Staff working papers in the International Finance and Discussion Papers (IFDP) series are primarily materials produced by staff in the Division of International Finance. These topics are focused on, though by no means limited to, international macroeconomics, international trade, global finance, financial institutions, and markets, as well as international capital flows

IFDP 2019-1259
Scarred Consumption (PDF)

Ulrike Malmendier and Leslie Sheng Shen

Abstract: We show that prior lifetime experiences can "scar" consumers. Consumers who have lived through times of high unemployment exhibit persistent pessimism about their future financial situation and spend significantly less, controlling for the standard life-cycle consumption factors, even though their actual future income is uncorrelated with past experiences. Due to their experience-induced frugality, scarred consumers build up more wealth. We use a stochastic lifecycle model to show that the negative relationship between past experiences and consumption cannot be generated by financial constraints, income scarring, and unemployment scarring, but is consistent with experience-based learning.

Keywords: Household consumption, experience effects, expectation, lifecycle model


IFDP 2019-1258
The Dollar and Emerging Market Economies: Financial Vulnerabilities Meet the International Trade System (PDF)

Abstract: This paper shows that dollar appreciations lead to declines in GDP, investment, and credit to the private sector in emerging market economies (EMEs). These results imply that the transmission of dollar movements to EMEs occurs mainly through financial conditions rather than net exports, contrary to what would be expected from the conventional Mundell-Fleming model. Moreover, the central role of the U.S. dollar in global trade invoicing and financing - the dominant currency paradigm - and the increased integration of EMEs into international supply chains weaken the traditional trade channel. Finally, as expected if financial vulnerabilities are prominent, EMEs with higher exposure to credit denominated in dollars and lower monetary policy credibility experience greater contractions during dollar appreciations.

Keywords: Dollar, balance sheet mismatch, dominant currency paradigm, global value chain, monetary policy credibility


IFDP 2019-1257
Fiscal Stimulus under Sovereign Risk (PDF)

Javier Bianchi, Pablo Ottonello, and Ignacio Presno

Abstract: The excess procyclicality of fiscal policy is commonly viewed as a central malaise in emerging economies. We document that procyclicality is more pervasive in countries with higher sovereign risk and provide a model of optimal fiscal policy with nominal rigidities and endogenous sovereign default that can account for this empirical pattern. Financing a fiscal stimulus is costly for risky countries and can render countercyclical policies undesirable, even in the presence of large Keynesian stabilization gains. We also show that imposing austerity can backfire by exacerbating the exposure to default, but a well-designed "fiscal forward guidance" can help reduce the excess procyclicality.

Keywords: Fiscal Stabilization Policy, Sovereign Default, Procyclicality


IFDP 2019-1256
The Economic Effects of Trade Policy Uncertainty (PDF)

Abstract: We study the effects of unexpected changes in trade policy uncertainty (TPU) on the U.S. economy. We construct three measures of TPU based on newspaper coverage, firms' earnings conference calls, and aggregate data on tari rates. We document that increases in TPU reduce investment and activity using both firm-level and aggregate macroeconomic data. We interpret the empirical results through the lens of a two-country general equilibrium model with nominal rigidities and firms' export participation decisions. In the model as in the data, news and increased uncertainty about higher future tariffs reduce investment and activity.

Keywords: Trade Policy Uncertainty; Textual Analysis; Tariffs; Investment; Uncertainty Shocks.


IFDP 2019-1255
Credit Migration and Covered Interest Rate Parity (PDF)

Abstract: This paper examines the connection between deviations in covered interest rate parity and differences in the credit spread of bonds of similar risk but different currency denomination. These two pricing anomalies are highly aligned in both the time series and the cross-section of currencies. The composite of these two pricing deviations – the corporate basis – represents the currency-hedged borrowing cost difference between currency regions and explains up to a third of the variation in the aggregate corporate debt issuance flow. I show that arbitrage aimed at exploiting one type of security anomaly can give rise to the other.

Appendix (PDF)

Keywords: Covered interest rate parity, limits of arbitrage, credit market segmentation, debt issuance, dollar convenience yield, foreign exchange rate hedge


IFDP 2019-1254
Exchange Rate Dynamics and Monetary Spillovers with Imperfect Financial Markets (PDF)

Ozge Akinci and Albert Queralto

Abstract: We use a two-country New Keynesian model with financial frictions and dollar debt in balance sheets to investigate the foreign effects of U.S. monetary policy. Financial amplification works through an endogenous deviation from uncovered interest parity (UIP) arising from limits to arbitrage in private intermediation. Combined with dollar trade invoicing, this mechanism leads to large spillovers from U.S. policy, consistent with the evidence. Foreign monetary policies that attempt to stabilize the exchange rate reduce welfare, and may exacerbate exchange rate volatility. We document empirically a link between UIP deviations and measures of credit market frictions, as predicted by the model.

Keywords: Financial Frictions; U.S. Monetary Policy Spillovers; Currency Premium; Uncovered Interest Rate Parity Condition


IFDP 2019-1253
US Equity Tail Risk and Currency Risk Premia (PDF)

Zhenzhen Fan, Juan M. Londono, and Xiao Xiao

Abstract: We find that a US equity tail risk factor constructed from out-of-the-money S&P 500 put option prices explains the cross-sectional variation of currency excess returns. Currencies highly exposed to this factor offer a low currency risk premium because they appreciate when US tail risk increases. In a reduced-form model, we show that country-specific tail risk factors are priced in the cross section of currency returns only if they contain a global risk component. Motivated by the intuition from the model and by our empirical results, we construct a novel proxy for a global tail risk factor by buying currencies with high US equity tail beta and shorting currencies with low US tail beta. This factor, along with the dollar risk factor, explains a large portion of the cross-sectional variation in the currency carry and momentum portfolios and outperforms other models widely used in the literature.

Keywords: Equity tail risk; Global tail risk; Currency returns; Carry trade; Currency momentum


IFDP 2019-1252
Forecasting High-Risk Composite CAMELS Ratings (PDF)

Lewis Gaul, Jonathan Jones, and Pinar Uysal

Abstract: We investigate whether statistical learning models can contribute to supervisors' off-site monitoring of banks' overall condition. We use five statistical learning and two forecast combination models to forecast high-risk composite CAMELS ratings over time (1984-2015), where a high-risk composite CAMELS rating is defined as a CAMELS rating of 3, 4, or 5. Our results indicate that the standard logit model, which is already widely used to forecast CAMELS ratings, comes close enough to be an adequate model for predicting high-risk ratings. We also find that the overall accuracy of the individual forecasts could be modestly improved upon by using forecast combination methods.

Keywords: Bank supervision and regulation, early warning models, CAMELS ratings, machine learning


IFDP 2019-1251
Risk-Taking Spillovers of U.S. Monetary Policy in the Global Market for U.S. Dollar Corporate Loans (PDF)

Seung Jung Lee, Lucy Qian Liu, and Viktors Stebunovs

Abstract: We study the effects of U.S. interest rates and other factors on risk-taking in the global market for U.S. dollar syndicated term loans. We find that, before the Global Financial Crisis, both U.S. and non-U.S. lenders originated ex ante riskier loans to non-U.S. borrowers in response to a decline in short-term U.S. interest rates and, after the crisis, in response to a decline in longer-term U.S. interest rates. After the crisis, this behavior was more prominent for shadow banks and less prominent for banks with relatively low capital. Separately, before the crisis, lenders originated less risky loans in response to U.S. dollar appreciation. Across the periods, the responses to risk appetite and economic uncertainty varied. To the extent that the Federal Reserve affects U.S. interest rates, we provide evidence of global risk-taking spillovers of U.S. monetary policy, which are important but not dominant factors for risk-taking in the market.

Keywords: Syndicated leveraged loans, risk-taking, global factors, U.S. monetary policy, global spillovers.


IFDP 2019-1250
Every Cloud has a Silver Lining: Cleansing Effects of the Portuguese Financial Crisis (PDF)

Daniel Dias and Carlos Robalo Marques

Abstract: Using firm-level data, this paper shows that the Portuguese financial crisis was a period of intensified productivity-enhancing reallocation. Aggregate productivity gains, both in manufacturing and services, came from relatively higher contributions of entering and exiting firms and from reallocation of resources between surviving firms. At the microlevel, the crisis reduced the probability of survival for high- and low-productivity firms, but it hit low-productivity firms disproportionately harder. We also found important heterogeneous effects across economic sectors regarding input reallocation that underline the importance of using data for the entire economy whenever similar studies are conducted.

Keywords: Productivity, firm-level data, entry, exit, survival


IFDP 2019-1249
Housing Choices and Their Implications for Consumption Heterogeneity (PDF)

Eva de Francisco

Abstract: This paper proposes a model to jointly explain some of the heterogeneous individual consumption behavior found in the recent empirical literature, such as the existence of a significant size of wealthy hand-to-mouth consumers, and negative marginal propensities to consume associated with housing upgrades. Agents live for a finite horizon, are heterogeneous in initial wealth, and can save in a liquid asset, and in an illiquid housing asset, that also provides housing services. When housing choices are very limited, the model replicates these empirical findings. Moreover, in the presence of unanticipated income shocks and endogenous credit constraints, this richness in marginal propensities to consume has significant implications for aggregate consumption, and helps explain the consumption behavior documented during the Great Recession as well as the consumption responses to recent tax rebates.

Keywords: The Great Recession, housing choices, consumption heterogeneity, wealthy hand-to-mouth consumers


IFDP 2019-1248
Monetary Policy, Housing Rents, and Inflation (PDF)

Daniel Dias and João B. Duarte

Abstract: In this paper we study the effect of monetary policy shocks on housing rents. Our main finding is that, in contrast to house prices, housing rents increase in response to contractionary monetary policy shocks. We also find that, after a contractionary monetary policy shock, rental vacancies and the homeownership rate decline. This combination of results suggests that monetary policy may affect housing tenure decisions (own versus rent). In addition, we show that, with the exception of the shelter component, all other main components of the consumer price index (CPI) either decline in response to a contractionary monetary policy shock or are not responsive. These findings motivated us to study the statistical properties of alternative measures of inflation that exclude the shelter component. We find that measures of inflation that exclude shelter have most of the statistical properties of the widely used measures of inflation, such as the CPI and the price index for personal consumption expenditures (PCE), but have higher standard deviations and react more to monetary policy shocks. Finally, we show that the response of housing rents accounts for a large proportion of the "price puzzle" found in the literature.

Keywords: Monetary policy; Housing rents; Inflation dynamics; "Price puzzle"; Housing tenure.


IFDP 2019-1247
Variance Risk Premium Components and International Stock Return Predictability (PDF)

Juan M. Londono and Nancy R. Xu

Abstract: In this paper, we document and explain the distinct behaviors of U.S. downside and upside variance risk premiums (DVP and UVP, respectively) and their international stock return predictability patterns. DVP, the compensation for bearing downside variance risk, is positive, highly correlated with the total variance premium, and countercyclical, whereas UVP is, on average, borderline positive and procyclical with large negative spikes around episodes of market turmoil. We then provide robust evidence that decomposing VP into its downside and upside components significantly improves domestic and international stock return predictability. DVP is a robust predictor at four to six months and exhibits a hump-shaped pattern, whereas UVP performs the best at very short horizons. These stylized facts highlight the importance of acknowledging asymmetry in equity risk premiums. Hence, in the second part of the paper, we rationalize the economic sources of DVP and UVP in an international dynamic asset pricing model featuring asymmetric and time-varying risk aversion and economic uncertainty in a partially integrated world economy. We show that DVP is mostly driven by the upside movements of risk aversion, whereas UVP loads significantly and negatively on downside economic uncertainty. Moreover, we find that DVP (UVP) transmits to international markets mostly through financial integration (real economic integration).

Keywords: Variance risk premium, downside variance risk premium, international stock markets, asymmetric state variables, stock return predictability


IFDP 2019-1246
Institutional Investors, the Dollar, and U.S. Credit (PDF)

Abstract: This paper documents that an appreciation of the U.S. dollar is associated with a reduction in the supply of commercial and industrial loans by U.S. banks. An increase in the broad dollar index by 2.5 points (one standard deviation) reduces U.S. banks' corporate loan originations by 10 percent. This decline is driven by a reduction in the demand for loans on the secondary market where prices fall and liquidity worsens when the dollar appreciates, with stronger effects for riskier loans. Today, the main buyers of U.S. corporate loans--and, hence, suppliers of funding for these loans--are institutional investors, in particular mutual funds, which experience outflows when the dollar appreciates. A shift of traditional financial intermediation to these relatively unregulated entities, which are more sensitive to global developments, has led to the emergence of this new channel through which the dollar affects the U.S. economy, which we term the secondary market channel.

Keywords: Leveraged loan market, commercial and industrial loans, U.S. dollar exchange rate, credit standards, institutional investors


IFDP 2019-1245
Liquidity Funding Shocks: The Role of Banks' Funding Mix (PDF)

Antonio Álvarez, Alejandro Fernandez, Joaquin Garcia-Cabo, and Diana Posada

Abstract: This study attempts to evaluate the impact of an increase in banks' funding stress and its transmission to the real economy, taking into account different funding sources banks can rely on. Using aggregate data from eight Euro area financial systems, we find that following a liquidity funding shock, both credit and GDP decline in different amounts and lengths. GDP reverts faster than credit. Furthermore, periphery countries experience a more pronounced fall in deposits and credit growth and the negative effects from the shock last longer than in core countries. Banks' funding seems to play a relevant role as periphery countries rely more on wholesale funding during normal times.

Keywords: Liquidity funding shocks, ECB policy, Euro Area


IFDP 2019-1244
The Global Factor in Neutral Policy Rates: Some Implications for Exchange Rates, Monetary Policy, and Policy Coordination (PDF)

Richard Clarida

Abstract: This paper highlights some of the theoretical and practical implications for monetary policy and exchange rates that derive specifically from the presence of a global general equilibrium factor embedded in neutral real policy rates in open economies. Using a standard two country DSGE model, we derive a structural decomposition in which the nominal exchange rate is a function of the expected present value of future neutral real interest rate differentials plus a business cycle factor and a PPP factor. Country specific "r*" shocks in general require optimal monetary policy to pass these through to the policy rate, but such shocks will also have exchange rate implications, with an expected decline in the path of the real neutral policy rate reflected in a depreciation of the nominal exchange rate. We document a novel empirical regularity between the equilibrium error in the VECM representation of the empirical Holston Laubach Williams (2017) four country r* model and the value of the nominal trade weighted dollar. In fact, the correlation between the dollar and the 12 quarter lag of the HLW equilibrium error is estimated to be 0.7. Global shocks to r* under optimal policy require no exchange rate adjustment because passing though r* shocks to policy rates 'does all the work' of maintaining global equilibrium. We also study a richer model with international spill overs so that in theory there can be gains to international policy cooperation. In this richer model we obtain a similar decomposition for the nominal exchange rate, but with the added feature that r* in each country is a function global productivity and business cycle factors even if these factors are themselves independent across countries. We argue that in practice, there could well be significant costs to central bank communication and credibility under a regime of formal policy cooperation, but that gains to policy coordination could be substantial given that r*'s are unobserved but are correlated across countries.

Keywords: Exchange rate, monetary policy, policy coordination


IFDP 2019-1243
Understanding Persistent Stagnation (PDF)

Pablo A. Cuba-Borda and Sanjay R. Singh

Abstract: We theoretically explore long-run stagnation at the zero lower bound in a representative agent framework. We analytically compare expectations-driven stagnation to a secular stagnation episode and find contrasting policy implications for changes in government spending, supply shocks and neo-Fisherian policies. On the other hand, a minimum wage policy is expansionary and robust to the source of stagnation. Using Bayesian methods, we estimate a DSGE model that can accommodate two competing hypotheses of long-run stagnation in Japan. We document that equilibrium selection under indeterminacy matters in accounting for model fit.

Keywords: Expectations-driven trap, secular stagnation, inflation expectations, zero lower bound


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Last Update: January 17, 2018