The Review of Economics and Statistics

[Replication Package]

Previous title: Carry Trades and Precautionary Saving: The Use of Proceeds from Foreign Currency Debt Issuance

The surge in foreign currency (FC) corporate debt in emerging economies has sparked concerns about macroeconomic stability, heightened by speculation about non-financial firms engaging in carry trades. Using firm-level data on the currency denomination of both assets and liabilities, we find evidence of firms' carry trades: firms save in local currency liquid assets and earn higher interest income after issuing short-term FC debt. They also set aside FC liquid assets as FX risk buffers. A large degree of heterogeneity in incentives is observed. Notably, listed firms participate more in carry trades and allocate less FX risk buffers than non-listed firms.

Journal of Money, Credit and Banking

Using firm-level data from emerging markets, we examine the effect of US dollar debt issuance on corporate risk-taking in the low-interest-rate environment after the global financial crisis. We find that the dollar debt issuance significantly increases issuers’ risk-taking. This effect is more pronounced when global banks have a stronger risk appetite. Following the dollar debt issuance, issuers significantly increase their investment spending but wind up with lower investment efficiency and larger financial vulnerability. Moreover, non-issuers also exhibit increased risk-taking when faced with rising intra-industry competition pressure from issuers. The intra-industry cross-sectional risk distributions are more tilted towards the downside. 

The Review of Economic Studies, Volume 90, Issue 5, October 2023, Pages 2395–2438

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We find strong empirical evidence that the liquidity yield on government bonds in combination with standard economic fundamentals can well account for nominal exchange rate movements. We find impressive evidence that changes in the liquidity yield are significant in explaining exchange rate changes for all the G10 countries, and we stress that the U.S. dollar is not special in this relationship. We show how these relationships arise out of a canonical two-country New Keynesian model with liquidity returns. Additionally, we find a role for sovereign default risk and currency swap market frictions.

 Journal of International Economics Volume 141, March 2023, 103715 

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A long-standing puzzle is the near-random-walk behavior of exchange rates. Recent literature has proposed models to forecast exchange rates at medium- and long-horizons. Such tests suffer from small-sample bias but inferring the true test distribution is difficult. We propose two approaches to address the problem. First, since economists are interested in the value of economic models versus purely statistical models, we propose a horse-race that pits the economic models not against the random walk, but against the forecasts from the level of the exchange rate. These economic models are challenged because the level of the exchange rate appears to be a more powerful predictor than “global risk” variables. We also propose a second more general but less powerful test. But with both tests we demonstrate using bootstraps that the random walk cannot be rejected, so the predictive power of the lagged exchange rate and many other variables is illusory. 

Journal of International Money and Finance 95, July 2019, 317-331

Recent research has found that the Taylor-rule fundamentals have power to forecast changes in U.S. dollar exchange rates out of sample. Our work casts some doubt on that claim. However, we find strong evidence of a related in-sample anomaly. When we include U.S. inflation in the well-known uncovered interest parity regression of the change in the exchange rate on the interest-rate differential, we find that the inflation variable is highly significant and the interest-rate differential is not. Specifically, high U.S. inflation in one month forecasts dollar appreciation in the subsequent month. We introduce a model in which a Taylor rule determines monetary policy, but in which not only monetary shocks but also liquidity shocks drive nominal interest rates. This model can potentially account for the empirical findings. 

Exchange-rate models fit very well for the U.S. dollar in the 21st century. A “standard” model that includes real interest rates and a measure of expected inflation for the U.S. and the foreign country, the U.S. comprehensive trade balance, and measures of global risk and liquidity demand is well supported in the data for the U.S. against other G10 currencies. The monetary and non-monetary variables play equally important roles in explaining exchange rate movements. In the 1970s – early 1990s, the fit of the model was poor but the fit (as measured by t- and F-statistics, and R2s) has increased almost monotonically to the present day. We make the case that it is better monetary policy (inflation targeting) that has led to the improvement, as the scope for self-fulfilling expectations has disappeared. We provide a variety of evidence that links changes in monetary policy to the performance of the exchange-rate model.

The surge in post-COVID-19 inflation has raised critical questions about its persistence and underlying drivers. We employ a high-dimensional Factor-Augmented Vector Autoregression (FAVAR) model, utilizing Lasso techniques to simultaneously capture unobserved common factors, sectoral heterogeneity, and latent intersectoral spillovers. We find that spillovers play a dominant role in sustaining aggregate inflation, surpassing the effects of sectoral heterogeneity and common factors. During the post-COVID period, sector-specific shocks significantly contributed to the variance and persistence of aggregate inflation. Counterfactual analysis reveals that eliminating spillovers would have reduced average post-COVID inflation by 22%, with inflation reverting to the mean three quarters earlier. 

We construct a two-country New Keynesian model in which the U.S. enjoys an “exorbitant privilege” as its government bonds are desired by banks both in the U.S. and abroad as superior collateral. In times of global stress, the dollar appreciates since the demand for high-quality collateral drives up the “convenience yield” earned by U.S. government bonds . There is “retrenchment” - each country reduces its holdings of foreign assets - a critical determinant of which is the endogenous response of prices and returns.  The model can account for the observed exchange rate and external position behavior of the U.S. While the model incorporates only a small change from a workhorse New Keynesian model with segmented financial markets, it synthesizes and reconciles three major perspectives: on exorbitant privilege, global financial intermediation, and convenience yields.

This paper studies the interaction between foreign exchange reserves and the currency composition of sovereign debt in emerging countries. Focusing on inflation targeting countries, we find that holdings of foreign reserves are associated with higher local currency sovereign debt, an exchange rate which is less sensitive to global shocks, and a lower exchange rate risk premium in local currency sovereign spreads. We rationalize these findings within a financially constrained model of a small open economy. The Sovereign values local currency debt as a hedge against endowment risk, but since the exchange rate tends to depreciate in times of global downturns, risk averse international investors charge an additional currency risk premium on this debt. When a country optimally uses foreign reserves to lean against the wind in response to global shocks, this dampens the response of the exchange rate, providing insurance for the global investor. By reducing the risk premium on local currency debt, foreign exchange reserves therefore facilitate a higher share of local currency debt in the sovereign portfolio. Quantitatively, we find the welfare benefits for the sovereign from optimal foreign reserves management can be very large.

Using a two-country model, this paper shows that the shift from foreign currency to local currency external borrowing does not eliminate the vulnerability of EMs to foreign financial shocks but instead results in “original sin redux”. A monetary tightening abroad is propagated to EM financial conditions through a tightening of foreign lenders’ financial constraints, driven in part by currency mismatches on their balance sheets. Foreign exchange intervention and capital flow management measures can mitigate global financial spillovers to EMs in the short run and a larger domestic investor base can reduce the vulnerability in the longer run.

Corporate external debt in emerging countries is very dollarized. We show this could create an externality to the sovereign and is reflected in sovereign spreads. Empirically, decomposing sovereign spreads into their credit default premium (default probability) and credit risk premium components, an increase in foreign-currency corporate debt is associated with a significant increase in the sovereign risk premium but does not change the sovereign default premium. We reconcile both findings in a quantitative model with risk-averse international investors, foreign-currency corporate debt makes the sovereign more likely to default in investors’ bad times when foreign-currency appreciates, thus increases the risk premium.