Robert Vermeulen. Net Foreign Assets (Com)position: Does Financial Development Matter?
Net Foreign Assets (Com)position:Does Financial Development Matter?Robert Vermeulen – De Nederlandsche BankJakob de Haan – De Nederlandsche Bank, RUG & CESIfoEesti PankTallinn, 8 May 2012Views expressed in this presentation do not necessarily coincide with those of De Nederlandsche Bank.
The paper in one slide• Investigate the empirical link between domesticfinancial development and1. Total net foreign asset position2. Net foreign equity position3. Net foreign debt position• Analyse 51 countries during 1970-2007• Pooled mean group estimator (long run relationship)• Confirm theoretical predictions of Mendoza et al. (2009)1. Financial development ↑ → Total net foreign asset position ↓2. Financial development ↑ → Net equity position ↑3. Financial development ↑ → Net debt position ↓
Motivation• Global savings glut drives global imbalances (Bernanke,2005, 2009)• Potential cause of financial crisis• Asian countries need to develop financial markets• Sustained deficits and surpluses create large net foreignasset positions• Even larger gross asset and debt positions• Currency denomination matters• Large net foreign asset positions undesirable• EU Commission scorecard indicator• Mandatory correction when very negative
Theoretical framework• Mendoza et al. (2009, JPE) model• Basic idea• 2 identical economies, only difference is the degree ofdomestic financial development• Financial development allows agents to buy statecontingent claims to insure against bad states ofnature• Agents in the financially more developed country arewilling to take more risk because they have insurance• In autarky both the return on capital and the interestrate are higher in the financially more developedcountry
Theoretical frameworkWhen both countries become financially integrated• The financially more developed country buys foreignproductive assets and sells domestic bonds• In equilibrium the financially more developed countryobtains a negative net foreign asset position• The NFA is negative in equilibrium because the returnon productive assets is higher• The model generates three testable predictions:1. Financial development ↑ → Total net foreign asset position ↓2. Financial development ↑ → Net equity position ↑3. Financial development ↑ → Net debt position ↓
Empirical literature• First paper to empirically link domestic financialdevelopment to net foreign asset positions• Preliminary analysis by Lane and Milesi-Ferretti (2000)• Gross asset positions and capital flows• Financial development has positive effect on grossforeign assets and liabilities (Lane, 2000)• Capital controls affect outflows, but not inflows (Biniciet al, 2011)• Financial development and current account position• No relationship (Gruber and Kamin, 2009)• Nonlinear relationship (Chinn and Ito, 2007)
Data• Net foreign asset (com)position• Lane and Milesi-Ferretti database• Large country coverage and timespan (1970-2007)• Financial development• Beck et al financial structure database• Private credit/GDP ratio• Other control variables• Current account• GDP growth• Exchange rate depreciation• Capital controls
Data• Calculating net foreign asset positions:• Total net asset position (= (total assets – total liabilities)/ GDP)• Net equity position (= (portfolio equity assets + FDIassets – portfolio equity liabilities – FDI liabilities) /GDP)• Net debt position (= (total debt assets – total debtliabilities) / GDP)• Private credit / GDP ratio• Anglo-Saxon view of financial development• Important for interpretation of results• Variable is not informative about stability
Methodology• Pooled mean group estimator (Pesaran et al, 1999)• Account for nonstationarity of variables• Relatively large number of countries (51)• Reasonably long time-span (1970-2007)• Too short for individual country VARs• Panel VAR too restrictive• PMG assumes common long run coefficients, while shortrun coefficients can differ across countries• Test appropriateness with Hausman test• Formally, in error correction form:ΔNFAp,i,t = φp,i*(NFAp,i,t-1 - θ0,p,i – θ1,p,i *FDi,t) +γ1,p,i *Δ FDi,t + Λp,i *Xi,t + εp,i,t
Benchmark results• Confirm theoretical predictions of Mendoza et al. (2009)1. Financial development ↑ → Total net foreign asset position ↓2. Financial development ↑ → Net equity position ↑3. Financial development ↑ → Net debt position ↓• Long run cointegrating relationship• Significant error-correction coefficient, but quite slow adjustment• Short run coefficients are important for model fit• Country-individual coefficients• Only average reported• Capture cross-country heterogeneity• Hausman test confirms validity of long-run restriction of acommon coefficient for all countries
Further robustness checks1. Financial development indicator• Bank credit/bank deposits• Total deposits/GDP2. Additional control variables• Net exports instead of current account• Real effective exchange rate instead of exchangerate3. Extending the long run cointegrated vector• “Cumulative” current accounts• GDP per capita
Conclusion• First paper documenting long run relationship domesticfinancial development and net foreign asset positions1. Financial development ↑ → Total net foreign asset position ↓2. Financial development ↑ → Net equity position ↑3. Financial development ↑ → Net debt position ↓• Confirm the theoretical predictions of Mendoza et al(2009, JPE)• Results suggest that in the long run financial developmentcontributes to diminishing current global imbalances• However, the process is slow: On average every yearabout 15 percent of the gap between the current and thelong-run position is closed