Composition of international capital flows

A survey of international capital flows. The abstract.

In an integrated world capital market with perfect information, all forms of capital flows are indistinguishable. Information frictions and incomplete risk sharing are important elements that needed to differentiate between equity and debt flows, and between different types of equities. This survey put together models of debt, FDI, Fpi flows to help explain the composition of capital flows.

With information asymmetry between foreign and domestic investors, a country which finances its domestic investment through foreign debt or foreign equity portfolio issue, will inadequately augment its capital stock. Foreign direct investment flows, however, have the potential of generating an efficient level of domestic investment.

In the presence of asymmetric information between sellers and buyers in the capital market, foreign direct investment is associated with higher liquidation costs due to the adverse selection. Thus, the exposure to liquidity shocks determines the volume of foreign direct investment flows relative to portfolio investment flows. In particular, the information-liquidity trade-off helps explain the composition of equity flows between developed and emerging countries, as well as the patterns of FDI flows during financial crises.

The asymmetric information between domestic investors (as borrowers) and foreign investors (as lenders) with respect to investment allocation leads to moral hazard and thus generate an inadequate amount of borrowings. The moral hazard problem, coupled with limited enforcement, can explain why countries experience debt outflows in low income periods; in contrast to the predictions of the complete-market paradigm.

Finally, we analyze a risk-diversification model, where bond holdings hedge real exchange rate risks, while equities hedge non-financial income fluctuations. An equity home bias emerges as a calibratable equilibrium outcome.

Type 1 and type 2 errors

Amidst a fantastic discussion of the trade off between different types of error, Cosma Shalizi quotes this section from James:

There are two ways of looking at our duty in the matter of opinion, — ways entirely different, and yet ways about whose difference the theory of knowledge seems hitherto to have shown very little concern. We must know the truth; and we must avoid error, — these are our first and great commandments as would-be knowers; but they are not two ways of stating an identical commandment, they are two separable laws. Although it may indeed happen that when we believe the truth A, we escape as an incidental consequence from believing the falsehood B, it hardly ever happens that by merely disbelieving B we necessarily believe A. We may in escaping B fall into believing other falsehoods, C or D, just as bad as B; or we may escape B by not believing anything at all, not even A.
Believe truth! Shun error! — these, we see, are two materially different laws; and by choosing between them we may end by coloring differently our whole intellectual life. We may regard the chase for truth as paramount, and the avoidance of error as secondary; or we may, on the other hand, treat the avoidance of error as more imperative, and let truth take its chance. Clifford ... exhorts us to the latter course. Believe nothing, he tells us, keep your mind in suspense forever, rather than by closing it on insufficient evidence incur the awful risk of believing lies. You, on the other hand, may think that the risk of being in error is a very small matter when compared with the blessings of real knowledge, and be ready to be duped many times in your investigation rather than postpone indefinitely the chance of guessing true. I myself find it impossible to go with Clifford. We must remember that these feelings of our duty about either truth or error are in any case only expressions of our passional life. Biologically considered, our minds are as ready to grind out falsehood as veracity, and he who says, "Better go without belief forever than believe a lie!" merely shows his own preponderant private horror of becoming a dupe. He may be critical of many of his desires and fears, but this fear he slavishly obeys. He cannot imagine any one questioning its binding force. For my own part, I have also a horror of being duped; but I can believe tbat worse things tban being doped may happen to a man in this world: so Clifford's exhortation has to my ears a thoroughly fantastic sound. It is like a general informing his soldiers that it is better to keep out of battle forever than to risk a single wound. Not so are victories either over enemies or over nature gained. Our errors are surely not such awfully solemn things. In a world where we are so certain to incur them in spite of all our caution, a certain lightness of heart seems healthier than this excessive nervousness on their behalf. At any rate, it seems the fittest thing for the empiricist philosopher.

This seems to resonate with the idea that over-confidence is at the heart of entrepreneurial development and the creation of new ideas. Without the failure, there is not likely to be success.

Investment bank income

The FT overview of investment bank 2009 earnings.

Bank barriers

Amidst an interesting look at new entrants to the banking industry the FT notes:

Analysts say that one of the biggest challenges for smaller banks is the onerous capital and liquidity requirements. Holding more high-quality capital – which yields low rates of interest – lifts costs, which are harder for smaller institutions to absorb, and constrains the business they can do. And new banks will have to meet these requirements upfront.

It seems that the new regulations on capital requirements will add to the scale economies associated with banking and make it harder for smaller players to break into the market.

Models and economics

Paul Krugman suggests that it was Keynes and Samuelson's effective use of economic models to understand and combat the great depression that helped gain the ascendancy over more complex and nuanced historical and institutional explanations. However, it appears that we reached a point where the institutional and historical context was lost. The model is just a model and the model used must be suited to the situation. The situation can probably only be assess with institutional and historical knowledge.

The current crisis does not appear to be that different from previous crises: there is a period of calm complacency and de-regulation; there is excess credit growth and increased risk-taking as the consequence of risk disappears into the background. What is new is the institutional and historical context: the international financial system is inter-connected; there is a huge increase in savings that is being intermediated between developing and developed countries; there is demand for safe assets.

Aggregation

Tim Harford discusses the issue of aggregation or the phenomenon of clustering of economic specialisation.

Recall the four possible hypotheses: knowledge spreads within industries; ideas are generated when different industries rub together; people learn from being around lots of smart people; or people benefit from the density of a labour market, which helps them find the perfect job.

There is evidence that all four have an effect. Even with the development of modern communications, it still seems that place matters.

McKinsey and the role of the US dollar

McKinsey discussion of the international role of the US dollar. McKinsey: What Matters
This follows their own cost-benefit analysis of the US dollars' position that concluded that the benefits were rather modest. There are three main issue for me:

1) If International Seniorage is so good, why do we have rules against dumping goods. Seniorage allows countries to dump goods for paper. It harms local industry at the expense of that overseas.
2) The issue of international currency faces international pressure to allow sufficient currency to help the world economy. Though it can be argued that this pressure can be ignored (as the BBK was largely able to do in the micro-environment of the EMS), it was not the case with the US from 1998 through 2005. Monetary policy was too loose as a result.
3) International reserve currency status is a version of the Dutch disease: international demand for the currency pushes up the exchange rate and harms manufacturing interest.

The Valuation Channel of External Adjustment

The IMF looks at the valuation channel for international adjustment.

The Valuation Channel of External Adjustment

Tobin tax

The FT looks at the Tobin tax and the some of the practical limitations of its use.

FT.com: UK - A tax on short-term debt would stabilise the system

Yield curve

The yield curve steepens. This increases the cost of borrowing for government, increasing the attraction of long-dated index-linked borrowing (see below). It should also help to reacapitalise banks. The steep yield curve is the most simple of the carry trades - borrow from the government at one rate and lend back to them at another. There is a liquidity risk, but...Even that can be hedged.

FT.com / UK - Federal Reserve renews vow to keep rates low

Ha - and you don't know it

Just to remind myself:

im in ur base, killing ur d00dz

or

im in ur fridge eating ur foodz

im in ur sweatshop making ur shooz

Financing the deficit

It is hard to see why the government does not take advantage of this imbalance of supply and demand to lock in very low real rates. It is clear that this is not just a hedge against inflation, this is due to pension fund demand to match the duration of assets and liabilities and to remove the inflation risk. With a huge amount of funding to be done, now seems to be the time to find out how much demand there is for this sort of security.

FT.com / Lex / Macroeconomics & markets - UK 50-year inflation-protected gilts: "Far, far away, there is bond. And, like many childhood stories that take place in another age and another land, it shares some of the qualities of a fairy tale. It is government-guaranteed to protect investors against the ogre of inflation for the next half century. Lately, it has delivered six-league boot-sized returns; since March, a gain of almost 40 per cent. As a fairytale hero, however, the UK’s 2055 index-linked gilt looks spent. Over the past three centuries, real UK yields have averaged 3 per cent. This bond offers a 10th of that, a mere 32 basis points."

Loss aversion

US treasury's loss aversion (and the risk of political backlash) halts the sale of Citigroup holding.

BBC News - Citigroup shares sale planned by US government 'halted': "The Treasury had been planning to sell $5bn worth of shares, but reports say it has reconsidered after the price was set below what it paid.
That would mean the US would have taken a politically unpalatable loss."

Equity analysis

The FT assesses a study of relative returns on equity over the last decade compared to the return on tbills.

Quasi-sovereign debt

The FT Lex column assesses the effect of Dubai on the quasi-sovereign debt.

So investors in quasi-sovereigns are likely to demand a higher risk premium. Analysts at the Royal Bank of Scotland suggest rating agencies may review assumptions on sovereign support, potentially bringing a wave of downgrades. In that case, the effects could be felt far and wide, from Russia’s “Kremlin Inc” companies such as Gazprom and Russian Railways, to South African or Israeli utilities. Borrowing costs will rise, at an awkward time for quasi-sovereign borrowers. For investors, Dubai is a reminder of the need for careful homework. And that if bonds offer a higher yield than sovereign debt, there is good reason.

Another issue is the way that uncertainty over backing for the debt encourages over-investment. This can also be seen in the case of Fannie Mae and Freddie Mac. If investors are able to convince themselves that there is state backing, the return looks very attractive and money flows into, encouraging additional bond issuance. The small risk premium remains due to the uncertainty, but this is not sufficient to compensate for the real risk. These developments, as has been the case in the US housing market and is now likely to be the case in Dubai, will lead to reduced investment in the likes of those entities that have been identified by the FT column.

Demand for money

Andrew Bailey from the Bank draws attention to the recent demand for cash which is probably a reflection of reduced confidence in the banking system.

As a share of nominal GDP, the value of notes in circulation declined from 6% in 1970 to a low point of 2.4% in the mid-1990s but has since stabilised and then increased, noticeably over the past two years. He explains that from a macroeconomic perspective, sustained low inflation has increased confidence in the real value of the currency since the mid-1990s, while more recently demand for banknotes has risen during the recession, particularly for £50 notes. This recent trend contrasts with the pattern in previous recessions. Rising demand for notes might reflect some loss of confidence in banks and very low interest rates, which reduce the opportunity cost of holding banknotes as a non-interest bearing asset. Andrew Bailey says that is “…pretty good prima facie evidence that there has been an increase in demand for banknotes as a store of value”. This pattern has been seen in other major currencies.