G1 | Macro Paper Warehouse

International Currencies and Capital Allocation

Using a new security-level dataset covering $32 trillion in global investment positions, this paper establishes that the currency a bond is denominated in – not the nationality of its issuer – is the dominant predictor of who holds it, and that this home-currency bias leaves most firms borrowing only at home while a small number of large foreign-currency issuers capture nearly all foreign bond capital. The data are Morningstar’s complete position-level holdings of open-end mutual funds and exchange-traded funds domiciled in over 50 countries, filtered to the 23 countries (14 of them inside the euro area, leaving 10 effective country units) where Morningstar’s coverage of fixed-income assets under management is at least a quarter of what the Investment Company Institute reports. Four facts follow. First, home-currency bias is strong and is identified within firm: comparing an investor country’s share of two bonds issued by the same parent but denominated differently, and controlling for maturity and coupon, Canadian funds hold a share of a Canadian-dollar bond about 90 percentage points larger than of a non-Canadian-dollar bond from the same issuer, with similarly large and precisely estimated coefficients for every other country (Table 2, p. 12). Running home-country and home-currency indicators side by side, the currency coefficient and R-squared are roughly twice those on country alone, and adding currency collapses the country coefficient while barely moving the currency one – so, at least for corporate bonds, the classic home-country bias documented since French and Poterba (1991) is largely confounded by home-currency bias (Table 4, pp. 14-15). Second, home-currency bias travels with a stark allocation of capital across firms: in each country a small number of large firms issue in foreign currency and borrow from foreigners, while most firms issue only in local currency and are held almost entirely by domestic investors. Probit estimates using Compustat, Worldscope and SDC data show that bigger firms are significantly more likely to issue in foreign currency on all four size proxies used (Table 5, p. 17). That this is not simply about which firms foreigners find unappealing is shown by the fact that the same local-currency-only firms do receive foreign equity investment (Figure 9b, p. 20). Third, the United States is the exception: a significant mass of medium-sized US firms issues only in dollars yet receives substantial foreign financing, which the authors read as the global taste for dollar debt effectively opening the capital account for local-currency US borrowers – a pattern found for no other country in the data (Section 4, pp. 16, 19-20). Fourth, in the time series the dollar’s role is recent rather than permanent: the dollar denominated 41 percent of global cross-border corporate debt holdings in the data in 2005 and the euro 38 percent, shares that were largely stable until 2008, after which the euro’s fell to 22 percent and the dollar’s rose to 63 percent (Introduction, p. 2; Section 5, pp. 21-22). The paper is explicit about its scope: the dataset contains quantities but not prices, so it cannot assess borrowing costs or quantify the value of the dollar’s privilege; it covers bond finance only and excludes bank lending; the analysis is of corporate rather than sovereign bonds; and the authors deliberately establish the four facts without identifying the mechanisms behind them, offering hedging costs, market segmentation by currency and fixed issuance costs as candidate explanations for future work to formalize.

Sovereign Bonds Since Waterloo

The paper asks a question the sovereign debt literature has mostly approached from the borrower’s side: given how often governments default, why do investors keep buying their bonds? It answers by measuring what creditors actually earned, assembling two new datasets and matching them bond by bond. The first is monthly price quotations for 1,552 foreign-currency sovereign bonds issued and traded in London and New York between 1815 and 2016 – 266,134 observations covering up to 91 countries in an unbalanced panel. The second is an archive of external default and restructuring events built largely from the annual reports of nineteenth- and early-twentieth-century bondholder organisations, yielding haircut estimates for 313 restructuring events in 91 countries and, crucially, the timing and size of missed or partial coupon payments at monthly frequency. The central finding is that the average real ex-post yearly return on a global portfolio of external sovereign bonds was 6.85% – about 4 percentage points above the “risk-free” benchmark of long-term UK and US government bonds, with the excess return running 2% to 4% depending on the era. Two things make that survive the defaults. First, defaults do not wipe creditors out: the average haircut is 44% (39% when weighted by amount restructured), with a standard deviation of about 30% and no visible time trend across 200 years, and outright repudiation is confined to revolutions and imperial break-ups. Second, roughly 70% of the 8.0% average nominal return – 5.6 percentage points – comes from coupons rather than capital gains, so returns keep accruing even while prices are depressed. The risk is real and priced: bonds of the 51 “serial defaulters” earn the highest returns (7.1% real, 4.6% excess) and also the highest volatility; after a default the cumulative return index falls about 15%, and an investor entering two years before default breaks even about four years after it, though the lower quartile of episodes never recovers within six years. Compared with other asset classes over the same two centuries, only US equities and a 16-country advanced-economy equity portfolio returned more, while the external sovereign bond portfolio’s Sharpe ratio is on a par with US equities and above US corporate bonds, UK equities, and domestic sovereign bonds. The authors are explicit about the scope limits: the sample is unbalanced with a near-total gap in the 1970s and 1980s syndicated-bank-loan era, so the 1980s debt crisis is largely absent; and they caution that the unusually good modern performance should not be read as a “new normal.”

The Dollar, Bank Leverage, and Deviations from Covered Interest Parity

The full text used here is BIS Working Paper No. 592 (revised July 2017), the freely available version of the paper published in American Economic Review: Insights in 2019. The question it takes up is why apparently risk-free arbitrage opportunities persist in the largest currency market in the world, and its answer begins with an observation about what the textbook argument leaves out: “in textbooks, there are no banks. In practice, though, such arbitrage typically entails borrowing and lending through banks, and the competitive assumption is violated due to balance sheet constraints that place limits on the size of the exposures that can be taken on by banks. Even for non-banks, their ability to exploit arbitrage opportunities rely on banks to provide leverage. Hence, if deviations from CIP persist, it must be because banks do not or cannot exploit such opportunities.” From there the paper documents a “triangular relationship” joining the strength of the dollar, the cross-currency basis and cross-border dollar bank lending, and argues that all three are readings of one thing: the shadow price of bank leverage, for which the dollar spot rate serves as a barometer. The evidence has four parts. First, time-series regressions on the ten most liquid currencies against the dollar (Australian, Canadian and New Zealand dollars, Swiss franc, Danish and Norwegian krone, euro, pound, yen, Swedish krona) over 1 January 2007 to 2 February 2016: a one percentage point appreciation of the broad dollar index is associated with a 2.6 basis point fall in the three-month basis without controls and 2.1 with them, against a 7 basis point standard deviation of daily basis changes; at quarterly frequency the five-year basis coefficient runs -1 to -1.4, so a one standard deviation move in the index (3 percent) implies a 3-4 basis point reduction, and the dollar alone explains 19 percent of the time-series variation. Results are similar and more significant in a post-January-2009 subsample, so they are not a crisis artefact. Second, an asset-pricing result in the cross-section: currency-specific dollar betas correlate with the mean basis at 85 percent for the three-month and 97 percent for the five-year horizon, with a unit increase in beta magnitude corresponding to 11 and 26 basis points of expected CIP-trade return respectively – and with a striking reversal of roles, since “the classical ‘safe haven’ currencies, such as the Japanese yen and the Swiss franc, have the highest exposure to the dollar factor, and high-yielding ‘carry’ currencies, such as the Australian dollar and the New Zealand dollar, have the lowest.” An out-of-sample event study of the 3.9 percent dollar appreciation between 8 and 29 November 2016 confirms it: the basis widened for all G10 currencies, most for the yen (from -70.3 to -90.5 basis points), and the post-election dollar beta correlates with the basis at 98 percent. Third, panel regressions with borrowing-country fixed effects show quarterly growth in dollar-denominated cross-border lending falling with both the broad dollar index and the bilateral rate, jointly and separately, for all sectors and for bank and non-bank borrowers alike – evidence, the authors argue, that the index “has explanatory power over and above the bilateral dollar exchange rate.” Fourth, 51 internationally active G10 banks: a 1 percent broad dollar appreciation goes with a 2 percent decline in bank equity, falling to 0.27 percent once market returns are controlled for, and the interaction with the five-year basis is significantly positive, so banks in currency areas with a more negative basis suffer more. The mechanism offered is the risk-taking channel of Bruno and Shin, in which a weaker dollar flatters dollar borrowers’ balance sheets, reducing tail risk in creditors’ portfolios and freeing capacity under a value-at-risk constraint; this is what the authors call the financial channel of exchange rates, and they emphasise that it “may operate in the opposite direction to the net exports channel.” The triangle is shown to hold for the euro in the post-crisis sample but not for other major currencies, which the authors read as pointing “to the unique role of international funding currencies.”