The Valuation Channel of International Adjustment

By

F. Ghironi, J. Lee, and A. Rebucci

The views expressed are those of the discussant and not those of the IDB or its Executive Board.

Risk Sharing Conference, October 22-23, 2010

Motivation• The relative importance, working, and risk

sharing role of the “financial channel” of external adjustment (GR, 2007) are the subject of an ongoing policy and academic debate

• Changes in NFA can arise from:– changes in quantities and prices of goods

and services: the "trade" channel of adjustment

– or changes in asset prices and returns: the "financial" channel of adjustment.

This paper• Focuses on the pure “capital gain and

loss” component of the of the financial channel of adjustment– Consistent with statistical practices and

data availability

It makes three points:

• The predictable component of valuation effects can be modeled without resorting to higher order approximations of the portfolio decision

• This component is non-negligible in NFA dynamics, although its risk sharing role is difficult to isolate

• The source of the shock triggering external adjustment matters

Outline

• Model overview• Decomposing NFA• Key result• Robustness• Other results• Conclusions

Model overview• Standard, symmetric, two-country, DSGE portfolio model with:– International trade in equity– No transaction costs (results in early

analysis robust)– Production under monopolistic competition

(endogenous labor) and flex prices– Productivity and government shocks (asset

markets are incomplete)– No trade frictions: LOP and PPP hold and no

role for RER

Budget constraint and NFA definition

Decomposing first-order changes in NFA (Solution details skipped)

Decomposing NFA (Cont.)

Valuation effects in response to productivity shocks are predictable

Relative importance of CA and Val

Intuition

Comparison with literature

Robustness• Persistent shocks (DS, 2009)

– When the shocks are permanent, CA does not move: the predictable component of Val is zero and the two definitions coincide (see Nguyen, 2009 for more discussion)

• In NPV terms, they are irrelevant for sustainability perspective (TvW, 2008):– True, but their time profile may matter in

practice (i.e., illiquidity may lead to insolvency as in some emerging market crisis of the past)

Differences

Other results• Government shocks don’t give rise to

predictable valuation effects in our simple model– Interesting to investigate relative role of

different shocks under alternative model structures

• Role for risk sharing: valuation effects are

a channel of risk sharing in the model. – Any quantification is model-dependent– More interesting to investigate this in the

data from the lenses of a particular model

Conclusions

Thank you