Cheap but Flighty: How Global Imbalances Create Financial Fragility - - PowerPoint PPT Presentation

Cheap but Flighty: How Global Imbalances Create Financial Fragility

by Toni Ahnert and Enrico Perotti Discussion: Fabio Castiglionesi

Department of Finance, Tilburg University European Banking Center

International Banking: Microfoundations and Macroeconomic Implications June 10th, 2014 – Amsterdam, DNB

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Aim of the Paper

• To explain instability in developed countries.
• To provide micro foundations of the relevant

channel.

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General Assessment

• Understanding the reasons behind the

financial fragility shown by developed countries is clearly relevant.

• The effort to focus on the crucial role

played by investors in developing countries (“saving glut”) is also really worth it!

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Summing up: Approach

• The model emphasizes safety over contingent

liquidity needs (Diamond and Dybvig, 1983).

• This shift is motivated by the evidence from

the recent crisis.

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Summing up: Features

• Main features about foreign investors:

1.Face political risk. 2.Have less information than domestic investors

• n “local” asset risk.

3.Have a preference for absolute safety.

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Summing up: Model (I)

• Basic trade off: Foreign investors provide

cheap funding (political risk) but expose to run the developed country even when solvent (uninformed).

• Without absolute safety, the optimal contract is

long term debt to all investors (mutual fund). Inefficient investment can arise but no fragility.

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Summing up: Model (II)

• With absolute safety the optimal contract is:
• Foreign investors choose short term debt;
• Domestic investors choose long term debt.
• Domestic insure foreign: they suffer losses in

case of a run in exchange of an higher return. Fragility is a feature of the optimal contract.

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Comments (I)

• Political risk in developing country as main

motivation to invest in developed country.

• My prior: Sovereign funds are the main driver of

the saving glut (China, Singapore, Middle-east countries...). No clear political risk for them.

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Comments (I)

• However… Badarinza and Ramadorai (2014)

show effects of political risk in housing market.

• Can we know more on how much the

investment flow is due to sovereign funds and private investors?

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Comments (II)

• The asymmetric information about the domestic

asset deserve more attention.

• The asset we are talking is US T-bill. Is it

realistic?

• The supportive literature (Petersen and Rajan,

2002) seems not appropriate.

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Comments (III)

• Extreme form of risk aversion is needed.
• Foreign investors obtain consumption

investing only in the foreign asset D.

• Consumption is determined from total

wealth (TW = D + Equity + Human Capital).

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Comments (III)

• It would be reasonable to assume extreme

risk aversion on the return of total wealth.

• Assume TW = D + E. (E has a continuum of

realizations.) Then TW is defined on “normal”

• preferences. Result: risk neutral on TW and

extreme risk averse on D. Is this consistent?

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Minor Comments

• Highlight better the difference with Gennaioli,

Shlaifer and Vishny (2011, 2013)

• Why needed political risk? Why is not

assuming (directly) absolute safety preferences?

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Conclusions

• The paper addresses a very important issue.
• It is very clear, and well written.
• Authors are also making an analysis with

endogenous safety rents.

• Big question: Can we shed light on WHY

(endogenously) there is safety seeking?

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Thank you for your attention!