Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies

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Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies Luis Felipe Céspedes Roberto Chang Central Bank of Chile Rutgers University & NBER September 2009 Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 1 / 34

Introduction: Interest Rates and Macroeconomic Fluctuations 1 In emerging economies, output and the cost of foreign borrowing move in opposite directions (Neumeyer-Perri, 2004) 2 In contrast, in advanced economies the real interest rate is acyclical or mildly procyclical Thus, for emerging economies, foreign credit becomes more expensive when they need it the most Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 2 / 34

Output and Interest Rates in Emerging Economies Argentina Brazil.3 6.2 4.1 2.10.0.06 0.05 -.1.04-2.00 -.2.02-4 -.05.00 -.10 -.02 -.15 80 82 84 86 88 90 92 94 96 98 00 -.04 1994 1995 1996 1997 1998 1999 2000 2001 GDP deviation Interest Rate deviation GDP dev I Rate dev Korea Mexico 4 8 2 4 0 0.050.025.000-2 -4.08.04-4 -8 -.025.00 -.050 -.075 -.04 -.100 1994 1995 1996 1997 1998 1999 2000 2001 -.08 1994 1995 1996 1997 1998 1999 2000 2001 GDP dev I Rate dev GDP dev I Rate dev Source: Based on Neumeyer and Perri (2004) Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 3 / 34

Output and Interest Rates in Developed Economies Australia 6 Canada 8 4 6.04.02 2 0-2 -4.04.02 4 2 0-2 -4.00-6.00-6 -.02 -.02 -.04 -.04 -.06 80 82 84 86 88 90 92 94 96 98 00 -.06 80 82 84 86 88 90 92 94 96 98 00 GDP Dev I Rate dev GDP dev I Rate dev Netherlands 2 New Zealand 8 1 4.04 0 0.02-1.06-4.00-2.04.02-8 -.02-3.00 -.02 -.04 -.04 80 82 84 86 88 90 92 94 96 98 00 -.06 82 84 86 88 90 92 94 96 98 00 GDP dev I Rate dev GDP dev I Rate dev Source: Based on Neumeyer and Perri (2004) Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 4 / 34

The Role of Risk Premia Much of the action in interest rates is due to movements in country spreads (Neumeyer & Perri, 2004; Uribe & Yue, 2004) And indeed, higher spreads are associated with lower output Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 5 / 34

The Role of Risk Premia Correlation of GDP and Spreads.6.4.2 0.2.4 PER PER MEX POL ZAF CHE PHI CZE AUS CHL BR NOR COL SWE CHL HUN CAN 0.2.4.6.8 1 Financial Development (Fin.Dep /GDP) NZ UK THA Source: Authors computations. Note. Spreads are the difference of 90d corporate lending rates minus deposit rates (IFS, local central banks) Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 6 / 34

The Role of Risk Premia Correlation of GDP and Spreads (2).6.4.2 0.2.4 MEX COL MEX PER POL BR SWE HUN BR HUN CHE NOR CZE ZAF CHL PHI AUS CAN NZ UK 0.2.4.6.8 1 Financial Development (Fin Dep / GDP) THA Source: Authors computations. Note. Spreads for emerging and developed economies are EMBI (C-EMBI) and OECD-MEI (90D corporate)-lending(local CB), respectively- Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 7 / 34

Australia versus Chile: Nice Case Studies Interest rates are procyclical in Australia & countercyclical in Chile High interest rates are associated with real exchange rate appreciation in Australia & depreciation in Chile Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 8 / 34

Our Conjecture in a nutshell Net worth effects and the currency composition of debts may imply that aggregate demand responds very differently to exchange rate fluctuations in advanced economies vis a vis developing ones Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 9 / 34

Our Strategy We develop a model of the joint determination of 1 Interest rates 2 Spreads 3 Exchange Rates 4 Business cycle fluctuations which is consistent with the facts just discussed Leading examples are Céspedes, Chang & Velasco (2004); Gertler, Gilchrist & Natalucci(2003) and Devereux, Lane & Xu(2004) With respect to CCV, we extend the model to confront some these data quantitatively so that it is useful for actual policy analysis Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 10 / 34

The Model A version of CCV (2004) Small open economy populated by workers and entrepreneurs Final (consumption and investment) goods are aggregates of home produce and imports No nominal rigidities capitalists borrow in the world market subject to agency problem Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 11 / 34

The Model Domestic Production Y t W t L t R t K t = AKt α L 1 α t = (1 α)p t Y t = αp t Y t Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 12 / 34

The Model Capital Production Production function for new capital K t+1 = Γ (K t, I t ) so the price of installed capital is given by Qt I = Qt K Γ 2 (K t, I t ) Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 13 / 34

The Model Financial Frictions As BGG (2000) foreign borrowing is subject to a costly state verification problem The typical entrepreneurs flow budget constraint is P t N t + S t D t = Q K t K t+1 Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 14 / 34

The Model The return to investment is equal to the cost of funds, inclusive of risk premium [ ( E t Kt+1 Rt+1 + Pt+1 K ) ] /St+1 Qt K = (1 + ρ t+1 ) (1 + η t+1 ) K t+1 /S t Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 15 / 34

The Model The risk premium is increasing on the ratio of total investment to net worth ( ) Q K (1 + η t+1 ) = Ψ t K t+1 P t N t Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 16 / 34

The Model And (aggregate) net worth is given by the return to past investment minus debt service (inclusive of bankruptcy costs) ] P t N t = ν [(1 φ t )(R t + Pt K )K t (1 + ρ t )S t D t Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 17 / 34

The Model Workers They can borrow and lend at the prevailing world interest rate Endogenous Time Preference as in Mendoza (1991) Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 18 / 34

The Model Parametrization We calibrate the model to data from Chile and Australia Differences (main) 1 A key difference is µ: elasticity of risk premium w.r.t. the ratio (0.12 for Chile & 0.06 for Australia) Investment NetWorth 2 Share of imported goods in the production of investment goods (50% in Chile and 25% in Australia) Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 19 / 34

Results 0.02 Figure: Chile: Adjustment path to interest rate shock 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 World r Output Investment 0.16 0 5 10 15 20 25 30 35 40 Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 20 / 34

Results 0.014 0.012 Figure: Chile: Adjustment path to interest rate shock World r Risk Prem 0.01 0.008 0.006 0.004 0.002 0 0 5 10 15 20 25 30 35 40 Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 21 / 34

Results 0.02 Figure: Chile: Adjustment path to interest rate shock 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 World r Output Investment 0.16 0 5 10 15 20 25 30 35 40 Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 22 / 34

Results 0.014 0.012 Figure: Chile: Adjustment path to interest rate shock World r Risk Prem 0.01 0.008 0.006 0.004 0.002 0 0 5 10 15 20 25 30 35 40 Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 23 / 34

Results Figure: Adjustment Path to Foreign Demand Shock: Chile 10 x 10 3 foreign demand output investment 10 x 10 3 foreign demand risk premium 8 8 6 6 4 4 2 2 0 0 2 0 5 10 15 20 25 30 35 40 2 0 5 10 15 20 25 30 35 40 Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 24 / 34

Results Figure: Adjustment Path to Foreign Demand Shock: Australia 10 x 10 3 foreign demand output investment 10 x 10 3 foreign demand risk premium 8 8 6 6 4 4 2 2 0 0 2 0 5 10 15 20 25 30 35 40 2 0 5 10 15 20 25 30 35 40 Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 25 / 34

Results Australia Chile Canada Mexico Model Data Model Data Data Data Consumption 1.05 0.65 0.91 0.85 0.55 0.85 Investment 9.22 2.96 12.18 2.11 2.41 2.10 Ex. Rate 6.54 3.57 7.51 2.30 2.63 2.24 Risk Prem 0.45 0.28 0.98 0.47 0.18 0.83 Risk Prem* 0.31 1.14 0.19 0.80 Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 26 / 34

Results Australia Chile Canada Mexico Model Data Model Data Data Data Consumption 0.56 0.67 0.79 0.92 0.59 0.33 Investment 0.25 0.73 0.53 0.81 0.70 0.44 Ex. Rate 0.09 0.46 0.43 0.61 0.24-0.02 Risk Prem -0.21 0.01-0.51-0.21 0.39-0.52 Risk Prem* 0.23-0.59 0.31-0.32 Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 27 / 34

Uncertainty shocks Uncertainty plays a key role in recent financial turmoil. But most in general, uncertainty affects risk premium in a business cycle frequency Considering role of uncertainty is important to understand role of financial frictions (Christiano et al) We use Bernanke, Gertler, Gilchrist (1999) to introduce uncertainty in a financial accelerator model.

Permanent uncertainty shock Permanent uncertainty shock 1.10 1.08 1.06 1.04 1.02 1.00 0.98 1.00 1.02 1.05 1.07 1.10 1.13 1.15 1.19 1.22 1.25 1.29 1.32 1.36 1.41 1.45 1.49 QK/N High volatility Low volatility Risk premium

Extension to the Model We aim at modelling the dynamics derived of a fully exogenous shock: Bloom s Index 9/11 Subprime Annualized Std. Dev. (%) 0 20 40 60 80 Implied/Observed S&P Volatility Methodology: Bloom (2009) 1970m1 1980m1 1990m1 2000m1 2010m1 Time Annualized Std. Dev. (%) 2nd moment shock Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 28 / 34

Links to Uncertainty: Spreads and Volatility Australian spreads vs. External Volatility Correlation: 0.02 Australian OECD/RBA Spread 0.01.02.03.04 1985q1 1990q1 1995q1 2000q1 2005q1 2010q1 time 10 20 30 40 50 60 S&P Volatility Australian OECD/RBA Spread S&P Volatility Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 29 / 34

Links to Uncertainty: Spreads and Volatility Canadian OECD MEI Spread.01.015.02.025.03.035 Canadian spreads vs. External Volatility Correlation: 0.05 1985q1 1990q1 1995q1 2000q1 2005q1 2010q1 time 10 20 30 40 50 60 S&P Volatility Canadian OECD MEI Spread S&P Volatility Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 30 / 34

Links to Uncertainty: Spreads and Volatility EMBI Chile 100 200 300 400 Chilean spreads vs. External Volatility Correlation: 0.67 1995q1 2000q1 2005q1 2010q1 time 10 20 30 40 50 60 S&P Volatility EMBI Chile S&P Volatility Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 31 / 34

Links to Uncertainty FX Volatility: CLP USD Implied/Observed FX Volatility CLP USD 0 10 20 30 40 < Start options trading < Float 1990m1 1995m1 2000m1 2005m1 2010m1 time Implied/Observed FX Volatility CLP USD 2nd moment shock HP trend volatility Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 32 / 34

Links to Uncertainty Implied/Observed FX Volatility CLP USD 0 10 20 30 40 FX Volatility: AUD USD Vertical line shows start of options trading 1985m1 1990m1 1995m1 2000m1 2005m1 2010m1 time Implied/Observed FX Volatility CLP USD 2nd moment shock HP trend volatility Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 33 / 34

Links to Uncertainty Australian FX Volatility vs. External Market Volatility Correlation: 0.57 S&P Volatility 0 20 40 60 80 0 10 20 30 40 AUD Volatility 1985m1 1990m1 1995m1 2000m1 2005m1 2010m1 Time S&P Volatility AUD Volatility Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 34 / 34

Links to Uncertainty Chilean FX Volatility vs. External Market Volatility Correlation: 0.71 S&P Volatility 0 20 40 60 80 0 10 20 30 40 CLP Volatility 2000m1 2002m1 2004m1 2006m1 2008m1 2010m1 Time S&P Volatility CLP Volatility Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 35 / 34

Links to Uncertainty Canadian FX Volatility vs. External Market Volatility Correlation: 0.45 S&P Volatility 0 20 40 60 80 0 5 10 15 20 25 CAD Volatility 1980m1 1990m1 2000m1 2010m1 Time S&P Volatility CAD Volatility Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 36 / 34

Links to Uncertainty Chile Firm Profits Volatility Index 0.2.4.6.8 1 0 20 40 60 Annualized Volatility 1990q1 1995q1 2000q1 2005q1 2010q1 Time Firm Profits CLP/USD S&P Source: Authors computations Luis Felipe Céspedes Roberto Chang Country Risk, Exchange Rates and Economic Fluctuations in Emerging Economies 37 / 34

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