1. Imperfections in international financial markets Tomáš Holub (Tomas.Holub@cnb.cz) International Macroeconomics FSV UK, 26 April 2016

2. The recent financial and economic crisis has increased the interest in studying financial market imperfections; Modern macroeconomics had not neglected this topic (see Obstfeld – Rogoff, chapter 6); But these were typically abstracted from in canonical general equilibrium models; Recently an effort to change this in order to be able to model the „feedback loop“. So far in the course: Ramsey model for small open economies with an assumed borrowing constraint; Krugman‘s 3rd-generation model with FX mismatches and an assumed borrowing constraint. Motivation

3. Information fully symmetric; Perfect enforcement of contracts; Complete financial markets; Investment carried out where it is most profitable (MPK=r; one interest rate for all borrowers / lenders), independently of the initial financial wealth of agents; No substantive role for financial intermediaries, „anonymous finance“. Perfect Financial Markets Savers Debtors Divine auctioneer

4. Information is asymmetric, contracts are hard to enforce; The creditors must thus scrutinize the debtors carefully, i.e. finance cannot be anonymous; Existence of various interest rates (risk premia etc.), credit rationing, collateral constraints, debt ceilings, banks etc. The Reality of Life Savers Fin. intermediariesDebtors Regulators ?

5. It was not predicted in advance − The crisis are hard to predict – see the 2nd and 3rd generation, poor performance of the EWS, etc. It was not a currency crisis, but a financial one; Macro-policies (remember the 1st generation) probably contributed to a build-up of vulnerabilities and bubbles; Financial innovation and supervisory failure; − Underestimation of the moral hazard problem (not studied in the course so far) Strong global contagion (financial and real channel); The Recent Crisis vs. Currency Crises Models (i)

6. Balance sheet weaknesses in some EMEs, e.g. currency mismatches and reliance on foreign ST financing, aggravated the problem (like in the 3rd generation); Pegged exchange rate faced hard times (but hard pegs have survived!, even though sometimes at a high cost); Policies: provision of liquidity,  deposit insurance, monetary and fiscal easing, restoring BSs, strengthened regulation, macro-prudential policies; Fiscal easing and bank bail-outs have led to debt sustainability problems in a number of countries (GR; IR; PT) – default risk. The Recent Crisis vs. Currency Crises Models (ii)

7. Origin of the Crisis Benign macro environment and low IRs before the crisis; Surplus of liquidity, search for yield, low pricing of risk; Growing asset prices (real estate prices etc.); Originate-to-distribute model, securitization. Political support for home ownership. ?

8. Some Thoughts on Securitization Securitization is a financial innovation helping to increase market liquidity and to distribute risks more broadly; Diversification of risks is one of key benefits of financial liberalization and innovations; More complete markets→ closer to the Arrow-Debreu world; But some risks cannot be diversified in reality; ♦ global shocks ♦ imperfect information, moral hazard, adverse selection, imperfect enforcement of contracts Broader distribution of risks increased moral hazard and created uncertainty on who had actually suffered losses.

9. Some Thoughts on Sovereign Risk Prior to the crisis, there was little differentiation between bond yields of the individual EA countries – moral hazard; From 2010 high risk premia charged on the EA‘s periphery. ?

10. Micro-foundations of the imperfections (topic of lecture) : − Imperfect enforcement of contracts − Asymmetric information  adverse selection; moral hazard Macro models with ad hoc assumptions of imperfections, studying their implications: − Static models (e.g. Krugman, 1999 - 3rd generation model) − Dynamic models: e.g. the growth model with human capital; DSGE models with financial imperfections (seminar topic) Models with Financial Imperfections

11. Micro-foundations of the imperfections (topic of lecture) : − Imperfect enforcement of contracts − Asymmetric information  adverse selection; moral hazard Macro models with ad hoc assumptions of imperfections, studying their implications: − Static models (e.g. Krugman, 1999 - 3rd generation model) − Dynamic models: e.g. the growth model with human capital; DSGE models with financial imperfections (seminar topic) Models with Financial Imperfections

12. Imperfect Enforcement + Sovereign Risk (O-R, ch. 6.2) Economy exists for two periods; Single tradable consumer good, can be converted into capital good (and vice versa) at no cost; Period 1 income Y 1 falls down from heaven; period 2 income is produced using Y 2 =F(K 2 ); Borrowing D 2 in internat. bond market at interest rate r. Sanctions for default limited to a fraction  of income.

13. Decision to Default With this debt level, it is better not to default. With this higher debt level, default becomes the preferred choice.

14. Debt Ceiling and FOC Here, the debt level is such that the debtor becomes indifferent between repayment and default.

15. Investment Response to Debt Beyond the debt ceiling, there is a discrete drop in investment. Investors know that they would pay penalty for default from future income – they reduce the future income by investing less. But creditors know this, and thus would not lend more than the debt limit.

16. Micro-foundations of the imperfections (topic of lecture) : − Imperfect enforcement of contracts − Asymmetric information  adverse selection; moral hazard Macro models with ad hoc assumptions of imperfections, studying their implications: − Static models (e.g. Krugman., 1999; 3rd generation model) − Dynamic models: e.g. the growth model with human capital; DSGE models with financial imperfections (seminar topic) Models with Financial Imperfections

17. Moral Hazard in Int. Lending (O-R, ch. 6.4) Economy exists for two periods (consumption only in 2); Single tradable good (real ER always equal to 1); Income of a representative household Y 1 falls down from heaven; Riskless borrowing / lending in international bond market at world interest rate r; No assets or debt at the beginning of period 1.

18. Full Information Case Marginal product equals the global interest rate, i.e. the economy achieves an efficient level of investment. We assume, i.e. the entrepreneurs need to borrow to achieve the efficient level of investment.

19. Imperfect Information Case Assume the creditors cannot observe the actual level of investment I and entrepreneurs can „hide“ part of their resources L abroad (e.g. secret foreign accounts). Creditors can only observe the outcome of the project.

20. Imperfect Information Case

21. The efficient level of investment cannot be achieved in equilibrium (marginal return for the entrepreneur has to be above r to discourage cheating); Higher/lower initial wealth of entrepreneurs raises/lowers I; Higher Z increases I (  IC), higher r lowers it (↓IC, ZP). Imperfect Information Case

22. Investment is skewed away from the efficient allocation (A) towards the richer country (B); Marginal return on capital is thus higher in poorer country; Capital may paradoxically flow „uphill“. 2-Country Model Equilibrium

23. The recent crisis has increased the focus on studying financial imperfections; Imperfect enforcement of contracts; imperfect info → moral hazard, adverse selection, etc.; The imperfections have important effects on equilibrium allocation of capital etc. (i.e. they reduce efficiency); Balance sheets and cash flow are important for the level of investment (i.e. higher wealth increases investment); Shocks to financial wealth may thus have important real consequences (i.e. adverse shocks to wealth lead to an economic recession); Credit channel of monetary policy transmission, DSGE models with financial frictions (see the seminar). Summary