Inelastic Financial Markets and Foreign Exchange Interventions (with Paula Beltran) [PDF]
Abstract: Are foreign exchange interventions effective at moving exchange rates? In this paper, we leverage the rebalancings of a local-currency government bonds index for emerging countries as a quasi-natural experiment to identify the required size of foreign exchange interventions to stabilize exchange rates. We show that the rebalancings create large and exogenous currency demand shocks that move exchange rates. Our results provide empirical support for models of inelastic financial markets where foreign exchange intervention serves as an additional policy tool to effectively stabilize exchange rates. Under inelastic financial markets, a managed exchange rate does not have to compromise monetary policy independence even in the presence of free capital mobility, relaxing the classical trilemma constraint. Our results show that to achieve a 1 % exchange rate appreciation, the average required intervention is about 0.4 % of annual GDP. We also show that countries with a free-floating exchange rate regime (free floaters) are more than three-fold more effective at stabilizing exchange rates than are countries with a managed exchange rate regime. This is because the volatile exchange rates for the free floaters lead to more inelastic financial markets and generate further departure from the trilemma.
Abstract: Are foreign exchange interventions effective at moving exchange rates? In this paper, we leverage the rebalancings of a local-currency government bonds index for emerging countries as a quasi-natural experiment to identify the required size of foreign exchange interventions to stabilize exchange rates. We show that the rebalancings create large and exogenous currency demand shocks that move exchange rates. Our results provide empirical support for models of inelastic financial markets where foreign exchange intervention serves as an additional policy tool to effectively stabilize exchange rates. Under inelastic financial markets, a managed exchange rate does not have to compromise monetary policy independence even in the presence of free capital mobility, relaxing the classical trilemma constraint. Our results show that to achieve a 1 % exchange rate appreciation, the average required intervention is about 0.4 % of annual GDP. We also show that countries with a free-floating exchange rate regime (free floaters) are more than three-fold more effective at stabilizing exchange rates than are countries with a managed exchange rate regime. This is because the volatile exchange rates for the free floaters lead to more inelastic financial markets and generate further departure from the trilemma.
A Theory of Sovereign Bond Safety: Country Size and Equity Rebalancing (with Xitong Hui) [under revision; draft on request]
Abstract: This paper provides a theoretical framework to understand sovereign bond safety in both normal and crisis times. Using a continuous-time two-country Lucas tree model with equity constraint, we argue that the country-size effect and the equity-rebalancing effect are the key determinants of sovereign bond safety. The country size effect spills over home production risk to a smaller country through trade and equity rebalancing; equity constraint limits equity rebalancing and creates endogenous UIP deviations in both normal and crisis times. In the period of crisis, the larger country's bond becomes a global safe asset when the country size effect dominates the equity rebalancing effect, as is the case with the United States. Our model mechanisms qualitatively explain the empirical evidence on the country-size and equity-rebalancing effect for both the G10 and emerging market currencies. Our model predictions also reconcile with the empirical facts of flight-to-safety and the covered interest parity (CIP) in both normal and crisis times.
Abstract: This paper provides a theoretical framework to understand sovereign bond safety in both normal and crisis times. Using a continuous-time two-country Lucas tree model with equity constraint, we argue that the country-size effect and the equity-rebalancing effect are the key determinants of sovereign bond safety. The country size effect spills over home production risk to a smaller country through trade and equity rebalancing; equity constraint limits equity rebalancing and creates endogenous UIP deviations in both normal and crisis times. In the period of crisis, the larger country's bond becomes a global safe asset when the country size effect dominates the equity rebalancing effect, as is the case with the United States. Our model mechanisms qualitatively explain the empirical evidence on the country-size and equity-rebalancing effect for both the G10 and emerging market currencies. Our model predictions also reconcile with the empirical facts of flight-to-safety and the covered interest parity (CIP) in both normal and crisis times.
``Too-Little" Sovereign Debt Restructurings (with Tamon Asonuma and Marcos Chamon) [under revision; draft on request]
Abstract: Sovereign debt restructurings often result in limited debt relief (``too-little" problem), followed by repeated restructurings. We find that for 197 restructurings with private external creditors in 1975–2020, (i) preemptive restructurings are quicker with smaller haircuts but more likely to be ``non-cured," needing a second restructuring within five years; (ii) restructuring strategies and outcomes tend to follow the previous restructuring (are ``sticky"); (iii) ``cured" post-default restructurings have better debt dynamics over the long horizon than ``non-cured" preemptive restructurings. To rationalize these facts, we build a simple two-period sovereign debt model with two types of restructurings—prior to and after income realization—between the debtor and foreign creditor. The foreign creditor's state-dependent consumption smoothing motive results in small haircuts at preemptive restructuring and this, in turn, results in high debt and new bond issues with high borrowing costs leading to a subsequent restructuring.
Abstract: Sovereign debt restructurings often result in limited debt relief (``too-little" problem), followed by repeated restructurings. We find that for 197 restructurings with private external creditors in 1975–2020, (i) preemptive restructurings are quicker with smaller haircuts but more likely to be ``non-cured," needing a second restructuring within five years; (ii) restructuring strategies and outcomes tend to follow the previous restructuring (are ``sticky"); (iii) ``cured" post-default restructurings have better debt dynamics over the long horizon than ``non-cured" preemptive restructurings. To rationalize these facts, we build a simple two-period sovereign debt model with two types of restructurings—prior to and after income realization—between the debtor and foreign creditor. The foreign creditor's state-dependent consumption smoothing motive results in small haircuts at preemptive restructuring and this, in turn, results in high debt and new bond issues with high borrowing costs leading to a subsequent restructuring.