Mallucci, Enrico
(2014)
Essays in international finance.
PhD thesis, London School of Economics and Political Science.
Abstract
This thesis contains three chapters. The first two chapters concentrate on the sovereign debt market and study how domestic holdings of government debt and financial intermediation influence yields and equilibrium debt levels. An innovative perspective emerges from these studies: Sovereign default risk and government yields crucially depend on the size of domestic debt and on its influence on the domestic credit market. This perspective surpasses the traditional view that exclusively relates sovereign default risk to the size of external debt and the economic cycle. The third chapter empirically investigates the functioning of international
capital markets and the behavior of market participants. The chapter studies how the different return components of aggregate equity and bond markets influence mutual fund flows and vice-versa. Two interesting results emerge. Firstly, the non-contemporaneous correlation between flows and returns is found to be predictable at least in the short run. This result rejects the standard perfect market assumption in macro-models which implies that the correlation between flows and returns is strictly contemporaneous. Secondly, evidence is found that excess returns in the equity markets are driven by cash-flow news. This is in contrast with the typical finding in the literature that discount rates news is the main driver of excess returns.
Identifying determinants of government incentives to default is central to understand how equilibrium prices and quantities iare determined in sovereign debt markets. The scholarly literature has focused on two factors to explain default risk: the size of external debt and the fluctuation of the economic cycle. While these two dimensions are certainly important, another aspect seems equally important: the internal versus external composition of debt. Reinhart and Rogoff (2008) empirically investigate the importance of domestic debt for sovereign default episodes and conclude that there is a “forgotten history of domestic debt”. While domestic debt dynamics are relevant to understand sovereign default risk, very little research has been devoted to it. The first chapter of my thesis fills in the gap by incorporating domestic debt in a theoretical model of sovereign default. This extension leads to three contributions. The first is a positive one. While standard sovereign default models (i.e. Arellano, 2008 and Aguiar and Gopinath, 2006) assume exogenous output costs to default, the introduction of domestic debt allows me to illustrate an endogenous mechanism linking defaults and output contractions through the credit market which is consistent with the empirics. The second contributions is quantitative. The introduction of domestic debt helps to reproduce the high debt to GDP ratios and the low frequency of default that is found in the empirics. Finally the last contribution is normative. When domestic investors act competitively domestic debt levels are found to be inefficiently low. A case is made for the introduction of Pigouvian subsidies that subsidize domestic purchases of government debt.
Sovereign defaults and banking crises tend to come in pairs. Understanding the link between these two phenomena is relevant to understand how the risk of sovereign default is priced by financial markets. In the second chapter of the thesis I focus on the underlying mechanisms of contagion between public debt and bank’s balance sheet. Using disaggregated banking data I analyze empirically the channels through which sovereign debt crises transmit to the banking sectors. I find that one of the main propagation mechanism operates through the collateral channel. When the default risk is high the price of government debt falls and the value of the asset that banks can pledge as a collateral on the wholesale market for liquidity contracts. Funding difficulties transmit thorough the balance sheet to the credit supply . The cyclicality of credit supply magnifies the negative impact of sovereign debt crises on output and consumption reducing the ex-ante incentives of issuing domestic debt. Lenders of last resort may mitigate the contraction of the credit supply in bad times offering liquidity in exchange for government debt. Following the monetary authority intervention the credit market recovers, sovereign yields fall and higher debt levels become sustainable.
The third chapter studies the functioning of international equity and bond markets and the behavior of its participant. The chapter focuses on the interaction between different return components of aggregate equity and portfolio flows. First, international equity and bond market returns are decomposed into changes in expectations of future real cash payments, interest rates, exchange rates, and discount rates. News about future cash flows, rather than discount rates, is the main driver of international stock returns. This evidence is in contrast with the typical results reported only for the US. Inflation news instead is the main driver of international bond returns. Next, the interaction between these return components and international portfolio flows is analyzed. Evidence consistent with price action, short-term trend chasing, and short-run overreaction in the equity market is found. International bond flows to emerging markets are found to be more sensitive to interest rate shocks than equity flows.
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