Financial Globalizationand Emerging Market Portfolios
Michael B. Devereux

Although emerging market Asian economies have experienced high growth
without crises for close to a decade, many commentators find the large
buildup of foreign exchange reserves among these economies both puzzlingand evidence of incipient global imbalances. This paper reviews some ofthe experiences of Asian countries over the last decade. We focus on the
degree to which Asian economies have experienced financial globalization,
meaning that their gross external asset and liability positions have grownsignificantly. In particular, while Asian economies have become significant
gross creditors in bonds and other fixed income assets, their liability
position in equity and foreign direct investment assets has also grownsignificantly. We show that a simple dynamic general equilibrium modelof portfolio choice in an emerging market economy can account for thistrend remarkably well.
Keywords: Asia; Financial globalization; Foreign direct investment; Foreignexchange rate reserves
JEL Classification: E52, E58, F41

University of British Columbia, Center for Economic Policy Research, and International Monetary
Fund (E-mail: devm@interchange.ubc.ca)
I thank the Social Sciences and Humanities Research Council of Canada, the Bank of Canada, andthe Royal Bank of Canada for financial support.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION.

101

I. Introduction
Since the crises of the late 1990s, the major emerging Asian economies have experienced close to a decade of uninterrupted growth. Capital inflows from industrial
countries in the form of foreign direct investment (FDI) as well as portfolio and bondinvestment have been strong, while on aggregate, Asian countries have been generating strong current account surpluses with the rest of the world. Sovereign spreads havebeen low by historic standards for a number of years. In addition, these countries haveto a significant extent eliminated their financial vulnerabilities displayed so clearly
during the crisis years by correcting the currency and maturity mismatches in theirnational balance sheets. Some countries have abandoned tight exchange rate pegs andmoved toward flexible inflation targeting. More generally, the quality of policymaking
in the fiscal and financial domain has improved greatly.
There is no single explanation for this positive trend among Asian emerging
market economies. High global saving has led to a prolonged period of low realinterest rates, reducing the potential for crises. The buildup of strong positive net external positions as well as large stocks of foreign exchange rate reserves has had the same
effect, and more generally has instilled strong confidence in the investment potentialof these countries. But in addition, real economic growth has been stimulated byhigh demand for exports to the industrial world (in particular, the United States), andcommodity price booms have generated huge net gains for many emerging countries.
One general feature of emerging economies’ recent experience that differs fromprevious episodes of high capital inflows and economic growth is the degree to which
they have been participants in the globalization of financial markets. Rather thansimply being recipients of net capital inflows or outflows, many emerging countries
have displayed growth in gross external financial assets and liabilities that is muchlarger than net positions. In this sense, their experience mirrors that of many
advanced economies, as documented in the seminal work of Lane and MilesiFerretti (2001, 2006). Although recent discussion of global imbalances has concentrated mostly on the size of net external surpluses of China and other emerging
economies, reflecting the apparently perverse situation of capital outflows from thedeveloping world to developed economies (or more accurately, the United States), in
the background there is a large degree of two-way capital flow. Emerging economies
have been accumulating large stocks of U.S. Treasury bills going into official reserveand other fixed income assets, but they have also been receiving large inflowsof FDI and portfolio equity investment, as well as private bond market inflows.
Lane and Milesi-Ferretti (2006) document this turnaround on the portfolio positionof emerging market economies taken as a whole. Compared with the situationin the mid-1990s, when many of these economies were substantial net debtors in
non-contingent assets such as bank loans and short-term U.S. dollar bonds, now they
have substantial net positive positions in fixed income assets, while being on the wholenet debtors in FDI and portfolio equity investment. There is an argument that this is
in fact a much more efficient form of financing development lending for emerging
market economies, in terms of achieving the most desired degree of internationalrisk sharing.

102 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Financial Globalization and Emerging Market Portfolios

This paper investigates the impact of financial globalization in emerging market
economies, paying particular attention to the determinants of country portfolio
positions. We explore the factors underlying the determinants of an optimal risksharing portfolio for an emerging market economy that needs to attract investment
capital but experiences country-specific macroeconomic risk. This loosely approximates the positions of the fast-growing Asian exporting economies. The question is,
how should investment be financed? One possibility is for these countries to borrow
substantially in the form of non-contingent foreign bank loans or from internationalbond markets to finance their own investment. In the mid-1990s, this roughly
described the financing patterns of many emerging economies. Another option,
however, is to accept FDI and equity investment. As noted, this has become the norm
for emerging economies in recent years. In our analysis, we interpret this financing
choice as an implication of financial globalization. In an environment where emerging
market economies can choose from an enhanced menu of international asset markets,an optimal financing pattern is to accept inflows of FDI and portfolio investment,
but to balance this with outflows of investment in fixed-income, non-contingent assets.
This offers one way to interpret the buildup of international reserve assets on the partof emerging economies.
Our analysis is built around a dynamic stochastic general equilibrium (DSGE)
model of the interaction between an emerging market economy and the rest of
the world. We follow Devereux and Saito (2006) in constructing a stochastic
continuous time framework with incomplete markets.1 Our results indicate that
financial globalization, wherein an emerging market economy may simultaneously
build up positive gross positions in non-contingent international bond assets, andnegative positions in FDI and portfolio equity, offers both welfare benefits and amore stable form of financing than what was available in the mid-1990s. In themodel, the emerging economy holds nominal bonds of the advanced economy, whileissuing FDI-equity claims that are held by the advanced economy. We interpret
nominal bond holdings as a measure of foreign exchange reserves. The model delivers
explicit solutions for the value of FDI, foreign exchange reserves, and total bondholdings in emerging market portfolios. The FDI position depends upon expected
returns in the emerging market, as well as growth risk in both the advanced economy
and the emerging market. Foreign exchange rate reserves depend on expected returns,
and growth volatility in the emerging market as well as in the advanced economy.
In addition, foreign exchange rate reserve holdings are sensitive to the monetary
policy followed by advanced economies. If the advanced economy follows a very
stable monetary policy, this will significantly boost emerging market foreign exchange
rate reserves. At the same time, a rise in the riskiness of the domestic income process
in emerging markets will lead to an increase in foreign reserve holdings.
Although the model is extremely rudimentary, we argue that it can give a coherent
account of the portfolio structure of emerging market Asian economies. The recent
1. There has been a rapid growth in the literature on incorporating portfolio dynamics in DSGE models. See
Devereux and Sutherland (2006, 2007), Engel and Matsumoto (2006), Evans and Hnatkovska (2005), and Tilleand van Wincoop (2007), among other papers, for alternative approaches.

103

buildup in foreign exchange rate reserves in Asian countries can be rationalized as a
response to observed movements in macroeconomic volatility in Asia and advanced
industrial economies. In particular, a combination of (1) a higher volatility of GDP
in Asian countries, (2) a lower volatility of GDP in advanced economies, and (3) a fallin the volatility of inflation in the United States (a more stable U.S. dollar pricelevel) works to increase foreign exchange rate reserve holdings in Asia. A simple
calibration to the U.S.–China case leads to a remarkably close fit between modeland data.
One qualification that should be noted is that the paper does not primarily
focus on current account imbalances or the size of net capital flows. Rather, we wish
to explore the determinants of gross capital flows and the structure of the external
portfolio positions for emerging market economies. Although our model does allow
for current account imbalances, it can account for a trend in the current accountonly by allowing for trend differences in savings rates. To jointly account for the
scale of global imbalances and the shifting portfolio composition without arbitrary
differences in savings propensities would require a more elaborate model than thatdeveloped here.
The paper is structured as follows. Section II discusses some recent features ofAsian external imbalances and portfolio composition. Section III presents a review ofrecent literature on global imbalances and Asian reserve holdings. Section IV develops
the model and presents a simple quantitative analysis. Some conclusions follow in
Section V.

II. Asian External Balance and Portfolio Structure
We focus on a subset of emerging market countries in Asia. The growing current
account surpluses of Asian countries are to a large degree the counterpart to the
U.S. current account deficit. For many emerging Asian countries, these current
account surpluses date back to the Asian crisis of the late 1990s. A large empiricaland theoretical literature has attempted to provide an explanation for thesesurpluses.
Figure 1 describes the evolution of current account to GDP ratios for a numberof Asian economies. All are currently in current account surplus, but this masks
distinct differences in their historical records. The fast-growing East Asian Tigers—
Korea, Malaysia, Thailand, and to a lesser extent Taiwan—all experienced significant
net capital inflows in the early 1990s, but were hit strongly by “sudden stops” during
the Asian crisis of 1997–98. Their current accounts swung sharply back into a surplus
position. Indonesia had a similar experience. In contrast, China experienced net
capital inflow only for one year in the 1990s. It was relatively immune to the direct
effects of the Asian crisis. In fact, its current account to GDP position deteriorated
somewhat during this period. From 2000–05, however, all countries experienced
strong surpluses. In particular, China’s current account surplus grew sharply in 2005
to nearly 7 percent of GDP.

104 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Financial Globalization and Emerging Market Portfolios

Figure 1 Ratio of Current Account to GDP[1] China[2] Malaysia

0.08

0.20

0.06

0.15
0.10

0.04

0.05

0.02

0.00

0.00

–0.05

–0.02
–0.04
1990

–0.10
95

2000

05

–0.15
1990

[3] Korea[4] Thailand

0.12
0.10
0.08
0.06
0.04
0.02
0.00
–0.02
–0.04
–0.06
1990

0.15

2000

05

0.10
0.05
0.00
–0.05
95

2000

05

–0.10
1990

[5] Indonesia[6] Taiwan

0.06

0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
–0.02
–0.04
1990

0.04
0.02
0.00
–0.02
–0.04
–0.06
1990

95

95

2000

05

95

2000

95

2000

05

05

Figure 2 breaks down the current account position into national savings andinvestment rates, relative to GDP. For Korea, Malaysia, and Thailand, the current
account improvement after the Asian crisis is substantially explained by a dramatic fallin investment, with a relatively stable savings rate. Taiwan started with a substantiallylower savings and investment rate than the other Asian countries, but then had a surge
in its savings and a fall in investment after the Asian crisis. For China, both investment and savings rates were quite stable in the late 1990s, but show a distinct increase
after 2000. The absolute savings rate in China is a remarkable 45 percent, but this isalso true for Malaysia. The key difference between China and the other East Asian
countries lies in the levels of investment. China has investment levels similar to thoseof the East Asian Tigers in the mid-1990s—above 40 percent of GDP, while the latter

105

Figure 2 Ratio of Savings and Investment to GDP[1] China[2] Malaysia

0.48
0.46
0.44
0.42
0.40
0.38
0.36
0.34
0.32
0.30
1990

0.53
0.48
0.43
0.38
0.33
0.28
0.23
95

2000

05

0.18
1990

[3] Korea[4] Thailand

0.45

0.48

0.40

0.43

95

2000

05

95

2000

05

95

2000

05

0.38

0.35

0.33
0.30

0.28

0.25
0.20
1990

0.23
95

2000

05

[5] Indonesia
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
1990

0.18
1990
[6] Taiwan

0.30
0.25
0.20

95

2000

05

Savings/GDP

0.15
1990

Investment/GDP

countries have converged down to investment rates in the range of 20 to 30 percent ofGDP, comparable to those of the advanced economies. A similar pattern is seen in thecomparative growth rates among countries (not shown here). Growth rates in the East
Asian Tiger economies fell sharply after 1997, but recovered quickly. Subsequent
growth rates, however, were lower than those of the early 1990s, and in the range ofthe growth rates of the United States in the recent past. In contrast, China’s growthrate increased in the early 2000s to the 9–10 percent range.
Figure 3 is based on the “External Wealth of Nations” database of Lane and MilesiFerretti (2006). It shows the level of gross assets and gross liabilities to GDP, following
the measurement adjustments made in Lane and Milesi-Ferretti (2006). For the period

106 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Financial Globalization and Emerging Market Portfolios

Figure 3 Ratio of Gross Assets and Liabilities to GDP[1] China[2] Malaysia

0.6

1.4

0.5

1.2
1.0

0.4

0.8

0.3

0.6

0.2

0.4

0.1

0.2

0.0
1990

95

2000

05

0.0
1990

[3] Korea[4] Thailand

0.7

1.4

0.6

1.2

0.5

1.0

0.4

0.8

0.3

0.6

0.2

0.4

0.1

0.2

0.0
1990

95

2000

05

0.0
1990

[5] Indonesia[6] Taiwan

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0
1990

95

2000

05

Gross assets/GDP

0.0
1990

95

2000

05

95

2000

05

95

2000

05

Gross liabilities/GDP

Source: Lane and Milesi-Ferretti (2006).

since 1990, all countries have been net debtors except for Taiwan, which is a substantial net creditor, although China’s net foreign assets also turned slightly positive in 2002.
Net foreign assets for China and Korea are a relatively small share of GDP, while
Malaysia and Thailand have higher net debt positions. Although valuation adjustment
through equity prices and exchange rates in Lane and Milesi-Ferretti (2006) breakthe direct link between the current account and net foreign assets, all countries haveexhibited an increase in them in the current decade.
Note that Figure 3 emphasizes that all the countries have substantial gross positions
on each side. In particular, China, Korea, Malaysia, and Taiwan have experienced

107substantial “financial globalization,” in the sense that both gross assets and grossliabilities have approximately doubled, as a proportion of GDP, since the early 1990s.
Indonesia and Thailand differ somewhat. They have had a substantial increase in theratio of gross assets to GDP in the current decade, but liabilities were substantiallyhigher in the mid-1990s, well over 100 percent of GDP for both countries, and havecome down considerably since then.
Figure 4 illustrates the composition of gross foreign assets and gross foreign liabilities
between equity and debt instruments. Here, debt instruments include official reserve
assets and portfolio debt. Equity includes FDI and portfolio equity. The figure shows
Figure 4 Composition of Gross Foreign Assets and Liabilities(Debt Instruments versus Equity Instruments)[1] China[2] Malaysia

1.2

1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
1990

1.0
0.8
0.6
0.4
0.2
0.0
1990

95

2000

05

[3] Korea[4] Thailand

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
1990

1.2

95

2000

05

95

2000

05

95

2000

05

1.0
0.8
0.6
0.4
0.2
95

2000

05

0.0
1990

[5] Indonesia[6] Taiwan

1.2

1.0

1.0

0.8

0.8

0.6

0.6
0.4

0.4

0.2

0.2
0.0
1990

95

2000

05

Share of debt in total assets

0.0
1990

Share of equity in total liabilities

108 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Financial Globalization and Emerging Market Portfoliosthat on the assets side, for all countries, the biggest fraction is in debt instruments,
with only a small portion in equity and FDI instruments. Figure 4 also highlights aless well-known aspect of recent portfolio behavior for Asian economies. The
composition of gross external liabilities has switched strongly toward an increasing
share of equity and FDI. For China, at the beginning of the sample, 70 percent of
external liabilities were in debt instruments, and only 30 percent were in equity instruments. By the end of the sample, this proportion had been exactly reversed. Korea had
an equally dramatic increase in the share of liabilities attributed to equity. A similar
though less strong turnaround is seen in Malaysia, Thailand, Indonesia, and Taiwan.
Figure 5 shows that official reserves constitute a growing share of total assets inthe current decade, rising to an astonishing 35 percent of GDP for China in 2004.
Figure 5 Ratio of Official Reserves to Total Assets[1] China[2] Malaysia

0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
1990

0.6
0.5
0.4
0.3
0.2
0.1
95

2000

05

0.0
1990

[3] Korea[4] Thailand

0.35

0.35

0.30

2000

05

95

2000

05

95

2000

05

0.30

0.25
0.20

0.25

0.15

0.20

0.10

0.15

0.05
0.00
1990

95

95

2000

05

0.10
1990

[5] Indonesia[6] Taiwan

0.25

0.8

0.20

0.7
0.6

0.15

0.5
0.10

0.4

0.05
0.00
1990

0.3
95

2000

05

0.2
1990

109

This huge holding of low-yielding assets (mostly in U.S. dollar Treasury bills) has led
to an increasing debate in the economics literature in the last few years.

III. Explaining Asian External Balances
Two strong features of the data emerge from the previous section. First and mostprominently, all Asian countries generated large current account surpluses following
the Asian crisis, and these have persisted over the last seven or eight years. Second, mostcountries have also recorded substantial growth in both gross assets and liabilities, anddistinct changes in their national balance-sheet composition, generating large stocks
on foreign exchange rate reserves on the assets side, and substantial growth in theshare of equity and FDI on the liabilities side.
What explains the huge Asian surpluses in this decade? This question has generated
a huge amount of literature in the last few years. A number of alternative accounts havebeen presented. One view is that the persistent current account surpluses represent aform of hedging or precautionary saving against the possibility of future “sudden
stops,” or abrupt cut-offs from access to capital markets. Caballero and Panageas (2006)
develop a model of a small open economy subject to a risk of sudden stops, andexamine the behavior of saving under a variety of alternative possibilities for hedging
sudden-stop risk. They note that saving is higher in an economy with the risk of
sudden stops. Jeanne and Ranciere (2006) and Jeanne (2007) interpret the buildup in
foreign exchange reserves in Asian economies as a form of collective insurance against
sudden stops, where the public sector has an advantage in providing resources tosmooth out the consumption effects of sudden stops. Mendoza, Quadrini, and Ríos-Rull(2007) develop a model of precautionary saving in response to non-insurable idiosyncratic income risk, and show that it can account for substantial foreign exchange reserve
accumulation of the kind seen in the data. They argue that either financial liberalizationor hedging against sudden stops can provide an explanation for the recent growth inemerging economies’ foreign exchange reserves.
One problem with these theories of precautionary saving is that they all work on
the savings side, and therefore do not provide an adequate explanation for one of
the main features apparent in Figure 2: that a large part of the Asian current accountexpansion can be attributed to a fall in investment, rather than a rise in savings. As wenoted, for Korea, Malaysia, and Thailand, current account surpluses were substantiallydriven by an investment collapse, with savings relatively unchanged. An alternativemodel of “global imbalances,” developed in Caballero, Fahri, and Gourinchas (2006),
attributes the joint process of savings and investment in emerging markets to theabsence of financial markets by which savings may be converted into profitable assets.
They argue that a key feature of emerging economies is an “asset shortage.” Even
though these economies may have high growth rates, real domestic returns may be
low because of the absence of adequate instruments for saving, leading them to invest
in advanced economies, which can offer a supply of assets unavailable in emerging
markets. Caballero, Fahri, and Gourinchas (2006) show that such financial distortions
in emerging markets can explain why such countries could run current account

110 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Financial Globalization and Emerging Market Portfolios

surpluses with advanced economies. Moreover, they show that the same financial
distortions may lead to low rates of investment in emerging economies.
Relatively few commentators have focused on the nature of two-way capital flows
between emerging markets and advanced economies. Dooley, Folkerts-Landau, andGarber (2004) argue that emerging market current account surpluses represent a collateral payment for the risk of FDI in emerging markets, but do not offer an explicit
model of this process. Ju and Wei (2007) argue that there is a “bypass” process of capital
flows, whereby informational imperfections in financial markets in emerging economies
make it desirable for residents to invest in advanced economies and then receive FDIfrom these economies. Neither of these papers, however, takes a general equilibrium
portfolio approach, as is done here. We now turn to the explicit portfolio model.

IV. A Portfolio Model of Reserve Accumulation
In this section, we develop a simple dynamic portfolio model to determine the joint
determination of optimal reserve holdings and FDI accumulation. The model isadapted from Devereux and Saito (2006). There is an advanced economy and an
emerging market economy. There is a single world good, which can be consumed orinvested by agents in each country. Two structural features differentiate the advanced
economy (home) from the emerging market economy (foreign). In the advanced
economy, there is a single risky technology for producing output, while in theemerging economy there are two risky technologies, which we could think of as a
“traditional” and a “modern” sector. Investors in the home country can invest in
the modern sector of the foreign country. We refer to this as FDI. The second key
distinction between the two economies concerns the form of international tradedassets. We assume that bonds denominated in the home-country currency (e.g.,
the “dollar”) are traded between countries, but there is no trade in foreign currencydenominated bonds. This captures the empirical feature that world bond markets arestill dominated overwhelmingly by a few major currency denominations, with the U.S.
dollar still the dominant acceptable denomination. In the model, foreign holdings ofhome-currency bonds are defined as foreign exchange reserves of the foreign country.
The equilibrium of the model may be used to illustrate the joint dynamics of homecountry FDI and foreign exchange reserve accumulation of the foreign country.
The difference between the two determines the evolution of the foreign countries’ net
foreign assets.
A. The Model
The model is explained in more detail in Devereux and Saito (2006), so we give justa very brief description here. In the home country, there is a risky linear technologythat uses capital and generates expected instantaneous return D with standard
deviation D . In the foreign country, there are two technologies: a traditional and amodern technology, with returns T , M and standard deviations T , M, respectively.
Capital can be turned into consumption without any cost. The return on the hometechnology (in terms of the homogeneous good) is given by

111

dQ i
–––– = D dt + D dB,
Qi(1)

where dB is the increment to a standard Weiner process. For simplicity, we assume
that the returns on all three technologies are independent, and that the covariances
between dB, dBT*, and dBM* are all zero.
International financial markets are incomplete. This is captured by the fact that
foreign-country residents cannot directly purchase shares in the technology of thehome country, and home residents can only buy shares in the modern sector of theforeign country (FDI). Again, we do not explicitly endogenize this constraint, but see
it as reflecting the inability of residents of large emerging market countries such as
China to invest directly in external equity markets. We do, however, allow for tradein the home-currency nominal bond, and a real risk-free bond.
Nominal bonds are denominated in the home currency by assumption. Althoughnominal bonds are risk-free in dollar terms, their real returns are subject to inflation
risk. Home-country inflation is modeled as follows:
dPi = dt + vdM.
–––
Pi
Thus, inflation has mean  i and standard deviation v. dM represents the increment
to a standard Weiner process. We assume that dM and dB have covariance givenby the parameter , but dBT* and dBM* are independent of dM. Hence,  will be a
critical parameter, capturing the way in which returns on nominal bonds co-vary
with real returns on the home technology. If  < 0, as most of our discussion below
presumes, then real bond returns are procyclical. We discuss the evidence for thisassumption below.
Let the instantaneous nominal return on currency i bonds be Rˆi . Then the real
return on bond i is
(R i −  i )dt − vi dMi ,where R i = Rˆi + vi2 is an adjusted nominal interest rate. This will be determined
endogenously as part of the world bond market equilibrium.
The budget constraint for the home country may be written as
dW =W [D (D − r ) + N (R h − h − r ) + M (M − r ) + r ]dt− Cdt +W (T D dB − nvdM + M M dBM ),(2)

where W is home-country wealth, and D , N , and M are the portfolio shares,
respectively, of the domestic technology, home-currency nominal bonds, and FDI.
Hence, 1 − D − N − M represents the share of the real risk-free bond.

112 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Financial Globalization and Emerging Market Portfolios

The foreign-country budget constraint is written symmetrically asdW * =W *[T* (T − r ) + N* (R h − h − r ) + M* (M − r ) + r ]dt− C *dt +W *(T* T dBT − N* vdM + M* M dBM ),(3)

Each country is populated by a continuum of identical agents with preferences
given by

E 0∫ 0 exp(−t )lnCi (t )dt,

(4)

where  is the rate of time preference.
B. Optimal Consumption and Portfolio Rules
With logarithmic utility, consumers follow the myopic consumption rule:C = W,C * = W *.

Optimal portfolio rules for the home country may be obtained as the solution to−1
 D  D2 −Dv 0   D − r 20  R −  − r  .
 N  = −Dv v
M   00
M2   M − r (5)For the foreign country, the equivalent conditions are−1 *T  T2 0 0   T − r *M  =  0 M2 0  R h −  − r  .
*N   0 0 2  M − r (6)

C. Asset Market Equilibrium
At any moment in time, an equilibrium in the market for nominal bonds determines
the nominal rates of return Rh . The nominal bond market clearing condition requiresthat the sum of home and foreign demand for nominal home-currency bonds is zero:NW + *NW * = 0.

(7)

Note that the assumption here is that home-currency nominal bonds are in zero world
net supply. We could explicitly model a fiscal agency that issues home-currency bonds,
but this would have no impact on the equilibrium foreign holdings of these bonds.
We have also allowed for trade in a real indexed bond, again in zero net world
supply. The market clearing condition for the real bond is described as(D + N + M − 1)W + (*T + *N + *M − 1)W * = 0.

(8)

113

Using (5), these two conditions may be solved for R and r. Define =W */(W * +W )as the ratio of foreign wealth to world wealth. To simplify the presentation, we willassume for the rest of this section that T = M and T = M . That is, the two sectors in
the emerging market country have identical returns and volatilities. Then we can derive
the solutions:
R ( ) = Z ( )R D + (1 − Z ( ))R M ,(9)r ( ) = H ( )rD + (1 − H ( ))rM .

(10)

where R D = rD + (D2)/(D2 + M2 )(M − D − M2 ) + , rM = M − M2 , R M = rM + , andrD = (M2 D + D2M − D2M2 )/(D2 + M2 ). Here R D (R M ) denotes the equilibrium nominal
return on home-currency bonds when the home (foreign) country is arbitrarily
wealthy, that is, → 1 ( → 0), and Z ( ) is a function of parameters and such that
Z (0) = 1, and Z (1) = 0. Likewise, rD (rM ) denotes the equilibrium risk-free return
when the home (foreign) country is arbitrarily wealthy, that is, → 1 ( → 0), where
H ( ) is a function of parameters and such that H (0) = 1, and H (1) = 0.
Thus, solutions (9) and (10) indicate that the equilibrium world nominal and real
rates of return are time-varying weighted averages of the rates of return that would
hold were either country to become arbitrarily large, and the weights depend on therelative size of each country in world wealth. Note that R D is a function of both
home and foreign technology parameters, because home-country residents can invest
directly in the foreign technology, while R M depends only on the foreign technology.
In addition, because home inflation is independent of foreign technology, R M isindependent of  and v. On the other hand, for values of D ≈ M and  < 0, we have
R D > rD . This is because for  < 0, the real return on the home-currency bond co-varies
positively with the home portfolio. For home agents to hold the home-currency bond,it must pay a higher rate of return than rD .
Using (9)–(10) in (5), we may derive the equilibrium portfolio holdings. Define= M2 (1 − ) + D2(1 + )(1 − 2) > 0. Then we can compute the equilibrium
home-country FDI holding as(M − D)(1 − ) + D2(1 − 2)∼D = ––––––––––––––––––––––––.

(11)

The FDI share of the portfolio is increasing in the return on the foreign modern sector,
but decreasing in the volatility of this sector. FDI is also affected by the volatility of
the home sector. When D ≈ M , an increase in D2 increases FDI, but this may bereversed when M > D .
Using (9) and (10), we may also compute the share of reserves and risk-free bondsin the foreign country portfolio asD– −(M − D)(1 − 2) + M2 (1 − –),∼N* = − –––––––––––––––––––––––––––v 

114 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007(12)

Financial Globalization and Emerging Market PortfoliosD − M) + M2 − D2(1 − 2 –.
)∼R* = − ∼N* + (1 − ) 2(
–––––––––––––––––––––––



(13)

For D ≈ M and  < 0, foreign exchange reserves are always positive, but holdingsof risk-free real bonds may be positive or negative. The total holdings of bonds (thesum of risk-free bonds and nominal bonds) is positive when D ≈ M and M2 ≈ D2.
What determines demand for reserves? From (12), total reserve holdings are negatively related to the excess return on the foreign technology, M − D , and negatively
related to the volatility of inflation in the home country, v. When D ≈ M, demand
for reserves is increasing in the volatility of the foreign technology, M2.
Note that both FDI, reserve holdings, and overall bond holdings will be timevarying, moving as the share of the foreign country in world wealth changes.
The dynamics of are determined by variations in relative wealth levels, driven by
the budget constraints (2) and (3) in combination with each country’s saving andportfolio allocation decisions.2
To illustrate this process, take the special case where D = M and M2 = D2. Then
FDI and reserves may be written as(1 − 2)
∼D = ––––––––––––> 0,
2 − 2(1 + )(14)

D– ––––––––––––
(1 − )
 > 0.
∼N* = − –––v 2 − 2(1 + ) (15)

In this case, equilibrium FDI holdings are independent of the return and volatility oftechnology risk in each country, and depend only on and  . For a given value of ,FDI is declining in the absolute value of . This is because having a short position inhome-currency bonds allows some risk sharing for the home country (when  < 0),which acts as a substitute for investing in FDI.
In the symmetric case of (14) and (15), total reserve holdings are higher, thegreater the technology volatility. Reserves are increasing in (the absolute value of ) .
As  rises in absolute value, home-currency bonds become a better hedging asset for
the foreign country.
How do FDI and foreign exchange reserves depend on ? From (15), the relationship between and the FDI share is non-monotonic. For very low values of ,indicating that the home country is relatively wealthy, the foreign country has a highshare in FDI, while when is in an intermediate range, this share is somewhat lower.
Foreign exchange reserve holdings are negatively related to . When the home country
is very large, foreign exchange reserves are a large fraction of the foreign portfolio of
the foreign country. These diminish as the foreign country wealth rises.

2. Devereux and Saito (2006) discuss the conditions for the stability of theprocess.

115

The foreign country has a gross asset position equal to (∼N* + ∼R* )W *, its total bondclaims against the home country, and a gross liability position equal to ∼DW, the FDI
holding of the home country. We can then define net foreign assets of the foreigncountry, relative to world wealth, as nfa = (∼N* + ∼R* ) − ∼D (1 − ). Using the above
solutions, we obtain[(D − M) − D2(1 − 2 )](1 + ) + M2
nfa = (1 − )–––––––––––––––––––––––––––––––.
This may be positive or negative. Net foreign assets are higher, the higher the return on
the home technology relative to the foreign technology and the higher the volatilityof the foreign technology. Net foreign assets are lower, the higher the volatility of
the foreign technology. Again, net foreign assets will be time-varying in response to
movements in .
Figure 6 illustrates the relationship between and net foreign assets of the foreigncountry. The dynamics of are driven by relative growth rates and the underlying
technology shocks of the two countries. For a low , the foreign country is relatively
poor, and it is a net debtor, as the value of its FDI liabilities is large relative to its
external bond holdings. As rises, this situation is reversed, as it builds up a large
nominal and real bond claim on the rest of the world. As tends to unity, the foreigncountry would become dominant in the world economy, and its net foreign assets,
relative to world wealth, would trend to zero.3
Figure 6 Ratio of Net Foreign Assets to GDP

0.15
0.10
0.05
0.00
–0.05
–0.10
–0.15
–0.20
–0.25
–0.30
0.0

0.1

3. The long-run mean of
inflation rate process.

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

will be determined by the underlying parameters and volatility of technologies and the

116 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Financial Globalization and Emerging Market Portfolios

D. Quantitative Assessment
For the general case, Table 1 provides a rough quantitative assessment of the size of
FDI, foreign exchange reserve holdings, and total bond holdings implied by themodel. For this calculation we use the following calibration, based partially on U.S.
data. Assume that the real risk-free rate of return on capital is 6 percent, approximately
the long-run return to equity in the U.S. economy. The average real GDP growth rateof consumption since 1980 is approximately 3 percent, with a standard deviation of
1.7 percent. In a symmetric steady state, the real risk-free interest rate is  − ( 2/2),
and the expected consumption growth rate is  − ( 2/2) −  . Setting  = 0.017,
 − ( 2/2) = 0.06, and  − ( 2/2) −  = 0.03 requires that  = 0.0601 and  = 0.0301.
The volatility of U.S. inflation since 1980 is 1.3 percent, which guides our choice ofv = 0.013. For the foreign country, we assume that  and  are the same as the UnitedStates, but we assume a more volatile GDP process, setting M = 0.03, to match China’s
GDP volatility over the 1980–2004 period. In addition, we set = 0.5 for thebaseline case. Finally, a value of  = −0.6 is used, following the estimate of Kydland
and Prescott (1990). We then illustrate the model’s implications for alternative valuesof D2, M2, and v.
Table 1 measures the share of GDP held in each portfolio category. We compare thisto the measured shares of equity and FDI liabilities, reserve assets, total bond assets,
and net foreign assets for China in 2004, obtained from Lane and Milesi-Ferretti(2006). The baseline case in fact does a remarkably good job at matching the observed
asset and liability positions of China. The ratio of implied reserve assets to GDP is
38 percent, almost exactly that in the data, and the ratio of FDI liabilities to GDP is
29 percent, very close to the observed 33 percent in the data. The ratio of bond assets
to GDP is 41 percent in the model, and 39 percent in the data, while the overall net
foreign assets in the model are 6 percent, slightly less than the 8 percent in the data.
Table 1 also reports the implications of a higher volatility of foreign technology,
and a lower volatility of home-country technology, as well as a lower volatility ofhome-country inflation. An increase in M increases reserve assets, bond assets, andnet foreign assets, while decreasing FDI liabilities of the home country. Intuitively,
a rise in M increases the demand for home-country fixed-income assets, reducing therate of return R and reducing the equilibrium FDI liabilities of the home country.
A fall in v leads to a substitution out of real indexed bonds toward nominal bonds forthe foreign country, while leaving FDI liabilities, overall bond assets, and net foreign
assets unchanged. Finally, a fall in D leads to a fall in FDI liabilities, and a rise inreserve assets, real bond assets, and net foreign assets of the foreign country.
Table 1 China: Assets and Liabilities Relative to GDP
Percent
Data
Baseline
High M
Low
Low D

FDI liabilities
33
29
21
29
14

Reserve assets
37
38
47
57
31

Bond assets
39
41
59
41
71

Net foreign assets
8
6
19
6
29

117

In summary, the model implies that a growth in reserve holdings of emerging
market countries might be attributed to (1) a rise in volatility of emerging markets,(2) a fall in GDP volatility in advanced economies, or (3) a fall in the volatility of inflation in advanced economies. In each case, there is a rise in reserve holdings of emerging
economies, as well as a rise in the net foreign asset position of these countries.
In summary, we may conclude that in terms of accounting for the qualitative andto some extent quantitative features of portfolio shares for emerging market economies,
a simple model driven by aggregate macroeconomic risk alone is reasonably successful.

V. Conclusions
Emerging market economies in Asia have experienced a remarkable episode of highand stable economic growth during the current decade. One view is that this stability
is generated by these countries’ persistent current account surplus positions and theimplicit “hedging” potential that this provides against sudden stops. In this paper, wehave emphasized a different mechanism, based on portfolio diversification principles
and the growth of equity-based financing of Asian investment. A simple portfolio
allocation model can provide an interpretation of this phenomenon. A complete
explanation of gross and net capital flows in Asian economies, however, would require
combining this model with an account of the high savings rates in Asia. We leave thisissue for future research.

References

Caballero, R., E. Fahri, and P.-O. Gourinchas, “An Equilibrium Model of ‘Global Imbalances’ and Low
Interest Rates,” NBER Working Paper No. 11996, National Bureau of Economic Research, 2006.
———, and S. Panageas, “Hedging Sudden Stops and Precautionary Contractions,” NBER Working
Paper No. 9778, National Bureau of Economic Research, 2006.
Devereux, M. B., and M. Saito, “A Portfolio Theory of International Capital Flows,” CEPR Discussion
Paper No. 5746, Center for Economic Policy Research, 2006.
———, and A. Sutherland, “Solving for Country Portfolios in Open-Economy Macro Models,” CEPR
Discussion Paper No. 5966, Center for Economic Policy Research, 2006.
———, and ———, “Monetary Policy and Portfolio Choice in an Open Economy Macro Model,”Journal of the European Economic Association, 5 (2–3), 2007, pp. 491–499.
Dooley, M., D. Folkerts-Landau, and P. Garber, “The Revived Bretton Woods System: The Effects ofPeriphery Intervention and Reserve Management on Interest Rates and Exchange Rates in Center
Countries,” NBER Working Paper No. 10332, National Bureau of Economic Research, 2004.
Engel, C., and A. Matsumoto, “Portfolio Choice in a Monetary Open-Economy DSGE Model,” NBER
Working Paper No. 12214, National Bureau of Economic Research, 2006.
Evans, M., and V. Hnatkovska, “International Capital Flows, Returns and World Financial Integration,”
NBER Working Paper No. 11701, National Bureau of Economic Research, 2005.
Jeanne., O., “International Reserves in Emerging Market Countries: Too Much of a Good Thing?”
Brookings Papers on Economic Activity, 1, 2007, pp. 1–55.
———, and R. Ranciere, “The Optimal Level of International Reserves for Emerging Market Countries:
Formulas and Applications,” IMF Working Paper No. 06/229, International Monetary Fund, 2006.
Ju, J., and S.-J. Wei, “Domestic Institutions and the Bypass Effect of Financial Globalization,” NBER
Working Paper No. 13148, National Bureau of Economic Research, 2007.

118 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Comment

Kydland, F., and E. Prescott, “Business Cycles: Real Facts and a Monetary Myth,” Quarterly Review,
Federal Reserve Bank of Minneapolis, 14, 1990, pp. 3–18.
Lane, P. R., and G. M. Milesi-Ferretti, “The External Wealth of Nations: Measures of Foreign Assets andLiabilities for Industrial and Developing Countries,” Journal of International Economics, 55, 2001,
pp. 263–294.
———, and ———, “The External Wealth of Nations Mark II: Revised and Extended Estimates ofForeign Assets and Liabilities, 1970–2004,” IMF Working Paper No. 06/69, International
Monetary Fund, 2006.
Mendoza, E., V. Quadrini, and J. V. Ríos-Rull, “Financial Integration, Financial Deepness, and Global
Imbalances,” NBER Working Paper No. 12909, National Bureau of Economic Research, 2007.
Tille, C., and E. van Wincoop, “International Capital Flows,” NBER Working Paper No. 12856,
National Bureau of Economic Research, 2007.

Comment
GEORGES PINEAU
European Central Bank
I would like to thank in particular the organizers of the conference for having invitedme. I should stress from the start that these are my personal views. They do notcommit my own institution.
My comments will first examine some elements of the model, which as you know
is an extension of a portfolio optimization framework to emerging markets. The
important feature is financial market incompleteness to rationalize gross international
capital flows among mature and emerging economies, which makes it also relevantfrom the perspective of global imbalances. (I will come back to this.) The second partof my comments will focus on international financial risk-sharing as far as emerging
markets are concerned. I will try to show differences with mature economies, the roleof market incompleteness and exchange rates, and I will have a short conclusion on
policy implications. The question of optimality, in particular as reflected in the way themodel is incorporating or accommodating market inefficiencies, will be touched on as
well as the implications this could have for the assessment of risks associated with
global imbalances. In this respect, I would tend to think that the current situation
might be less benign than the model might suggest.
On the model itself, the paper is concerned with the participation of emerging
markets in international financial risk-sharing, mainly through increased balance-sheet
size, and through portfolio optimization, although under constraints. (I will come backto this.) The implicit policy message is that global imbalances are seen as the outcomeof a balance-sheet optimization process. The net external position is a rather benign
outcome of optimal balance-sheet leveraging and portfolio diversification, underconstraints, and I think these constraints are important in this respect.
As already mentioned by the author, today’s paper is an extension of Devereux andSaito (2006). An important point here is that Devereux and Saito (2006) assume
complete financial markets, because there is effective financial risk-sharing among
mature economies. Today’s paper is looking at an emerging market in relation to amature economy, and as stressed by the author, the important assumption is market

119

incompleteness. As I said, one of the specific contributions of the paper is that it is a
general equilibrium approach, so in a way there is some reference to Dooley, FolkertsLandau, and Garber (2004), except that those authors do not use a general equilibrium
model to account for this distribution of assets and liabilities as far as mature economies
and emerging economies are concerned. Today’s paper addresses both the matureeconomies and the emerging economies in one global approach, which differs from theapproaches taken by Tille (2005) or Jeanne and Ranciere (2006).
I will try to comment on some of the features of the model. As I already mentioned,
the savings and investment net positions are not accounted for by the model, but themodel focuses on the composition of gross assets and liabilities. At the same time, one
may want to recall that savings-investment net positions are relevant for capital flows
as shown in Prasad, Rajan, and Subramanian (2006). I will return to this in a moment.
In Devereux and Saito (2006), the main diversification driver is the cyclicality or
differences in cyclicality in inflation and real returns, that is, the fact that in the
United States price developments tend to be countercyclical, while in other matureeconomies it is not the case, which means that monetary policy, as well as nominal
exchange rates, are important for cross-border financial risk-sharing.
In today’s paper, the main driver relates to differences in technology, in particular,
disparity in volatility of real returns. There is no role for the cyclicality of prices inrelation to GDP, and one possible reading is that the exchange rate does not have any
bearing either. On this issue of volatility, in particular of the business cycle in the
United States, which is an important driver for the emerging economy to invest inbonds in the United States, Figure 1 just shows that it is true when one looks at the
Figure 1 U.S. Business Cycle Volatility and Current Account

0.5

Current account as a percentage of GDP

0.000400.000350.0

0.000300.00025–0.5

0.00020–1.0

0.000150.00010–1.50.00005
0.00000

19
60
/Q
1
19
65
/Q
1
19
70
/Q
1
19
75
/Q
1
19
80
/Q
1
19
85
/Q
1
19
90
/Q
1
19
95
/Q
1
20
00
/Q
1
20
05
/Q
1

–2.0

Current account deficit (left scale)Conditional volatility – GARCH(1,1) (right scale)
Source: European Central Bank staff calculations based on Fogli and Perri (2006).

120 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Comment

conditional volatility of the business cycle that there has been a significant decline in
the United States, and this has been associated with the widening of the current
account deficit in the United States. Of course, one interpretation of this development is also that this lower volatility of the business cycle or the “great moderation”
might imply lower precautionary savings in the United States, which is reflectedin the negative current account position. The interpretation in today’s paper is that it
is also an incentive for the foreign country to invest in the United States, because
it provides stability or a good hedge compared with the volatility of technology or
returns in the foreign country.
I will now try to focus more specifically on certain assumptions or parameters ofthe model. The first one is whether the incomplete market assumption is too restrictive, in a way. The question there is that by imposing such strong restrictions, inother words, the fact that the emerging country can invest only in bonds while thedomestic country can invest only in equity or contingent liabilities, the author might
affect negatively the meaningfulness of the portfolio optimization model. Specifically,
as said in the paper, the risk-return trade-offs are not endogenized because theserestrictions are imposed.
Related to that, one question is whether this assumption—that is, this rather
strong limitation on opportunities for investment by the home country or the foreigncountry—is in line with actual constraints in terms of capital account restrictions, orin terms of actual capital flows. One may just consider that of course there is not
only the possibility for mature economies to invest in foreign direct investment (FDI)
with the development of emerging economies’ local bond markets, and at the sametime it is also possible for emerging markets to invest in types of mature economies’
securities other than sovereign bonds. One thinks of the setting up of sovereign
wealth funds by emerging economies, and this is an empirical issue that is importantto keep in mind.
The exchange rate is pegged, at least implicitly, because what is important for theforeign country is the conduct of stability-oriented monetary policy by the homecountry. This also might be seen as a consequential restriction, because it reduces risk
diversification opportunities. Another question is the equivalence between policymotivated preferences by the official-sector investors and profit-oriented portfolio
optimization decisions by private-sector agents.
Another interesting feature is the assumption that returns on home assets dependon both home and foreign technologies, while returns on foreign assets are related
only to foreign technology. Then the question is whether U.S. interest rates are more
influenced by developments in the emerging markets than the reverse. At least thiswould be one implication of this assumption in the model.
The last point is about the simulation itself. The wealth share of the foreigncountry, 50 percent, seems to be retained to replicate the current foreign exchange
reserves and FDI ratios in the United States and China. It seems that the actual sharemight be lower, and this would imply that we have not yet reached a steady state,
and then this would entail further increase in global imbalances or balance sheets.
I come to the international financial risk-sharing issue. I will be quick on that,just to recall that dynamic stochastic general equilibrium (DSGE) models have been121

predicting stronger international financial risk-sharing in emerging economies than is
supported by evidence. This is the so-called “quantity anomaly,” and the main factor
behind it relates to incomplete international financial markets in emerging economies.
This is confirmed empirically. There is a recent paper—which was mentioned
this morning—by Kose, Prasad, and Terrones (2007), showing that even the recent
increase in the size of balance sheets of emerging markets has not improved theirability to share risk internationally. There is no consumption smoothing, and thereason is a so-called threshold effect, that is, the underdevelopment of domestic
financial markets.
Linked to that is the question of whether there is optimality, since it is unclear towhat extent emerging markets are benefiting from portfolio diversification/optimization. The question is whether they should not address first market imperfections as far
as their domestic financial sectors are concerned.
The other question is the sign of net external positions and use of foreign savings
by emerging countries. Prasad, Rajan, and Subramanian (2006) show that there is no
negative correlation between GDP growth and current account position in emerging
markets, in contrast to developments observed in mature economies. Again, it is due
to either incomplete domestic financial markets or undervalued exchange rates. Just to
take an example, the case of more complete financial markets is illustrated by the newmember states of the European Union (EU), which have negative net external positions
in line with the standard assumption that capital flows are going downstream. Also,
positive FDI into those countries is reflecting a lack of domestic savings and the absenceof capital account restrictions. In addition, strong credit growth in those countries,
partly funded from external sources, enables consumption smoothing.
Keeping this example of the new EU member states in mind, the last point is about
the issue of exchange rate level, which is also a factor mentioned by Prasad, Rajan, andSubramanian (2006). A point to stress is that if one looks at the International Monetary
Fund estimates of equilibrium exchange rates for relevant new EU member states andrelevant Asian emerging market economies, you see that the EU member states havealigned or overvalued exchange rates while 50 percent of Asian emerging markets haveundervalued exchange rates.
Next, policy implications. I would say that there is an ambiguous outcome offinancial globalization in emerging markets, since it reflects in part market distortions/inefficiencies, which constrain full use of portfolio optimization. There is a needfor emerging markets to develop (more) complete domestic financial markets tomitigate distortions and reap the benefits of more efficient domestic and international
resource allocation. Also, with domestic financial deepening there would be lessneed to manage capital flows and exchange rates, while emerging countries would
be better able to rely on foreign savings to enhance domestic absorption. The lastpoint is that another welfare-enhancing outcome of addressing these domestic
distortions in emerging markets, as far as financial sectors are concerned, would beto reduce the risk of disorderly market developments associated with persisting
global imbalances.

122 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Comment
References

Devereux, M., and M. Saito, “A Portfolio Theory of International Capital Flows,” CEPR Discussion
Paper No. 5746, Center for Economic Policy Research, 2006.
Dooley, M., D. Folkerts-Landau, and P. Garber, “The Revived Bretton Woods System: The Effects ofPeriphery Intervention and Reserve Management on Interest Rates and Exchange Rates in Center
Countries,” NBER Working Paper No. 10332, National Bureau of Economic Research, 2004.
Fogli, A., and F. Perri, “The Great Moderation and the U.S. External Imbalance,” Monetary andEconomic Studies, 24 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2006,
pp. 209–225.
Jeanne, O., and R. Ranciere, “The Optimal Level of International Reserves for Emerging Market Countries:
Formulas and Applications,” IMF Working Paper No. 06/229, International Monetary Fund, 2006.
Kose, M., E. Prasad, and M. Terrones, “How Does Financial Globalization Affect Risk Sharing?
Patterns and Channels,” Conference on New Perspectives on Financial Globalization held by
the International Monetary Fund in Washington, D.C., on April 26–27, 2007.
Prasad, E., R. Rajan, and A. Subramanian, “Patterns of International Capital Flows and Their Implications
for Economic Development,”Proceedings, Federal Reserve Bank of Kansas City, 2006, pp. 119–158.
Tille, C., “Financial Integration and the Wealth Effect of Exchange Rate Fluctuations,” Federal Reserve
Bank of New York Staff Report No. 226, Federal Reserve Bank of New York, 2005.

Comment
MARK M. SPIEGEL4
Federal Reserve Bank of San Francisco
I would like to thank the Bank of Japan for organizing this conference and inviting
me, and in particular for asking me to discuss today’s paper. I really enjoyed it.
One way to place the contribution of this paper is to ask, “What are the uniquecharacteristics of emerging Asian economies relative to the rest of the world?” We
might have a shopping list along these lines: Asian economies tend to have highsavings rates. They tend to currently be running large current account surpluses.
Many of them have huge holdings of foreign reserves, which in reference to this paper
one could characterize as fixed-income assets. They are also a popular destination
for portfolio equity and for foreign direct investment (FDI), which in the context of
this paper we would characterize as variable-income assets.
As this paper also notes, Asian nations have become much more financially integrated with the rest of the world. There has been a big increase in gross positions ofAsian external assets and liabilities, much bigger than the net rate of increase in theseassets. This pattern is not unique to Asia. It is exhibited by other economies anddeveloped countries as well, as noted in recent research by Lane and Milesi-Ferretti(2006). Today’s paper asks, “Can we use the recent phenomenon of increased grosspositions in assets and liabilities to explain the other unique characteristics of Asian
economies listed above?”
There is a burgeoning literature examining the phenomenon of large gross asset
positions. Caballero, Fahri, and Gourinchas (2006) address this question in terms of
4. Opinions are my own and not necessarily those of the Federal Reserve Board or the Federal Reserve Bank of
San Francisco.

123segmented financial markets. In their paper, savings instruments are only available in
the North, but FDI can move from North to South, resulting in a pattern of investment similar to the one derived in today’s paper. Another related paper is Evans and
Hnatkovska (2006), which looks at different intensities of market segmentation.
They ask the question, “What happens when there is a move to full integration ininternational financial markets?” They find that when you go to full integration,
where the agents can invest in both their own and foreign equities, there is a large
decrease in trade in bonds. This would suggest that part of the big increase in grosspositions in bonds is attributable to the market segmentation discussed in today’s
paper. Finally, Devereux and Sutherland (2006) also solve for optimal gross asset
positions under segmented markets.
The model in today’s paper has two countries: there is an advanced economy, which
has a single technology, and an emerging economy that has two sectors, a traditional
sector, and a modern sector. The modern sector is only operable by FDI from theadvanced country.
The assumption of complete market segmentation in this manner is strong. Agentsin the South cannot invest in equities in the advanced technology. They cannot buy
shares in, say, Goodyear, which will then invest in a plant in the emerging market
economy. In addition, the advanced economy is also segmented in the sense that it
can only invest in the modern sector of the emerging economy. It cannot invest in the
traditional sector. To defend this strong assumption, which buys a lot of analytic
simplification, today’s paper uses the example of China, which is a net creditor insecurities, but also an important destination for FDI.
The advanced economy assets include internationally tradable bonds, which aredenominated in the home-country currency, and equity shares in the home-country
multinational, which are not internationally tradable. In the emerging economy, there
are also bonds denominated in the home-country currency, but they are completely
non-tradable. Instead, the emerging economy agents can hold advanced-country bondsthat are associated in the model in the paper with international reserves, and in thecalibration exercise are associated with the level of reserves held by China. There isalso a risk-free asset in the background in this model that bears some analysis, butmainly it is there to simplify the analytics.
So what are the results of the model? First, the model demonstrates that the FDI
share of the advanced-country investment portfolio is increasing in the return on
FDI, decreasing in the volatility of return on FDI, and if the expected returns in
the home sector are close to those of the FDI (meaning the modern technology
investment in the emerging market countries), the FDI share is also increasing in thevolatility of home-sector returns. These are all very intuitive results. The second set ofresults concerns the “reserve holdings” of the emerging market country agents. Reserve
holdings are decreasing in the excess return on FDI, decreasing in advanced-country
inflation volatility, and if expected returns in the home sector are sufficiently close
to those of FDI, also increasing in the volatility of FDI. All of these relationships are
pretty intuitive, as well.
We get stronger results if we look at a special symmetric case, where the expected
returns in the South’s modern sector are sufficiently close to the expected return in

124 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Comment

the advanced-country modern sector. If those expected returns and their variances areroughly the same, FDI is decreasing in the absolute value of the covariance between
inflation and the home technology shock, a parameter labeled  in the paper.
The intuition behind this result is that when  increases in absolute value (fornormal parameter values, we would expect that  would tend to be a negative term),
this raises the degree to which you can hedge by having a short position in domestic
bonds. When you are able to hedge more, in terms of having a short position indomestic bonds, your overall portfolio becomes less risky. In the case of the UnitedStates–China example, this would correspond to having China hold more of yourcountry’s bonds. Part of the reason that agents in the North engage in FDI is that
FDI is a vehicle for hedging. When the absolute value of  increases, the reduction
in risk from holding short positions in domestic bonds is greater. As a result, theNorthern agents have less incentive to engage in FDI, which is an alternative source ofhedging. In the special symmetric case where the returns are expected to be the same,the only incentive for being in one asset or another is due to risk considerations.
The other result in the symmetric case is that the total reserves held by the emerging market economy are going to be increasing in the absolute value of  as well.
The intuition here is that for the emerging economy, an increase in the absolute valueof  improves the hedging performance of the advanced-country bonds, raising thedemand for these assets by agents in the emerging economy.
The calibration exercises in the paper provide some further results. Southern
reserve positions are increasing in emerging market volatility, which is intuitive as theSouthern demand for hedging opportunities provided by these assets is increased.
Reserve positions are also found to be decreasing in advanced-country inflation and
GDP volatility. Again, these results are intuitive, as the quality of advanced-country
bonds as hedging vehicles is decreasing in both of these arguments.
Let me turn now to some comments. Before criticizing the paper, I would like topraise it, because I think that it is a very nice treatment and that the basic idea andthe results in the paper are quite intuitive. Recall that the basic assumptions arethat production in the emerging economy under the advanced technology is only
available through FDI, and that Southern owners of capital in an emerging economy
cannot directly buy equity in advanced multinationals. Because Southern owners ofcapital want to produce under the modern technology, they effectively lend money tothe multinationals by purchasing advanced-economy bonds. These then get repatriated to the emerging market economy through FDI. These very simple, albeit strong,
assumptions deliver the expansion of the gross positions that are observed in the data.
My first comment is, is this really an Asian story? The assumptions in the model
might be considered a little heavy-handed for leading Asian economies. As wediscussed, there is a lot of market segmentation in the paper. Emerging economies arecompletely prohibited from buying equity shares in the multinationals of theadvanced country. These assumptions are motivated in the paper by the restrictions
that exist on Chinese capital outflows.
However, if we look at the data, it does not appear to be the case that the growthof equity in total liabilities has been exceptional in Asia. Figure 1 depicts the valueof this ratio for China, Korea, and the ASEAN economies as a group, as well as the125Figure 1 Share of Portfolio Equity and FDI in Total Liabilities, 1998–2004

0.8

Ratio

0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
1998

2001
Non-Asia EMBI

China

04
Korea

ASEAN

non-Asia Emerging Market Bond Index (EMBI) countries as a control.5 It can beseen that with the exception of Korea, the rate of growth in the share of equity intotal liabilities has not been exceptional. The growth in this share in either the
ASEAN economies or China from 1998 to 2004 has been modest relative to the
non-Asian emerging bond market countries.
Second, what of the contention that purchases of foreign reserves by agents in theSouth are financing FDI from North to South? Let us concentrate on China, whose
restrictions on capital outflows have been stressed to motivate the segmented markets
assumptions maintained in the model. Figure 2 shows the ratio of equity in the total
liability portfolio as well as the level of reserve holdings. As we all know, there has
been a large buildup in Chinese foreign exchange reserves in recent years. However,the share of FDI and portfolio equity and overall Chinese liabilities was almost as
high in 1998 as it was in 2004. So, whatever is driving this big increase in reserves,it does not look like it is gross movement of positions trying to finance additional
FDI holdings.
The pattern of Korean equity shares in Figure 1 appears to match the predictionsof the model more closely, but I am afraid that it may be a little harder to accept
the restrictions which the theory placed on the capital account for the Korean case.
In particular, Koreans do not face restrictions on capital outflows, such as purchasesof foreign equities. An alternative plausible story is that Korea, along with a numberof other East Asian emerging market economies, was “overbanked” in the 1990s, andthe growth in the equity share in liabilities in these countries represented a recovery
from very low portfolio investment shares after the 1997 Asia crisis.
5. The non-Asian EMBI countries in our sample include Argentina, Bolivia, Brazil, Bulgaria, Ecuador, Mexico,
Morocco, Nigeria, Panama, Peru, Poland, Russia, South Africa, and Venezuela.

126 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Comment

Figure 2 China, 1998–2004

0.8

Ratio

US$ millions

0.7

700
600

0.6

500

0.5
400
0.4
300
0.3
200

0.2

100

0.1
0.0

0
1998

2001

04

Share of FDI and portfolio equity in total liabilities (left scale)Foreign currency reserves, excluding gold (right scale)

One alternative to the risk-hedging motivation posited in today’s paper to explain
the buildup in gross asset positions is the so-called “mercantilist motive,” which
would explain reserve buildups by Asian nations as efforts to resist exchange rate
appreciation (e.g., Dooley, Folkerts-Landau, and Garber [2003]). The mercantile
story could also, unlike this story, partially explain imbalances in the current account,as Southern countries build up stocks of foreign reserves as “collateral” against future
opportunistic behavior against multinationals operating in their country.
Lastly, one issue that is unresolved in the paper is that the net Asian positions,that is, the large current account surpluses currently run by these nations, remain
unexplained. Savings rates are taken as given in this model, so the net position is notgoing to be explained, except to the extent that savings can be influenced by changes
in hedging opportunities. One might take this as a weakness of the paper, in that thebuildup in large gross positions in many Asian nations may be related to theirbuildups in large net positions, but this model is relatively silent on this issue.
One interesting issue that could be confronted with this model concerns thewelfare effects of incomplete markets. Even given the strict segmentation in this model,
the ability to build up gross positions to circumvent this restriction may indicatethat the welfare costs might not be that high if alternative forms of finance could serve
as substitutes. Still, the simple model presented above is missing a lot of real-world
frictions associated with FDI to run this kind of a horse race, such as issues ofsovereign risk and technology transfer.
To conclude, I would say that I learned a lot from this paper, and I think it is agood way to start to address the question of large buildups of gross asset positions.

127

This model could be used to yield measures of the gains from increased financial
integration that previous works cannot, because they do not concentrate on the optimal
agent portfolios.
However, while this paper suggests that market segmentation can contribute tounderstanding portfolio positions in emerging Asia and its main trading partners,
I am not sure if this channel is the whole story. In particular, I think there is still a lotof room for proponents of the argument that mercantilist motivations have driven
the runup in holdings of foreign reserves in these nations, in particular due toexchange rate policies. It may also be the case that this model is better fitting to otheremerging market economies, say, in Latin America, than those in Asia. I think thatthe assumptions of the model, such as the restrictions on international capital movements, appear to best fit China over this period, but when we look at the data, other
Asian nations such as Korea match the empirical predictions of the model better.
It seems difficult to come up with an Asian case that matches both.

References

Caballero, R. J., E. Fahri, and P.-O. Gourinchas, “An Equilibrium Model of ‘Global Imbalances’ and Low
Interest Rates,” NBER Working Paper No. 11996, National Bureau of Economic Research, 2006.
Devereux, M. B., and A. Sutherland, “Solving for Country Portfolios in Open-Economy Macro Models,”
CEPR Discussion Paper No. 5966, Center for Economic Policy Research, 2006.
Dooley, M., D. Folkerts-Landau, and P. Garber, “An Essay on the Revived Bretton Woods System,”
NBER Working Paper No. 9971, National Bureau of Economic Research, 2003.
Evans, M., and V. Hnatkovska, “Solving General Equilibrium Models with Incomplete Markets andMany Assets,” mimeo, Georgetown University, 2006.
Lane, P. R., and G. M. Milesi-Ferretti, “The External Wealth of Nations Mark II: Revised and Extended
Estimates of Foreign Assets and Liabilities, 1970–2004,” IMF Working Paper No. 06/69,
International Monetary Fund, 2006.

General Discussion
Responding to the comments by the discussants, Michael Devereux first stressed thatthe assumption of market segmentation was not only important but also realistic. He
stated that it was possible to have market segmentation in the model across anotherdimension, for example, by assuming that some U.S. assets are non-tradable andsome are tradable. With such an assumption, however, he claimed that the model
would have similar results. As for the issue of the savings-investment position and thecurrent account, he replied that his general equilibrium model actually determined
the long-run distribution of net foreign assets endogenously, although the model did
not provide a good explanation for the massive buildup of current account surpluses in
East Asian countries over the last eight or nine years. With regard to the issue ofChina’s modest increase in the share of foreign direct investment (FDI) in its externalliabilities relative to its large increase in foreign exchange reserves, he remarked thatthe model did not necessarily predict a concurrent increase in both FDI and foreignexchange reserves.

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General Discussion

In the general discussion, several participants pointed to the implicit role of precautionary saving motives in Devereux’s model. Maurice Obstfeld (University of California
at Berkeley) proposed an alternative view: that in face of the increased uncertainties
in the environment following the financial crises of the late 1990s, agents in East Asian
countries decreased their illiquid investments and accumulated liquid investments. This
could result in increased foreign exchange reserves. Devereux accepted the view andreplied that the shift of savings into liquid assets may be responsible for the decline ininvestment. Anton Braun (University of Tokyo) pointed out that the precautionarysaving motive was, in fact, operating in Devereux’s model.
Several participants commented on the issue of the equity premium from theperspective of financial globalization. Obstfeld argued that one of the puzzling things
about China’s reserves portfolio was that it earned so little in comparison withthe returns paid to its FDI liabilities and that this was not fully explained by risk
aversion. He acknowledged that the issue was beyond the scope of Devereux’s modeland remarked that understanding the equity premium at the global level could bevery important. Devereux replied that it was still an open question whether theequity premium existed or not and depends on how the data are treated. Kenichiro
Watanabe (Bank of Japan) argued that the same investment opportunities in emerging
markets could yield different returns depending on who invested in them: for example,
U.S. multinational firms or local investors. Watanabe claimed that the difference inreturns seemed to be one reason why FDI has replaced emerging market domestic
investments. Devereux agreed with Watanabe on this viewpoint.
In relation to the issue of the goodness of fit of the model to the data, several
participants made comments by referring to country experiences. Shaghil Ahmed(Board of Governors of the Federal Reserve System) claimed that Devereux’s explanationon the level of foreign exchange reserves could not be applied to changes in recent years
in Chinese reserves. Referring to Chinese data, Ahmed emphasized that the surge in
foreign exchange reserves in tandem with the surge in the current account surplus overthe past few years remained unexplained by the model. Devereux replied that the levelof foreign exchange reserves could be changing in the model alongside net wealth, but
he did not try to capture this relationship. Braun suggested that it would be interesting
to separate government and private-sector savings to see what was going on behind thepatterns in the savings rates. He also claimed that the view about output stability in
Korea before 1998 was very different from that after 1998 and that the model could be
used to explore which configuration of model parameters could reproduce the change
in output stability. Sanghoon Ahn (Korea Development Institute) suggested threeobservations to be explained by the model in East Asian countries, especially in Korea:(1) countries (including Korea) that experienced the financial crises in the late 1990s
dramatically improved their current account position and this seemed to be related tothe significant depreciation of their currencies; (2) Korea’s current account surplus
appeared to be narrowing, mainly because of the large increase in the services balance
deficit; and (3) Korea’s high savings rate could be explained by savings in the corporate
sector, while household savings were declining very rapidly.
Several participants posed questions about the modeling and its implications.
Ippei Fujiwara (Bank of Japan) asked about the implications of the model for optimal

129monetary policy in the global economy. He pointed out that the model seemed to besuggesting that, and contrary to conventional wisdom, monetary policy should notcompletely stabilize price developments. Devereux replied that this unconventional
implication was simply due to a feature of the assumptions in the model that theprice level was determined exogenously. Hans Genberg (Hong Kong Monetary
Authority) asked why the model needed to include traditional technology and therisk-free bond. Devereux replied that a traditional sector was necessary for setting up
incomplete markets and a risk-free bond was merely for ensuring the algebra made iteasier to obtain clear-cut solutions.

130 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007