FINANCIAL INTEGRATION, SHORT RUN EXCHANGE RATE VOLATILITY IN PORTFOLIO BALANCE

M 0 D E LS ‘I’

VICTOR ARGY

Macquaric University

An important development in the last decade or so has been the increased financial integration amongst developed economies. The reasons for this are well known: the growth of trade links, ‘the increased presence of multinationals, technological developments in communications, transportation and information gathering, financial innovations, the escalation of Euro-currency markets and international banking and, most important, the progressive dismantling of capital controls (Obstfeld, 1986; Argy, 1987: Bryant, 1987).

What are the macro-implications of this increase in financial integration? In a previous paper (Argy, 1989) the author investigated this question using a formal macro model for a small economy. In particular, the paper asked how, in the face of a variety of potential disturbances to which an economy was exposed, increased integration might impact on the volatility of real interest rates, real exchange rates, output and prices. The analysis was undertaken for both fixed and flexible rates as well as for zero and full wage indexation. The general conclusion was that integration was likely, on balance, to be destabilising to those variables of concern to governments.

This paper addresses similar issues but now using a quite different model, one which is much more oriented to short run analysis. The model is a portfolio balance model of a small economy. This model is now widely used (a) to represent the monetary sector of a larger macro model (Allen and Kenen, 1980) (b) to analyse the short run monetary effects, notably on interest rates and exchange rates of disturbances (Branson, 1977) (c) in the modelling of the exchange rate (Murphy and Van Duyne, 1980; Bisignano and Hoover, 1982: Bacltus, 1984).

The paper focuses on the use of the model, as in (b) , to address the question of how increased financial integration impacts on the exchange rate in the short run. We conclude that, a t least for a country which is a net creditor vis-a-vis the rest of the world, increased integration is likely to destabilise exchange rates. This parallels our previous results. However, for the net debtor country (e.g. Australia) the outcomes turn out to be very ambiguous.

The author IS grateful to G Madden and to two anonymous refcrees for helpful comments

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11. THE MODEL A N D EXCHANGE RATE SOLUTION

We assume that there a re only three financial assets available t o residents: domestic money (on which interest is not paid) ( M o ) , domestic bonds ( B ) and foreign bonds ( F A ) . Foreigners are assumed to hold no assets in the domestic economy. Residents do not hold foreign money (see Branson, 1977, 1980).

The sum of the three financial assets comprises domestic financial wealth (Wh). The demand for each of these, as a proportion of total financial wealth is assumed to be a function of output (Y) and relative returns, (rd, r f + m).

E

THE HOME ECONOMY

!!@ = b,Y - b,rd - b,(rf + u) Wh E

= - b,Y + b,rd - b,(rf + m) Wh E

E.FA = - b, ,Y - b,,rd + b,,(rf + m) Wh E

Wh = M O + B + E.FA

(3)

(4)

b, = b6 + b , , b, = b, + b , , b , , = b, + b,

Equations 1 to 3 represent the asset demands for money, domestic and foreign bonds, each as a proportion of home wealth. It is assumed that as output increases the demand for domestic and foreign bonds decreases and the demand for domestic money increases (for a similar assumption see Backus, 1984). If the domestic interest rate increases the demand for domestic bonds increases a t the expense of domestic money and foreign bonds. Finally i f the return on foreign bonds increases (either because the interest rate rises or there is an expected devaluation of the home currency) the demand for foreign bonds increases now at the expense of both domestic money and bonds.'

Equation 4 is the definition of wealth, which comprises the three financial assets. It is worth noting that FA may be negative or positive since a country may be a net creditor (FA positive), e.g. Japan, or a net debtor (FA negative), e.g. Australia ais-a-ais the rest of the world.

Given the wealth constraint one of the three asset demands for the home economy is redundant. We, therefore, disregard the foreign asset equation and focus on the demands

'The equations could have been written in real terms. Each real asset demand would then be afunction of output, the relative expected returns and real wcalth. If the elasticity of each real asset demand uis a vis wealth is unity then prices drop out of the money market equations altogether. This is an unsatis- factory feature of the portfolio balance model when it is used to represent the monetary sector in a complete model of the open economy. However, it is of no significance here since we are dcalingwith a time horizon over which prices are fixed by definition.

1989 FINANCIAL INTEGRATION, SHORT RUN EXCHANGE RATE VOLATILITY 31

for money and bonds, using the wealth constraint. The equations for the home economy can now be combined to find solutions for the exchange rate and the domestic interest rate.

MO. FA Ard = 4 AY + ( b 3 + Wh2 ) AE - (wh - M o ) *Mo - bi (Arf + AEe)

b2 b, b , Wh: b2

+ &AB + M ~ A F A b, W h b2 W h 2

Ard = bbAY + (wh - :) AB - (B) AMo + b, ( A $ + AEe) b, b, W h b, W h b7

AFA b, + B.FA ) A E - ( b , W h b, b7Whr

- (-

( 5 )

Equation 5 represents money market equilibrium while (6) represents bond market equilibrium. These two equations can be used to solve jointly for the exchange rate and the domestic interest rate, in terms of all the exogenous variables in the model: Y , Mo, r f + Ee, B , FA.

The solution for the exchange rate is:

B.FA + Mo.FA k , = b+ b+ ~

b, b , b7Wh2 b2Wh2

and for the interest rate

k,) ( W h - M o ) + k,b,B AM^ Ard = - i b7 ( k l - k,b,b,Wh’

+ b, ( k , - k,) M O + k,b, ( W h - B ) AB k,b,b,Wh’

, k , = 4 + !!!?!? < k , b, b2Wh2

We now proceed to introduce a (simpler) model for the rest of the world

32 AUSTRALIAN E C O N O M I C PAPERS J U N E

THE REST 01: THF, WORLD

Mof = b 1 4 Y f - wi

B f = - b , , Y f + b , , r f W f

W f = M o f + Bf (11)

Equations 9-1 1 represent the rest of the world which is assumed to be very large relative to our home economy. Home demand for foreign bonds is ignored since by definition these bonds are negligible in relation to their total supply.

For the rest of the world the solution for the interest rate is:

An increase in foreign output or an increase in the foreign budget deficit will increase the foreign interest rate while an increase in the money supply abroad will lower the interest rate.

We now use (12) to eliminate the foreign interest rate from the exchange rate equation (7) for the home economy. To simplify we rcwritc (7) as

A E = a , A M o + a , ( A r f + A E e ) - a, AFA (k) a4 AB - a, A Y (13)

where a4 has the only ambiguous sign.

We now substitute (12) into (13)

A E = a , A M o + a, AEe - a, AFA (k) a4 AB - a, A Y + a,, A Y f

- a7 AMOf + A B f

where a , =

bl,

(14) brings out more explicitly the role of relative supplies of assets in determining the exchange rate. If domestic money increases the currency devalues; if foreign money increases the currency appreciates, because the foreign interest rate falls. If there is a current account surplus (holdings of foreign assets increases) there is an appreciation but this has no effect on the economy of the rest of the world. If there is a domestic deficit and

1989 FINANCIAL INTEGRATION, SHORT RUN EXCHANGE RATE VOLATILITY 33

the supply of domestic bonds increases the effect on the currency is ambiguous, although it is easily shown that if domestic and foreign bonds are close substitutes the currency will appreciate. If there is a foreign budget deficit and the supply of foreign bonds increases the rise in the foreign interest rate will lead to an outflow of capital and hence to a devaluation of the home currency.

Finally, domestic and foreign output also enter into the equation. An increase in domestic output leads to an appreciation because there is an increase in money demand which in turn means that residents sell both domestic and foreign bonds; these sales will generate a potential inflow which strengthens the currency. An increase in foreign output, given the foreign money supply, increases foreign interest rates which in turn forces down the currency.

111. ASSET SUBSTITUTION. EXCHANGE RATE VOLATILITY FOR

DIFFERENT DISTURBANCES

Before examining how increased asset substitution affects the amplitude of the exchange rate for each exogenous disturbance we try to clarify the meaning of asset substitution in the context of our own model.

There are two concepts of integration embodied in the model. The first is very conventional and focuses on bond asset substitution. The second, less conventional, focuses on money-foreign bond substitution (there is n o foreign money held so pure currency substitution is explicitly excluded).

The literature on bond asset substitution has tended to distinguish three meanings of integration, corresponding to differences in the concept of net returns (Obstfeld, 1986). The first is the degree of which nominal covered returns on comparable assets are equalised i.e. the degree to which closed interest rate parity holds. The second is the degree to which nominal expected returns are equalised i.e. the degree to which ex ante or uncovered interest rate parity holds. The third is the degree to which real returns are equalised (real interest rate parity).

Since the paper deals with the very short run, only the first two meanings are relevant to this paper.

Consider first the deviation from the covered (closed) parity condition

rd - r f - == DCP E

where F is the forward rate and DCP is the deviation from covered parity. Covered parity of course holds when DCP is zero.

We can also write

where RP is the potential risk premium.

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Substituting (16) into (15) we have

rd - rf - Ee-E = DCP + RP (17) E

(rf + M ) is the expected return on foreign investment, rd is the return on home

investment. If the two returns are equal asset substitution is perfect. The wedge between the two returns is equal to the sum of DCP and RP i .e. asset substitution is imperfect if covered parity does not hold and/or if there is a risk premium.

Deviations from (on shore) covered parity (DCP) can occur for a number of reasons which have been widely discussed in the literature (Argy, 1989). The most significant deviations are likely to come from differences in the tax coverage and treatment across countries and from capital controls. Taxation considerations are doubtless important but it has proved very difficult to take them explicitly into account (see Levi, 1977; Fultao and Hanazalti, 1987). Capital controls have been gradually dismantled in most developed economies; there is also now a substantial body of evidence linking the relaxation of controls to the covered differential (Argy, 1989).

E

Another potential source of imperfection in the degree of asset substitution comes from the possible existence of a risk premium. This remains a controversial area. The results of a now large empirical literature remain somewhat inconclusive. Nevertheless, there would be some presumption that a risk premium exists. (For recent evidence for this see Koedijlt and Ott, 1987.) This premium might actually have increased with increased exchange rate volatility.

We conclude, therefore, that the degree of bond asset substitution will depend principally on tax considerations, the use made of capital controls and the risk premium.

In the model bond asset substitution manifests itself through an increase in b7 and b, (given b, and b,). With b7 = b, + b,* and b, , = b3 + b, this also means that b , , and b, , increase. It is also not unreasonable to assume, as we do, that the ratio b7/b, remains unchanged.

The second concept of integration concerns money - foreign bond substitution. In the model this manifests itself through the coefficient b,. b, represents the degree to which foreign bonds and domestic money are substitutes for one another. So we also enquire how an increase in b, impacts on exchange rate volatility.

The methodology we employ is the following. We ask how increased asset substitution affects the amplitude of the change in the exchange rate for each exogenous disturbance in the model. Each exogenous variable is subject to a random disturbance. These random disturbances are also assumed to be uncorrelated. (Although the analysis could easily be cast in terms of variances nothing much is in fact gained from doing this).

Three questions need to be addressed here very briefly. First, how exogenous are the independent variables? Second, does integration affect the degree of linkage in the independent variables? Third, should exchange rate expectations be treated as exogenous?

On the first question it is evident that over a longer time horizon the exogenous variables will be closely linked. For example a change in money will also affect output and the current account. However, we have emphasised that we are concerned with very short run analysis, before such linlts become evident. (See, for example, Branson, 1977.)

1989 FINANCIAL INTEGRATION, SHORT RUN EXCHANGE RATE VOLATILITY 35

To a large extent we have also answered the second question. We might, nevertheless, still ask: is it true that increased integration increases the links between say foreign output and domestic output? This precise question is addressed in Argy (1989). The answer turns out to be extremely complex and depends on the model used and the particular disturbance assumed to originate abroad (real, monetary, supply).

Third should exchange rate expectations be treated as exogenous? In some degree this is not so unreasonable: now and again expectations about exchange rates d o change as a result of developments (e.g. political) which have nothing directly to d o with the exogenous variables in the model.* Alternatively, one could assume exchange rate expectations are formed rationally or adaptively. In our context, if the disturbances are random the assumption of constant expectations would also be roughly consistent with rational expectations. The alternative assumption of adaptive expectations, would, in general, act to amplify further exchange rate effects of exogenous disturbance^.^

We will in what follows distinguish two ways in which the volume of money may change, either a t home or abroad. First through an open market operation. In this case we have AMo = - AB and A M o f = - A B f . Second through a budget deficit. In this case the change in money is exogenous.

Table I summarizes the results for the case where the country is a net creditor. It is evident that an increase in ‘bond’ substitution will in most cases increase the amplitude of the exchange rate adjustment. There is only one unambiguous exception: the case of sterilised foreign exchange market intervention. The last involves a swap of bonds for foreign assets; the closer these two are substitutes for one another the less will be the exchange rate adjustment. When the two assets are perfect substitutes the exchange rate does not change (Humpage, 1986). There are two ambiguous cases (the home deficit financed by bonds and the current account surplus); the first of these is also likely to amplify exchange rate volatility.

The results are not nearly so straightforward for the case of an increase in substitutability between money and foreign bonds. Here the outcomes are mixed. In general we can say that for disturbances originating abroad and for a change in the expected exchange rate exchange rate volatility increases; while on the other hand for disturbances originating in the home economy exchange rate volatility declines.

The results are even less straightforward for the case of the country which is a net debtor to begin with. Equation 7 reveals that all the signs are now ambiguous; this case, therefore, cannot be pursued further without detailed knowledge of the underlying coefficients.

IV. ASSET SUBSTITUTION A N D INTEREST RATE VOLATILITY

We have focused in this paper on the question of how increased asset subtitution affects the amplitude of the change in the exchange rate for each exogenous disturbance. The analysis could be extended to a n examination of how interest rate volatility is affected, for

‘The assumption of fixed expectations is also made in Branson’s widely cited paper and is in fact common to many portfolio balance models.

’This is easily seen from equation 7. The coefficient attaching to Ee is less than unity. I f Ee = f7E where f7 < 1 it is evident that the exchange rate effect will be amplified.

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each disturbance, again by increased asset substitution. In particular, we would like to see if there is any potential trade-off between exchange rate volatility and interest rate volatility i.e. if increased asset substitution increases exchange rate volatility a t the expense of decreased interest rate volatility.

We consider only the effects of increased bond asset substitution (very little of substance can be concluded about interest rate volatility for the case of increased money - foreign bond asset substitution).

TAHLE I Asset substitution, exchange rate volatility in a

portfolio balance model (Net creditor position)

Effect on volatility of exchange rate'

Exogenous change (a) Inc in b, and b, (b) Inc in b,

1.

2.

3.

4.

5.

6 .

7 .

8.

9.

10.

11.

Home open market operation (AM0 = -AB)

Foreign open market operation

Home budget deficit financed by money creation (AMo)

Foreign budget deficit financed by money creation (AMof)

Home deficit finance by bonds (AB)

Foreign deficit financed by bonds (ABf )

Increase in home output ( A y )

Increase in foreign output (Ayf )

A current account surplus (AFA)

An expected devaluation (AEe)

Sterilised intervention in foreign exchange market (AFA = -AB)

(AMof = -ABf)

+

+

+

+

?(+)I

+ + + ?

+

-

'We suppose that the ratio b,lb, remains unchanged.

'+ means increased volatility - decreases volatility.

'If substitution sufficiently high to begin with (+).

1989 FINANCIAL INTEGRATION, SHORT RUN EXCHANGE RATE VOLATILITY 37

It is easily demonstrated that for an increase in homeoutput, an open market purchase or an increase in the home deficit financed by money, increased asset substitution moderates the fluctuation in the interest rate. If a n increase in the budget deficit financed by bonds leads to an appreciation of the currency the associated increase in the interest rate will again be moderated as asset substitution increases. The effects of a current account surplus are ambiguous. Increased asset substitution moderates both the exchange rate and interest rate effects of a sterilised foreign exchange market intervention.

The effects of an expected devaluation are identical to the effects of a rise in the foreign interest rate. All foreign disturbances are absorbed in a change in the foreign interest rate. A rise in the foreign interest rate devalues the currency but has an ambiguous effect on the home interest rate. As asset substitution increases and the lower is b,, the greater is the likelihood that the home interest rate will rise. If the home interest rate did rise increased asset substitution will amplify this rise. (In the reverse case when the home interest rate falls the fall is moderated by asset substitution.)4

It is evident that the results are complicated. To sum up, it would seem that for most disturbances at home there is something of a trade-off but for disturbances originating abroad there is a good chance that exchange rate and interest rate volatility will both be amplified. Such conclusions make intuitive sense: increased asset substitution will keep the home interest rate closer to the foreign interest rate. If there is n o change in the latter increased asset substitution moderates the change in the home interest rate; the reverse is true of a change in the foreign interest rate.

‘To see these results more rigorously differentiate equations 1 and 4 substitute (4) into (1) then substitute the exchange rate solution (7) into (1) amplified.

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REFERENCES

Allen, P. R. and Kenen, P. B. (1980), Asset Markets, Exchange Rates and Economic Integration (Cambridge: Cambridge University Press).

Argy, V. ( l987) , “International Financial Liberalisation -The Australian and Japanese Experiences Compared”, Bank of lapan Monetary and Economic Studies, vol. 5, no. 1 .

Argy, V. (l989), “International Financial Deregulation - Implications for Insulation, Exchange Kate Volatility and Policy Effectiveness”, Australia Japan Research Centre - Pacific Economic Papers (PEP) series, February.

Backus, D. (1984), “Empirical Models of the Exchange Rate: Separating the Wheat from the Chaff”, Canadian journal o f Economics, vol. XVII, no. 4.

Bisignano, J , and Hoover, I<. ( l982) , “Some Suggested Improvements to a Simple Portfolio Balance Model of Exchange Rate Determination with Special Reference to the U.S. DollarKanadian Dollar Rate”, Weltwirtschaftliches Archiv, 1.

Branson, W. ( l977) , “Asset Markets and Relative Prices in Exchange Rate Determination”, Sozialwis- senchaftliche Annalen, 1. Also in Reprints in International Finance, 20, Princeton University, June 1980.

Bryant, R. C. ( l987) , “International Financial Intermediation”, The Brookings Institution,

Fukao, M. and Hanazaki, M. (1986), “Internationalisation of Financial Markets and the Allocation of

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Capital”, OECD Economic Studies, no. 8 Spring.

Humpage, 0. F. ( l986) , “Exchange-Market Intervention: The Channels of Influence”, Econoinic Review, Federal Reserve Bank of Cleveland, Quarter 3 .

Koedijk, I<. G . and Ott, M. (1987), “Risk Aversion, Efficient Markets and the Forward Exchange Rate”, Federal Reserve Bank of St. Louis, December.

Levi, M. D. (1977), “Taxation and ‘Abnormal’ International Capital Flows”, /ournu1 of Political Economy, vol. 85, no. 3.

Murphy, R. G . and Van Duyne, C. (1980), “Asset Market Approaches to Exchange Rate Determi- nation: A Comparative Analysis”, Weltwirtschaftliches Archiv, 4, Band 116.

Obstfeld, M. (1986), “Capital Mobility in the World Economy: Theory and Measurement”, Carnegie- Rochester Conference Series on Public Policy, 24, North-Holland.