Chilean money
Chilean money
Valuation changes are crucial for understanding countries’ external positions. We analyse whether emerging market economies benefit from risk-sharing in the international monetary system through the valuation channel.
Valuation changes have become a significant issue in international finance. Lane and Milesi-Ferretti (2001) finds that they are crucial for understanding countries’ external positions, particularly their net international investment positions (NIIP), in the context of expanding gross external positions.
Valuation changes have been studied for their role in external adjustment (Gourinchas and Rey 2007), and in recent research that has emphasised the role of the US as an insurance provider (Maggiori 2017, Atkeson et al. 2022, Gourinchas and Rey 2022, Devereux et al. 2023, Kekre and Lenel 2024). In times of global turbulence, investors flee to reserve currency and safe assets. With the US at the centre of the international financial system, this translates into an appreciation of the US dollar (USD) and an increase in the value of treasury bonds, leading to wealth transfers from the US to the rest of the world as the US is short in dollars and safe assets, and long in foreign currency and risky assets. Furthermore, the US has also been transferring wealth to other economies due to an increase in the value of US firms, especially since roughly 2007 (Atkeson et al. 2022). As a result, valuation effects, through variations in the prices of assets and exchange rate, significantly impact the evolution of the NIIP.
Global movements in the value of the USD are one of the main mechanisms of international risk sharing. The old conventional wisdom in emerging market economies (EMEs) was that a depreciation of their currencies could have detrimental effects on financial stability and public finances due to currency mismatches. A related issue is the so-called ‘original sin’ (Eichengreen and Hausmann 1999, Eichengreen et al. 2005, Eichengreen et al. 2007), in which countries cannot issue sovereign debt in their currencies and instead borrow in USD. Thus, despite a depreciation of the local currency having a positive effect through the trade channel, it can also have a negative effect through the valuation channel. The latter effect could also trigger a fiscal or financial crisis.
Ultimately, whether or not EMEs benefit from risk-sharing in the international monetary system through the valuation channel must be analysed empirically, a task we undertake in De Gregorio and Peña (2024).
Studying emerging market economies
We begin by analysing Chile during a period of intense social unrest, the third quarter of 2019, which was followed by COVID-19. Between the third quarter of 2019 and fourth quarter of 2021, the NIIP went from -20 to -5% of GDP, while the accumulated deficit in the current account was -6% of GDP. This implies that valuation effects amounted to 21% of GDP. These valuation effects were explained by a real depreciation of the Chilean peso of 17%, and a stock market return differential of 75 percentage points with the US. The transfer from the rest of the world was significant and contributed to Chile’s ability to navigate turmoil in this period with a robust financial system and sound external position. Importantly, these valuation effects are also consistent with evidence regarding price-induced valuation changes (Atkeson et al. 2022), and exchange rate-induced valuation changes during the pandemic (Hale and Juvenal 2023).
We use a panel of 20 EMEs to further analyse previous issues, using data from 1999 to 2021 from the External Wealth of Nations dataset (Lane and Milesi-Ferretti 2007) and currency composition data from Bénétrix et al. (2019). We (1) analyse how exchange rates, particularly the bilateral exchange rate against the USD, have impacted EMEs’ external positions, (2) analyse price-induced valuation changes, and examine how strongly they react to changes in the values of US firms, and (3) analyse the countercyclicality of valuation effects.
First, we find that the data from Bénétrix et al. (2019) shows that EMEs have significantly reduced their currency exposure to the USD, allowing them to take advantage of an appreciation of the USD (see Figure 1). More financially integrated economies (with more assets and liabilities) receive larger wealth transfers in the face of a dollar appreciation. When estimating panel regressions to analyse the correlation between the bilateral exchange rate against the USD and valuation changes as a fraction of GDP, we find that exchange rate depreciations are associated with positive valuation changes for the whole period. The beneficial effects of domestic currency weakening are only robustly significant in the period between 2008 and 2021, consistent with the evolution highlighted in Figure 1. It is also interesting to note that until 2008, EMEs were reducing their restrictions to capital flows (Chinn and Ito 2006), a process which was partially reverted afterward. However, the degree of financial openness measured as the share of international assets plus liabilities over GDP increased for most of this period. This means that EMEs with positive exposure to the USD were in a particularly advantageous position to benefit from exchange rate-induced valuation changes in the latter period.
Figure 1: Average USD net financial weights
Average USD net financial weights
Average USD net financial weights
Notes: This figure plots the evolution of the average net financial weight for the US dollar as defined by Lane and Shambaugh (2010) for 20 emerging economies. Their values capture the relation between net foreign assets and bilateral exchange rate changes against the USD. Positive values imply that a depreciation against the USD increases the value of countries’ net foreign assets. Data comes from the updated External Wealth of Nations database (Lane and Milesi-Ferretti 2018) and a dataset on the currency composition of a large group of countries (Bénétrix et al. 2019). Blue contour shows 2 standard deviations.
Second, EMEs also benefit from increases in the value of US firms. A decline in the local stock market also reduces their NIIP. Our regressions show that more financially open economies face greater valuation effects. This is particularly the case in the 2008-2021 period. To get a broad idea of the importance of price and exchange rate-induced valuation changes, we plot the cumulative current account, which tracks how net foreign assets would have evolved in the absence of valuation changes, cumulative price-induced valuation changes, and cumulative exchange rate-induced valuation changes (Figure 2). Figure 2 shows that valuation changes are a significant explanatory factor for EMEs’ external position. Exchange rate-induced valuation effects have been more relevant than price-induced valuation changes in recent years. Notably, starting in 2012, exchange rate-induced valuation changes have partly offset the persistent current account deficits, consistent with Figure 1 and the evolution of the dollar during this period. Over this same period, cumulative price-induced valuation effects have roughly been zero.
Figure 2: Cumulative current account and valuation changes
Cumulative current account and valuation changes
Cumulative current account and valuation changes
Notes: Average cumulative current account and valuation effects across all EMEs in our sample starting in 1999. All series start at 0 by construction.
Finally, we look at how valuation effects contribute to risk sharing by analysing how countercyclical they are with respect to real GDP. In particular, we look at the correlation between valuation changes over a certain timeframe, and change in real GDP over that same period. While we find no significant correlation using year-to-year data, valuation effects are robustly countercyclical in the medium-run (a period of five years). This is summarised in Figure 3 for total valuation changes, and Figure 4 for price and exchange rate-induced valuation effects separately.
Figure 3: Evolution of countercyclicality parameter–medium-run
Evolution of countercyclicality parameter–medium-run
Evolution of countercyclicality parameter–medium-run
Notes: This figure plots the point estimates along with bars for 2 standard errors for a regression of total valuation effects over 5 years as a fraction of GDP against the change in real GDP during that same period, for each year between 2004 and 2021.
Figure 4: Evolution of countercyclicality parameter—medium-run
Panel A: Price-induced valuation changes
Price-induced valuation changes
Panel B: Exchange rate-induced valuation changes
Exchange rate-induced valuation changes
Exchange rate-induced valuation changes
Notes: This figure plots the point estimates along with bars for 2 standard errors for a regression of price-induced (in Panel A) and exchange rate-induced (in Panel B) valuation effects over 5 years as a fraction of GDP against the change in real GDP during that same period, for each year between 2004 and 2021.
These figures show that (1) valuation effects have become more countercyclical over time, (2) price-induced valuation effects are not strongly countercyclical, and (3) exchange rate-induced valuation effects have become significantly more countercyclical since around the global financial crisis. This implies that the reduction in EMEs’ currency exposure against the USD illustrated in Figure 1 has allowed them to benefit from risk-sharing via valuation changes. This occurred in a context where widespread financial integration reached its plateau around the global financial crisis.
Implications for emerging market economies
Our results are significant for various reasons. First, the results on the effects of exchange rate fluctuations on EMEs’ external wealth contradict the old view on exchange rate depreciations in EMEs, in which a depreciation can have negative consequences on public finances as well as the stability of the financial system. Our results suggest that, in our sample of EMEs, currency mismatches and the issue of the original sin are no longer significant enough for depreciations to be detrimental to their external positions. despite potentially damaging effects in other dimensions. They also provide evidence on how EMEs’ currency exposure has evolved since 1999 and show that the most marked improvement happened in the pre-2008 period, coinciding with a process of international financial deepening in many EMEs.
Second, although it is clear that advanced economies benefit from a dollar appreciation due to a flight to safety through the valuation channel, a pessimistic view would argue that EMEs would not benefit from these dynamics. However, our findings indicate that EMEs also enjoy the benefits of a global insurance provider.
While we find no evidence of price-induced valuation changes being countercyclical, exchange rate-induced valuation changes are strongly countercyclical in the medium-run. This highlights the importance of the reduction in EMEs’ currency exposure to the USD in the pre-2008 period.
Finally, our results point towards a relevant benefit of financial integration. Most of the existing evidence on financial integration and economic performance has focused on periods before the global financial crisis, finding negative or mixed results. In contrast, we show that these persistent benefits may exist even after a period of widespread financial integration, with the caveat that maximising financial openness will not maximise its benefits. At the levels of financial opening observed in our sample of EMEs, we find that financial integration is beneficial and contributes to economic stability.
References
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Chile emerging markets emerging economies exchange rates Risk sharing