Understanding the sources of high current account fluctuations in 5 developed economies

Abstract. The global economy has, in recent times, continued to face large and unprecedented external imbalances. Despite reductions recorded in aggregate current account (saving less investment) to global output ratio, the imbalances still remain. The main contributors to the imbalances have been the world’s developed economies. These developed economies have experienced fluctuating current account balances over the years and the fluctuation has contributed to a slow correction of the imbalances. This paper identifies 5 developed economies with the highest fluctuations in current account balances and analyses the sources of these fluctuations. The countries are Singapore, Latvia, Iceland, Norway and Estonia. Results obtained suggest that 1) temporary shocks account for most current account fluctuations, and the excess response to temporary shocks is as stable and pronounced as in previous studies; 2) permanent shocks drive current account fluctuations in Iceland and Latvia but not in Norway, Estonia, and Singapore; 3) Singapore demonstrates the most support for the two-good intertemporal model, since external supply and demand shocks account for its current account fluctuations.Keywords. Current account fluctuations, two-good inter-temporal model, VAR and impulse response, V5 Economies.JEL. F32, F41, F21, C22

Sovereign Risk, Cross-Currency Basis and Equity Markets: A Cross-Market Dynamic Interaction

To explore the propagation of shocks across markets, this paper examines the dynamic connections between three distinct markets: credit default swaps (CDS), equities, and cross-currency basis swaps (CCBS) of four major individual economies: Eurozone, UK, Australia, and Japan. We use CDS spreads, CCBS spreads and stock market returns to capture sovereign credit risk, dollar funding liquidity and stock market performance, respectively. Our results show there is a feedback mechanism connecting these markets, for most of these economies. We document that higher CDS spreads induce wider CCBS spreads and declines in stock market returns. We equally show that positive shocks to CCBS spreads lessen CDS spreads and enhance stock market returns. Finally, we show that positive shocks to the stock market are associated with lower CDS spreads and tighter CCBS spreads. These findings are supported by Granger-causality analysis and are robust across subperiods and empirical specifications. Underpinning the feedback mechanism is the role of CDS as an indicator of potential default on obligations in the financial markets

Explaining Differences in Income Levels of Africa’s Largest Economies – A Development Accounting Perspective

Drawing upon the experience of Africa’s largest economies, this paper examines the phenomenon of income discrepancies in Africa and applies the combined methodologies of Development Accounting (DA) à la Caselli (2005) and Business Cycle Accounting (BCA) à la Chari, Kehoe and McGrattan (2007) in a standard neoclassical, small open economy model. Classified into 2 equal-numbered groups – G1 and G2 – based on output size and region of location, the economies comprise Sub-Saharan Africa’s top 3 economies (G1: Nigeria, South Africa and Angola), and North Africa’s top 3 economies (G2: Egypt, Algeria and Morocco). Distortions in production efficiency, labour and capital, collectively termed wedges, are calculated, and the extent, evolution and impact of the wedges are determined for the period 1990 to 2013. Empirical results show that although efficiency wedge plays an important role in explaining income differences, labour wedge and investment wedge are also important for understanding income differences in Africa and, by extension, bridging the gap

Inflation Differential as a Driver of Cross-currency Basis Swap Spreads

Over the last decade, the foreign exchange derivatives market has witnessed a collapse of covered interest parity (CIP). Not only does this collapse give rise to large deviations from CIP, it has unlocked a stream of exploitable arbitrage opportunities across currencies. In this paper, we introduce two new factors - inflation differential and relative economic performance - as potential drivers of deviations from CIP. Employing data on G10 cross-currency basis swap spreads viz a viz the U.S. dollar, we document a striking new evidence that higher inflation differential and incremental improvement in relative economic performance drive the basis wider, and hence arbitrage profits higher for U.S. dollar investors, in the post crisis period. Our main empirical results in general are robust to an extended number of controls, variations in sampling frequency, and consideration of alternative specifications, but the additional explanatory power is low

Optimal Asset Allocation of a Pension Fund: Does The Fear of Regret Matter?

Abstract. In this paper, which presents a simplified behavioral finance model, we incorporate regret into the decision-making process of a pension fund and derive the optimal asset allocation of a final-wealth-maximizing pension fund in the accumulation and decumulation phases. We find that the optimal allocation must be congruent in both phases if and only if the pension fund is upside regret averse. In particular, our results suggest that allocation to risky assets must increase through time in the accumulation and decumulation phases so that the pension fund can realize gains from any upsides in the risky asset market, thereby maximizing final wealth and limiting the feeling of regret ex-post. Although decisions in both phases are congruent, we find that the optimal asset allocation generally depends on wealth levels. This evidence implies that separate management of the accumulation and decumulation phases of a pension fund decreases available wealth levels and is not an optimal strategy.Keywords. Financial Markets. Asset allocation. Log-logistic. Modified utility. Mortality. Pension fund. Regret aversion.JEL. G23, G11, C61

Wider Covered Interest Parity Deviations and Lower Stock Returns: Evidence from the Eurozone

Financial economists have in recent times begun to analyze the reasons for and determinants of the non-zero cross-currency basis swap spread, a measure of the extent of deviations from covered interest parity (CIP) and risk-less arbitrage. They have however not examined the potential effects of the basis on the market performance of major asset classes, particularly the riskiest asset class – stocks – and how stock markets behave in response to changes in the basis. This paper addresses this question by examining how stock returns in the eurozone respond to changes in and shocks to the euro cross-currency basis. Our results show that there is a positive relationship between changes in the basis and stock market returns. Wider deviations from CIP go pari-passu with declines in stock returns, especially for the long-end basis. The relationship is strongest and most significant during periods of crisis but is generally preserved across the whole sample period. Although the effect of global risk sentiment, proxied by the VIX, on returns is generally the strongest, we show that the positive relation between stock returns and changes in the basis is preserved even after controlling for VIX, dollar exchange rate and other stock-return drivers

Broad Dollar Shocks and Economic Activity in Trade-Heavy Countries: The Role of Government Size

This paper investigates how government size influences the responses of government expenditure and economic growth to broad dollar shocks in 155 trade-heavy countries across 6 continents from 1995 to 2019. In most cases, we document that the magnitude of contractions in expenditures and economic growth from broad dollar appreciations depends on the size of government. Countries with large governments experience a more severe negative impact from dollar appreciations than countries with smaller governments and this is true for different expenditure types: total, current and capital government expenditures. Accordingly, government size plays a role in the disparities observed in the responses of expenditure and growth to broad dollar shocks across these countries

Understanding the Sources of High Current Account Fluctuations in 5 Developed Economies

The global economy has, in recent times, continued to face large and unprecedented external imbalances. Despite reductions recorded in aggregate current account (saving less investment) to global output ratio, the imbalances still remain. The main contributors to the imbalances have been the world’s developed economies. These developed economies have experienced fluctuating current account balances over the years and the fluctuation has contributed to a slow correction of the imbalances. This paper identifies 5 developed economies with the highest fluctuations in current account balances and analyses the sources of these fluctuations. The countries are Singapore, Latvia, Iceland, Norway and Estonia. Results obtained suggest that 1) temporary shocks account for most current account fluctuations, and the excess response to temporary shocks is as stable and pronounced as in previous studies; 2) permanent shocks drive current account fluctuations in Iceland and Latvia but not in Norway, Estonia, and Singapore; 3) Singapore demonstrates the most support for the two-good intertemporal model, since external supply and demand shocks account for its current account fluctuation

Explaining Differences in Income Levels of Africa’s Largest Economies – A Development Accounting Perspective

Drawing upon the experience of Africa’s largest economies, this paper examines the phenomenon of income discrepancies in Africa and applies the combined methodologies of Development Accounting (DA) à la Caselli (2005) and Business Cycle Accounting (BCA) à la Chari, Kehoe and McGrattan (2007) in a standard neoclassical, small open economy model. Classified into 2 equal-numbered groups – G1 and G2 – based on output size and region of location, the economies comprise Sub-Saharan Africa’s top 3 economies (G1: Nigeria, South Africa and Angola), and North Africa’s top 3 economies (G2: Egypt, Algeria and Morocco). Distortions in production efficiency, labour and capital, collectively termed wedges, are calculated, and the extent, evolution and impact of the wedges are determined for the period 1990 to 2013. Empirical results show that although efficiency wedge plays an important role in explaining income differences, labour wedge and investment wedge are also important for understanding income differences in Africa and, by extension, bridging the gap

Eurozone Real Output and Covered Interest Parity Deviations: Can Stronger Real Output Lessen the Deviations?

Evidence shows that covered interest parity deviations have expanded over time in the EUR/USD cross currency basis swap market – the world’s largest basis swap market – even across the less erratic long-end of the basis swap curve. We analyze the long-run impact and dynamic interdependencies of eurozone macroeconomic factors on the long-end of the EUR/USD cross-currency basis swap spread, utilizing quarterly data from 2003–2018. Our stylized model predicts that a rise in euro area real output relative to the US would lead to a tighter euro basis swap spread; however, an increase in euro area money supply relative to the US as well as a depreciation of the euro would widen the euro basis in the long run. Our model suggests that the magnitude of the effect of real output on the basis is particularly more pronounced than the magnitude of the individual or combined effect of money supply increases and euro depreciation on the basis. Interestingly, our empirical results are consistent with these predictions. In addition, after examining convergence to long run, we find that among the eurozone variables, it is the cross-currency basis that is the predominant adjusting variable in the event of a divergence from the estimated long-run relation. Finally, using accumulated impulse response, we show that shocks to the exchange rate which strengthen the US dollar have permanent effects on the basis