ARNOLDSHAIN SEMINAR XI. June 25-28, University of Antwerp, Beliguim. Endogenous risk premium and terms of trade: evidence for developing countries* Sergio Barone Ricardo Descalzi

Presentation 1. Introduction 2. Theoretical Framework and Main Hyphotesis Review of literature Working hyphotesis 3. Empirical aplicaction Estimation estrategy Results 4. Conclutions

1. Introduction GENERAL PROBLEM: scarce capital flows to poor countries. Why capital flow from poor to rich countries? We can explain this direction of capital flow from differential between the interest rate paid by the rich and poor countries for theirs debts?, How do you explain this difference? Geographical Distribution and income level of capital flows

More specifically: What the relation of the terms of trade and the risk premium? 1. Introduction

2. Theoretical Framework and Working Hyphotesis Review of Literature: Lucas (1990): He points out three reasons : (a) The capital return (marginal product of capital in terms of capital per capita) is not equalize across countries by differences in human capital stock between rich and poor countries; (b) knowledge spillovers; (c) political risk: due to the difficulty of the creditor country to ensure compliance with loan agreements (sovereign risk).

Alfaro, L., Kalemli-Ozcan, S., Volosovych, V. (2005) classifiy theoretical explanations of the Lucas paradox in two groups (a) differences between the fundamentals; (i) factors of production "lost" (specification problems in aggregate production function), (ii) government policies, (iii) institutional structure and theirs effects on TFP (Alfaro contribution) Imperfections in the capital market; ( b) Imperfections in the capital market; ; (i) sovereign risk ; asymmetric information (adverse selection); (moral hazard) ; (expensive verification of events); (ii) asymmetric information (a) ex-ante (adverse selection); (b) interim (moral hazard) Gertler and Rogoff (1990); (c) ex-post (expensive verification of events); 2. Theoretical Framework and Working Hyphotesis

Two periods, one good, endowment Two investing posibilities in order to utilize in 1. Lend abrod at tisk-free rate Invest in a risky technology: Individual budget restriction in the first period is: Where is the amount that the economy borrows from the rest of the world 2. Theoretical Framework and Working Hyphotesis Units of capital in period 1 yield in 2: units output with probability

With regard to the information structure, it is supposed that the lenders are able to observe endowments, the production function and the amount that debtor country borrows. But, they can not observe what the borrower does with the funds he borrow from abroad: that is, creditors are not allowed to observed and the borrower, for example, could secretly lend abroad rather than invest in the proyects. Finally, the realized aoutput is freely observed by lenders. 2. Theoretical Framework and Working Hyphotesis

Capital stock with Function MR (Market Return): This equation indicates that lenders must recieve the market rate of return. When increases, the poor economy increase her borrowing, then she has to offer to creditors a greater rate to get additional funds. Funtion IC (Incentive Constraint): It equates the expected gain from investing with the country´s opportunity cost (given by the risk-free rate) of secretly holding assets abroad. If increases, then optimal fall because the expected profit from invested is reduced.

Given the uncollateralized borrow the risk-premium is endogenous. The economy must paid above the free-risk rate to financing capital above their Wealth or collateral. The rate of interest is: Terms of Trade Shocks and Risk-Premium

3.Empirical Aplication: Estimation Estrategy

VariableCoefficient Expected Sign Negative Positive Negative Positive Negative Negative No Significant 3. Empirical Aplication Expected Results

3.Empirical Aplication We estimeted POLS, RE, FGLS, FE y FEFGLS. Dependent variable logarithm of the risk premium (PR). Two Samples: (i) N=75 t=30; variables incluided : logarithm of terms of trade (LNTOT), Ratio of dependency (RD), financial deepness (M2GDP), inflation (INFL), Trade Openness (AC) Growth (GROWTH). (ii) N=69 t=30; Financial Openness de Facto (APF)

3. Empirical Aplication : Results

The risk premium is negatively correlated with the Terms of Trade. That is, it checks the collateral effect of the terms of trade. The relationship between the terms of trade and the risk premium is higher for less developed countries. Inflation directly affects the risk premium. The anti-inflation policy is important to reduce country risk and reverse the shortage of funds to finance their development. Trade openness is significant only for upper middle income countries and high. Growth is not significantly different from zero for low income countries. For other categories of income is significant and negative. For low-income countries terms of trade improvement appear to be more relevant than the growth. 4. Conclusions