Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Lecture 6: Intertemporal Choice in an Open Economy Gregory Corcos Eco572: International Economics

October 22, 2014

Trade and Finance

Openness

Intertemporal Models

Eco572: International Economics Part 1: International Trade 1

Comparative Advantage

2

The Neoclassical Model of International Trade

3

International Trade Under Imperfect Competition

4

Trade Policy

5

Multinational Enterprises and Foreign Direct Investment

Part 2: International Finance 6

Intertemporal Choice in an Open Economy

7

The Foreign Exchange Market

8

The Equilibrium Exchange Rate

9

Foreign Exchange Crises

Global Imbalances

Trade and Finance

Openness

Intertemporal Models

Lecture 6: Outline

1

From International Trade to International Finance

2

Financial Openness

3

Intertemporal Current-Account Equilibrium

4

Global Imbalances

Global Imbalances

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

From International Trade to International Finance

Gains from trade come from the decoupling of production and consumption within each country. International financial markets allow countries to decouple production and consumption over time. In this lecture, we will discuss: how external imbalances can be rationalized in an intertemporal setting why they can be a matter of concern

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

External Accounts: Balance of Payments (BoP)

The BoP registers all transactions between a country’s residents and non-residents in a year. Flows, not stocks. Structure: Exchange of goods and services and net factor income are recorded in the Current Account (CA) Non-financial capital transfers (eg. intellectual property) are recorded in the Capital Account Financial transactions are recorded in the Financial Account

Double-entry accounting: each transaction enters once in credit and once in debit. The BoP must be balanced. CurrentAccount+CapitalAccount+FinancialAccount+NetErrorsAndOmissions = 0

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Selected BoPs in 2012

I. Current Account A. Goods and Services 1.Goods 2.Services B. Income C. Current Transfers II. Capital Account III. Financial Account 1.Direct Investment 2.Portfolio Investment 3.Other Investment III. Reserve Assets IV.Net Errors and Omissions

China +193.1 +231.8 +321.6 -89.7 -42.1 +3.4 +4.3 -21.1 +191.1 +47.8 -260 -96.6 -79.8

Euro Area +166.5 +242.2 +125.2 +117 +65.1 -140.9 +6.6 -185.9 -4.8 +95.4 -258.3 -18.3 +12.9

USA -440.4 -534.7 -741.5 +206.8 +223.9 -129.7 +7 +439.4 -222 +586.8 +70.2 +4.5 -5.9

All figures in USD bn. Source: SAFE, ECB, BEA, own calculations.

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

External Accounts: International Investment Position (IIP)

The IIP records stocks of a country’s foreign assets/liabilities at a given point in time. These include: stocks and other equity, bonds, bank loans... When market valuation is too fragile, values are based on historical costs. Net Foreign Assets are assets netted out of liabilities. NFAs equal cumulated CA surpluses/deficits, modified for errors and omissions and market revaluation. GrossAssets − GrossLiabilities = NFA

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

From External to National Accounts National accounting identity Y =C +I +G +X −M Can be rewritten as: (Y − T − C − I ) + (T − G ) = X − M net private savings+net gov’t savings=net national savings There is a tight relationship between net savings and the current account balance. Should Y be GDP or GNP? GNP equals GDP plus factor income received abroad by residents, minus factor income paid at home to non-residents. If Y is GDP, then X − M= trade balance If Y is GNP, then X − M=current account in most countries, the difference between GDP and GNP is low (less than 5% of GDP)

Trade and Finance

Openness

Intertemporal Models

Savings and Investment Imbalances

Global Imbalances

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

How to Measure Financial Openness

As with trade openness, one can measure financial openness in two ways: de jure: legal barriers to financial flows (e.g. Chinn-Ito index) de facto: measure of financial activity relative to GDP (e.g. |CA| GDP , foreign liabilities/GDP)

De jure financial openness is maximal when there is: current-account convertibility: no controls on currency convertibility for the purpose of trading goods and services and paying factor income financial-account convertibility: no controls on direct investments, portfolio investments, bank loans with non-residents

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Chinn-Ito index

Source: Chinn and Ito (2008). The index is the first principal component of 4 categories of restrictions: (i) existence of multiple exchange rates (ii) restrictions on CA transactions (iii) restrictions on FA transactions (iv) export proceeds surrender requirement. The index is based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). The IMF’s methodology changed slightly in 1996. Further details.

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Chinn-Ito index Shows an increasing trend in financial openness Based on the existence of 4 types of currency exchange restrictions: multiple exchange rates restrictions on CA transactions (e.g. limits on tourists’ exchange holdings) restrictions on FA transactions (e.g. taxes on short term capital inflows) export proceeds surrender requirement (e.g. share of export proceeds to be deposited in authorized domestic banks)

Based on the IMF’s AREAER report on 24 advanced and 128 emerging economies. Measurement issues: measures the existence rather than intensity of capital controls does not capture whether restrictions target inflows or outflows or special transactions

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

The Feldstein-Horioka puzzle

If capital could move freely and costlessly, there would be no correlation between a country’s savings and investment. Feldstein and Horioka (1980) showed a high correlation even in the OECD. Still true in the 2000’s. Candidate explanations: ’home bias’ in investment due to asymmetric information country risk/insufficient creditor protection both government savings and investment are procyclical transaction costs

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

The Lucas Paradox

Consider a 2 country world where North residents are older and richer than South’: the life-cycle model predicts that North residents save more the Solow model predicts that capital has a higher return in South

’Lucas paradox’: why don’t we observe more capital flows from North to South? Candidate explanations: low productivity, lack of skills, corruption in South financial underdevelopment forces South to save before investing, and to hold safe and liquid North assets weak safety net forces South to hold precautionary savings

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

A One-Good, One-Asset, Two Period Model Assumptions: small open economy, exogenous supply, free asset trade, no government, discount factor β < 1 The representative consumer maximizes: y2 c2 ≤ y1 + 1+r 1+r u 0 (c1 ) ⇒ 0 = β(1 + r ) u (c2 )

max u(c1 ) + βu(c2 ) s.t. c1 + c1 ,c2

(Euler)

The FOC tells us that: consumption is smoothed over time 1 when β is close to 1+r consumption is almost time invariant 1 if consumers are impatient in the sense of β < 1+r then consumption is higher in the first period

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Gains From Financial Openness

c2  

C  

c2  

Uopenness   Y  

y2  

Uautarky  

c1  

y1  

c1  

Under financial autarky the economy is at Y. Under openness it gains from reallocating consumption to C. Here the country runs a CA surplus first.

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

The Logarithmic Utility Example Suppose u(ct ) = ln ct , t = 1, 2. Then the FOC yields: c2 = β(1 + r ) c1 Substitute in the budget constraint to solve for c1 and c2 : c2 y2 c1 + = c1 (1 + β) = y1 + ≡Y 1+r 1+r This implies: Y 1+β β(1 + r )Y c2 = 1+β c1 =

In the special case where β(1 + r ) = 1 consumption c is constant over time. The country has a CA surplus if y1 > c and a CA deficit otherwise.

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Net Foreign Assets Dynamics Denote by NFAt net foreign assets held at time t. Current account balance CAt ≡ yt − ct + rNFAt At t=2 NFAs increase by CA1 . NFA2 = NFA1 +CA1 = NFA1 +y1 −c1 +rNFA1 = y1 −c1 +(1+r )NFA1 With only two periods we must have NFA2 + CA2 = 0, so that the intertemporal budget constraint imposes: NFA1 =

1 1 (c1 − y1 ) + (c2 − y2 ) 1+r (1 + r )2

External debt is sustainable only with future CA surpluses. Infinite horizon: if limt→+∞ (1 + r )t−1 NFAt = 0 then the debt sustainability
t P 1 condition is NFA1 = +∞ (ct − yt ). t=1 1+r

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

A Two-Good, One-Asset, 2-Period Model Suppose good T is costlessly tradable and good N is completely nontradable. The Law of one price states that T∗

ptT = pSt t with St the nominal exchange rate. Cobb-Douglas utility function:   U(c1T , c1N , c2T , c2N ) = γ ln c1T + (1 − γ) ln c1N + β γ ln c2T + (1 − γ) ln c2N

Define the consumer price index as Pt = (ptT )γ (ptN )1−γ and N the relative price of nontradables as Qt = pptT . t

Then Pt = ptT (Qt )1−γ and the law of one price implies  1−γ ptT ∗ Pt∗ (Qt )1−γ Qt Pt 1−γ Pt = (Qt ) = = ⇒ St ∗ ∗ 1−γ St St (Qt ) P Qt∗ | {z t} Real Exchange Rate

The RER depends on the relative price of nontradables, with an elasticity equal to the nontradables share in consumption.

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Exogenous output: ytN and ytT . Denote net exports of T by xt . At goods market equilibrium ytN = ctN and ytT = ctT + xt . Consider the consumer’s problem: max

c1T ,c1N ,c2T ,c2N

  {γ ln c1T + (1 − γ) ln c1N + β γ ln c2T + (1 − γ) ln c2N }

s.t. c1T + Q1 c1N +

Q1 y2N + y2T c2T + Q2 c2N ≤ Q1 y1N + y1T + 1+r 1+r } {z | Y

FOC: c2T cN Q1 c T γ cT γ = β(1+r ); 2N = β(1+r ) ; 1N = Q1 ; 2N = Q2 T Q2 c1 1−γ 1−γ c1 c1 c2 Solving for consumption levels: T

c1 =

γ 1+β

Y;

N

c1 =

1−γ Q1 (1 + β)

Y;

T

c2 =

β(1 + r )γ 1+β

Y;

N

c2 =

β(1 + r )(1 − γ) Q2 (1 + β)

Y

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

By definition of nontradables ctN = ytN , so in equilibrium: yN Q2 = β(1 + r ) 1N Q1 y2 If y1N = y2N then impatience.

Q2 Q1

= β(1 + r ), the RER will depend on

1 ) will consume more at t=1, so Impatient countries (β < 1+r that CA1 < 0 and CA2 > 0, which requires Q2 < Q1 . 1 ) Patient countries (β > 1+r

Suppose there is a positive transitory shock in period 1 in one sector: shock on nontradables dy1N > 0: fall in Q1 , consumers substitute away from T , rise in CA1 . shock on tradables dy1T > 0: higher RER at t=1 and CA surplus, extra income smoothed

A positive transitory shock on tradables in period 2 would have the opposite effect: CA deficit and lower RER at t=1.

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Problems With Imbalances

If one can rationalize CA deficits in an intertemporal framework, what is the problem with global imbalances? P unsustainably persistent F∞ = F0 + t=0 (yt − ct )(1 + r )t symptom of bubbles symptom of low productivity growth symptom of distortions: fixed exchange rate, tax or legal distortions, distortions on external finance symptom of credit cycles

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

US CA Deficit Financing In the 2000’s US external debt has mirrored Asian Central Banks’ accumulation of US bonds. Particularly true of China where the managed exchange rate has caused the CB to accumulate foreign assets. The US’ IIP could have been even lower: USD depreciation and market revaluation, lower returns on US assets.

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Explanations For Global Imbalances

Strong candidates: Asian ’savings glut’ (Bernanke): insufficient social security, low financial development, government surpluses, defiance against IMF create excess savings in Asia. Low US savings: ageing population, consumption credit boom, lax monetary policy of the Fed Other explanations: Future productivity gains in the US? less likely since US CA deficit financing involves mostly gov’t, not corporate bonds. RMB undervaluation? gradual loosening of managed peg since 2005

Trade and Finance

Openness

Intertemporal Models

Global Imbalances

Conclusion

International trade and capital flows are tightly related. Capital flows can be analyzed in an intertemporal framework. The one-asset model rationalizes external debt under conditions on future CA surpluses. The two-asset model relates the RER to CA balances. Shocks to the tradable and nontradable sectors have different effects on CA balances. Global imbalances, which are partly related to savings behavior in the US and China, are a cause for concern. Since 2009, G20 members have agreed to assess and reduce imbalances, based on indicative guidelines set by the IMF.