Nominal revaluation of cross-border assets, terms-of-trade changes, international portfolio diversification, and international risk sharing.

• Author: Kim, Soyoung

1. Introduction

   All nominal assets are subject to nominal risks. The real value of nominal debt decreases under inflation. In open economies, nominal cross-border assets are subject to nominal risks, such as inflation risks and exchange rate risks. That is, when the price level and exchange rates fluctuate unexpectedly, the real value and real interest income of nominal cross-border assets change, and wealth is redistributed internationally. This is called the "nominal revaluation of cross-border assets." (1)

   This international wealth redistribution or international wealth transfer is enormous when substantial nominal cross-border assets are held. In major industrial countries, foreign assets and liabilities have reached their GDP levels. Holdings of foreign assets by the United States were 73% of its GDP, and its foreign liabilities were 95%, in 2000. The ratios for the United Kingdom were even larger, 260% and 276%, respectively, in 1999.2 In these circumstances, substantial wealth is transferred internationally through the "nominal revaluation of cross-border assets." In the United Kingdom, the annual average of this wealth redistribution was more than 5% of its annual GDP during the period 1987-2000. (3)

   This "nominal revaluation of cross-border assets" can work as international risk sharing under some restrictive conditions. When income and the price level move inversely, the real value and real return on nominal assets are proportional to income. Thus, by cross-owning or trading nominal assets internationally, countries can share some country-specific risks. In his simple two-period model where the only sources of uncertainty are endowment shocks, Svensson (1989) showed that even a perfect pooling equilibrium can result by trading only nominally risk-free bonds under a monetary policy that generates negative correlation between endowment and the price level. However, he did not emphasize the role of the mechanism in overall international risk sharing, and possibly for this reason, the result is not well known. In this paper, I apply the idea to the aggregate level of international risk sharing by considering all types of nominal cross-border assets as opposed to limiting the study to only nominal bonds them selves.

   The mechanism can be thought of as a nominal analogy to Cole and Obstfeld (1991). In Cole and Obstfeld's (1991) model, changes in the terms of trade can automatically transfer wealth to insure country-specific risks. In the nominal revaluation, the relative "nominal" price (nominal exchange rate) changes between countries, instead of relative "real" price (terms of trade) changes, make international risk sharing possible. (4)

   Cole and Obstfeld (1991) further suggested that the welfare gains from international portfolio diversification may be small, and the "home bias" in international portfolio investments may be justified since changes in the terms of trade can insure some country-specific risks. (5) Similarly, if the nominal revaluation works as international risk sharing, it may serve as another justification for home bias in equities since equities are only parts of total cross-border nominal assets, and the nominal revaluation of other cross-border assets (such as bonds, direct investments, currencies, loans, and so on) can provide risk sharing. (6)

   On the other hand, the nominal revaluation has some interesting implications on the comparison between the flexible and the fixed exchange rate regimes. If it works as (or against) international risk sharing, it provides another merit (or drawback) of the flexible exchange rate regime since the changes in the nominal exchange rate can provide international risk sharing (or increase the country-specific risks).

   This paper empirically examines three international risk-sharing channels: the nominal revaluation of cross-border assets, the terms-of-trade channel suggested by Cole and Obstfeld (1991), and cross-border security ownership (or international portfolio diversification) that is thought of as a natural way of sharing country-specific risks. First, I examine the magnitude of the wealth transfers by each channel to examine whether it is substantial enough to have an economic importance.

   Second, I examine whether it works as international risk sharing. In this respect, I estimate the correlation between returns (or wealth transfers) of each channel and consumption differentials (the difference between per capita consumption growth rates of a country and the rest of the world), that is, whether each channel actually pools country-specific consumption risks. The empirical methods are informal but quite intuitive and different from previous studies. Consequently, this study provides some new perspectives on international risk-sharing research.

   Section 2 develops a simple theoretical model to illustrate the operation of the nominal revaluation since the channel is not well known. In the model, there are two sources of disturbances: endowment shocks and monetary policy shocks. The nominal revaluation works as international risk sharing in the presence of endowment shocks as in Svensson's (1989) model, but it works against international risk sharing in the presence of monetary policy shocks, which is not considered in Svensson (1989). The theoretical model shows the operation of the nominal revaluation in the world of incomplete risk sharing (or incomplete markets), in contrast to Svensson's (1989) model describing the world of complete risk sharing (or complete markets). The theoretical model is also used to motivate the empirical part.

   Section 3 estimates the magnitude of wealth transfers through three risk-sharing channels. Section 4 empirically examines whether the nominal revaluation contributes to pooling country-specific consumption risks. Section 5 examines whether the terms-of-trade channel and cross-border security ownership work as international risk sharing. Section 6 discusses implications of the findings in relation to previous literature and future research directions.

2. Nominal Revaluation of Cross-Border Assets

   The following model illustrates the operation of the nominal revaluation of cross-border assets. In this model, the only assets traded internationally are nominally risk-free bonds, which represent general nominal cross-border assets, not just nominal bonds themselves. Equity trading, which is a natural way to share country-specific risks, is not allowed. In addition, by assuming only one consumption good and purchasing power parity, the terms of trade is constant. Thus, the risk-sharing mechanism suggested by Cole and Obstfeld (1991) is not available. I show that, even in this world, some country-specific risks can be shared by the nominal revaluation of cross-border assets.

   There are several differences between Svensson (1989) and the following model. In addition to endowment shocks (which is considered by Svensson) that make the nominal revaluation an international risk-sharing mechanism, there are monetary shocks (which are not considered by Svensson) that generate the nominal revaluation but have adverse effects on international risk sharing. This is an example in which the nominal revaluation does not work as an international risk-sharing mechanism. In addition, while the nominal revaluation on interest income is emphasized in Svensson (1989), the nominal revaluation on the value of existing assets, which is the dominant part in the real world, is emphasized in the following model. Finally, I examine the operation of the mechanism in incomplete markets in contrast to Svensson's (1989) complete market model.

   The following model has several simplifications that may not be very realistic. Those simplifications are made to derive simple analytic solutions and to illustrate the operation of this possible international risk-sharing mechanism. The empirical studies in section 3 are based on more general conditions, and the empirical works examine whether this possible mechanism works as international risk sharing in the real world. Since the main purpose of the model is the illustration of the channel, I present the model only briefly. Detailed analyses are reported in the Appendix.

   Simple Model with One-Period Nominal Bonds (Debts)

   Income is endowed in each period. As a world economy, there are no real savings, but each country can trade intertemporally by holding foreign nominal bonds and issuing one-period nominal bonds to foreigners. For the simplest international setting, several assumptions are made. Each country has its own money, and private agents hold only domestic money issued by their government. There is only one consumption good. The nominal exchange rate is defined as e = p/[p.sup.*], where p([p.sup.*]) is the domestic (foreign) price level. Each country issues nominal bonds (debt) denominated in its currency to the other; that is, one country holds nominal bonds of the other denominated in the other's currency. Money holdings are motivated by transaction mode which depend on consumption velocity.

   Consumer Optimization

   Home

   Each individual in the home country maximizes his lifetime utility subject to his intertemporal budget constraints. There are several sources of income: endowment ([Y.sub.t]), transfer from the government ([[tau].sub.t]), gross interest income receipts (interest and principal) from foreign nominal bonds holdings denominated in foreign currency ([e.sub.t][r.sup.*.sub.t-1][B.sup.*.sub.t-1]\[P.sub.t], where [r.sup.*.sub.t-1] is the gross interest rate of the foreign bonds), and sales of domestic nominal bonds denominated in the home currency ([B.sub.t]\[P.sub.t]). He allocates his income to consumption ([C.sub.t](1 + [gamma][Florin]([V.sub.t])) where [gamma][Florin]([V.sub.t]) is the transactions cost term, which is a function of consumption velocit, [V.sub.t] = [P.sub.t][C.sub.t]\[M.sub.t]), changes in money holdings (([M.sub.t] - [M.sub.t-1])/[P.sub.t]), gross interest...