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 2017-1203
Sentiment in Central Bank's Financial Stability Reports (PDF)

Ricardo Correa, Keshav Garud, Juan M. Londono, and Nathan Mislang

Appendix (Excel)

Abstract: Using the text of financial stability reports (FSRs) published by central banks, we analyze the relation between the financial cycle and the sentiment conveyed in these official communications. To do so, we construct a dictionary tailored specifically to a financial stability context, which assigns positive and negative connotations based on the sentiment conveyed by words in FSRs. With this dictionary, we construct a financial stability sentiment (FSS) index. Using a panel of 35 countries for the sample period between 2005 and 2015, we find that central banks' FSS indexes are mostly driven by developments in the banking sector and by the indicators that convey information about the health of this sector. We also find that the sentiment captured by the FSS index translates into changes in financial cycle indicators related to credit, asset prices, and systemic risk. Finally, our results show that central banks' sentiment deteriorates just prior to the start of banking crises.

Keywords: Financial stability, Central bank communications, Text analysis, Dictionary, Sentiment index.

DOI: https://doi.org/10.17016/IFDP.2017.1203

IFDP 2017-1202
Reversals in Global Market Integration and Funding Liquidity (PDF)

Amir Akbari, Francesca Carrieri, and Aytek Malkhozov

Abstract: This paper looks at the reversals in global financial integration through the funding liquidity lens. First, we construct a segmentation indicator based on differences in funding liquidity across countries as measured by the performance of betting-against-beta strategies. Second, we find that funding liquidity shocks help explain recent reversals in integration in the absence of explicit foreign investment barriers. These findings are consistent with tighter limits to arbitrage and increased home bias during funding distress periods. Our empirical analysis is guided by a margin-CAPM model generalized to an international setting.

Keywords: International Finance, Market Segmentation, Integration Reversals, Funding Liquidity

DOI: https://doi.org/10.17016/IFDP.2017.1202

IFDP 2017-1201
International Illiquidity (PDF)

Aytek Malkhozov, Philippe Mueller, Andrea Vedolin, and Gyuri Venter

Abstract: We build a parsimonious international asset pricing model in which deviations of government bond yields from a fitted yield curve of a country measure the tightness of investors' capital constraints. We compute these measures at daily frequency for six major markets and use them to test the model-predicted effect of funding conditions on asset prices internationally. Global illiquidity lowers the slope and increases the intercept of the international security market line. Local illiquidity helps explain the variation in alphas, Sharpe ratios, and the performance of betting-against-beta (BAB) strategies across countries.

Keywords: Liquidity, Market Frictions, Capital Constraints, International CAPM

DOI: https://doi.org/10.17016/IFDP.2017.1201

IFDP 2017-1200
Capital-Task Complementarity and the Decline of the U.S. Labor Share of Income (PDF)

Abstract: This paper provides evidence that shifts in the occupational composition of the U.S. workforce are the most important factor explaining the trend decline in the labor share over the past four decades. Estimates suggest that while there is unitary elasticity between equipment capital and non-routine tasks, equipment capital and routine tasks are highly substitutable. Through the lenses of a general equilibrium model with occupational choice and the estimated production technology, I document that the fall in relative price of equipment capital alone can explain 72 percent of the observed decline in the U.S. labor share. In addition, I find that differences in labor share trends across sectors can be accounted for by varying sensitivities of cost of production to the price of equipment capital.

Keywords: Labor share, technological change, capital-task complementarity, elasticity of substitution, job polarization, Bayesian estimation.

DOI: https://doi.org/10.17016/IFDP.2017.1200

IFDP 2017-1199
Disaster Risk and Asset Returns: An International Perspective (PDF)

Karen K. Lewis and Edith X. Liu

Abstract: Recent studies have shown that disaster risk can generate asset return moments similar to those observed in the U.S. data. However, these studies have ignored the cross-country asset pricing implications of the disaster risk model. This paper shows that standard U.S.-based disaster risk model assumptions found in the literature lead to counterfactual international asset pricing implications. Given consumption pricing moments, disaster risk cannot explain the range of equity premia and government bill rates nor the high degree of equity return correlation found in the data. Moreover, the independence of disasters presumed in some studies generates counterfactually low cross-country correlations in equity markets. Alternatively, if disasters are all shared, the model generates correlations that are excessively high. We show that common and idiosyncratic components of disaster risk are needed to explain the pattern in consumption and equity co-movements.

Keywords: Rare disaster, asset returns, international correlations

DOI: https://doi.org/10.17016/IFDP.2017.1199

IFDP 2017-1198
The Effect of Foreign Lending on Domestic Loans: an Analysis of U.S. Global Banks (PDF)

Edith X. Liu and Jonathan Pogach

Abstract: This paper examines the effect of foreign lending on the domestic lending for US global banks. We show that greater foreign loan growth complements, rather than detracts from, domestic commercial lending. Exploiting a confidential data (FFIEC 009) on international loan exposure of US banks, we estimate that a 1% increase in foreign office lending is associated with a 0.6% growth in domestic commercial lending, suggesting complementarity across these lending channels. However, when capital raising is tight during the Global Financial Crisis of 2008, we find that foreign lending did come at the expense of domestic lending.

Keywords: Multinational, Global Banking, Commercial Loans, Foreign Investments

DOI: https://doi.org/10.17016/IFDP.2017.1198

IFDP 2017-1197
"Low-For-Long" Interest Rates and Banks' Interest Margins and Profitability: Cross-Country Evidence (PDF)

Stijn Claessens, Nicholas Coleman, and Michael Donnelly

Abstract: Interest rates in many advanced economies have been low for almost a decade now and are often expected to remain so. This creates challenges for banks. Using a sample of 3,385 banks from 47 countries from 2005 to 2013, we find that a one percentage point interest rate drop implies an 8 basis points lower net interest margin, with this effect greater (20 basis points) at low rates. Low rates also adversely affect bank profitability, but with more variation. And for each additional year of "low for long", margins and profitability fall by another 9 and 6 basis points, respectively.

Keywords: Interest rates, Bank profitability, Net interest margin, Low-for-long

DOI: https://doi.org/10.17016/IFDP.2017.1197

IFDP 2017-1196
Uncertainty, Currency Excess Returns, and Risk Reversals (PDF)

Lucas Husted, John Rogers, and Bo Sun

Abstract: In this paper we provide strong evidence that heightened uncertainty in the U.S. real economy or financial markets significantly raises excess returns to the currency carry trade. We posit that this works through the influence of uncertainty on global investors� risk preferences. Macro and financial uncertainty also lower foreign exchange risk reversals, an effect that is particularly strong for high interest rate portfolios. Our results are consistent with the idea that an increase in uncertainty regarding the U.S. economy or financial markets increases investors� risk aversion, which in turn drives up the expected returns and the cost of protection against crash risk in the FX market.

Keywords: Exchange rates, uncovered interest parity, uncertainty

DOI: https://doi.org/10.17016/IFDP.2017.1196

IFDP 2017-1195
Incentive Contracting Under Ambiguity Aversion (PDF)

Qi Liu, Lei Lu, and Bo Sun

Abstract: This paper studies a principal-agent model in which the information on future firm performance is ambiguous and the agent is averse to ambiguity. We show that if firm risk is ambiguous, while stocks always induce the agent to perceive a high risk, options can induce him to perceive a low risk. As a result, options can be less costly in incentivizing the agent than stocks in the presence of ambiguity. In addition, we show that providing the agent with more incentives would induce the agent to perceive a higher risk, and there is a discontinuous jump in the compensation cost as incentives increase, which makes the principal reluctant to reset contracts frequently when underlying fundamentals change. Thus, compensation contracts exhibit an inertia property. Lastly, the model sheds some light on the use of relative performance evaluation, and provides a rationale for the puzzle of pay-for-luck in the presence of ambiguity.

Keywords: Ambiguity, Executive compensation, Options, Relative performance evaluation

DOI: https://doi.org/10.17016/IFDP.2017.1195

IFDP 2017-1194
Unconventional Monetary and Exchange Rate Policies (PDF)

Joseph E. Gagnon, Tamim Bayoumi, Juan M. Londono, Christian Saborowski, and Horacio Sapriza

Abstract: This paper explores the direct effects and spillovers of unconventional monetary and exchange rate policies. We find that official purchases of foreign assets have a large positive effect on a country�s current account that diminishes considerably as capital mobility rises. There is an important additional effect through the lagged stock of official assets. Official purchases of domestic assets, or quantitative easing (QE), appear to have no significant effect on a country�s current account when capital mobility is high, but there is a modest positive impact when capital mobility is low. The effects of purchases of foreign assets spill over to other countries in proportion to their degree of international financial integration. We also find that increases in US bond yields are associated with increases in foreign bond yields and in stock prices, as well as with depreciations of foreign currencies, but that all of these effects are smaller on days of US unconventional monetary policy announcements. We develop a theoretical model that is broadly consistent with our empirical results and that highlights the potential usefulness of domestic unconventional policies as responses to the effects of foreign policies of a similar type.

Keywords: current account balance, unconventional monetary policy, foreign exchange intervention, quantitative easing

DOI: https://doi.org/10.17016/IFDP.2017.1194

IFDP 2017-1193
Learning, Prices, and Firm Dynamics (PDF)

Paulo Bastos, Daniel A. Dias, and Olga A. Timoshenko

Abstract: We document new facts about the evolution of firm performance and prices in international markets, and propose a theory of firm dynamics emphasizing the interaction between learning about demand and quality choice to explain the observed patterns. Using data from the Portuguese manufacturing sector, we find that: (1) firms with longer spells of activity in export destinations tend to ship larger quantities at lower prices; (2) older exporters tend to use more expensive inputs; (3) revenue growth within destinations (conditional on initial size) tends to decline with market experience; and (4) input prices and quantities tend to increase with revenue growth within firms. We develop a model of endogenous input and output quality choices in a learning environment that is able to account for these patterns. Counterfactual simulations reveal that minimum quality standards on traded goods reduce welfare by lowering entry in export markets and reallocating resources from old and large towards young and small firms.

Keywords: Learning about demand, prices, product quality, firm dynamics, quality standards.

DOI: https://doi.org/10.17016/IFDP.2017.1193

IFDP 2017-1192
Complex-Task Biased Technological Change and the Labor Market (PDF)

Colin Caines, Florian Hoffman, and Gueorgui Kambourov

Abstract: In this paper we study the relationship between task complexity and the occupational wage- and employment structure. Complex tasks are defined as those requiring higher-order skills, such as the ability to abstract, solve problems, make decisions, or communicate effectively. We measure the task complexity of an occupation by performing Principal Component Analysis on a broad set of occupational descriptors in the Occupational Information Network (O*NET) data. We establish four main empirical facts for the U.S. over the 1980-2005 time period that are robust to the inclusion of a detailed set of controls, subsamples, and levels of aggregation: (1) There is a positive relationship across occupations between task complexity and wages and wage growth; (2) Conditional on task complexity, routine-intensity of an occupation is not a Signiant predictor of wage growth and wage levels; (3) Labor has reallocated from less complex to more complex occupations over time; (4) Within groups of occupations with similar task complexity labor has reallocated to non-routine occupations over time. We then formulate a model of Complex-Task-Biased Technological Change with heterogeneous skills and show analytically that it can rationalize these facts. We conclude that workers in non-routine occupations with low ability of solving complex tasks are not shielded from the labor market effects of automatization.

Keywords: Occupational Task Content; Complex Tasks; Wage Polarization; Skills

DOI: https://doi.org/10.17016/IFDP.2017.1192

IFDP 2017-1191
The Anatomy of Financial Vulnerabilities and Crises (PDF)

Seung Jung Lee, Kelly E. Posenau, and Viktors Stebunovs

Abstract: We extend the framework used in Aikman, Kiley, Lee, Palumbo, and Warusawitharana (2015) that maps vulnerabilities in the U.S. financial system to a broader set of advanced and emerging economies. Our extension tracks a broader set of vulnerabilities and, therefore, captures signs of different types of crises. The typical anatomy of the evolution of vulnerabilities before and after a financial crisis is as follows. Pressures in asset valuations materialize, and a build-up of imbalances in the external, financial, and nonfinancial sectors follows. A financial crisis is typically followed by a build-up of sovereign debt imbalances as the government tries to deal with the consequences of the crisis. Our early warnings indicators which aggregate these vulnerabilities predict banking crises better than the Credit-to-GDP gap at long horizons. Our indicators also predict the severity of banking crises and the duration of recessions, as they take into account possible spill-over and amplification channels of financial stress to from one to another sector in the economy. Our indicators are of relevance for macroprudential and crisis management, in part, because they perform better than the Credit-to-GDP gap and do not suffer from the gaps econometric flaws.

Keywords: credit-to-GDP gap; crisis management; financial vulnerabilities; early warning system; financial crises; banking crises; currency crises; macroprudential policy

DOI: https://doi.org/10.17016/IFDP.2017.1191

IFDP 2017-1189
How Biased Are U.S. Government Forecasts of the Federal Debt? (PDF)
Supplemental materials (.zip): This file includes the data, code, and output for the empirical and analytical results in this paper.

Abstract: Government debt and forecasts thereof attracted considerable attention during the recent financial crisis. The current paper analyzes potential biases in different U.S. government agencies' one-year-ahead forecasts of U.S. gross federal debt over 1984-2012. Standard tests typically fail to detect biases in these forecasts. However, impulse indicator saturation (IIS) detects economically large and highly significant time-varying biases, particularly at turning points in the business cycle. These biases do not appear to be politically related. IIS defines a generic procedure for examining forecast properties; it explains why standard tests fail to detect bias; and it provides a mechanism for potentially improving forecasts.

Keywords: Autometrics, bias, debt, federal government, forecasts, impulse indicator saturation, heteroscedasticity, projections, United States.

DOI: https://doi.org/10.17016/IFDP.2017.1189

IFDP 2017-1188
Risk Taking and Interest Rates: Evidence from Decades in the Global Syndicated Loan Market (PDF)

Seung Jung Lee, Lucy Qian Liu, and Viktors Stebunovs

Abstract: We study how low interest rates in the United States affect risk taking in the market for cross-border corporate loans. Because banks tend to originate these loans with intent to sell to nonbank investors, we examine risk taking by the broad financial system. To the extent that actions of the Federal Reserve affect U.S. interest rates, our analysis provides evidence of cross-border spillover effects of U.S. monetary policy and highlights the global lending and risk-taking channels. We find that movements in the U.S. interest rates have an important effect on ex-ante credit risk of cross-border corporate loans, though the channels are different in the pre- and post-crisis periods. Before the crisis, banks made ex-ante riskier loans to non-U.S. borrowers in response to a decline in U.S. short-term interest rates, and, after it, banks and nonbanks originated such loans in response to a decline in U.S. longer-term interest rates. Economic uncertainty, risk appetite, and the U.S. dollar exchange rate appear to play a limited role in explaining ex-ante credit risk. Our results highlight the potential policy challenges faced by central banks in affecting credit risk cycles in their own jurisdictions.

Keywords: Syndicated loans, risk taking, monetary policy, international spillovers.

DOI: https://doi.org/10.17016/IFDP.2017.1188

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Last update: March 22, 2017