Interest Premium, Sudden Stop, and Adjustment in a Small Open - PowerPoint PPT Presentation

Introduction The Model Evaluation and Policy Conclusion Interest Premium, Sudden Stop, and Adjustment in a Small Open Economy Péter Benczúr István Kónya Magyar Nemzeti Bank and Central European University MNB/CEPR/BOI 2013

Introduction The Model Evaluation and Policy Conclusion D ISCLAIMER The views expressed are those of the authors and do not necessarily reflect the official view of the Magyar Nemzeti Bank (the central bank of Hungary).

Introduction The Model Evaluation and Policy Conclusion M OTIVATION ◮ The crisis of 2008-2009 hit many small open economies by tightening their external conditions ◮ The CEE economies provide a good laboratory ◮ Important differences in initial conditions and responses ◮ NFA per GDP ◮ Exchange rate regime ◮ Currency mismatch ◮ Balance sheet adjustment ◮ Current account ◮ Traded-nontraded reallocation

N ET F OREIGN A SSETS 0 −50 NFA, %GDP −100 Czech Republic Hungary −150 Poland 1995 2000 2005 2010 Net foreign asset positions, %GDP. Source: Eurostat.

CDS S PREADS 600 Czech Republic Hungary Poland 400 CDS spread 200 0 2002q3 2005q1 2007q3 2010q1 2012q3 5−year sovereign CDS spreads. Source: Bloomberg. Back

D EBT AND CDS S PREADS Romania 500 Hungary 400 ∆ CDS spread, b.p. Bulgaria 300 200 Poland Czech Republic Slovenia 100 −120 −100 −80 −60 −40 −20 Net foreign assets, %GDP Maximum increase in CDS spreads after 2008Q3. Source: Eurostat, Bloomberg .

F OREIGN C URRENCY L ENDING Czech Republic Hungary .6 Poland .5 Foreign currency lending .4 .3 .2 .1 2002 2004 2006 2008 2010 2012 Foreign currency MFI loans, % total loans. Source: ECB.

Introduction The Model Evaluation and Policy Conclusion T ABLE OF C ONTENTS Introduction The Model Evaluation and Policy Conclusion

Introduction The Model Evaluation and Policy Conclusion T HIS P APER ◮ The crisis: a permanent tightening in the cost of foreign borrowing (and a one-period drop in export demand) ◮ Calibrate the model to Hungarian data, evaluate quantitative fit conditional on only two shocks ◮ Counterfactuals: exchange rate regime, initial indebtedness ◮ Is “optimal” policy conditional on initial conditions? ◮ Two-sector, flexible price model with money-in-the-utility and debt-dependent interest rate ◮ Interest premium highly nonlinear, similar to credit constraint Go ◮ Downward nominal wage rigidity (internal devaluation) Go ◮ Currency mismatch

Introduction The Model Evaluation and Policy Conclusion L ITERATURE ◮ Nominal growth, model ingredients: Benczúr-Kónya (JIMF 2013) ◮ Real models of the current account and real exchange rates: Kehoe and Fernandez de Cordoba (2000), Bems and Hartelius (2006) ◮ Small open economy models with money: Rebelo and Vegh (1995) and Burstein, Eichenbaum and Rebelo (2007) ◮ Exchange rate regimes and financing frictions: Cook and Devereux (2006), Gertler, Gilchrist and Natalucci (2007), Brzoza-Brzezina and Makarsky (2011), Heer and Schubert (2012) ◮ Sudden stops: Curdia (2008), Christiano et al. (JME 2009) ◮ Valuation effects: Tille (2005) ◮ Downward nominal wage rigidity: Fahr and Smets (2010)

Introduction The Model Evaluation and Policy Conclusion M ODEL ◮ Production: exports and nontradables, consumption: imports and nontradables ◮ Sector-specific investment with adjustment costs ◮ Money-in-the-utility and non-linear, debt-dependent foreign interest premium ◮ Endogenous labor supply, downward nominal wage rigidity ◮ Monetary policy: degree of exchange rate flexibility ◮ Small open economy with downward-sloping export demand

Introduction The Model Evaluation and Policy Conclusion M ECHANISM ◮ MIU implies households hold assets (money) in domestic currency; foreign borrowing assumed to be in foreign currency ⇒ currency mismatch ◮ Higher premium makes HHs poorer, debt more expensive ◮ External rebalancing ⇒ exchange rate depreciates ⇒ mismatch exacerbated ◮ Fixed exchange rate protects HH balance sheets, but hinders CA adjustment through exports ◮ In standard models, valuation effects for CB reserves exactly offset this ◮ Here, premium depends only on unconsolidated HH position ◮ CB reserves earn lower interest rate

Introduction The Model Evaluation and Policy Conclusion T HE C ENTRAL B ANK ◮ Per period budget constraint � � B c t − R c t − 1 B c + D t − R d S t t − 1 D t − 1 + T t = H t − H t − 1 t − 1 � �� � CB foreign reserves ◮ Policy rule in terms of exchange rate flexibility � H t � ρ s � S t � 1 − ρ s = 1 H t − 1 S t − 1 ◮ Reserve policy H t B c t = ρ h S t

Introduction The Model Evaluation and Policy Conclusion C URRENT A CCOUNT ◮ Private debt � H t − R c � t − 1 H t − 1 B h t − R t − 1 B h TB t − ρ h = t − 1 S t S t − 1 ◮ Total debt � H t − 1 � B h t + B c R t − 1 − R c − R t − 1 B t − 1 TB t − ρ h = t t − 1 S t − 1 � �� � B t ◮ Money is not neutral! ◮ Debt vs. reserves ◮ Interest rate on reserves

Introduction The Model Evaluation and Policy Conclusion E XPERIMENTS ◮ We simulate the deterministic, nonlinear model ◮ Transition from an initial to a new steady state ◮ Long-run NFA per GDP ( b y = ¯ B h / ¯ Y ): − 1 ⇒ 0 ◮ Unexpected, permanent shock ◮ (First period only: large decline in export demand) ◮ Counterfactuals ◮ Different exchange rate regimes ◮ Lower initial indebtedness

C ALIBRATION Parameters Notation Value Calibration target Discount rate β 0 . 96 Real interest rate Depreciation δ 0 . 06 Literature Imports share in C λ 0 . 36 National accounts Import share in I λ I 0 . 44 National accounts Capital share in X α T 0 . 42 National accounts Capital share in NT α N 0 . 37 National accounts Labor supply elast. 1 /ω 1 / 3 Literature Wage markup σ w 3 . 5 Literature ν w ; ξ w Wage adjustment function 1; 100 Literature Cap. adj. cost φ 5 Literature η 0 . 5 Exp. demand elast. HU DSGE model Importance of money γ 0 . 35 Euro Area M1/GDP b 0 , ¯ Initial/new NFA/GDP b − 1 , 0 HU data, int. av. Go Linex parameters ν , ξ 0 . 01, 2 CDS ⇑ in HU, CZ Central bank reserves ρ h 1 HU M1/Reserves Monetary policy ρ s 0 . 2 Exchange rate resp.

Baseline simulations 0.09 1.15 −0.6 Baseline 0.08 −0.8 Exchange rate NFA per GDP Interest rate Data 1.1 0.07 −1 0.06 1.05 −1.2 0.05 0.04 1 −1.4 0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10 1 1 1.05 Non−tradable rel. price 1 0.9 0.95 Money stock Export 0.95 0.8 0.9 0.9 0.7 0.85 0.85 0.8 0.8 0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10 1 1 1.05 1 0.95 0.9 Consumption Employment Investment 0.95 0.9 0.8 0.9 0.85 0.7 0.85 0.8 0.8 0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10

Introduction The Model Evaluation and Policy Conclusion B ASELINE R ESULTS ◮ Data points: pre-crisis trends removed ◮ Model captures relevant movements qualitatively, often quantitatively as well ◮ Money drops too little, consumption too much, and NT relative price too little ◮ Cumulative three period changes closer to data ◮ Portfolio adjustment costs, illiquid assets? ◮ Price rigidities? ◮ Employment, exports

Alternative exchange rate regimes 1.45 1.065 −0.4 1.4 Fixed −0.6 Flexible 1.06 1.35 Baseline −0.8 1.3 FT interest rate Exchange rate NFA per GDP 1.055 −1 1.25 1.2 −1.2 1.05 1.15 −1.4 1.1 1.045 −1.6 1.05 1 1.04 −1.8 0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10 1.2 1.15 1 1.15 1.1 0.98 1.1 1.05 Tradable production 0.96 Consumption 1.05 Employment 1 0.94 1 0.95 0.92 0.95 0.9 0.9 0.9 0.85 0.88 0.85 0.8 0.8 0.75 0.86 0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10

Policy comparison with lower initial indebtedness 1.15 1.05 −0.35 Fixed 1.049 −0.4 Flexible 1.048 −0.45 1.1 FT interest rate 1.047 Exchange rate NFA per GDP −0.5 1.046 −0.55 1.045 −0.6 1.05 1.044 −0.65 1.043 −0.7 1.042 1 1.041 −0.75 0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10 1.05 1.05 1 0.99 1 1 Tradable production 0.98 Consumption Employment 0.95 0.95 0.97 0.9 0.9 0.96 0.85 0.85 0.95 0.8 0.8 0.94 0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10

Introduction The Model Evaluation and Policy Conclusion C OUNTERFACTUAL R ESULTS ◮ Flexible exchange rate ◮ Employment falls less (DNWR), export sector declines less ◮ Consumption drops more, because of valuation effects ◮ Fixed exchange rate ◮ Employment falls more (DNWR), export sector declines more ◮ Consumption falls less, because HH balance sheets are protected ◮ Lower indebtedness : flexible regime better for consumption

Introduction The Model Evaluation and Policy Conclusion C ONCLUSION ◮ We built a simple two-sector model to quantitatively evaluate the impact of the crisis of 2008-2009 in a small open economy ◮ Key features are external interest premium, currency mismatch, DNWR ◮ Model captures stylized facts well (even quantitatively) ◮ We highlight the interactions between the exchange rate regime and initial indebtedness ◮ Export sector and employment vs. balance sheets and consumption ◮ Exchange rate policy of central bank important for tradeoff ◮ Many things still to be explored! Regional comparisons