The Drivers of Financial GlobalizationThe Drivers of Financial Globalization

Philip R. Lane Philip R. Lane IIIS, Trinity College DublinIIIS, Trinity College Dublin

WBI Paris SeminarWBI Paris SeminarCapital Flows,Capital Flows, Monetary Policy and Current Monetary Policy and Current

Issues in International FinanceIssues in International FinanceApril 2007April 2007

IntroductionIntroduction

Measuring Financial Measuring Financial GlobalisationGlobalisationDrivers of International Financial IntegrationDrivers of International Financial IntegrationExternal Capital StructureExternal Capital StructureBilateral investment patternsBilateral investment patternsDeterminants of Net PositionsDeterminants of Net PositionsReturns, Exchange Rates and Capital FlowsReturns, Exchange Rates and Capital Flows

Scale of Global Financial DevelopmentScale of Global Financial Development

Global financial assets in 1990: $40 trillionGlobal financial assets in 1990: $40 trillionGlobal financial assets in 2005: $120 trillionGlobal financial assets in 2005: $120 trillion(sum of equity market capitalization, bond market (sum of equity market capitalization, bond market capitalization and bank deposits)capitalization and bank deposits)

Global Investor BaseGlobal Investor Base

Institutional investors (pension funds, mutual funds, Institutional investors (pension funds, mutual funds, insurance companies): $21 trillion in 1995, $53 trillion in insurance companies): $21 trillion in 1995, $53 trillion in 20052005Hedge funds: $50 billion in 1990, $1.4 trillion in 2005Hedge funds: $50 billion in 1990, $1.4 trillion in 2005Emerging markets: central banks and sovereign wealth Emerging markets: central banks and sovereign wealth fundsfunds

CrossCross--Border ActivityBorder Activity

Global crossGlobal cross--border flows tripled over 1995border flows tripled over 1995--2005, 2005, reaching $14.5 trillion in 2005 (14.5 percent of world reaching $14.5 trillion in 2005 (14.5 percent of world GDP)GDP)20012001--2005: doubling of cross2005: doubling of cross--border portfolio assets to border portfolio assets to $19 trillion$19 trillionUS: $2.3 trillion to $4.6 trillionUS: $2.3 trillion to $4.6 trillionJapan: $0.6 trillion to $2.1 trillionJapan: $0.6 trillion to $2.1 trillionEurope: increase of $6.1 trillion during 2001Europe: increase of $6.1 trillion during 2001--2005.2005.EM bond funds: $27 billion in 2000 to $230 billion in EM bond funds: $27 billion in 2000 to $230 billion in 2006.2006.

Measuring financial globalizationMeasuring financial globalization

Restrictions on capital movementsRestrictions on capital movementsArbitrage gaps between onshore and offshore ratesArbitrage gaps between onshore and offshore ratesVolumeVolume--based measures: scale of international balance based measures: scale of international balance sheet; scale of gross capital flowssheet; scale of gross capital flowsVolumes important in capturing exposures and linkage Volumes important in capturing exposures and linkage mechanismsmechanisms

EWN Mark II: Dataset on external position (assets EWN Mark II: Dataset on external position (assets and liabilities) for 145 countriesand liabilities) for 145 countries

Extends and improves the dataset in Lane and MilesiExtends and improves the dataset in Lane and Milesi--Ferretti (JIE 2001)Ferretti (JIE 2001)From 67 countries to 145 countries (nearly universal From 67 countries to 145 countries (nearly universal coverage)coverage)Coverage extended to 1970Coverage extended to 1970--20042004Much larger availability of stock estimates from national Much larger availability of stock estimates from national authoritiesauthorities

Dataset Dataset ““outputsoutputs””

External assetsExternal assetsPortfolio equityPortfolio equityForeign direct investmentForeign direct investmentDebt assetsDebt assets

•• Portfolio debt (for some countries/periods)Portfolio debt (for some countries/periods)•• Other investment assets (for some countries/periods)Other investment assets (for some countries/periods)

Reserve assets (net of gold)Reserve assets (net of gold)Financial derivatives Financial derivatives (limited coverage)(limited coverage)

Dataset Dataset ““outputsoutputs”” (II)(II)

External liabilitiesExternal liabilitiesPortfolio equityPortfolio equityForeign direct investmentForeign direct investmentDebt liabilitiesDebt liabilities

•• Portfolio debt (for some countries/periods)Portfolio debt (for some countries/periods)•• Other investment liabilities (for some countries/periods)Other investment liabilities (for some countries/periods)

Financial derivatives (Financial derivatives (limited coverage)limited coverage)

Data inputsData inputsInternational Investment Positions (when reported)International Investment Positions (when reported)Balance of payments flowsBalance of payments flowsWorld BankWorld Bank’’s Global Development Finance (external debt)s Global Development Finance (external debt)FDI stocks and flows from UNCTADFDI stocks and flows from UNCTADStock of portfolio equity holdings in the US and by US residentsStock of portfolio equity holdings in the US and by US residents(Warnock)(Warnock)CPIS Portfolio SurveyCPIS Portfolio SurveyBIS BIS locationallocational banking statisticsbanking statisticsNational sourcesNational sourcesHistorical data from Sinn (1990)Historical data from Sinn (1990)IMF desksIMF desksetc....etc....

Estimation methodsEstimation methods

Eclectic...Eclectic...Stock data, complemented by cumulative Stock data, complemented by cumulative capital flows with valuation adjustmentscapital flows with valuation adjustments

For portfolio equity, valuation reflects stock For portfolio equity, valuation reflects stock market pricesmarket pricesFor debt, its currency compositionFor debt, its currency compositionFor FDI, international relative pricesFor FDI, international relative prices

CaveatsCaveats

Substantial degree of uncertainty for estimatesSubstantial degree of uncertainty for estimatesSome offshore centers missingSome offshore centers missingLarge world NFA discrepancyLarge world NFA discrepancy

Some data featuresSome data features

Acceleration in scale of crossAcceleration in scale of cross--border asset trade (more border asset trade (more so for advanced nations)so for advanced nations)Increase in relative importance of equity finance for Increase in relative importance of equity finance for developing countriesdeveloping countriesMost advanced countries have positive net equity, Most advanced countries have positive net equity, negative net debt positions; most developing countries negative net debt positions; most developing countries have negative net equity positionshave negative net equity positionsWeakening correlation between CA and D(NFA)Weakening correlation between CA and D(NFA)Cumulative impact of valuation channel importantCumulative impact of valuation channel important

Figure 3. International Financial Integration: Industrial Group and Emerging Markets/Developing Countries Group, 1970-2004

0

50

100

150

200

250

300

350

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Emerging and developing economies

Industrial countries

Figure 4. Financial Integration versus Trade Integration: Industrial Group and Emerging Markets/Developing Countries Group, 1970-2004

0

100

200

300

400

500

600

700

800

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Industrial countries

Developing countries and emerging markets

Figure 5. International Equity Integration: Industrial Country Group and Emerging Markets and Developing Country Group, 1970-2004

0

20

40

60

80

100

120

140

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Industrial countries

Developing countries and emerging markets

Figure 6. Equity Share in External Liabilities: Industrial Country Group and Emerging Markets and Developing Country Group, 1970-2004

10

15

20

25

30

35

40

45

50

55

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Industrial countries

Developing countries and emerging markets

Figure 7. External Debt and Official Reserves, Emerging Markets and Developing Group, 1970-2004

Gross external debt (pct of exports )

Official reserves (pct of exports)

20

50

80

110

140

170

200

230

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Table 4. Indicators of Int. Fin. Integration, Table 4. Indicators of Int. Fin. Integration, Emerging Markets (ratios of GDP)Emerging Markets (ratios of GDP)

1982 1992 2002

Average net external position -26.7% -21.1% -20.6% Average external assets 16.6% 26.5% 61.1% of which: foreign exchange reserves 5.1% 11.1% 19.4% FDI + portfolio equity 0.5% 2.0% 9.3% Average external liabilities 43.3% 49.9% 81.7% of which: FDI + portfolio equity 5.1% 9.6% 34.5%

Source: authors’ calculations based on Lane and Milesi-Ferretti (2001) and IFS.

Figure 8. Net foreign assets and GDP per capita: All Countries, 2004.

ROM

SERPOL

BHZ

MACSLO

CRO

LIT

HUN

LAT

EST

SLK CZEUZBUKR

TKMCHN

TAJ

RUS

MOLBUL

KYR

KAZGEO

ALBBEL

AZE

ARM

PNG

ZMB

BUR

UGA

TUNTOG

TAN

SWA

SUD

NAM

SEN

RWA

NGA

MOZ

MOR

MAU

MAL

MDG

LIB

KEN

CIVGUIGHA

GBN

ETH

CHA

CMR

BOT

ANG

ALG

VTM

THA

SGP

PHL

PAKNEP

MYS

LAO

KOR

IDO

IND

HKG

TAI

SLKCAM

MYA

BGD

YEM

EGY

UAE

SYR

SAU

QTR

OMN

LBN

KWT

JOR ISR

IRN

CYP

BAH

TTOJAM

VEN

URU

PER

PAR

PANNIC

MEXHND

GUA

SLVECU

DOMCRI

COLCHL

BRA

BOL

ARG

SAF

NZE

AUS

TUR ESPPRT

MLT

IRE

ICEGRE

FIN

JPN

CAN

SWI

SWE

NOR

NET

LUX

ITA

GERFRA

DEN

BEL

AUTUK

USA

-150

-100

-50

0

50

100

150

200

250

300

4 5 6 7 8 9 10 11 12

Log GDP per capita

NFA

(pct

of G

DP)

Figure 9. Net Foreign Assets by Country Group (percent of Group GDP), 1980-2004

Other industrial countries

Emerging and developing countries

United States

-25

-20

-15

-10

-5

0

5

10

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Figure 10a. Change in NFA/GDP, 1996-2004: Industrial Countries

Industrial countries

United States

United Kingdom

Austria

Belgium

Denmark

FranceGermany

Italy

Netherlands

Norway

Sweden Canada

Japan

Finland

Greece

Iceland

Ireland

Portugal

Spain

Australia

New Zealand

-120

-100

-80

-60

-40

-20

0

20

40

60

80

-120 -100 -80 -60 -40 -20 0 20 40 60 80

Note: Switzerland is not displayed (NFA of 111% of GDP in 1996 and 149% of GDP in 2004).

Figure 10b. Change in NFA/GDP, 1996-2003: Africa

South Africa

Angola

Botswana

Cameroon

Chad

Congo, Republic of

Congo, Dem. Rep. of

Benin

Ethiopia

Gabon

Ghana

GuineaCôte d'Ivoire

Kenya

Madagascar

Malawi

Mali

Mauritius

MozambiqueNiger

Nigeria ZimbabweRwanda

Senegal

Namibia

Sudan

Swaziland

Tanzania

Togo

Uganda

Burkina Faso

-250

-200

-150

-100

-50

0

50

-250 -200 -150 -100 -50 0 50

NFA (pct of GDP), 1996

NFA

(pct

of G

DP)

, 200

3

Africa

Figure 10c. Change in NFA/GDP, 1996-2004: Asia

China,P.R.: Mainland

Hong Kong S.A.R.

India

Indonesia

KoreaMalaysia

Pakistan

Philippines

Singapore

Sri Lanka

Taiwan p.o.C.

ThailandBangladeshCambodia

Lao People's Dem.Rep

Nepal

Vietnam

Papua New Guinea

-130

-100

-70

-40

-10

20

50

80

110

140

170

200

230

260

-130 -100 -70 -40 -10 20 50 80 110 140 170 200 230 260

NFA (pct of GDP), 1996

NFA

(pct

of G

DP)

, 200

4

Asia

Figure 10g. Change in NFA/GDP, 1996-2004: Western Hemisphere

Latin America

Trinidad and TobagoJamaica

Venezuela, Rep. Bol.

Uruguay

Peru

Paraguay

Panama

Mexico

Honduras

Haiti

Guatemala

El Salvador

Ecuador

Dominican Republic

Costa Rica

ColombiaChile

Brazil

Bolivia

Argentina

-120

-100

-80

-60

-40

-20

0

20

-120 -100 -80 -60 -40 -20 0 20

NFA (pct of GDP), 1996

NFA

(pct

of G

DP)

, 200

4

Figure 11a. Net Equity Position versus Net Debt Position: Industrial Group, 2004

NZE

AUS ESP

PRT

ICE

GRE

FIN

JPN

CAN

SWI

SWE NOR

NET

ITA GERFRA

DENBEL

AUT

UK

USA

-50

-40

-30

-20

-10

0

10

20

30

40

50

60

-150 -100 -50 0 50 100 150

Net debt (pct of GDP)

Net

equ

ity (p

ct o

f GD

P)

Figure 11b. Net Equity and Net Debt Position: Emerging Markets and Developing Countries, 2004

ROM

POL

BHZ

MAC

SLO

CROLIT

HUN

LAT

EST

SLK

CZE

UZBUKR TKM

CHNTAJ

RUS

MOLBUL

KYR

KAZGEO

ALB

BEL

AZE

ARM

PNGZMB

BUR

UGA

TUN

TOG

TAN SWASUD NAM

SEN

RWA

NGAMOZMOR

MWI

MAL

MDG

LIB

KEN

CIV

GUI

GHA

GBN

ETH

CHA

CMR

BOT

ANG

ALG

VTM

THA

SGP

PHL

PAK

NEP

MYS

LAOKOR

IDO IND

HKG

TAI

SLK

CAM

MYA

BGDYEM

EGY

UAE

SYR

SAUQTROMN

LBN

KWT

JORISR

IRN

CYP

BAH

TTO

JAM

VENURU

PER

PAR

PAN

NIC

MEXHND

GUA

SLVECU

DOM

CRI

COLCHLBRA

BOL

ARG SAFTUR

MLT

-120

-70

-20

30

80

130

-110 -60 -10 40 90 140 190 240 290

Net debt (pct of GDP)

Net

equ

ity (p

ct o

f GD

P)

Table 5a. Matrix of Net Debt and Net Equity Positions: Industrial Countries, 2004

Industrial countries

NET EQUITY <0 >0

<0 6 11

NET DEBT >0 3 3

Table 5b. Matrix of Net Debt and Net Equity Positions: Emerging Markets and Developing Countries, 2004

Developing countries

NET EQUITY

<0 >0

<0 73 0 NET DEBT

>0 31 8

Dynamics of External PositionsDynamics of External Positions

In addition to role of capital flows, increasing importance In addition to role of capital flows, increasing importance of valuation effects (capital gains and losses on external of valuation effects (capital gains and losses on external assets and liabilities)assets and liabilities)Valuation channel an important transmission mechanism Valuation channel an important transmission mechanism for exchange rate movementsfor exchange rate movementsAdvanced countries versus emerging market economiesAdvanced countries versus emerging market economies

An accounting frameworkAn accounting frameworkNFA accumulation equation:NFA accumulation equation:

Taking ratios of GDP:Taking ratios of GDP:

1t t t t tB B CA KG−− = + +Ε

1 1

1 1(1 )(1 )

A Lt t t t t t t

t t t t tt t t

i A i L KG gb b bgst bY g

π επ

− −− −

− + +− ≡ + − +

+ +

Accounting framework (II)Accounting framework (II)We can reWe can re--arrange terms of the previous arrange terms of the previous equation in a more familiar form:equation in a more familiar form:

Where Where aa is the stock of gross external assets.is the stock of gross external assets.When rates of return on assets and When rates of return on assets and liabsliabs are are equal, this is the familiar debt accumulation equal, this is the familiar debt accumulation eqneqn. . When they are not, When they are not, gross positions matter!gross positions matter!

1 1 11 1

L A Lt t t t

t t t t t tt t

r g r rb b bgst b ag g

ε− − −

− −− ≡ + + +

+ +

Large industrial countries: NFA 2001Large industrial countries: NFA 2001--20042004

Cumulative trade balance

Cumulative inv. income KA, EO Growth K-gains

United States -16.7 -8.3 -19.8 1.0 -0.9 4.0 7.4

United Kingdom -3.7 -9.1 -15.3 7.4 0.6 0.9 -2.9

Euro Area -9.8 -5.6 4.1 -2.5 0.4 1.4 -9.0

Canada -4.8 -5.7 18.5 -9.7 -1.0 1.8 -15.2

Japan 24.3 14.5 5.0 6.8 -1.2 0.3 3.7

Table 2. Decomposition of change in net foreign assets, 2001-2004

Initial NFA (2000)

Change in net foreign assets

Other factorsCumulative current account

Table 8a. Cumulative Current Account and Change in Net Foreign Asset Position: Industrial Group, 1972-2004

(1) (2) (3) Change

in NFACumulative

current account

Difference

Switzerland 142.6 121.4 21.2 United States -23.1 -38.4 15.2 Canada -9.2 -16.5 7.4 United Kingdom -13.3 -19.3 6.0 Austria -17.1 -18.7 1.6 Australia -62.3 -60.4 -1.8 Germany 7.6 10.9 -3.3 Belgium 30.1 33.6 -3.6 France 4.7 9.2 -4.5 Norway 65.5 71.1 -5.6 Japan 37.6 44.2 -6.6 Portugal -68.4 -58.7 -9.7 Ireland -19.3 -5.0 -14.3 Denmark -10.5 5.3 -15.9 Italy -18.4 -1.6 -16.8 Greece -73.4 -55.7 -17.7 Spain -48.7 -24.7 -24.0 New Zealand -93.2 -66.4 -26.7 Sweden -9.5 18.0 -27.6 Finland -10.7 18.8 -29.5 Iceland -91.8 -49.6 -42.2 Netherlands -8.0 48.5 -56.5

Table 8b. Cumulative Current Account and Change in Net Foreign Asset Position: Selected Developing Countries, 1982-2004

(1) (2) (3) Change

in NFACumulative

current account

Difference

Argentina -40.3 -54.3 14.1Chile -20.9 -31.7 10.8India -8 -10.1 2South Africa 0.3 -1 1.3Mexico -32.3 -30.3 -2Brazil -34.8 -32.6 -2.2China 7.3 18.1 -10.9Korea 0 14.8 -14.8Thailand -24 -8.8 -15.2Turkey -39.4 -16.8 -22.7Malaysia 4.9 30.3 -25.4Philippines -39.8 -6.4 -33.4Venezuela 26 62.1 -36.1Indonesia -45.4 -4.5 -40.9

Table 6. Correlation Between Current Account and Change in Net Foreign Assets: Industrial Countries and Emerging Markets, Annual Data, 1971-2004

Industrial countries Emerging markets

1971-2004 0.42 0.58

1971-1981 0.71 0.72

1982-1992 0.63 0.68

1993-2004 0.34 0.47

Determinants of International Financial IntegrationDeterminants of International Financial Integration

Benchmark: expect very high levels of IFI under frictionless traBenchmark: expect very high levels of IFI under frictionless tradedeView recent evolution as convergence to benchmark, in line with View recent evolution as convergence to benchmark, in line with reductions in costs of trade and increases in gains to diversifireductions in costs of trade and increases in gains to diversificationcation

We explore the role of a wide set of determinants:We explore the role of a wide set of determinants:Capital account liberalizationCapital account liberalizationTrade in goods and servicesTrade in goods and servicesPer capita GDPPer capita GDPDomestic financial depthDomestic financial depthDomestic Domestic stockmarketstockmarket capitalizationcapitalizationPrivatizationPrivatizationTax structureTax structureQuality of financial regulationQuality of financial regulation

Level of International Financial IntegrationLevel of International Financial Integration

Increasing in income per capitaIncreasing in income per capitaIncreasing in trade openness Increasing in trade openness -- complementaritycomplementarityIncreasing in domestic financial developmentIncreasing in domestic financial developmentIncreasing in external account liberalizationIncreasing in external account liberalization

Panel Analysis of financial integration, Panel Analysis of financial integration, 19821982--20012001

(Dep. Var.: change in financial integration)(Dep. Var.: change in financial integration) (1) (2) (3) (4) (5)

0.17 0.03 0.02 -0.01 -0.01 External

Liberalization (3.69)*** (.5) (.36) (.5) (.2) Trade openness 2.35 2.96 1.10 1.53 (3.62)*** (4.88)*** (3.37)*** (4.58)***

2.15 0.99 1.56 Log GDP per capita (2.74)*** (3.65)*** (5.06)***

0.92 0.93 Stock market capitalization (18.3)*** (17.4)***

Adjusted R2 0.12 0.31 0.41 0.89 0.9 Number of obs. 72 72 72 66 59

Institutions and Capital FlowsInstitutions and Capital Flows

Good institutions lead to:Good institutions lead to:Greater financial integrationGreater financial integrationGreater ability to attract capital inflowsGreater ability to attract capital inflowsImproved Improved ‘‘qualityquality’’ of inflows of inflows –– more portfolio equity, more more portfolio equity, more FDI, more bondsFDI, more bondsImproved Improved ‘‘qualityquality’’ of outflows of outflows –– less capital flight; lower less capital flight; lower need to hold reservesneed to hold reservesLower spreadsLower spreads

Institutional mix: general versus financialInstitutional mix: general versus financial

Dynamics of External Capital StructureDynamics of External Capital StructureFariaFaria et al, JEEA, April/May 2007et al, JEEA, April/May 2007

Focus on emerging markets and developing economiesFocus on emerging markets and developing economiesExternal capital structure: (total liabilities/GDP); (equity External capital structure: (total liabilities/GDP); (equity liabilities/total liabilities); (FDI liabilities / equity liabilliabilities/total liabilities); (FDI liabilities / equity liabilities)ities)Institutional Quality Index from Kaufman et al (World Institutional Quality Index from Kaufman et al (World Bank), available 1996Bank), available 1996--20042004Financial Reform Index: Financial Reform Index: DetragiacheDetragiache et al (IMF)et al (IMF)Country SizeCountry SizeGDP per capitaGDP per capitaTrade opennessTrade opennessNatural resourcesNatural resources

Existing LiteratureExisting Literature

Lane and Lane and MilesiMilesi--FerrettiFerretti (2001); Wei (2001); (2001); Wei (2001); Albuquerque (2003); Albuquerque (2003); FariaFaria and Mauro (2004); and Mauro (2004); KraayKraay et al et al (2005); (2005); RazinRazin and and SadkaSadka (2006)(2006)Empirical analysis: predominant focus is on crossEmpirical analysis: predominant focus is on cross--sectional variationsectional variationOur contribution: take advantage of greater data Our contribution: take advantage of greater data availability along the time series dimension (for both availability along the time series dimension (for both external capital structure and potential covariates)external capital structure and potential covariates)

External Capital Structure: CrossExternal Capital Structure: Cross--SectionSection1996 and 20041996 and 2004

1996

(1) (2) (3) (4) (5) (6)Total Eq.Share FDI/Equity Total Eq.Share FDI/Equity

Institutional quality index -0.53 0.120** -0.051 .124 0.101** -.053(0.36) (0.046) (0.032) (0.114) (0.045) (0.036)

GDP (log) -0.11 0.030** -0.069*** -0.09** 0.03** -0.066***(0.10) (0.013) (0.009) (0.033) (0.013) (0.011)

GDP per capita (log) 0.15 -0.002 0.029 -0.004 0.002 0.037*(0.2) (0.026) (0.018) (0.067) (0.026) (0.021)

Openness 1.38*** 0.066 -0.054 0.21 0.138*** -0.041(0.47) (0.060) (0.060) (0.13) (0.052) (0.043)

Natural resources 0.49 0.171** 0.046 0.18 0.186** 0.051(0.53) (0.068) (0.047) (0.18) (0.071) (0.058)

Constant 0.82 -0.113 1.59*** 1.63*** -0.042 1.56***(1.17) (0.149) (0.10) (0.38) (0.15) (0.12)

Observations 79 79 79 77 77 77R-squared 0.21 0.34 0.51 0.20 0.36 0.40

2004

Dynamics of External Capital Structure: IDynamics of External Capital Structure: I Full

(1) (2) (3) (4) (5) (6)Total Eq.Share FDI/Equity Total Eq.Share FDI/Equity

Institutional quality index -0.05 0.06 -0.066 -0.003 0.047 -0.062(0.17) (0.05) (0.046) (0.19) (0.065) (0.084)

Financial reform index -1.2* 0.54** -0.065(0.66) (0.23) (0.28)

GDP (log) -0.081* -0.045*** -0.007 -0.10 -0.013 -0.015(0.048) (0.015) (0.014) (0.076) (0.026) (0.032)

GDP per capita (log) 0.113*** 0.032** 0.005 0.138* -0.003 0.009(0.04) (0.012) (0.011) (0.073) (0.025) (0.03)

Openness 0.92*** 0.077 0.005 0.22 0.115 -0.034(0.34) (0.10) (0.091) (0.52) (0.18) (0.22)

Natural resources -0.234 0.004 0.117 0.98 -0.13 0.465(0.39) (0.11) (0.105) (0.70) (0.24) (0.30)

Constant 0.03 0.24*** -0.005 0.28 0.12 .015(0.14) (0.04) (0.04) (0.22) (0.08) (0.16)

Observations 65 67 67 37 37 37R-squared 0.32 0.18 0.05 0.31 0.25 0.11

Narrow

Dynamics of External Capital Structure: IIDynamics of External Capital Structure: II Full

(1) (2) (3) (4) (5) (6)Total Eq.Share FDI/Equity Total Eq.Share FDI/Equity

Institutional quality index -0.054 0.04 -0.072 -0.01 0.056 -0.071(0.15) (0.051) (0.051) (0.18) (0.081) (0.084)

Financial reform index -1.33 0.49* -0.071(0.81) (0.26) (0.37)

GDP (log) -0.066 -0.032** -0.011 -0.11 -0.005 -0.016(0.049) (0.014) (0.011) (0.10) (0.033) (0.039)

GDP per capita (log) 0.076* 0.029** 0.10 0.116 -0.002 0.008(0.044) (0.014) (0.009) (0.09) (0.031) (0.04)

Openness 0.66** 0.12 -0.016 0.17 0.116 -0.029(0.32) (0.10) (0.074) (0.66) (0.25) (0.25)

Natural resources -0.038 0.024 0.126 0.76 -0.072 0.451(0.65) (0.14) (0.118) (0.78) (0.29) (0.39)

Gap -0.45*** -0.28** -0.34*** -0.63** -0.14 -0.41(0.13) (0.12) (0.126) (0.29) (0.23) (0.32)

Constant 0.09 0.19*** -0.004 0.40 0.10 .019(0.12) (0.04) (0.036) (0.26) (0.09) (0.12)

Observations 65 67 67 37 37 37R-squared 0.49 0.26 0.15 0.44 0.26 0.19

Narrow

SummarySummary

CrossCross--section: section: larger, more open economies with a better larger, more open economies with a better institutional quality score and a greater reliance on natural reinstitutional quality score and a greater reliance on natural resource source production have a greater equity share in external liabilities production have a greater equity share in external liabilities Time series: Time series: shift towards equity financing is stronger among those shift towards equity financing is stronger among those countries that have undertaken a greater degree of domestic countries that have undertaken a greater degree of domestic financial reform; importance of gradual adjustmentfinancial reform; importance of gradual adjustmentNext steps: Next steps: which are the most important institutional changes and which are the most important institutional changes and dimensions of financial reforms?; impact of financial globalizatdimensions of financial reforms?; impact of financial globalization on ion on domestic financial sectors; verify whether an increase in the eqdomestic financial sectors; verify whether an increase in the equity uity share of liabilities is indeed associated with improved internatshare of liabilities is indeed associated with improved international ional risk sharing and greater financial stabilityrisk sharing and greater financial stability

Bilateral Investment PatternsBilateral Investment Patterns

What explains why country A invests in country B?What explains why country A invests in country B?Country ACountry A’’s propensity to invest overseass propensity to invest overseasCountry BCountry B’’s general attractiveness as a destinations general attractiveness as a destinationBilateral linkages between A and BBilateral linkages between A and B

―― Important for Important for ‘‘investor baseinvestor base’’―― Important for transmission of shocksImportant for transmission of shocks―― Important for risk analysisImportant for risk analysis―― Important for asset pricing and return Important for asset pricing and return comovementscomovements

Bilateral LinkagesBilateral Linkages

Optimal diversification has a bilateral dimensionOptimal diversification has a bilateral dimension―― Trade riskTrade risk―― GDP / return riskGDP / return risk•• Information frictionsInformation frictions―― Gravity variables (Distance, Language, Colonial Ties Gravity variables (Distance, Language, Colonial Ties …… ))―― Also Trade volumeAlso Trade volume•• Bilateral trading costsBilateral trading costs―― Bilateral exchange rate stability, language, common Bilateral exchange rate stability, language, common

institutional framework etcinstitutional framework etc

Main FindingsMain Findings

Asset holdings significantly correlated with trade linkagesAsset holdings significantly correlated with trade linkagesDistance also matters (more so for FDI, banks than Distance also matters (more so for FDI, banks than portfolio flows)portfolio flows)Institutional similarityInstitutional similarityAsset holdings less influenced by Asset holdings less influenced by ‘‘return hedgingreturn hedging’’ factorsfactorsStrong impact of currency union (EMU) Strong impact of currency union (EMU) –– on equity; on equity; portfolio debtportfolio debtMore generally, More generally, ‘‘regionalregional’’ policies matterpolicies matter

Determinants of Net External PositionsDeterminants of Net External Positions

LongLong--Term Capital Movements:Term Capital Movements:Level of income per capitaLevel of income per capitaDemographic factorsDemographic factorsLevel of public debtLevel of public debtDomestic Financial Sector (?)Domestic Financial Sector (?)Structural differences more influential, with Structural differences more influential, with decline in investor home biasdecline in investor home bias

New Systemic ViewsNew Systemic Views

Outsourcing of financial intermediationOutsourcing of financial intermediationImperative to maintain Imperative to maintain ‘‘undervaluedundervalued’’ exchange rate in exchange rate in order to facilitate exportorder to facilitate export--driven growthdriven growthRestrictions on private capital flows to prevent arbitrageRestrictions on private capital flows to prevent arbitrageBrettonBretton Woods IIWoods IISimilar sentiment: Caballero, Similar sentiment: Caballero, FarhiFarhi, , GourinchasGourinchas; ; Mendoza, Mendoza, QuadriniQuadrini, Rios, Rios--RullRull

Temporary FactorsTemporary Factors

Differences in business cyclesDifferences in business cyclesRecovery from 1990s financial crisesRecovery from 1990s financial crisesCommodity price boom (especially oil)Commodity price boom (especially oil)(Global savings glut and/or weak investment)(Global savings glut and/or weak investment)Offsetting factors: excess reserves, domestic spending Offsetting factors: excess reserves, domestic spending pressures, domestic reformpressures, domestic reformDomestic financial Domestic financial liberalisationliberalisationEMUEMU

Sustainability of US positionSustainability of US position

Role of valuation channelRole of valuation channelAnalysis of Portfolio AdjustmentAnalysis of Portfolio AdjustmentLooking to the FutureLooking to the Future

Valuation effectsValuation effectsEuro area, Japan, and U.S., 2002Euro area, Japan, and U.S., 2002--20052005

Factor → NFA at end-2001

Change in NFA

2001-05

Cumul. trade

balance

Cumul investm. income

Valuation changes

Effects of growth

Other factors 1/

Term in eq (2) →

01b 05 01b b− 2005

2002t

t

bgst=∑

20051 1

2002

A Lt t t t

t t

i A i LY

− −

=

−

∑

2005

2002

t

t t

KGY=

∑2005

12002 (1 )(1 )

t tt

t t t

g bg

ππ −

=

+− + +

∑2005

2002t

t

ε=∑

Euro Area -7.2 -7.2 3.3 -2.0 -9.2 2.7 -1.9

Japan 32.5 0.8 5.7 7.1 -7.4 -2.9 -1.7 United States -23.8 2.3 -20.6 0.9 17.2 4.5 0.4

SummarySummary

US made large net returns on its external US made large net returns on its external portfolio over 2001portfolio over 2001--20052005Continued in 2006: large equity market Continued in 2006: large equity market return differentialreturn differentialSustainable?Sustainable?

Sources of Net Valuation GainsSources of Net Valuation Gains

Composition effect (long equity, short debt; maturity Composition effect (long equity, short debt; maturity structure)structure)Return differentials within categoriesReturn differentials within categoriesPortfolio returnsPortfolio returnsFDI returnsFDI returnsDifferentials and currency movementsDifferentials and currency movementsBehavior of international investorsBehavior of international investors

Exchange rates and rates of returnExchange rates and rates of return

1 1

1 1

A Lt t t t t

A Lt t t

t tt t t

R E T r A r L

R E T r rA LR E R R E R R E R

− −

− −

= −

∂ ∂ ∂= −

∂ ∂ ∂

Overall effect depends onOverall effect depends onScale of foreign asset and liability holdingsScale of foreign asset and liability holdingsRelation between RER and rates of return on Relation between RER and rates of return on foreign assets and liabilitiesforeign assets and liabilitiesWill depend on composition (e.g. equity v debt; Will depend on composition (e.g. equity v debt; domestic currency v foreign currency)domestic currency v foreign currency)

Exchange Rates: Advanced EconomicsExchange Rates: Advanced Economics

Liabilities mostly in domestic currency; assets have high Liabilities mostly in domestic currency; assets have high FC componentFC componentDepreciation generates net capital gainDepreciation generates net capital gainBut interest rate parity kicks in if depreciation expectedBut interest rate parity kicks in if depreciation expectedTiming: Timing: GourinchasGourinchas--ReyRey find US dollar depreciates when find US dollar depreciates when US net external liabilities cyclically largeUS net external liabilities cyclically largeLucas critique: nonLucas critique: non--exploitable policyexploitable policyMonetary policy driven by domestic concernsMonetary policy driven by domestic concerns

Emerging MarketsEmerging Markets

Devaluations raise dom.Devaluations raise dom.--currency payouts on foreign currency payouts on foreign liabilitiesliabilities——balancebalance--sheet effectssheet effects!!Trend real appreciation?Trend real appreciation?Improve riskImprove risk--sharing: FDI and equity promote closer link sharing: FDI and equity promote closer link between dom. econ. performance and rates of return; between dom. econ. performance and rates of return; increase levels of FC reservesincrease levels of FC reservesAlternative forms of debt? Alternative forms of debt?

DomesticDomestic--currency bond marketcurrency bond marketGDPGDP--indexed bonds; other indexation schemesindexed bonds; other indexation schemes

Erosion of home bias and demand for dollar assetsErosion of home bias and demand for dollar assetsSymmetry in reduction in home bias?Symmetry in reduction in home bias?High returns in US?High returns in US?

Evidence on returns suggest importance of factors such Evidence on returns suggest importance of factors such as portfolio compositionas portfolio composition

Investor Investor BehaviourBehaviour and the US Positionand the US Position

The US external portfolio (net)The US external portfolio (net)US net external position: underlying components (ratio of GDP)

Net other claims

Net portfolio debt

Net portfolio equity + FDI

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Composition of US KComposition of US K--inflowsinflows

United States: capital inflows

-2%

0%

2%

4%

6%

8%

10%

12%

14%

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Other debtPortfolio debtFDIEquity

Portfolio DynamicsPortfolio Dynamics

Relative returns heavily influenced by exchange rateRelative returns heavily influenced by exchange rateIncreases in US external liabilities associated with Increases in US external liabilities associated with subsequent depreciationsubsequent depreciationDecline in relative returns associated with subsequent Decline in relative returns associated with subsequent decline in equity/FDI flows but increase in debt flowsdecline in equity/FDI flows but increase in debt flows

Returns and Portfolio FactorsReturns and Portfolio Factors

Regress return differentials on (i) NFA position; Regress return differentials on (i) NFA position; (ii) share of US in outstanding portfolio; (iii) (ii) share of US in outstanding portfolio; (iii) share of US in lagged capital flowsshare of US in lagged capital flows

Partition between exchange rate and other Partition between exchange rate and other return componentsreturn components

Capital Flows and Portfolio FactorsCapital Flows and Portfolio Factors

Regress capital flows on lagged returns Regress capital flows on lagged returns and outstanding US portfolio shareand outstanding US portfolio share

Allow for persistence in capital flowsAllow for persistence in capital flows

Table 6. Rate of Return Differentials and The Real Exchange Rate

D(REER) Adj. R2 DW

(1) All 0.79 (6.52)*** 0.44 2.08(2) Debt 0.77 (7.92)*** 0.79 1.69(3) Portfolio equity 0.99 (3.97)*** 0.26 2.17(4) FDI 0.92 (3.55)*** 0.18 2.17

(5) Stocks 1.46 (3.12)*** 0.31 1.39(6) Bonds 0.71 (2.96)*** 0.27 2.32(7) Growth 1.38 (0.61) -0.04 1.71

Table 7. Rate of Return Differentials and Portfolio Factors

(1) (2) (3) (4) (5) (6) (7)

D(REER) DEBT EQ FDI STK BOND GROW

D(REER) 0.78 0.59 0.83 1.33 0.78 0.03(13.62)** (3.0)*** (3.0)*** (5.35)*** (3.1)*** (.63)

NFA(-1) 0.52 0.23 0.8 0.6 0.81 0.58 0.07(1.97)* (2.71)** (5.2)*** (1.25) (2.56)** (1.63) (1.93)*

STOCK_SHARE(-1) -0.29 0.26 -1.19 -0.65 -0.76 1.43 0.13(.37) (.84) (4.78)*** (1.25) (4.56)*** (1.62) (1.58)

FLOW_SHARE(-1) -0.84 -0.14 -0.02 -0.86 0.03 -0.7 0.023(1.82)* (.91) (2.06)* (1.48) (2.38)** (1.4) (.33)

adj R2 0.24 0.8 0.57 0.23 0.54 0.27 -0.02

DW 1.55 2.33 2.14 1.92 1.79 2.5 1.97

Table 8. Capital Flows and Portfolio Factors

(1) (2) (3) (4) (5) (6) (7) (8)

ALL ALL DEBT DEBT EQ EQ FDI FDIABS REL ABS REL ABS REL ABS REL

LAG 0.54 0.24 0.24 0.8 -0.83 -0.45 0.58 0.4(2.96)*** (1.92)* (1.53) (1.64) (5.26)*** (1.67) (4.39)*** (2.38)**

ROR_LAG -0.06 -1.45 -1.44 1.05 0.16 -0.13 0.17 0.1(.32) (3.43)*** (3.56)*** (1.03) (4.93)*** (.05) (2.77)** (.97)

LEVEL(-1) 0.11 -0.09 1.14 -0.19(1.11) (.8) (5.75)*** (2.42)**

SHARE(-1) -0.28 -0.97 -5.86 -0.29(1.04) (1.64) (1.26) (2.14)**

adj R2 0.33 0.54 0.37 -0.006 0.67 0.05 0.66 0.35

DW 1.62 1.73 1.92 1.67 1.87 1.85 1.9 2.06

Looking to the FutureLooking to the FutureIs foreign capacity to absorb US liabilities declining?Is foreign capacity to absorb US liabilities declining?

1.1. Decline of equity inflowsDecline of equity inflows2.2. Within debt, increased reliance on official flowsWithin debt, increased reliance on official flows

However, However,

1.1. Limits to official flowsLimits to official flows2.2. Limits to valuation channel as an adjustment Limits to valuation channel as an adjustment

mechanismmechanism