Pierre-Olivier Gourinchas | Macro Paper Warehouse

A Preferred-Habitat Model of Term Premia, Exchange Rates, and Monetary Policy Spillovers

The paper develops a two-country preferred-habitat model in which currency and bond markets are populated by different investor clienteles — currency traders with price-elastic demand for foreign assets, and bond investors whose preferences are habitat-specific by country and maturity — with segmentation partly overcome by global arbitrageurs who have limited capital and bear mean-variance risk. Risk premia in the model are time-varying, connected across markets, and consistent with the empirical violations of Uncovered Interest Parity (UIP) and the Expectations Hypothesis (EH): in particular, currency carry trade (CCT) and bond carry trade (BCT) strategies earn abnormally high expected returns in ways that co-vary across the two markets in a manner the standard frictionless model cannot generate. Through these time-varying, connected risk premia, large-scale bond purchases (QE) lower domestic bond yields, lower foreign bond yields, and depreciate the purchasing country’s currency; short-rate cuts also lower foreign yields, but with smaller effects than bond purchases. A key structural finding, quantified in the estimated model calibrated to US and Eurozone data, is that currency returns are nearly uncorrelated with long-maturity bond returns — an exchange-rate disconnect — yet the currency market is instrumental in transmitting bond demand shocks across countries, because arbitrageurs hedge their cross-currency positions in bond markets and vice versa. Sterilized foreign-exchange interventions have strong effects on the exchange rate but weak effects on bond yields, while QE/QT has weak effects on the exchange rate but sizeable effects on foreign bond yields — a sharp asymmetry that follows directly from the disconnect.

Capital Flows to Developing Countries: The Allocation Puzzle

The development-accounting literature holds that most cross-country income differences reflect TFP differences, which in a textbook neoclassical growth model has a sharp implication for capital: a country whose productivity is converging on the frontier should invest more and borrow more from abroad, both to build the capital stock and to smooth consumption forward. This paper tests that implication on 68 developing countries over 1980-2000 – a period chosen because financial openness rose sharply and because two decades is long enough to look past crises and world cycles – and finds the cross-country correlation runs the wrong way. Korea, with average TFP growth of 4.1 percent a year and an average investment rate of 34 percent, received almost no net capital inflows; Madagascar, whose TFP fell 1.5 percent a year with an investment rate barely reaching 3 percent, received 7 percent of GDP in inflows every year. Fitted across the sample the slope of net inflows on productivity growth is -0.72 (p = 0.1 percent), and it survives controlling for initial capital scarcity, initial debt and population growth. This is what the authors name the allocation puzzle, and they are careful to separate it from the Lucas puzzle about the small overall level of flows: since developing-country productivity on average did not catch up at all (average catch-up -0.10), the small aggregate level is not especially surprising, and is consistent with Lucas’s own explanation. The puzzle is about the cross-section – Asia caught up (0.19) yet borrowed only 11 percent of initial output, while Latin America (-0.24) and Africa (-0.17) fell behind yet received 37 and 39 percent. Two decompositions narrow the target. Inserting a capital wedge calibrated to each country’s investment rate and a saving wedge calibrated to its observed flows, the investment wedge alone cannot account for the pattern; matching the data requires a saving wedge strongly negatively correlated with catch-up, so that catching-up countries behave as if subsidising saving and falling-behind countries as if taxing it. Hence “the allocation puzzle is a saving puzzle.” Splitting flows into public and private following Aguiar and Amador (2011), private inflows are positively related to catch-up (slope 0.29, p = 4 percent) while public flows are strongly negatively related (slope -0.79, p < 1 percent), with reserve accumulation doing much of the work: open developing countries whose catch-up rose 10 percentage points accumulated reserves worth about 30 percent of initial output. Financial openness does not attenuate the puzzle but strengthens it, because public outflows respond to growth more strongly than private inflows do in open economies. The paper is explicit that it offers a diagnosis rather than a solution: the wedges “should not [be interpreted] as an explanation,” and the closing survey of candidate mechanisms is “meant… to provide a tentative road map,” with “no attempt… made to discriminate empirically between these explanations.”

Dominant Currency Paradigm

Standard open-economy macro models assume that export prices are sticky either in the producer’s currency, in which case a depreciation improves the terms of trade and competitiveness, or in the destination’s currency, in which case it worsens them. Neither matches the invoicing evidence: the vast majority of world trade is priced in a small number of dominant currencies, with the dollar playing an outsized role. This paper builds an alternative “dominant currency paradigm” from three joint ingredients – infrequently adjusted prices set in a dominant currency, strategic complementarities in pricing that make desired markups variable, and roundabout production using imported inputs – and derives four sharp testable implications: the bilateral terms of trade should be insensitive to bilateral exchange rates; for non-US countries import price pass-through should be high but driven by the dollar rather than the bilateral exchange rate, and more so the higher the country’s dollar invoicing share; import quantities should likewise be driven by the dollar rate, with US import quantities much less responsive; and a uniform appreciation of the dollar should reduce trade among countries other than the United States. The tests use two new datasets: bilateral non-commodity price and volume indices built from UN Comtrade for more than 2,500 country pairs covering 91 percent of world trade, 1992-2015, and firm-10-digit-product-country-quarter customs records for Colombia, an economy that invoices 98 percent of its exports in dollars. All four implications hold. Regressing bilateral terms of trade growth on bilateral exchange rate growth gives a contemporaneous coefficient of 0.037 with a 95 percent confidence interval of [0.02, 0.05], against a predicted 1 under producer currency pricing and −1 under local currency pricing, and the coefficient shrinks further toward zero once relative producer prices are controlled for. A standard bilateral pass-through regression implies near-complete pass-through – a 10 percent depreciation of the importer’s currency against the exporter’s raises import prices about 8 percent within the year – but adding the dollar exchange rate and time fixed effects knocks the bilateral coefficient from 0.76 to 0.16, with the dollar coefficient at 0.78 absorbing almost all of it, and raising a country’s dollar invoicing share by 10 percentage points raises contemporaneous dollar pass-through by 3.5 to 7.6 percentage points. On volumes the contemporaneous dollar elasticity is roughly −0.19 to −0.13 while the bilateral elasticity is an order of magnitude smaller; the euro is far less important than the dollar in both sets of regressions. Consistent with 97 percent of US exports and 93 percent of US imports being dollar-invoiced, bilateral pass-through into US export prices is complete on impact and close to zero for US import prices, and US import volumes are essentially unresponsive to the bilateral exchange rate (an implied 0.003 percent contemporaneous response to a 1 percent dollar depreciation, against −0.12 percent for non-US importers), so US trade balance adjustment runs through exports rather than imports. Aggregating the bilateral panel, a 1 percent ceteris paribus dollar appreciation against all other currencies predicts a 0.6 percent contraction in rest-of-world trade volume within the year, persisting for at least two years, controlling for proxies for the global business and financial cycles; dollar pass-through into foreign CPI and PPI averages 11 and 28 percent within the year and rises with the dollar invoicing share. The Colombian microdata reproduce all of this and additionally let the authors estimate the model: the estimated invoicing shares are essentially DCP, the estimated model tracks the observed dynamics of pass-through while PCP and LCP counterfactuals do not, and removing strategic complementarities and imported inputs halves four-quarter export pass-through from 65 to 30 percent. The authors are explicit about interpretation: the volume regressions “do not capture structural demand elasticity parameters” and “conflate expenditure switching and shifts in aggregate import demand,” so they are predictive relationships rather than structural estimates; and the invoicing currency is taken as given, with the argument that the model’s own ingredients are the ones that would generate dominant-currency pricing endogenously.