Chapitre 5 : Portfolio diversification and capital flows. Bien connaitre Gross capital flows et valuation effects

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1 Chapitre 5 : Portfolio diversification and capital flows Bien connaitre Gross capital flows et valuation effects Deficit of US financed bay China and emerging countries. China should borrow from developed countries with relatively lower growth expectation, such as US. Reduction in capital flow, would lead to a depreciation of the dollar. I) Assets from different countries : imperfect substitutes With a real mobility of capital, the return on assets should be the same for all countries. In practical terms, this mean that interest rate paid by the Greek government for foreign loans should be the same as that paid by the Swedish gov. Greek bonds VS Swedish bonds => Default Risk is different => Debt of Greece is an Euro VS Debt of Swedis is an Crowns and the exchange rate can change in the time. Additionally, investor prefer to diversify their assets portfolio in face of risky assets. II) Gross Capital Flows and Current Account Let B = NIIP= net inter investment position B>0 country is let lender B<0 country is net borrower B = F-D F = stock of foreign credit D = foreign debt The CA can be written as : CA = TB + IB Assumption : the income balance = only interest payments. Credit and debt denominated in the same currency Example : Dev countries have difficulty to acquiring foreign debt in their money. Income Balance = IB = it-1*bt or Différent interest rates First term of IB = net foreign debt payment if the interest rate on the credit were equal to one on the foreign debt. Second term : the impact of the difference between the two interest rate. The greater the stock of reserves, the greater the value of this negative term in the country s current account.

2 Credit in foreign currency and debt in domestic currency The income balance, measured in dollar, is : Income balance We define D as the value of the debt measured in dollars at the time it was contracted. Its value in domestic currency is : Dt = Dbarre / St-1 Substituting into income balance equation, we arrive at : An exchange rate depreciation also increases the second term: it reduces the difference between the interest paid on the foreign debt and that received on credit. Current account Finally, the CA in this case is represented by : capture d écran 19h For a country with a net foreign debt, F - D <0 and that can borrow in its own currency, exchange rate depreciation has a positive impact on the CA balance trough two channels : 1. trade balance : foreign products become relatively more expensive => lower imports and higher exports => a greater trade balance. 2. cost of foreign debt : given that its average return measured in foreign currency, given by It-1 St-1 / St, also reduces. Greek Debt Crisis Greece has a high debt rate as a reaction of the risk of default. Debt has an unsustainable trajectory. In 2011 : Export = 22.4 / Import = 42.1 Trade with the Eurozone was responsible for 52,9% of the total Greek trade. We see that a depreciation of the euro would have a positive impact on the CA by means of the IB by means of three effects : - Lower foreign debt service measured in dollars - Lower impact (nagative) of the interest rate differential between the Greek debt and the rest of the Eurozone on the CA, given that the gross value of credit in euros would have a lesser value in dollars. - Power interest rate differential between the Greek debt and credit in dollars. Net international investment Position Mystery of USA => net debtor but net income on international investment.

3 Dark Matter Stock of assets inferred based on the returns observed. In the US case, it infers a positive NIIP balance, assuming the country paid on its debt the same interest rate that it received for its credit. Two reason for the dark matter found in the American external accounts : - The US paid lower interest rate on its debt than what it received on credit from other countries = exorbitant privilege - Depreciation of the dollar => Higher relative return on assets in a foreign currency the country holds. Valuation Effect The Ca balance should correspond to the negative financial account balance. This relation is resented by : Ca = -FA= Bt+1 - B The balance in current account should correspond to the variation of the NIIP. CA balance = the balance of the purchase and sale of assets with the rest of the world, but does not take into account eventual changes in the value of assets either held or sold by the country. Nevertheless, changes in the value of assets affect the net indebtedness of the country, or in other words, its NIIP. Exchange rate depreciation => lower value in dollars of the debt dominated in domestic currency => lower net foreign indebtedness.

4 Part 2 A deeper discussion on risk aversion and international portfolio diversification Theory of portfolio diversification describes the gains from trade of assets, of assets with one type of risk for assets with another type of risk. => In order to avoid or reduce risk => People have risk aversion The aim is t have a portfolio in the average of expect return. Each point in a indifference curve represents a set of contingency plans for consumption with which the investor is equally satisfied

5 Part 3 : Country Risk we showed that when investors are risk averse (reality!), they care both about the return of the asset and the related risk; the reduction (not elimination!) of risk can be achieved through the diversification of asset portfolios We should also discuss : Why do assets have different risk? Review : - In general there are 3 basic characteristics of an assets that an investor takes in consideration : the return, the liquidity ans the risk of the assets. - Investor can compare the return of the different assets. The debt crisis is the inability to repay sovereign debt Step 1 : higher fear of default => higher outflows and lower inflows of capital => lower investment and higher interest rate. Step 2 : lower income => lower tax revenues for the gov => lower probability off dealing with the payment => higher probability of default. Gov decision to repudiate the debt when governments decide to repudiate their debts they will not loose the total control over the assets they have financed with the debt The decision to repudiate the debt has a cost for the gov : temporary exclusion from the future borrowing and higher cost of capital. Determinants of sovereign debt spread : Debt/GDP When the country debt gets larger respect to the size of the country s economy (Debt/GDP), then the country decrease the probability of repaying the debt (increase the risk of default). Déterminant of sovereign debt spread : GDP growth if the GDP grows, the country reduces the size of debt compared to the economy, has larger ressources to repay the debt, and thus lower probability of default. Any determinant of growth is therefore potentially a determinant of sovereign risk premium, such as quality of institutions/government, productive investments, exports. Other determinant : Higher spread if higher debt/gdp recent rescheduled of payments higher Debt service/export higher volatility of exports Lower spread if better credit rating higher growth rates higher reserves/short-term debt Volatility ans level of macroeconomics fundamentals : «The volatility of fundamentals should matter for the pricing of defaultable debt, just as the level of these fundamentals does. All else equal, a country with more volatile fundamentals is more likely to experience a severe weakening of fundamentals which may force it into default. This risk should be reflected in a higher yield spread on its bonds».

6 Among other control variables they include: 1.A measure of a country s recent default history. In fact, Reinhart et al. (2003) argued that history of default is an important predictor of future default. 2.Global factors such as changes in aggregate risk aversion, world interest rates, and liquidity 3.Country-specific: external debt to GDP (Debt/GDP) and the ratio of reserves (including gold) to GDP (Reserves/GDP) (note these variables might be endogenous!) 4.Credit rating 5.Time and regional fixed effects The role of credit rating Credit rating are released on roder to improve information on the risk of the assets Credit rating agency use a large set of criteria to determine the rating of a given asset Sometines rating changes have a strong impact on the sovereign spreads. Part 4 : Brief presentation of the international Capital Markets What are the available financial instruments to diversifie the portfolio of assets? Different instruments : Stocks / Bonds / Commodities / deposits in different currencies / forward contracts / Swaps /real estate and land / factories and equipment Assets can be classified : Debt instrument : Bonds and deposits Equity instruments : stocks and real estate Bond finance : gov or private sector bond are sold to foreign indiv and institution Official lending : The World bank or other official agencies lend to governments. Bank finance : commercial banks or securities firms lend to foreign gov of foreign businesses. Foreign direct investment : a firm directly acquires or expands operations in a subsidiary film. Portfolio equity investment : a foreign investor purchase equity for his portfolio. Debt finance includes bond finance, bank finance, and official lending. Equity finance includes direct investment and portfolio equity investment. While debt finance requires fixed payments regardless of the state of the economy, the value of equity finance fluctuates depending on aggregate demand and output. The Participants : - Commercial banks and other depository institutions - Nonbank financial institutions such as securities firms, pension funds, insurance companies, mutual funds - Private firms - Central banks and government agencies Offshore banking Outside of the boundaries of a country. There are 3 types of offshore banking institutions : - An agency office - A subsidiary bank - A foreign branch

7 Offshore currency deposit Is a bank deposit denominated in a currency other than the currency that circulates there the bank resides. Offshore currency trading has grown for three reasons : - growth in international trade and international business - avoidance of domestic regulations and taxes - political factors (avoid confiscation by a gov). Reserve requirements : Are the primary example of a domestic regulation that banks have tried to avoid through offshore currency trading. Une banque doit garder en réserve une fraction des dépôts en monnaie étrangère sur son compte banque central, elle ne touche aucun intérêts dessus. Avec une banque en offshore, pas besoin et en plus de ca peut toucher des intérêts.