as much component as possible, distinguishing different type of flows and inflows from outflows. Policy prescriptions on how to contain real exchange rate volatility, in particular appreciations, should depend on which flows have the highest effect, if any. We use a series of instrumental variables to capture the exogenous shock to each type of low. We also look at the relevance of Pension Funds, Sovereign Funds, Central Bank Reserves and Cross-Border financial flows. In addition to the RER we also look at effects on tradable and non-tradable asset prices using data on stock prices. The variables we use are able to explain a relevant proportion of RER volatility. Keyword: EconLit Subject Descriptor:

2 1. Introduction Following the global crisis of 28-29, several emerging countries, particularly Latin America, have seen their currencies appreciate significantly. The Brazilian real, for example, gained about 5% against the dollar during the year. Similar trends have shown the Chilean peso and Colombian peso. As shown in Figure 1a, Latin America is a region where the real exchange rate has been particularly volatile, although as shown in Figures 1b and 1c, there is considerable diversity among these countries. 6 5 Figure 1a Volatility of RER by Region Avg Std Dev DEV EAS EEU EU LAC OTH Region Figure 1b

3 Avg Std. Dev Volatility of RER by Country ARG BRA CHL COL MEX PER VEN Country Avg Std Dev Figure 1c Volatility of RER by Country: excluding crisis episodes ARG BRA CHL COL MEX PER VEN Country Owned construction using IFS data. The recent appreciation has led several economies to take steps to curb the appreciation, including taxes on capital flows and massive purchases of international reserves. In the present work, we do not wonder whether these measures are effective or not, but we rather wonder about the real culprits of the appreciation. The exchange rate is, without doubt, very important in any economy, but especially in

4 small open economies. Frenkel and Ross (26) study the link between real exchange rate and unemployment in Latin America, concluding that real exchange rate appreciations cause an increase in unemployment. Similarly, Galindo et al. (26) found that in Latin America appreciations of the real exchange rate are accompanied by job losses in the industrial sector, a result that depends on the degree of dollarization of the economy. These results are consistent with findings in Mejía- Reyes (24). There are also studies examining the impact of exchange rate misalignment on the economy. Aguirre and Calderón (25) and Razin and Collins (1997), found adverse effects of deviations from real exchange rate to the level that determine the fundamental variables on growth. In some cases, the effects found are not linear. Charles Engel (21) shows that this salting can have major impacts on welfare. Given the importance of real exchange rate, it is imperative to study its determinants. There are several previous studies on the determinants of the real exchange rate. Career and Restout (28) investigated the determinants of long-term real exchange rate, contrasting the countries of South America with Central America and the Caribbean. The authors find evidence contrary to the theory of Purchasing Power Parity and found a number of variables affecting long-term level of this variable. Similar results are found by Caporale and Gil-Alana (28). Much emphasis has been placed in the external determinants of real exchange rate in Latin American countries. Reinhart et al. (1993) found that the region's real exchange rate is largely determined by external variables such as interest rates in the U.S. and capital flows originated in developed countries. Somewhat similar findings are made by other authors such as

5 Izquierdo et al. (28) and Edwards (1998). In a recent paper, Engel (21) breaks down the forces behind the movements of real exchange rate between real long-term component and a residual associated with the risk premium. In this paper we focus on the impact of exogenous shocks to flows of currencies on the real exchange rate. Not only analyze capital flows, but also those associated with the current account. For many commodity-exporting economies, flows coming from the high price of these commodities will be higher than capital flows and may well be a more important determinant of fluctuations in the real exchange rate. Figure 3 shows the importance of each component for the case of Chile, Colombia and Peru. Also, price increases of imported goods like oil, can significantly affect the real exchange rate. Figure 2a: Currency Flows in Chile: Trade and Capital Flows

6 Figure 2b: Currency Flows in Colombia: Trade and Capital Flows Figure 2c: Currency Flows in Chile: Trade and Capital Flows Source: IMF Note: data in millions of US$. We focus on the volatility of real exchange: appreciations and depreciations. The present work does not seek to establish the determinants of long-term level of real exchange rate, which is more related to the Dutch disease literature. The former is of

7 great importance since it is debatable whether policies can affect the level of the exchange rate but is at least arguable that policies may affect the volatility of it. A second important contribution of this paper is to study net and gross liability/assets as amplifier or buffer of exogenous shocks on real exchange rate. A sudden stop of capital flows, due for example by a change in the willingness of foreign savers to invest in the domestic economy, increases the costs of capital and therefore a country with high net liability will face an outflow of currencies and therefore an depreciation. Although, international assets holdings by residents provide the first line of defense against these non-fundamental-driven shocks to capital flows. The key price variable is the expected return in the domestic economy. Drops in inflows must push up domestic returns if domestic assets invested abroad are to return to the domestic economy. An economy s ability to absorb shocks to capital inflows will depend on its level of financial development (which will affect the interest rate response) and the stock of gross international assets (which places bounds on the size of the shock that can be absorbed). Arguably, developed economies are better prepared to face financial shocks along both dimensions. The second line of defense is provided by productive assets, capable of generating export revenues that offset the inflows. Another important aspect that relates to the above, is the impact of external demand shocks and how important has been the policy of stabilization funds to reduce the volatility that they introduce. For TOT shocks, we should expect that countries with or without gross assets held abroad should have the same behavior in term of flows of currencies and real exchange rate. After a negative shock of TOT inflows should fall and outflows increase.

8 In terms of local financial development is important to see the role that they are playing in terms of boost or reduce the fluctuations of the exchange rate in the short run. It is important at this point is to analyze the role of institutional investors. These two point are beyond the scope of this paper. Another relevant related aspects, that go beyond the scope of this paper, is the role played by local financial development and institutional investors (sovereign funds) to increase or smooth the volatility of the exchange rate, probably more important for countries such as Chile in Latin America. Same for SWFs and net international reserves. Figure 3 shows the diversity of policies that have followed Chile, Colombia and Peru in this regard. Figure 3

9 A major difficulty faced by this type of study is to differentiate the exogenous component of foreign exchange flows from the endogenous response. The interest of this work is to study how exogenous shocks to different components of the balance of payments affect the volatility of real exchange rate. It is therefore necessary to find a set of instrumental variables to identify each component. For example, in the case of exports, their price can be a good proxy of the exogenous component, provided the price is determined in international markets as is the case of commodities.

10 Therefore, the work breaks down the balance of payments in as many components as possible, distinguishing inflows from outflows. This is done for a large number of emerging countries. Thus, we build a panel data set. Then we instrument each of these components in order to determine how shocks to each of them affect the real exchange rate. The rest of the paper proceeds as follows. Section 2 presents, in a small open economy, the effect of TOT and risk aversion shocks on RER, capital flows and output. This paper follows the growing literature on the analysis of portfolio composition and financial markets in dynamic general equilibrium models. 1 Section 3 describes the data used in the empirical part and estimates a panel VAR for 28 countries. Finally, section 4 concludes. 2.- General Equilibrium Models with portfolio choice and TOT and capital flows International financial integrations has been one of the salient global economic developments in recent decades. Countries have accumulated substantial cross-border holdings, and there have been sizable shifts in the composition of asset and liability positions. In particular, the size of countries' external portfolios is now such that fluctuations in exchange rates and asset prices cause very significant reallocations of 1 Related papers are Engel and Matsumoto (25), Evans and Hnatkovska (26), and Kollman (26).

11 wealth. In this new scenario, exchange rate plays a dual role played in influencing both trade and net capital flows and net capital gains on external holdings. 2 This paper follows the idea developed in Devereux and Sutherland (26), which incorporate optimal portfolio choice in a standard dynamic general equilibrium macro model. This feature is incorporated into a simple two-country, with different sizes, model of an open economy with Calvo price-setting, stochastic productivity/term of trade shocks and capital flow shocks. In this set up, to hedge domestic and foreign shocks, households hold foreign asset and liabilities at the same time. RER and asset/liabilities allow households to reduce consumption volatility. The value of an asset is determined by the expected present discounted value of its current and future payouts. Since persistent productivity shocks drive the real payoffs of assets, price stickiness should have only a small effect on the expected present value. One of the central insights of this paper is that transitory price stickiness can have a large impact on international asset choice. It draws on the observation that, under flexible goods prices, terms-of-trade changes can provide substantial insurance for productivity shocks, even in the absence of trade in assets. For example, a negative domestic productivity shock reduces the supply of home goods, but the effects of this shock on home income can be offset, to some extent, by an increase in the relative price of exports. If prices are flexible, portfolio diversification may not increase expected utility much because of the automatic risk diversification from the terms-of-trade adjustment. However, the risks encountered under sticky prices cannot be insured by terms-of-trade movements. While these risks may be only transitory, 2 See Engel and Matsumoto (29)

12 they might have a dominant role in portfolio choice because the portfolio is the only means of insuring against these shocks. When prices are sticky, the mix of home and foreign equities can differ dramatically from the mix under flexible prices, even when prices adjust relatively rapidly. Lane and Milesi-Ferretti (21,26) document the huge growth in the size and complexity of international financial portfolios over the last decade. They show that many countries have built up large gross holdings of different financial assets, both in equities and bonds. Since this may have substantial implications for the potential for cross-country risk-sharing, it is likely to have repercussions for the analysis of monetary policy and REER volatility. 3.- Empirical methodology In order to capture the impact of external trade and financial shocks on Real Exchange Rate we estimate the following structural VAR: Y c, t = A1Y c, t ApYc, t p + vc; t where c denotes country, t time, A a (4x4) matrix of parameters, p the number of lags in the VAR, and v a vector of structural errors, with v c t Bec, t, =. e vector of orthogonal shocks. The variables of the VAR are included in vector y as: Y t Pexpt _ Shock Inflow_ Shock = NetCapFlows lreer where Pext_Shock is the log of export price multiply by the previous year exports, Inflow_shock is the log rate of total inflows to emerging economies, NetCapFlows is

13 net capital flows to country c divided by nominal GDP (t-1), and REER is the log of real exchange rate (IMF). We control for seasonality (dummies). To study whether countries with asset and liabilities abroad have different reactions to external shocks we split the sample between countries with high excess financial asset (total external liabilities plus total assets abroad minus the absolute value of net asset abroad) 3 We impose the following restrictions on the parameters in the A matrixes to identify the exogeneity of home country shocks and feedbacks between the endogenous variables of the model: A A A = A A A A A A A A 34 A44 The zeros in the first two rows impose that export prices and capital flows to emerging countries are not affected by changes in the host country. We do not impose any structure for the exogeneity of net capital flows and real exchange rate (last two columns). In addition we assume that the relationship between the structural errors (v) and the reduced form disturbances (e) is given by: v c, t = Bec, t where B B B = B B B B B B B B 34 B44 As above, the zeros in the first two rows implies there is no feedback between foreign 3 This measure asset and liabilities abroad above the required to have countries net foreign position. This measure is equivalent to excess job reallocation in the macro-labor literature. See Davis, Haltiwanger and Schuh (1996).

14 shocks and local variables. The zeros in the second row guarantee that there is no contemporaneous effect between trade shocks and capital inflows shocks. In some specifications we impose that the coefficient b43 is zero. In this case the trade and capital inflows shocks are treated completely symmetrically. Using a quarterly panel of data for 28 countries during , we estimate the model above and compute impulse response functions that we use to analyze the differential response of real exchange rate to different external shocks. Real exchange rate and net capital inflows are mainly obtained from the IMF s International Financial Statistics and Central Banks. Table 2 presents the summary of the data used. The standard deviation of the real exchange rate is cc%. Table 2: Summary Statistics Variables are Annual Rate of growth Excess Standard Deviation Country Obs Period Asser-Liab RER Ex.Inflow Shock Ex.Exp P. Shock 1 Argentina Australia Bolivia Brazil Chile Colombia Costa Rica Greece Indonesia Ireland Israel Latvia Malaysia Mexico New Zealand Peru Phillipines Portugal Russian Fede South Africa Thailand Turkey Uruguay Venezuela, R czech republ hungary Total Corr

15 Source: Central Banks, IFS and countries super-intendencies. Results We estimate the structural VAR, with fixed effect, described above for Real Exchange Rate in our sample of 28 emerging countries. Following Love and Zicchino (26), in Table 3 we report the results of the model with four variables, using 4 lags, and considering the whole sample (28 Countries). We also report graphs of the impulse-response functions and the error bands for the real exchange rate to external export prices and capital inflows shocks. Table 3: Baseline Results (Whole sample; 4 lags) Response of Real Exchange Rate (rate of growth) to: Export Price Shock Foreign Capital Inflows Shock Period Coef Std.Error Coef Std.Error.3%.13%.26%.13% 1.16%.2%.46%.2% 2.31%.24%.31%.25% 3.34%.27%.13%.27% 4.37%.25%.2%.29% 5.44%.21%.3%.3% 6.52%.18%.6%.28% 7.57%.17%.1%.24% 8.59%.17%.13%.21% 9.6%.17%.14%.19% 1.62%.17%.15%.17% 11.64%.16%.15%.16% 12.65%.16%.16%.15% 13.67%.16%.16%.13% 14.68%.16%.17%.12% 15.68%.16%.17%.11% 16.69%.16%.18%.1% 17.69%.16%.18%.1% 18.69%.16%.18%.9% 19.69%.16%.18%.9% 2.69%.16%.18%.8% Observations: 1555 Countries: 28

16 Figure 3(a) reports the impulse response of the real exchange rate to a one standard deviation of the exports price shock. Export prices increase 3.5% after the first quarter and then falls. After 3 years, export prices are still 2% above the long run equilibrium. The export shock (of 3.5%) implies RER appreciation by.5% during the first two quarters, and the effect is not different from at the conventional significance level. In figure 3(b) we observe the effect of external capital inflows on real exchange Rate. Capital flows increase 1% during the first quarter, then they start to fall. After 4 period they are not significantly different from. There is significant effect on real exchange rate during the first 3 quarters. It peaks during the second quarter with.5% appreciation. Figure 3a: Response of RER to Export Price Shock The Whole Sample

17 Figure 3b: Response of RER to Capital Inflow Shock The Whole Sample Differences between countries with different level of gross external positions. In the section we split countries between those with excess gross capital flows above and below the sample median. We do this, since as mentioned above more integrated countries should compensated capital outflows of foreign investor after a negative capital inflow shock. gross liability/assets as amplifier or buffer of exogenous shocks on real exchange rate. A sudden stop of capital flows, due for example by a change in the willingness of foreign savers to invest in the domestic economy, increases the costs of capital and therefore a country with high net liability will face an outflow of currencies and therefore an depreciation. Although, international assets holdings by residents provide the first line of defense against these non-fundamental-driven shocks to capital flows.

18 The key price variable is the expected return in the domestic economy. Drops in inflows must push up domestic returns if domestic assets invested abroad are to return to the domestic economy. An economy s ability to absorb shocks to capital inflows will depend on its level of financial development (which will affect the interest rate response) and the stock of gross international assets (which places bounds on the size of the shock that can be absorbed). As above we also explore the response of real exchange rate to a export price and capital inflows shocks. Table 2 and 3, and Figures 4 and 5 report the results for this exercise. Figure 4a: Response of RER to Export Price Shock Countries with excess gross flows Figure 4b: Response of RER to Capital Inflows Shock Countries with excess gross flows

19 Figure 4a: Response of RER to Export Price Shock Countries with low excess gross flows Figure 4b: Response of RER to Capital Inflows Shock

20 Countries with low excess gross flows Panel (a) of figure 4 shows the response of Spanish foreign banks to a home shock. As expected an improvement (worsening) of credit conditions in Spain increases (diminishes) credit in the host country. Panels (b) and (c) show the response of non Spanish foreign banks and of domestic banks to the same shock. We find statistically significant responses after 2 quarters suggesting that there may be some contagion effects that may come through feedback effects through the impact on GDP that is plotted in panel (d). Figure 6 shows the same responses to a shock to non-spanish foreign banks. As opposed to shocks related to Spanish foreign banks, in this case we find no significant response in any of our credit measures, to the non-spanish foreign shock. Non-Spanish foreign banks apparently respond less to their home country conditions than Spanish ones. Similarly, and because of this we do not find feedback effects, or contagion, to Spanish foreign banks and domestic banks. We do find a positive response to GDP to this shock that may be explained by the

21 inter-linkages between Latin America and the rest of the advanced world which transcend this banking channel. Finally in figure 7 we plot the impulse response functions of credit to a domestic GDP shock. The results resemble those in the previous model. We find that domestic banks respond less to domestic shocks than foreign banks. Among foreign banks we find a much stronger response in non-spanish than in Spanish foreign banks. Conclusions References Engel, Charles and Akito Matsumoto (29). The International Diversification Puzzle When Goods Prices Are Sticky: It s Really about Exchange-Rate Hedging, Not Equity Portfolios. American Economic Journal: Macroeconomics, 1:2,

22 Appendix: Data Definition Variable P expt _ Shock Inflow _ Shock c, t c, t Exp = GDP c, A c, A abs( Infl = GDP c Pexptc, t Pexpt * Pexpt c Infl c, t 4 c, t 4 ) Infl _ Emergt Infl _ Emerg * Infl _ Emerg Outfl 3 c, t τ c, t τ NetCapFlow s = τ = = GDPc, t τ Outfl 3 c, t τ GrossOutfl ows = τ = = GDPc, t τ t 4 t 4 Definition Average annual export share over the whole period multiplied by the quarter year on year rate of growth of export prices. Source WDI and IMF. Average annual capital inflows over nominal GDP (in absolute term) for the whole period multiplied by the quarterly year on year rate of growth of total capital inflows. Source WDI and IMF. For lags moving average of net capital inflows over GDP. Source IFS-IMF and WDI. For lags moving average of gross capital outflows over GDP. Source IFS-IMF and WDI.