IFM Program Meeting

March 4, 2011
Roberto Chang, Rutgers University, and Kristin Forbes, MIT, Organizers

Andrew K. Rose, UC, Berkeley and NBER, and Tomasz Wieladek
Financial Protectionism: the First Tests

Rose and Wieladek provide the first empirical tests for financial protectionism, defined as a nationalistic change in banks' lending behavior as the result of public intervention, which leads domestic banks either to lend less or at higher interest rates to foreigners. They use a bank-level panel dataset spanning all British and foreign banks providing loans within the United Kingdom (UK) between 1997Q3 and 2010Q1. During this time, a number of banks were nationalized, privatized, given unusual access to loan or credit guarantees, or received capital injections. The authors use standard empirical panel-data techniques to study the "loan mix," domestic (British) loans of a bank expressed as a fraction of its total loan activity. They also study effective short-term interest rates, though their dataset here is much smaller. They examine the loan mix for both British and foreign banks, both before and after unusual public interventions such as nationalizations and public capital injections. They find strong evidence of financial protectionism. After nationalizations, foreign banks reduced the fraction of loans going to the UK by about 11 percentage points and increased their effective interest rates by about 70 basis points. By way of contrast, nationalized British banks did not significantly change either their loan mix or effective interest rates. Succinctly, foreign nationalized banks seem to have engaged in financial protectionism, while British nationalzsed banks have not.

Gianluca Benigno, London School of Economics; Huigang Chen, JD Power; Christopher Otrok, University of Virginia; Alessandro Rebucci, Inter-American Development Bank; and Eric Young, University of Virginia
Financial Crises and Macro-Prudential Policies

Stochastic general equilibrium models of small open economies with occasionally binding financial frictions are capable of mimicking both the business cycles and the crisis events associated with the sudden stop in access to credit markets (Mendoza, 2010). Benigno, Chen, Otrok, Rebucci, and Young study the inefficiencies associated with borrowing decisions in a two-sector small open production economy. They find that this economy is much more likely to display "under-borrowing" rather than "over-borrowing" in normal times. As a result, macro-prudential policies (that is, Tobin taxes or economy-wide controls on capital inflows) are costly in welfare terms in our economy. Moreover, macro-prudential policies aimed at minimizing the probability of the crisis event might be welfare-reducing in production economies. This analysis shows that there is a much larger scope for welfare gains from policy interventions during financial crises. That is to say that, within this modeling approach, ex post or crisis-management policies dominate ex ante or macro-prudential ones.

Michael Kumhof, International Monetary Fund
International Currency Portfolios

Kumhof develops a theory that endogenizes the currency composition of international nominal bond portfolios in general equilibrium. He emphasizes the critical roles of government debt and of government policies, and thereby reconnects to the partial equilibrium portfolio balance literature of the 1980s. Consistent with recent empirical findings, optimal private sector foreign currency positions are found to be small and possibly negative, with their size decreasing in exchange rate volatility. Optimal private sector domestic currency positions are large and increasing in domestic interest rates. Uncovered interest parity is replaced by a relationship that also depends on outstanding bond stocks.

Olivier Jeanne, Johns Hopkins University and NBER, and Anton Korinek, University of Maryland
Managing Credit Booms and Busts: A Pigouvian Taxation Approach

Jeanne and Korinek study a dynamic model in which the interaction between debt accumulation and asset prices magnifies credit booms and busts. They find that borrowers do not internalize these feedback effects and therefore suffer from excessively large booms and busts in both credit flows and asset prices. A Pigouvian tax on borrowing may induce borrowers to internalize these externalities and thus increase welfare. The researchers calibrate the model by reference to the U.S. small and medium-sized enterprise sector and the household sector, and find the optimal tax to be counter-cyclical in both cases, dropping to zero in busts and rising to approximately half a percentage point of the amount of debt outstanding during booms.

Daniel Paravisini, Columbia University and NBER; Veronica Rappoport, Columbia University; Philipp Schnabl, New York University; and Daniel Wolfenzon, Columbia University and NBER
Dissecting the Effect of Credit Supply on Trade: Evidence from Matched Credit-Export Data

Paravisini, Rappoport, Schnabl, and Wolfenzon estimate the elasticity of exports to credit shocks. They exploit the disproportionate reduction in credit supply by banks with a high share of foreign liabilities during the 2008 financial crisis as a source of variation. Using matched customs and firm-level bank credit data from Peru, they compare changes in exports of the same product and to the same destination by firms borrowing from different banks, which allows them to account for variation in non-credit determinants of exports. On the intensive margin, the elasticity of exports to credit is 0.23, and it is relatively constant across firms of different size, industry, and other observable characteristics. The authors find that both the frequency and the average size of shipments are sensitive to credit shocks. On the extensive margin, the elasticity of the number of firms that continue supplying a product-destination export market is 0.36, but credit has no effect on the number of entrants. The estimated elasticities imply that the negative credit supply shock accounts for 15 percent of the drop in Peruvian exports during the financial crisis.

Barry Eichengreen, UC, Berkeley and NBER, and Hui Tong, International Monetary Fund
The Impact of Chinese Exchange Rate Policy on the Rest of the World: Evidence from Firm-Level Data

Eichengreen and Tong aim to gauge the global effect of renminbi revaluation on stock markets. To deal with the potential endogeneity of exchange rate movements, they identify 29 instances of actual or market-perceived changes in China's currency policy from 2003 to 2010 that were driven by domestic or foreign political pressure and not by macroeconomic news. Using data on 12,300 firms operating in tradeable sectors in 44 economies, they find that stock returns increased with renminbi revaluation expectations, but this reaction was related more to improved market sentiment than to specific trade channels. In terms of trade channels, the expectations of renminbi appreciation reduce the relative stock returns of firms providing components or raw materials to China as inputs for that country's exports. They also find some evidence that expectations of renminbi appreciation reduce the stock prices of financially-constrained firms.

Charles Engel, University of Wisconsin, Madison and NBER
The Real Exchange Rate, Real Interest Rates, and the Risk Premium

The well-known uncovered interest parity puzzle arises from the empirical regularity that, among developed country pairs, the high interest rate country tends to have high expected returns on its short-term assets. At the same time, another strand of the literature has documented that high real interest rate countries tend to have currencies that are strong in real terms - indeed, stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two strands - one concerning short-run expected changes and the other concerning the level of the real exchange rate - have apparently contradictory implications for the relationship of the foreign exchange risk premium and interest-rate differentials. Engel documents the puzzle and shows that existing models cannot account for both empirical findings.

Stephanie E. Curcuru and Charles P. Thomas, Federal Reserve Board, and Francis E. Warnock, University of Virgina and NBER
On Returns Differentials

Curcuru, Thomas, and Warnock categorize and analyze the first three waves of research on U.S. returns differentials and they discuss (and update) an assessment of this literature by BEA. While estimates of U.S. returns differentials have ranged from exorbitant to very small, the evidence points to a modest differential in favor of the United States. The differential comes primarily from a differential in direct investment yields, so the authors examine those. They show that the DI yield differential, and hence the overall U.S. returns differential, owes to a wedge between U.S. firms' domestic and foreign earnings. This wedge, in turn, is well explained by country-specific factors such as tax rates and risk. The small differential between yields earned by foreign MNCs in the United States and those earned by U.S. firms' domestic operations is explained well by the relative youth of the MNCs. In sum, the differential is small, and whatever differential exists comes from well-understood differences in the earnings of U.S. MNCs abroad and foreign MNCs in the United States.

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