POLICY RESEARCH WORKING PAPER 3059 Do Capital Flows Respond to Risk and Return? Csar Calder6n Norman Loayza Luis Servin The World Bank Development Research Group Macroeconomics and Growth May 2003 POLICY RESEARCH WORKING PAPER 3059 Abstract This paper explores empirically the role of risk and employs a dynamic panel estimation procedure allowing return in the observed evolution of net foreign asset for unrestricted short-run heterogeneity across countries, positions of industrial and developing economies. The using the pooled mean group estimator recently paper adopts a dynamic approach in which investors' developed by Pesaran, Shin, and Smith (1999). The portfolios adjust gradually to their long-run equilibrium, empirical results lend considerable support to the defined by a standard Tobin-Markowitz framework. The model when applied to countries with low capital parameters characterizing the long-run equilibrium are controls and/or high and upper-middle income. The estimated using data on foreign assets and liabilities of a results for countries with either high capital controls or large number of industrial and developing countries low per capita income are less supportive of the stock spanning the period from 1965 to 1997. The paper equilibrium model for net foreign asset positions. This paper-a product of Macroeconomics and Growth, Development Research Group-is part of a larger effort in the group to understand international capital flows. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Tourya Tourougui, room MC3-301, telephone 202-458-7431, fax 202-522- 3518, email address ttourougui@worldbank.org. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The authors may be contacted at nloayza@worldbank.org or Iserven@worldbank.org. May 2003. (45 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by Partnerships, Capacity Building, and Outreach Do CAPITAL FLOWS RESPOND TO RISK AND RETURN?* C6sar Calder6n Central Bank of Chile Norman Loayza The World Bank Luis Serven The World Bank JEL classification codes: F32, F37, GIl This work was supported by the Latin American Regional Studies Program of the World Bank and the Reseach Program of the Central Bank of Chile. We are grateful to Gian Maria Milesi-Ferreti, Phil Lane, Klaus Schmidt-Hebbel, Raimundo Soto, and Alan Stockman for valuable discussions. We also thank participants at the 1999 Latin America Meetings of the Econometric Society, the 1999 LACEA Meetings and the 2000 Winter Camp on International Finance for valuable comments. George Monokroussos and Rashmi Shankar provided excellent research assistance. Corresponding author. Address: The World Bank, 1818 H St NW, Washington DC 20433. E-mail address: Iserven(a)lworldbank.org. Phone 202-4737451 Do CAPITAL FLOWS RESPOND TO RISK AND. RETURN? 1. INTRODUCTION One of the major puzzles in international economics is the failure of standard portfolio models to explain the observed patterns of cross-country capital allocation. The search for solutions to this puzzle has attracted a great deal of theoretical and empirical work. 1 Most of this effort has focused on explaining the 'home-bias' effect, according to which domestic investors disproportionately favor domestic over foreign asset holdings. As the literature has amply documented, individuals do not appear to do a good job at diversifying risks across countries: they hold too little of their wealth in foreign assets, much less than predicted by conventional risk-return portfolio equilibrium models.2 Rather than attempting to explain the well-documented divergence between observed portfolio shares and those predicted by theory, this paper examines the empirical validity of a weaker theoretical prediction, namely that international asset positions should systematically respond to risk and return conditions. Thus, the aim of the paper is to check whether -- and how much -- international capital flows reflect market incentives, and if the effects of the latter are similar across the world or there are significant differences among countries and/or specific country groups. In following this positive approach, we implicitly take as given the 'home bias' of international portfolios - i.e., we allow for unobserved country-specific characteristics that may affect net foreign asset (henceforth NFA) positions and, more generally, we allow for heterogeneity across countries in the response of NFA positions to risk and return fundamentals. The paper's framework is guided by a Tobin-Markowitz model of portfolio diversification in which the share of domestic investors' wealth allocated to foreign assets depends on four factors: investment returns in the home country relative to the rest of the world, investment risk in the home country relative to the rest of the world, the degree of co-movement between investment returns at home and abroad, and the ratio of foreign-owned to domestic- owned wealth. 1 Lewis (1999) provides a comprehensive overview of this literature. 2 See, for example, French and Poterba (1991) for the case of intemational equity portfolios. Tesar and Werner (1995) show that the same puzzle arises with bonds. 2 This framework characterizes long-run portfolio equilibrium. However, costs and frictions to instantamous portfolio reallocation - arising from sources such as investors' imperfect information, congestion effects or investment adjustment costs - may drive a wedge between short-run and long-run portfolio equilibrium.3 Further, these frictions, and hence portfolio dynamics, may differ across countries. The paper's empirical analysis focuses on the estimation of the long-run portfolio equilibrium condition, while allowing for unrestricted cross-country heterogeneity in the short-run dynamics. The paper extends previous literature along three dimensions. First, it builds on a recent strand of the literature that adopts an international portfolio equilibrium approach to the analysis of the current account (Ventura 2002).4 Our paper shares with this literature the emphasis on risk and adjustment costs as essential ingredients for explaining the observed patterns of international asset portfolios. However, that literature has focused primarily on the impact of wealth changes on capital flows (what has been termed the portfolio growth effect). In contrast, the present paper also brings into focus the determinants of international investors' portfolio shares, for given levels of their wealth (the portfolio rebalancing effect). Second, the paper implements empirically the portfolio diversification model using a comprehensive data set on foreign assets and liabilities that covers a large number of developing and industrial countries and spans the years from 1965 to 1997. Importantly, the data encompass not only industrial economies, which have been the focus of previous empirical literature, but also a large number of emerging markets and developing economies. Using this information, we can assess the empirical robustness of the portfolio model across different country groups and alternative measures of risk and return. Third, the paper follows a novel econometric approach to the estimation of the long-run portfolio equilibrium condition in a heterogeneous dynamic panel setting, using the Pooled-Mean Group estimator recently developed by Pesaran, Shin, and Smith (1999). This approach combines the efficiency gains from restricting long-run parameters to be the same across See Bacchetta and van Wincoop (1998) for a theoretical discussion of portfolio dynamics arising from these and other sources. 4 Along similar lines, the paper's portfolio equilibrium approach to capital flows also brings it close to a strand of the literature on 'current account sustainability' that underscores the role of international investors' portfolio choices in shaping the sustainable current account (see Mann 2002 for references). By shedding light on the factors that shape international portfolio diversification and its time path, the analysis in this paper could be readily adapted to identify current-account trajectories consistent with portfolio equilibrium. 3 countries (the units in the panel) with the flexibility and consistency gains of country-specific short-run adjustment. Further, the approach allows formal testing of the long-run pooling restrictions imposed by the model - i.e., the homogeneity across countries of the parameters describing the long-run portfolio equilibrium condition. The paper's plan is as follows. Section 2 describes the analytical framework and presents the econometric strategy for estimation of the long-run relationship implied by the model. Section 3 briefly summarizes the main features of the NFA data and the measures of investment returns and risks used in the empirical analysis. Section 4 presents the empirical results from estimation of the model for various groups of countries. The model is first implemented on the full country sample, and then separately on country groups that differ in per capita income level and restrictions to international portfolio diversification. Section 5 concludes. 2. METHODOLOGY 2.1 A portfolio-diversification approach to external asset positions Our analytical framework follows recent literature underscoring the role of investment risk and adjustment costs in the allocation of agents' wealth between domestic and foreign assets, and thus in the determination of capital flows (Ventura 2002). This literature shows that those two ingredients are needed to reconcile theoretical predictions and observed facts on the dynamics of countries' asset portfolios. Specifically, we adopt a portfolio-diversification approach according to which external asset positions are driven by portfolio equilibrium in the long run and by the dynamic forces shaping asset reallocation in the short run. Long-run equilibrium obtains when domestic and foreign investors achieve the desired allocation of their asset portfolio across countries. However, imperfections and frictions in real and financial markets may prevent the instantaneous achievement of the optimal portfolio. Short-run external equilibrium is then given by the adjustment path towards investors' long-run equilibrium portfolio. In our framework, the optimal portfolio allocation follows along the lines of the standard Markowitz-Tobin model of mean-variance investors. As is well known, the model can be derived under fairly standard assumptions from intertemporal optimization by forward-looking, risk- averse agents. Such procedure can be shown to yield an optimal saving/consumption plan 4 characterized by the permanent income hypothesis, and an optimal allocation of wealth between domestic and foreign assets characterized by mean-variance portfolio optimization. 5 The key property of mean-variance investors is that the desired share of each asset in their total wealth depends only on the distribution of asset returns and not directly on the level of wealth.6 In our context of international diversification, the optimal portfolio share allocated to assets in a given country can be divided into two pieces, namely, the 'speculative' component and the 'minimum variance' component (using the terminology in Adler and Dumas 1983). An increase in mean returns in the country leaves unaffected the 'minimum variance' piece of the portfolio but raises the 'speculative' component and thus leads to an expansion of investors' portfolio share in that country. Analogously, a decrease in the variance of investment returns in the country, holding constant the 'speculative' component, raises the 'minimum variance' piece, thus producing an increase in investors' portfolio share in the country. The same effect occurs when the co- variation of country investment returns with those in the rest of the world decreases -holding constant the 'speculative' component, lower co- variation with the world economy implies that investments in the country provide a better hedge against systemic (world-wide) risk. Formally, let A represent world assets and W the wealth of world residents. Obviously, A = W. Let At represent the assets located in country i and W represent the wealth of country i's residents. The assets located in foreign countries and the wealth of foreigners are respectively represented by Ap- A-Ai and W = W-W. Let aj; be the share of wealth of country i's residents that they desire to allocate to country i's assets, and let af, represent the share of foreigners' wealth that they desire to allocate to country i's assets. Hence when actual and desired portfolio shares coincide, we have that Ai = a, W + aft Wf. As explained above, desired portfolio shares are assumed increasing in the anticipated return of country i's assets relative to those abroad, decreasing in their perceived riskiness relative to external assets, and decreasing in the co-movement of country i's returns with those in the rest of the world. We denote these three factors REgl, Rif, and COv, respectively. In (long- The analytical derivations are standard, and thus for brevity they are not reproduced here. For the general case, the details can be found in Merton (1971). For an application similar to ours, see Kraay and Ventura (2000). 6 Of course, in the intertemporal optimization framework these results require (standard) simplifying assumptions such as log utility or homothetic preferences and lognormal returns (see Merton 1971). Even under such conditions, wealth and capital stocks may still affect indiiectly the return characteristics of available assets. 5 run) portfolio equilibrium, the desired holdings of country i's assets by domestic plus foreign residents should be equal to the country's total existing assets; that is, ail REilf,RT,I,CO,,1f-W + afi(RE,l ,RIsI ,COif }Wf = A, where the sign over each argument corresponds to the sign of the partial derivative. It is important to keep in mind that the aj, 0 and at() functions above may embody different preferences of domestic and foreign investors, including differential attitudes towards domestic and foreign assets - i.e., home-bias effects (Lewis 1999). The net foreign asset position of a country is the difference between the wealth owned by its residents and the assets located in the country. Therefore, in long-run equilibrium the net foreign asset position of country i will be given by: NFA = W - (a,, W, + aft W) (2) For given portfolio shares art and afi, equation (2) highlights the dependence of the net foreign asset position on wealth stocks, which is at the core of Kraay and Ventura's (2000) analysis of the current account. Normalizing by dividing both sides of (2) by country i's wealth, we get: NF, Wr -=1 - a,- - (3) We can then express equation (3) as follows: NF4 - + + - = f(RE,,fRil, CO,lf,Wf /W) (4) Equation (4) defines the long-run equilibrium relationship resulting from optimal asset allocation across countries. Note that the ratio of net foreign assets to wealth depends on the relative wealth o( domestic residents, even though portfolio shares are themselves independent of wealth. For empirical implementation we shall take a linear approximation to (4): W P+P'RE*lf+J*lf +f36 (NoFAl +I~I fS) 6 where the stars denote long-run values, and the idiosyncratic intercept Po captures country- specific factors that we do not model exp licitly.7 We view the above equations as characterizing long-run portfolio equilibrium, and hence expressions (4)-(5) describe the wealth share of net foreign assets in the long run. However, the dynamics of NFA along the adjustment path may show temporary departures from these long-run equilibrium rules, reflecting existing constraints to immediate portfolio adjustment.8 These may arise from various sources (Bacchetta and van Wincoop 1998; Ventura 2002): (i) investors' imperfect information (e.g., gradual learning about the state of the world, or about the permanence of reforms which affect asset returns but may initially suffer from imperfect credibility); (ii) congestion effects, such as increasing marginal costs to foreign investment due for example to its use of internationally immobile labor inputs; (iii) costs of adjusting the capital stock - such as investment irreversibility -- that make investment respond sluggishly to aggregate disturbances (Caballero 1998, Dixit and Pindyck 1996). While we do not model explicitly such dynamic effects here, in our empirical implementation we take them into account by employing a suitably expanded version of (5) allowing for lagged effects of risk, return and relative wealth. This is discussed in the next subsection 2.2 Econometric Estimation Empirical implementation of the model outlined in the previous section on a large cross- country time-series sample poses two main issues. First,- the model defines a long-run relationship between the ratio of net foreign assets, wealth shares, and expected returns and risks. However, given the imperfections in international financial and factor markets, stock equilibrium does not hold at every point in time but is achieved gradually in the long run. Therefore, in the empirical analysis, the process of short-run adjustment must complement the long-run equilibrium model. Second, it seems reasonable to assume that countries can differ regarding the market imperfections and barriers to portfolio reallocation that govern short-term dynamics - and perhaps even in the parameters characterizing the long-run equilibrium. Thus, we must allow for parameter heterogeneity across countries. We deal with each of these two issues in turn. For example, it could reflect the effects of home bias on long-run net foreign asset holdings. 8 Kraay and Ventura (2000) underscore the discrepancies between the short- and long-run patterns of change of NFA. Ventura (2002) stresses the need to take into consideration adjustment costs to account for these differences. 7 Single-country estimation The challenge we face is to estimate long- and short-run relationships without being able to observe the long- and short-run components of the variables involved. Over the last decade or so, a booming cointegration literature has focused on the estimation of long-run relationships among I(1) variables (Johanssen 1995, Phillips and Hansen 1990). From this literature, two common misconceptions have been derived. The first one is that iong-run relationships exist only in the context of cointegration among integrated variables. The second one is that standard methods of estimation and inference are incorrect. A recent literature, represented in Pesaran and Smith (1995), Pesaran (1997) and Pesaran and Shin (1999), has argued against both misconceptions. These authors show that simple modifications to standard methods can render consistent and efficient estimates of the parameters in a long-run relationship between both integrated and stationary variables and that inference on these parameters can be conducted using standard tests. Furthermore, these methods avoid the need for pre-testing and order-of- integration conformability given that they are valid whether the variables of interest are 1(0) or I(1). The main requirements for the validity of this methodology are that, first, there exist a long-run relationship among the variables of interest and, second, the dynamic specification of the model be augmented such that the regressors are strictly exogenous and the resulting residual is serially uncorrelated.9 Pesaran and co-authors label this the "autoregressive distributed lag (ARDL) approach" to long-run modeling. Appendix B presents an illustration of the main assumptions and properties of the ARDL approach. In order to comply with the requirements for standard estimation and inference, we embed the long-run portfolio equilibrium condition (5) into an ARDL(p,q) model. In error-correction form, this can be written as follows: = y'=d + [B'jARE1f,_j +B' ARI + BJ ACO,fJ_ + B ( +p{-- +PI3,RE,,f,, +02RI,f, +fliCOL,f,,_+ +7,, (6) 9 It is worth noting that the assumption of a unique long-run relationship underlies implicitly the various single- equation based estimators of long-run relationships commonly found in the cointegration literature. Without such assumption, these estimators would at best identify some linear combination of all the long-run relationships present in the data. 8 where