Ebook Macroeconomic and Welfare Implications of Financial Globalization
It is well documented that since the mid-1980s there has been a surge in capital flows due to the increased integration of world financial markets. Such episodes naturally lead to question the macroeconomic and welfare implications of increased financial liberalization. Most of the theoretical literature so far has shown that increasing international financial linkages should help to improve consumption smoothing possibilities in face of country$specific shocks. This is the starting assumption motivating the works by Backus and Smith [5], Mendoza [40], Baxter and Crucini [7] who study the business cycle implications of restricting international asset trading. This paper builds a small open economy model with collateral constraints on foreign lending to show that financial globalization coupled with limited enforcement in financial markets can increase consumption volatility and reduce welfare.
The model used in this paper is a small open economy model where risk averse agents consume durable and nondurable goods, supply labour services and finance consumption with foreign lending. The latter is constrained by a borrowing limit in which foreign lending is secured by collateral in the form of durable stock. The small open economy produces and trades nondurable consumption goods with the rest of the world as there is imperfect substitution between home and foreign consumption. Accumulable durables play the role of collateral and can be seized by foreign lenders in the event of default. The reason for introducing durable goods is twofold. First, they account for a large portion of measured consumption and for this reason the current account becomes more variable as agents tend to lump their purchases of durables. Second, given the size of the transactions agents borrow mostly to finance the purchase of durable rather than that of non durable goods. In this paper we assume that durables play the role of collateralizable wealth but they also provide utility services (see Davis and Heatcote [27], Miles [43] and Iacoviello [28]). The latter assumption allows to account both, for the welfare effects of fluctuations in durable goods and for the business cycle implications of imperfect substitutability between durable and non$durable goods. Finally, I assume that agents face adjustment costs on durable consumption, an assumption that allows to reproduce persistence in the pattern of durable and in response to various shocks (see Topel and Rosen [53], Erceg and Levin [23]). The borrowing limit allows to model the assumption of imperfect financial linkages, while the degree of financial liberalization is captured by the parameter characterizing the sensitivity of foreign lending to the value of collateral as a higher value of this parameter relaxes the constraint on foreign lending. In modelling the type of borrowing constraint I follow Kiyotaki and Moore [30], Kocherlakota [33], Chari, Kehoe and McGrattan [17] among others. In this model net asset accumulation is determined by the borrowing constraint and depends on the value of collateral: domestic impatient agents borrow from foreign patient agents. The difference in the discount factors between domestic and foreign agents renders the constraint binding at all states and times and allows to pin down uniquely the distribution of assets across countries.
The quantitative properties of the model are studied under a variety of shocks (productivity, government expenditure, foreign demand shocks). Several results stand out. First, despite the market incompleteness the dynamic of the small open economy is stationary. The net asset accumulation is uniquely determined in the steady state and it is saddle path stationary in a neighborhood of the steady state. A crucial assumption for this result is that foreign agents have higher discount rates than domestic lenders. Domestic impatient agents borrow from foreign patient residents so that the small open economy experiences a persistent current account deficit. Despite this, the current account deficit leads to stationary dynamics. The impulse response analysis shows also that the model is able to replicate some important stylized facts such as the co-movements of durable and non$durable consumptions and the countercyclical behavior of the current account. Most important the presence of collateral constraints on foreign lending coupled with adjustment costs induces persistent current account imbalances, a feature consistent with recent evidence for countries experiencing a high degree of financial globalization.
Secondly, I find that an increase in financial liberalization increases consumption volatility in response to shocks even relative to that of output. This is so since an increase in the sensitivity of foreign lending to the value of collateral has three effects: (i) a wealth effect, (ii) a wedge/substitution effect, (iii) a valuation effect. Consider a shock which boosts the economy and increases demand.
First, a higher degree of financial liberalization, by relaxing the borrowing limit, induces a positive wealth effect. For the borrower an exogenous increase in credit availability is akin to a positive income shock. Contrary to consumption smoothing agents, borrowers are impatient and tend to increase borrowing in the face of such a positive income shock. Ultimately higher availability of foreign lending allows for an increase in the demand for both durable and non durable goods, therefore increases collateralizable wealth. Overall this effect tends to increase non$durable consumption volatility.
Second, when an additional unit of collateral becomes available the shadow value of relaxing the liability constraint is higher the bigger the sensitivity of foreign lending to collateral. The shadow value represented by the lagrange multiplier on the collateral constraint acts as a tax on durable goods. An increase in this wedge induce agents to substitute durable with non durable consumption as the current value of the first decreases relative to the second. Such wedge/substitution effect induces a higher increase in (non durable) consumption volatility, the bigger the sensitivity of the debt to collateral.
Finally, a shock that increases the price of durable also increases the collateral value of the durable good, thereby increasing the borrowing capability at the extensive margin. Such valuation effects work in the same direction as the wealth effect.
I finally consider the welfare consequences of financial liberalization and find that it is welfare detrimental in an economy with imperfect risk sharing. This is so since financial liberalization increases volatility of all variables producing utility services, namely durable and non$durable consumption and employment, thereby reducing the welfare of risk averse agents. A crucial feature of the welfare analysis is the use of second order approximated solutions which allow to account for the effects of stochastic volatility both on first and second moments of the variables that enter agentsmutility.
The current paper is related to several strands of the literature. On the empirical side several studies document that an increase in financial openness coupled with less developed financial markets tend to increase both output and (non$durable) consumption volatility (even in terms of that of output). By inspecting countries with high degree of informational asymmetries and less developed financial markets Gavin and Hausmann [25] find a positive link between capital flows and output volatility, while Bekaert, Harvey and Lundblad [11], Kose, Prasad and Terrones [34] and Kose, Prasad, Rogoff and Wei [35] find that an increase in financial openness tends to increase consumption volatility (even relative to that of output). All those studies stress the role of limited international risk sharing for economies whose financial markets are characterized by strong informational asymmetries and poor financial development.
On the theoretical side, much work has been done in the past to study the role of financial integration for business cycle fluctuations. Most of the analyses have found that restricting asset trading does not alter significantly the business cycle implications of the standard international RBC model. More recently some authors have studied the implications of portfolio allocations (see Devereux and Sutherland [21]), while others have introduced various forms of international financial market incompleteness. Levchenko [38] uses a framework with limited commitment as in Kocherlacota [33] and shows that domestic risk sharing arrangements might deteriorate in face of financial integration. He finds that in this case individual consumption might become more volatile but aggregate consumption volatility will nevertheless decrease. Finally Mendoza and Smith [41] study the quantitative implications of introducing a collateral constraint that limits external debt. They find that when the constraint does not bind standard productivity shocks cause typical real business cycle effects, while a binding constraint can increase consumption and current account volatility in presence of high leverage.
This paper is also related to a recent literature that has shown that binding collateral constraints can be used successfully in closed economy models to replicate several business cycle stylized facts. The rest of the paper is divided as follows. Section 2 presents related literature and empirical evidence. Section 3 presents the model and calibration. Section 4 presents the results. Section 5 concludes.
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