An Empirical analysis with Application

Portfolio Risk

• Risk Premium & Portfolio Diversification• Bias in the forward exchange market

as a predictor of the future spot exchange rate • What makes a currency risky?• The gains from international diversification• The portfolio balance model• Appendix: Intervention in the Foreign Exchange Market

• Sovereign Risk• Sovereign spreads

• Procyclical fiscal policy

• Appendices: (1) Car crash analogy (2) Greece & the euro’s debt crisis

Does the Forward Market Offer an Unbiased Predictor of the Future Spot Exchange Rate?

• More particularly, does the forward discount equal the mathematically expected percentage change in the spot rate:

(fd)t = Et Δst+1 ?

• Given Covered Interest Parity, it is the same as the question whether the interest differential is an unbiased predictor:

(i-i*)t = Et Δst+1 ?

• So then, does the interest differential equal the mathematically expected percentage change in the spot rate?

Is the interest differential an unbiased predictor of the future spot exchange rate?

Usual finding: No. Bias is statistically significant: (i-i*)t ≠ Et Δst+1 ..

In fact, Et Δst+1 is much closer to zero (a random walk).

The bias is known in the markets as the “carry trade”:One can make money, on average, going short in a low-i currency and long in a high-i currency.

How can this be?

One interpretation: Rational expectations fails, Δste ≠ EtΔst+1

Another: Uncovered interest parity fails, i-i*t ≠ Δste

What makes a currency risky to a portfolio investor?

• If uncertainty regarding the value of the currency (variance) is high.

• If you already hold a lot of assets in that currency.

• If currency is highly correlated with other assets you hold. What matters is how much risk the currency adds to your overall portfolio.

The gains from international diversification

James Tobin: The theory of optimal portfolio diversification

“Don’t put all your eggs in one basket.”

The theory was worked out for stocks in the Capital Asset Pricing Model (CAPM).

Applies to all assets: bonds, equities;domestic, foreign.

International markets offer a particular opportunity for diversification, because they move independently to some extent.

Diversification lowers risk to the overall portfolio.

The investor can achieve a lower level of risk by diversifying internationally.

Assets with high individual uncertainty don’t necessarily pay higher returns on average. Not if the risk is diversifiable. Only the risk that an asset contributes to the uncertainty of the aggregate portfolio merits an extra average rate of return (risk premium).

High risk-aversion

Medium risk- aversion

Low risk- aversion

Placing 20% of your portfolio abroad reduces risk (diversification).After that point, the motive for going abroad is higher expected return;

investors who are more risk averse won’t go much further.

Purely USRisk →

↑ Return

After that, the gainin expected return

comes at the expenseof higher risk.

Similarly, putting 25%of the global portfolio in emerging markets gives diversification.

Risk →

↑ Return

PORTFOLIO BALANCE MODEL

• Portfolio investors should allocate shares in their portfolios to countries’ assets as: - a decreasing function of the asset’s risk, and - an increasing function of its expected rate of return (risk premium).

• Valuation effect: a 1% increase in supply of $ assets (whether in the form of money or not) can be offset by a 1% depreciation, -- so that portfolio share is unchanged, and -- therefore no need to increase expected return to attract demand.

• One implication: As its debt grows, a deficit country will eventually experience depreciation of its currency, or its interest rate will be forced up, or both.

• Another implication: => FX intervention can have an effect even if sterilized.

Appendix: Intervention in the $ foreign exchange market

was effective in 1985, to bring down the $, represented by the G-5 agreement at the Plaza Hotel;

and to have been effective at times subsequently (though not always).

Since 2001, the ECB, Fed, & BoJ have intervened very little;

But other floaters intervene more often, e.g., major emerging market countries.

US FX intervention, even though sterilized, can sometimes be effective: The Plaza Accord of 1985 brought the dollar down,

and the G-7 meeting of 1995 brought it up.

Sovereign Risk In the past, sovereign risk (i.e, risk of default by governments)

was normally assumed zero for major borrowers such as the US, Japan, Euroland.

Then bonds are identified only by currency of denomination, and “risk” was just exchange risk.

But default risk was always an issue for developing countries. Assets are identified not just by currency, but also by the issuer; risk also includes default risk, requiring its own risk premium

“sovereign spreads.” Recently

Most European countries are now back in that situation. Investors may start to see US debt as carrying sovereign risk too.

Sovereign spreads depend on general sensitivity to risk, as reflected in the VIX (option-implied volatility of US stock market)

More importantly, sovereign spreads depend on country-specific characteristics

especially: the country’s debt/GDP ratio,

whether the ratio is expected to come down in the future (the definition of sustainability),

whether the country has a past reputation for defaulting (“debt intolerance”),

and whether somebody is expected to bail it out(moral hazard).

After joining the euro, Greece never got its budget deficit below the 3% of GDP limit of the Stability & Growth Pact, nor did the debt ever decline toward the 60% limit

Spreads for Greece, Portugal & other Mediterranean members of the € were near zero, 2001-07, until they shot up in 2008-11 under fears of sovereign default risk.

Country creditworthiness is now inter-shuffled

“Advanced” countries (Formerly) “Developing” countries

AAA Germany, UK Singapore

AA+ US, France

AA Belgium Chile

AA- Japan China

A+ Korea

A Spain Malaysia, South Africa

A- Brazil, Thailand, Botswana

BBB+ Italy Colombia

BBB- Iceland, Ireland India

BB+ Indonesia, Philippines

BB Portugal Costa Rica, Jordan

B Burkina Faso

CCGreece

The historic role reversal Some emerging markets have earned credit ratings

higher than some so-called advanced countries.

Over the last decade some emerging market countries finally developed countercyclical fiscal policies:

They took advantage of the boom years 2003-2008 to run budget primary surpluses. By 2007, Latin America had reduced its debt to 33% of GDP,

as compared to 63 % in the United States. So they were able to respond to 2008-09 recession by fiscal expansion.

Debt levels among top-20 rich countries (debt/GDP ratios ≈ 80%)

are now > twice those of the top-20 emerging markets ..

Ratio of public debt to GDP among advanced countriesis the highest since the end of WW II

Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012

Pro-cyclical fiscal policyTHESE 3 PAGES WERE IN L3 APP. IN 2010

In the textbook approach, benevolent governments are supposed use discretionary fiscal (& monetary) policy to dampen cyclical fluctuations.

expanding at times of excess supply, and contracting at times of excess demand.

In practice, policy has often been procyclical, i.e., destabilizing, in developing countries.

Political economy explanations for destabilizing fiscal policy

• #1 : Political Budget Cycles– Politicians expand just before elections, so that

rapid growth will buy votes; the cost comes later (debt, inflation, reserve loss, devaluation)

– Example: The Mexican sexenio (until 2000)– Do politicians really fool voters this way? Yes, for awhile.

#2: Procyclical government spending Due, e.g., to commodity cycle

Dutch Disease in commodity booms, and the need to retrench in downturns.

Bias toward optimism in official forecasts.

Historic role reversal in the cyclicality of fiscal policy in industrialized vs. developing countries

Previously, fiscal policy was procyclicalin developing countries:

Governments would raise spending in booms; and then be forced to cut back in downturns.

Especially Latin American commodity-producers.

Correlations between Gov.t Spending & GDP1960-1999

pro

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all

Pro-cyclical spending

Counter-cyclical spending

G always used to be pro-cyclical

for most developing countries.

Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”

The procyclicality of fiscal policy, cont.The procyclicality of fiscal policy, cont.

An important development -- some developing countries, were able to break

the historic pattern in the most recent decade: taking advantage of the boom of 2002-2008

to run budget surpluses & build up reserves,

thereby earning the ability to expand fiscally in the 2008-09 global recession.

Correlations between Government spending & GDP 2000-2009

pro

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In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:Negative correlation of G & GDP.

What determines countries’ fiscal performance?

Fundamentally: Quality of institutions. This does not mean “tough” rules, if they lack enforceability –

like SGP, debt ceiling or Balanced Budget Amendment.

Better would be structural budget targets (Swiss) with forecasts from independent experts (Chile).

Since 2000, while many developing countries have graduated from pro-cyclical spending to countercyclical,

the US, UK & euro countries have seemingly forgotten how to run countercyclical fiscal policy. They instead enacted higher spending & tax cuts

in the expansion & contraction after the recession hit.

APPENDIX 2: The Euro Crisis & Greece

6 mistakes made by euro leaders Admitting Greece to the € in the first place,

a country that was not yet ready.

Pretending to enforce the fiscal criteria: BD < 3% of GDP & Debt < 60% of GDP.

Allowing Mediterranean countries’ bonds spreads near 0 helped by investors’ under-perception of risk (2003-07) and artificial high credit ratings. But also ECB acceptance of Greek bonds as collateral.

When the crisis hit, the leaders buried their heads in the sand: 2 years ago, sending Greece to the IMF was “unthinkable.” 1 year ago, restructuring of the debt was “unthinkable.”

The current strategy: austerity and the Fiscal Compact.

The Treaty of Maastricht (1991) surprised many economists by emphasizing fiscal criteria BD < 3% & Debt < 60% of GDP, as qualifications for

membership. Skeptical German taxpayers believed that,

before the € was done, they would be asked to bail out profligate Mediterranean countries.

European elites adopted the fiscal rulesto demonstrate that these fears were groundless.

• The motivation • was the same for the No Bailout Clause• and the subsequent Stability & Growth Pact (1997)

After the euro came into existence

it became clear the German taxpayers had been right and the European elites were wrong.

E.g., Greece persistently violated the 3% deficit rule.

The large countries violated the rule too.

SGP targets were “met” by overly optimistic forecasts.

SGP threats of penalty had zero credibility.

Yet each year the ostrich elites stuck their heads deeper & deeper into the sands.

When PASOK leader George Papandreou became PM in Oct. 2009,

he announced that “foul play” had misstated the fiscal statistics

under the previous government:

the 2009 budget deficit ≠ 3.7%, as previously claimed, but > 12.7 % !

Missed opportunity

The EMU elites had to know that someday a member country would face a debt crisis.

In early 2010 they should have viewed Greece as a good opportunity to set a precedent for moral hazard: The fault egregiously lay with Greece itself.

Unlike Ireland or Spain, which had done much right.

It is small enough that the damage from debt restructuring could have been contained at that time.

They should have applied the familiar IMF formula: serious bailout, but only conditional on serious policy reforms & serious Private Sector Involvement.

But the ostriches stuck their heads ever further down in the sand.

There is even less reason now to think Brussels can impose fiscal constraints on borrowers or ask unlimited transfers from creditor country taxpayers than

before.

Any solution to the euro crisis must include a way to prevent repeats in the long term.

As the Maastricht architects knew all along, this means a way of preventing fiscal moral hazard: preventing individual countries from running big deficits & debts, expecting

to be bailed out in the event of a crisis. The German taxpayers are no more

supportive of a “transfer union” than ever.

Merkel’s “fiscal compact” is the 6th mistake: yet another declaration of determination

to strengthen the SGP, incl., via budget limits in national laws/constitutions. One SR problem: Europeans think austerity is expansionary.

Another explanation for pro-cyclical fiscal policy.