Gains from Asset Trade

Intro

In this chapter, we see how financially open economies can, in theory, reap gains from financial globalization in the long run.
We first look at the factors that limit international borrowing and lending, then we look at how a nation’s ability to use international financial markets allows it to accomplish three different goals:
- Consumption smoothing (by steadying consumption when income fluctuates)
- Efficient investment (by borrowing to build a productive capital stock)
- Diversification of risk (by trading of stocks between countries)

Borrowing constraint

The ability to borrow in times of need and lend in times of prosperity has profound effects on a country’s well-being.
Using changes in an economy’s external wealth, we can derive the key constraint that limits its borrowing in the long run: the long-run budget constraint (LRBC).
The LRBC tells us precisely how and why a country must, in the long run, “live within its means.”

Borrowing constraint

When a household borrows $100,000 at 10% annually, there are two different ways it can deal with its debt each year:

Case 1 A debt that is serviced. You pay the interest but you never pay any principal.
Case 2 A debt that is not serviced. You pay neither interest nor principal. Your debt grows by 10% each year.

Case 2 is not sustainable. Sometimes called a rollover scheme, a pyramid scheme, or a Ponzi game, this case illustrates the limits on the use of borrowing.

In the long run, lenders will not allow the debt to grow larger. This is the essence of the long-run budget constraint.

Long-run budget constraint

Here are some assumptions we make in the model economy:

The country is a small open economy: The country is a price taker and cannot influence prices in world markets for goods and services, nor can it influence the real interest rate.
It is a real economy: Prices are perfectly flexible. Analysis is in terms of real variables, and we ignore monetary aspects of the economy. There is one real good and one real asset.
The asset, real debt, carries a real interest rate , the world real interest rate, which is constant. The country can lend or borrow an unlimited amount at this interest rate.

Long-run budget constraint

The country pays a real interest rate on its start-of-period debt liabilities L and is also paid r* on its start-of-period debt assets A. Net interest income payments equal to , or , where W is external wealth .
There are no unilateral transfers (NUT = 0), no capital transfers (KA = 0), and no capital gains on external wealth. Therefore, there are only two nonzero items in the current account: the trade balance TB and net factor income from abroad, .

Long-run budget constraint

Change in external wealth from end of to end of is given by:

Wealth at the end of the year thus:

LR budget constraint

At the end of year 0:

We assume that all debts owed or owing must be paid off, and the country must end that year with zero external wealth.

At the end of year 1:

Cobined:

2 period budget constraint become:

LR budget constraint

Divide our previous equation with , we get:

The present value of X in period N is the amount that would have to be set aside now so that, with accumulated interest, is available in periods. If the interest rate is , then the present value of is .

LRBC

Let go to infinity, we get infinite sum and arriveat LRBC:

A debtor (creditor) country must have future trade balances that are offsetting and positive (negative) in present value terms.

Perpetual Loan

Let’s compute for any stream of constant payment starting in period 1:

For example, the PV of such a stream of payments of a perpetual loan, with and equals:

LRBC

Since TB=GDP-GNE, LRBC says that in present value terms, a country’s expenditures (GNE) must equal its production (GDP) plus any initial wealth.

Present value of present and future GNE = present value of country’s spending.

Exorbitant privilege

The US has been a net debtr with since the 1980s. Negative external wealth leads to a deficit n net factor income from abroad with . Yet as we saw yesterweek, US net factor income from abroad has been positive throughout this period.

The only way a net debtor can earn a positive net interest income is by receiving a higher rate of interest on its assets than it pays on its liabilities.
e.g., in the 1960s French officials complained that the US has the “exorbitant privilege” of being able to borrow cheaply while earning higher returns on its foreign investments.

Manna from Heaven

The United States enjoys positive capital gains, KG, on its external wealth. These large capital gains on external assets and the smaller capital losses on external liabilities are gains that cannot be otherwise measured, so their accuracy and meaning is controversial.
Some skeptics call these capital gains “statistical manna from heaven.”
Others think these gains are real and may reflect the United States acting as a kind of “venture capitalist to the world.”
As with the “exorbitant privilege,” this financial gain for the United States is a loss for the rest of the world.

US privilege

Conclusion

When we add the +1.5% capital gain differential to the +0.5% interest differential, we end up with a US total return differential (interest+capital gains) of about 2% per year since the 1980s. For comparison, in the same period, the total return differential was close to zero in every other G7 country.

Emerging market

The US borrows low and lends high. For most poorer countries, the opposite is true. They borrow high and lend low. This is because they are riskier borrowers and lenders.

Because of country risk, investors typically demand a risk premium before they will invest in any assets issued by these countries, whether government debt, private equity, private debt, or FDI.

Close vs Open

Consumption smoothing

In this section, we use the long-run budget constraint and a simplified model of an economy to examine the gains from financial globalization.

We focus on the gains that result when an open economy uses external borrowing and lending to eliminate an important kind of risk, namely, undesirable fluctuations in aggregate consumption.

Consumption smoothing

We now examine the gains from external borrowing and lending, allowing an economy to eliminate fluctuations in aggregate consumption. We adopt some additional assumptions:

Real output or GDP (denoted Q) is produced using labor as the only input. Production of GDP may be subject to shocks; depending on the shock, the same amount of labor input may yield different amounts of output.
We use the terms “household” and “country” interchangeably. Preferences of the country/household are such that it will choose a level of consumption C that is constant over time. This level of smooth consumption must be consistent with the LRBC.

Consumption smoothing

For now, we assume consumption is the only source of demand. Both investment I and government spending G are zero; therefore, GNE equals personal consumption expenditures C.
Our analysis begins at time 0, and we assume the country begins with zero initial wealth inherited from the past, so that W−1 is equal to zero.
We assume that the country is small and the rest of the world (ROW) is large, and the prevailing world real interest rate is constant at . In the numerical examples that follow, we will assume per year.

Consumption smoothing

These assumptions give us a special case of the LRBC that requires the present value of current and future trade balances to equal zero (amid zero initial wealth):

Close vs Open

In a closed economy, TB will always be zero, trhus LRBC will always be satisifed. There won’t be any gains from financial globalization. Under no shock, the same thing is true. No need to do anything.

period	0	1	2	3	4	…
GDP Q	100	100	100	100	100	…	2,100
GNE C	100	100	100	100	100	…	2,100
TB	0	0	0	0	0	0	0

Close vs Open

Suppose there’s unanticipted -21 shock in year 0 then returns to Q=100 after that. with , PV reduces by 1%. With no trade of asset, the reduction of GDP equate exactly with GDP, because in a closed economy, TB=0.

period	0	1	2	3	4	…
GDP Q	79	100	100	100	100	…	2,079
GNE C	79	100	100	100	100	…	2,079
TB	0	0	0	0	0	0	0

Close vs Open

However, under open economy regime, consumption can be smoothen while still satisfying LRBC by reducing consumption by 1% for each year. The present value of C is then: 99 + 99/0.05 = 2,079. PV GDP = PV GNE.

period	0	1	2	3	4	…
GDP Q	79	100	100	100	100	…	2,079
GNE C	99	99	99	99	99	…	2,079
TB	-20	+1	+1	+1	+1	…	0
NFIA	0	-1	-1	-1	-1	…	-
CA	-20	0	0	0	0	…	-
W	-20	-20	-20	-20	-20	…	-

Generalizing

Suppose, more generally, that output and consumption are initially stable at some value with and external wealth of zero. The LRBC is satisfied.
If output falls in year 0 by ΔQ and then returns to its prior value for all future periods, then the present value of output decreases by ΔQ.
To meet the LRBC, a closed economy lowers its consumption by the whole ΔQ in year 0.
An open economy can lower its consumption uniformly (every period) by a smaller amount so that ΔC < ΔQ.

Consumption smoothing

A loan of in year 0 requires interest payment of in later years.
In future years consumption cuts create trade surpluses of , and if these are to cover the interst paymets, then must be chosen so that

where is the amount borrowed in year 0. Rearranging above, we get

Permanent shock

With a permanent shock, output will be lower by ΔQ in all years, so the only way either a closed or open economy can satisfy the LRBC while keeping consumption smooth is to cut consumption by ΔC = ΔQ in all years.

Comparing the results for a temporary shock and a permanent shock, we see an important point:

Consumers can smooth out temporary shocks—they have to adjust a bit. But the adjustment is far smaller than the shock itself—yet they must
adjust immediately and fully to permanent shocks.

Gains from smoothing

Financial openness allows countries to “save for a rainy day.” Without financial institutions, you have to spend what you earn each period.

Using financial transactions to smooth consumption fluctuations makes a household and/or country better off.
In a closed economy, Q = C, so output fluctuations immediately generate consumption fluctuations.
In an open economy, the desired smooth consumption path can be achieved by running a trade deficit during bad times and a trade surplus during good times.

C and financial openness

Does the evidence show that countries avoid consumption volatility by embracing financial globalization?
The ratio of a country’s consumption to the volatility of its output should fall as more consumption smoothing is achieved.
In our model of a small, open economy that can borrow or lend without limit, this ratio should fall to zero when the gains from financial globalization are realized.

-Since not all shocks are global, countries ought to be able to achieve some reduction in consumption volatility through external finance.

Some evidence

Feenstra & Taylor compute consumption volatility/output volatility of 166 countriesfrom 1990-2010, then arrange them from least open to most open. <100%=not volatile. Apparently even in a relatively open countries, (desile 8), ratio still exceed 100%

Remarks

The lack of evidence suggests that some of the relatively high consumption volatility must be unrelated to financial openness.

Consumption-smoothing gains in emerging markets require improving poor governance and weak institutions, developing their financial systems, and pursuing further financial liberalization.

Sovereign Wealth Funds

Countries may engage in precautionary saving, whereby the government acquires a buffer of external assets, a “rainy day” fund.
Precautionary saving is on the rise and takes two forms. The first is the accumulation of foreign reserves by central banks, which may be used to achieve certain goals, such as maintaining a fixed exchange rate, or as reserves that can be deployed during a sudden stop.
The second form is called sovereign wealth funds, whereby state-owned asset management companies invest some of the government savings.

SWF

During a three-year copper boom, Chile set aside $48.6 billion, more than 30 percent of the country’s gross domestic product, resisting calls for more government spending.
At the time, the finance minister Andrés Velasco was criticized for austerity, but after the global credit freeze in 2008, Chile unveiled a $4 billion package of tax cuts and subsidies, including aid to poor families.
“People finally understood what was behind his ‘stinginess’ of early years,” said Sebastian Edwards, a Chilean economist at the University of California, Los Angeles.

Efficient investment

Openness may also deliver gains by improving a country’s ability to augment its capital stock and take advantage of new production opportunities.
Assume that producing output requires labor and capital, which is created over time by investing output.
When we make this change, the LRBC must be modified to include investment I as a component of GNE. We still assume that government consumption G is zero.
With this change, the LRBC becomes

Efficient investment

Since PV of TB is the difference between PV of Q and C,

A closed economy, in which external borrowing and lending are not possible, the trade balance is zero in all periods, and the LRBC is automatically satisfied.
An open economy, in which borrowing and lending are possible, the trade balance can be more or less than zero, and we must verify that the LRBC is

Efficient investment

Baseline case, no investment: Q=100, C=100, I=0, TB=0. W=0

Now assume a shock in year 0 in the form of a new investment opportunity: requires an expenditure of 16 units, and will pay off in future years by increasing the country’s output by 5 units in year 1 and all subsequent years (but not in year 0).
Output would be 100 today, then 105 in every subsequent year.
The present value of this stream of output is 100 plus 105/0.05 or 2,200, and the present value of consumption must equal 2,200 minus 16, or 2,184.

Efficient investment

period	0	1	2	3	4	…
GDP Q	100	105	105	105	105	…	2,079
GNE C	104	104	104	104	104	…	2,079
GNE I	16	0	0	0	0	…	16
TB	-20	+1	+1	+1	+1	…	0
NFIA	0	-1	-1	-1	-1	…	-
CA	-20	0	0	0	0	…	-
W	-20	-20	-20	-20	-20	…	-

The economy run a deficit TB to invest, then surplus to pay em back.

Generalizing

Suppose that a country starts with zero external wealth, constant output Q, consumption C equal to output, and investment I equal to zero.
An investment opportunity appears requiring ΔK units of output in year 0. This investment will generate an additional ΔQ units of output in year 1 and all later years (but not in year 0).

Investment will increase the PV of C in and only if

Efficient investment

The change in is simply . Investment will increase the PV of consumption if and only if . Rearranging:

Dividing by , investment is undertaken when

Firms will invest in projects as long as the marginal product of capital, or MPK, is at least as great as the real interest rate.

Efficient investment

In an open economy, firms borrow and repay to undertake investment that maximizes the present value of output.
When investing, an open economy sets its MPK equal to the world real rate of interest.
In a closed economy, any resources invested are not consumed. More investment implies less consumption. This creates a trade-off.
Financial openness helps countries to “make hay while the sun shines” without having to engage in a trade-off against the important objective of consumption smoothing.

Norway case

Can poor country gain?

If the world real interest rate is r* and a country has investment projects for which MPK exceeds r*, then the country should borrow to finance those projects. With this in mind, we ask: Why doesn’t more capital flow to poor countries?

To look at what determines a country’s marginal product of capital, economists use a version of a production function that maps available capital per worker, k = K/L, and the prevailing level of productivity A to the level of output per worker, q = Q/L, where Q is GDP.

Production fn approach

where is a number between 0 and 1 that measures the contribution of capital to production, or the elasticity of capital with respect to output. θ is estimated to be 1/3, and setting the productivity level at 1, we have:

MPK, the slope of the production function is given by

efficient investment

Assuming countries have the same level of productivity, A = 1, our model implies that the poorer the country, the higher its MPK, due to the assumptions of diminishing marginal product and a common productivity level.
Investment ought to be very profitable in Mexico (and India, and all poor countries).
Investment in Mexico should continue until rates of return are equalized. This trajectory is called convergence.
If the world is characterized by convergence, countries can reach the level of capital per worker and output per worker of the rich country through investment and capital accumulation.

Lucas paradox

In his widely cited article “Why Doesn’t Capital Flow from Rich to Poor Countries?” Nobel laureate Robert Lucas wrote:

If this model were anywhere close to being accurate, and if world capital markets were anywhere close to being free and complete, it is clear that, in the face of return differentials of this magnitude, investment goods would flow rapidly from the United States and other wealthy countries to India and other poor countries. Indeed, one would expect no investment to occur in the wealthy countries. . . .

Efficient investment

To see why capital does not flow to poor countries, we now suppose that A, the productivity level, is different in the United States and Mexico, as denoted by country subscripts. Then:

Efficient investment

The data show that Mexico’s capital per worker is about one-third that of the United States.
If the model were true, Mexico would have a level of output level per worker of (1/3)1/3 = 0.69 or 69% of the U.S. level. However, Mexico’s output per worker was much less, 43% of the U.S. level.
This gap can be explained only by lower productivity in Mexico. We infer A in Mexico equals 0.43/0.69 = 63% of that in the United States, meaning Mexico’s production function and MPK curves are lower than those for the United States.
The MPK gap between Mexico and the United States is much smaller, which reduces the incentive for capital to migrate to Mexico from the United States.

A vs k

For many developing countries, the predicted gains due to financial globalization are large with the benchmark model, but small once we correct for productivity differences.
Allowing for productivity differences, investment will not cause poor countries to reach the same level of capital per worker or output per worker as rich countries.
Economists describe this outcome as one of long-run divergence between rich and poor countries.
Unless poor countries can lift their levels of productivity, access to international financial markets is of limited use.
There are not enough opportunities for productive investment for complete convergence to occur.

A vs k

An older school of thought focused on A as reflecting a country’s technical efficiency, construed narrowly as a function of its technology and management capabilities.
Today, many economists believe that the level of A may primarily reflect a country’s social efficiency, construed broadly to include institutions, public policies, and cultural differences.
And indeed there is some evidence that, among poorer countries, capital tends to flow to the countries with better institutions.

A vs k

Other factors are against the likelihood of convergence.

The model makes no allowance for risk premiums to compensate for the risk of investing in an emerging market (e.g., risks of regulatory changes, tax changes, expropriation, and other political risks).
Risk premiums can be substantial, and may be large enough to cause capital to flow “uphill” from poor to rich.

A vs k

The model assumes that investment goods can be acquired at the same relative price, but in developing countries, it often costs much more than one unit of output to purchase one unit of capital goods.
The model assumes that the contribution of capital to production is equal across countries, but the capital’s share may be much lower in many developing countries. This lowers the MPK even more.

A vs k

The model suggests that foreign aid may do no better than foreign investors in promoting growth.
Economists dispute whether foreign aid can make a difference to long-term development and growth.
The argument also extends to nonmarket and preferential lending offered to poor countries by international financial institutions such as the World Bank.
Proponents argue that aid can finance public goods that can provide externalities sufficient to jolt a poor country out of a bad equilibrium or “poverty trap.” Aid skeptics reply that the evidence for such effects is weak.

World bank

The World Bank (worldbank.org), based in Washington, D.C., is one of the Bretton Woods “twins” established in 1944 (the other is the International Monetary Fund).

Its main arm, the International Bank for Reconstruction and Development, has 188 member countries. Its principal purpose is to provide financing and technical assistance to reduce poverty and promote sustained economic development in poor countries.

The World Bank can raise funds at low interest rates and issue AAA-rated debt as good as that of any sovereign nation. It then lends to poor borrowers at low rates.

Foreign aid

Nobody doubts that vast amounts of aid have been squandered, but there are reasons to think that we can improve on that record.

We now understand that the kind of aid you give, and the policies of the countries you give it to, makes a real difference.

There’s still a lot wrong with the way that foreign aid is administered. Too little attention is paid to figuring out which programs work and which don’t, and aid still takes too little advantage of market mechanisms, which are essential to making improvements last.

Diversification of risk

Diversification can help smooth shocks by promoting risk sharing. With diversification, countries may be able to reduce the volatility of their incomes without any net lending or borrowing.

We consider two countries, A and B, with outputs that fluctuate asymmetrically.
There are two possible “states of the world,” with equal probability of occurring. State 1 is a bad state for A and a good state for B; state 2 is good for A and bad for B.
We assume that all output is consumed, and that there is no investment or government spending. Output is divided 60–40 between labor income and capital income.

Home portfolio

Both countries are closed, and each owns 100% of its capital. Output is the same as income.
A numerical example is given in Table 6-6, panel (a).
In state 1, A’s output is 90, of which 54 units are payments to labor and 36 units are payments to capital; in state 2, A’s output rises to 110, and factor payments rise to 66 for labor and 44 units for capital. The opposite is true in B: In state 1, B’s output is higher than it is in state 2.
The variation of GNI about its mean of 100 is plus or minus 10 in each country. Because households prefer smooth consumption, this variation is undesirable.

Risk diversification

World Portfolio

Two countries can achieve partial income smoothing if they diversify their portfolios of capital assets.
For example, each country could own half of the domestic capital stock, and half of the other country’s capital stock. Indeed, this is what standard portfolio theory says that investors should try to do.
The results of this portfolio diversification are shown in Table 6-6, panel (b).
Capital income for each country is smoothed at 40 units, the average of A and B capital income in panel (a), also illustrated in Figure 6-9.

Risk diversification

How does the balance of payments work when countries hold the world portfolio?
Consider country A. In state 1 (bad for A, good for B), A’s income or GNI exceeds A’s output. The extra income is net factor income from abroad, which is the difference between the income earned on A’s external assets and the income paid on A’s external liabilities.
With that net factor income, country A runs a negative trade balance, which means that A can consume more than it produces.
Adding the trade balance of –4 to net factor income from abroad of +4 means that the current account is 0, and there is still no need for any net borrowing or lending.

Risk diversification

Generalization

Let us generalize the concept of capital income smoothing through diversification.

Each country’s payments to capital are volatile. A portfolio of 100% of country A’s capital or 100% of country B’s capital has capital income that varies by plus or minus 4 (between 36 and 44). But a 50–50 mix of the two leaves the investor with a portfolio of minimum, zero volatility (it always pays 40).
In general, there will be some common shocks, which are identical shocks experienced by both countries. In this case, there is no way to avoid this shock by portfolio diversification.
But as long as some shocks are asymmetric, the two countries can take advantage of gains from the diversification of risk.

Generalization

Limits to Diversification

Labor income risk (and hence GDP risk) may not be diversifiable through the trading of claims to labor assets or GDP.
But capital and labor income in each country are perfectly correlated, and shocks to production tend to raise and lower incomes of capital and labor simultaneously.
This means that, as a risk-sharing device, trading claims to capital income can substitute for trading claims to labor income.

Home bias puzzle

In practice, we do not observe countries owning foreign-biased portfolios or even the world portfolio.

Countries tend to own portfolios that suffer from a strong home bias, a tendency of investors to devote a disproportionate fraction of their wealth to assets from their own home country, when a more globally diversified portfolio might protect them better from risk.

Diversification in US

Risk Diversification

If countries were able to borrow and lend without limit or restrictions, they should be able to cope quite well with the array of possible shocks, in order to smooth consumption.

In reality, as the evidence shows, countries are not able to fully exploit the intertemporal borrowing mechanism.
In theory, if countries were able to pool their income streams and take shares from that common pool of income, all country-specific shocks would be averaged out, and the sole undiversifiable shocks would be common global shocks.

Risk diversification

Financial openness allows countries—like households—to follow the old adage “Don’t put all your eggs in one basket.”

In practice, however, risk sharing through asset trade is limited. The market for claims to capital income is incomplete because not all capital assets are traded (e.g., many firms are privately held and are not listed on stock markets), and trade in labor assets is legally prohibited.
Investors have shown very little inclination to invest their wealth outside their own country, although that may be slowly changing in an environment of ongoing financial globalization.

Conclusion

Financial markets help households smooth consumption in the face of shocks to their income.
Financial markets allow firms to borrow in order to invest efficiently in productive projects and permit investors to diversify their portfolios across a wide range of assets.
The same principles apply to countries, subject to the long-run budget constraint. They face income shocks, new investment opportunities, and country-specific risks.
However, the use of global financial markets is still limited. Even in advanced countries, consumption shocks remain, investment is often financed out of domestic saving, and a home bias persists in investors’ portfolios.

Conclusion

We see no consumption smoothing gains in poorer countries, and there is little scope for development based on external finance until productivity levels are improved.
Many emerging markets are still on the road to full financial liberalization, and large barriers remain.
Institutional weaknesses in developing countries may hinder the efficient operation of the mechanisms we have studied. Such weaknesses may be corrected by the stimulus to competition, transparency, accountability, and stability that financial openness may provide.
The benefits of financial globalization are likely to be much smaller for these countries, and they must also be weighed against potential offsetting costs, such as the risk of crises.