Inelastic Financial Markets and Foreign Exchange Interventions (with Paula Beltran) [pdf] Submitted
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. We show that countries with a free-floating exchange rate regime (free floaters) are more than twice 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. We show that countries with a free-floating exchange rate regime (free floaters) are more than twice 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 International Asset Returns: Country Size and Equity Rebalancing (with Xitong Hui) [pdf] [ssrn] Updated draft
Abstract: This paper provides a theoretical framework to understand the returns of sovereign bonds issued in different currencies in both normal and crisis times. Using a continuous-time two-country Lucas tree model with equity constraint, we show that the country-size effect and the equity-rebalancing effect are the key determinants of sovereign bond returns. The country size effect spills over home production risk to the smaller country through trade and equity rebalancing; equity constraint limits equity rebalancing and contributes to endogenous uncovered interest parity deviations in crisis times. In a period of crisis, the larger country’s sovereign bond becomes even safer when the country-size effect collaborates with the equity-rebalancing effect, as is the case with the United States. Our model mechanisms are supported by the empirical evidence for a set of advanced and emerging market economies.
Abstract: This paper provides a theoretical framework to understand the returns of sovereign bonds issued in different currencies in both normal and crisis times. Using a continuous-time two-country Lucas tree model with equity constraint, we show that the country-size effect and the equity-rebalancing effect are the key determinants of sovereign bond returns. The country size effect spills over home production risk to the smaller country through trade and equity rebalancing; equity constraint limits equity rebalancing and contributes to endogenous uncovered interest parity deviations in crisis times. In a period of crisis, the larger country’s sovereign bond becomes even safer when the country-size effect collaborates with the equity-rebalancing effect, as is the case with the United States. Our model mechanisms are supported by the empirical evidence for a set of advanced and emerging market economies.
``Too-Little" Sovereign Debt Restructurings (with Tamon Asonuma) 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.