1. Possible explanations of the puzzles Capital market imperfections and/or Trade costs in good markets? Michele Pacillo and William Robson

2. Risk Sharing and Imperfections of International Capital Markets Why are international capital markets less integrated than national capital markets?

3. Theoretical approaches: overview ‘ Sovereign Risk ’ – Direct Creditors Sanctions – Reputation Asymmetric Information – Hidden information – Moral hazard – Adverse selection

4. Sovereign Risk (SR) Definition. Broadly, situations in which a country defaults on loan contracts with foreign creditors Historical Evidence. In the 1980 ’ s Latin American countries and in the 1990 ’ s Eastern European countries had troubles in repaying their debts Regularities. (1) SR involved developing countries and (2) partial rather than complete defaults. Potential Solution. Establishment of a supranational legal authority capable to enforce contracts across the borders Partial Solutions – Direct Creditors Sanctions – Reputation

5. Penalties – such as the exclusion from the credit markets – are able to support repayment? Bulow-Rogoff: the threat of punishment does not guarantee the enforcement of the contract if: - the debtor country is able to enter into other financial contracts - and the creditors are not able to monitor and control the country ’ s deals Direct Sanctions

6. Reputation If the only cost of default is the ‘ loss ’ of reputation that brings to immediate and permanent exclusion from world capital markets, it is enough to support repayment? Reputation may support international lending. However: - there exist many ‘ trigger strategy ’ equilibria supporting different degree of risk sharing including none In practice the exclusion is never permanent

7. Sovereign Debt Distortions The inadequacy of the above incentives may create distortions in the debtor country: - under borrowing or over borrowing - distortions in domestic economy (Sachs and Cohen 1985, Diaz-Alejandro 1985) and government policy - the fiscal burden imposed by the debt leads to capital flights and abandonment of profitable investment opportunities (Eaton and Gersovitz, 1988)

8. Risk Sharing and Asymmetric Information A key variable or performance for the loan contract may be observed only by the borrower: – creating incentives to lie to the creditors about this variable or its performance in order to maximize its utility – leading to a suboptimal level of risk sharing and lending transactions in credit markets may be limited by adverse selection problem: a “ bad ” borrower may drive out the “ good ” borrower when the lender cannot observe borrower quality, leading to a collapse of the market in the extreme case

9. References Obsfeld, M., Rogoff, K., Foundations of International Macroeconomics, MIT Press, ch. 6, 1996. Grossman, G., Rogoff, K., Handbook of International Economics, Vol. III, North Holland, ch. 38, 1995.

10. Trade Costs in goods markets and the existence of Non-tradable Goods Two possible solutions to The Puzzles.

11. Two Approaches Non-Tradable Goods – This approach splits all goods into those that can be traded and those that can ’ t and considers the implications there might be for the puzzles. Trade/Transaction Costs – This approach considers the existence of trade costs within the goods market (only) as a solution to the puzzles.

12. Non-tradable Goods Home Bias in Goods – Simply, having some goods that are physically non-tradable means there is a proportion of products that people cannot buy from abroad. However, this notion fails to explain the extent of the bias, in theory the bias should be as high as the proportion of goods that are non-tradable. In practice it is higher. Home Bias in Equity – Having a proportion of goods that are non-tradable means there is a proportion of securities that promise delivery of only non-tradable output so these can only be traded domestically too.

13. Non-tradable Goods – It may be possible, though, to have international trade in claims indexed to random non-tradable endowments but payable in tradable goods. – However, because forward contracts for non-tradables can only be traded domestically, no common relative prices force equality in marginal rates of intertemporal substitution across countries as happens with tradable goods. – This means that an investor can not diversify his risk more than by holding claims to foreign non-tradables than he could by holding domestic non-tradables.

14. Trade/Transaction Costs Solution to the Feldstein-Horioka Puzzle. – Consider a small country who ’ s actions have no impact on world prices or the foreign real interest rate. – Introducing transaction costs on goods means that home consumption patterns can affect home relative prices and the home real interest rate. – The interplay of transaction costs and the elasticity of substitution between home and foreign goods can cause the home real interest rate to vary significantly from the foreign real interest rate.

15. Trade/Transaction Costs Solution to the Home Bias Puzzle. – Goods The interaction of trade costs with the elasticity of substitution between home and domestic goods causes a home bias in the consumption of goods. Even small trade costs can result in a significant home bias if the elasticity of substitution is large enough.

16. Trade/Transaction Costs – Equity Trade costs alter the prices of both the home and foreign goods. Working through the derivation of the model results in the Arrow-Debreu equilibrium portfolio shares being dependant on the elasticity of substitution and the level of trade cost. Even small trade costs in this framework can result in the large home bias found in the empirical evidence.

17. Trade/Transaction Costs Solution to the Backus-Kehoe-Kydland Puzzle. – Obstfeld and Rogoff regard this puzzle to be a corollary of the Feldstein-Horioka Puzzle and the Home Bias in Equity Puzzle. It is therefore solved with the same line of thought. – Due to home bias people do not spread their risks properly internationally and so there is less correlation observed between country consumption than if risk was spread optimally.

18. References Obstfeld, M. and Rogoff, K. “ The Six Major Puzzles in International Macroeconomics: Is there a Common Cause? ”, NBER Working Paper No.7777, 2000