ARNOLDSHAIN SEMINAR XI.

June 25-28, 2013. University of Antwerp, Beliguim.

Endogenous risk premium and terms of trade: evidence for developing countries*

Sergio Barone Ricardo Descalzi

PresentationPresentation1. Introduction

2. Theoretical Framework and Main Hyphotesis

Review of literature

Working hyphotesis

3. Empirical aplicaction

Estimation estrategy

Results

4. Conclutions

1. Introduction1. IntroductionGENERAL PROBLEM: scarce capital flows to poor countries. Why capital flow from poor to rich countries?

Low Lower middle Upper middle High TOTALEast Asia & Pacific 0.08% 2.61% 0.28% 14.48% 17.44%Europe & Central Asia 0.01% 0.18% 1.38% 49.41% 50.99%Latin America & Caribbean 0.03% 1.31% 1.90% 3.24%Middle East & North Africa 0.02% 0.65% 0.19% 1.95% 2.82%North America 24.10% 24.10%Sub-Saharan Africa 0.53% 0.05% 0.32% 0.90%South Asia 0.50% 0.03% 0.52%TOTAL 1.16% 4.83% 4.07% 89.94% 100.00%Fuente: Elaboración propia en base a datos de Lane, P. and Milesi-Ferretti, G. "The External Wealth of Nations

Mark II: Revised and Extended Estimates of Foreign Assets and Liabil ities, 1970-2004. IMF Working Paper 06/69.

Distribución Geógrafica y por niveles de Ingreso del Flujo de Capitales 1970 a 2004

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 1970-2004.

More specifically:

What the relation of the terms of trade and the risk premium?

1. Introduction1. Introduction

2. Theoretical Framework and Working 2. Theoretical Framework and Working HyphotesisHyphotesis

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)

(b) Imperfections in the capital marketImperfections in the capital market; ;

(i) sovereign risk;;

(ii) asymmetric information asymmetric information (a) ex-ante (adverse selection);(adverse selection); (b) interim ((moral hazardmoral hazard) ) Gertler and Rogoff (1990);; (c) ex-post (expensive verification of events);(expensive verification of events);

2. Theoretical Framework and Working 2. Theoretical Framework and Working HyphotesisHyphotesis

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 Hyphotesis2. Theoretical Framework and Working Hyphotesis

1 2, W W

1Wr

Units of capital in period 1 yield in 2:

units output with probability k

units output with probability 0 1 k

1W b k

b

•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.

1 2, W W

2. 2. Theoretical Framework and Working HyphotesisTheoretical Framework and Working Hyphotesis

Capital stock with *V kZ

*k

kV

MR

IC

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.

k

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.

Z*k

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:

Vk

2

gL Z W rr r

k V k

Z

*k

V

MR

ICMR´

´V

Terms of Trade Shocks and Risk-Premium

3.Empirical Aplication: Estimation 3.Empirical Aplication: Estimation Estrategy Estrategy

Variable Coefficient Expected Sign

Negative

Positive

Negative

Positive

Negative

Negative

Negative

Negative

No Significant

3. Empirical Aplication3. Empirical Aplication

Expected ResultsExpected ResultsExpected ResultsExpected Results

12RD

2M GDP3

INFL 4DEGDP 5AC 6

GROWTH 7

1L

7LGROWTH

TOT

TOT 1M

7M

3.Empirical Aplication3.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 : 3. Empirical Aplication : ResultsResults

3. Empirical Aplication : 3. Empirical Aplication : ResultsResults

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. Conclusions4. Conclusions