Monetary policy shocks and portfolio choice - European Central Bank

Wo r k i n g Pa p e r S e r i e s No 1122 / december 2009

Monetary Policy Shocks and Portfolio Choice

by Marcel Fratzscher, Christian Saborowski and Roland Straub

WO R K I N G PA P E R S E R I E S N O 112 2 / D E C E M B E R 20 0 9

MONETARY POLICY SHOCKS AND PORTFOLIO CHOICE 1 by Marcel Fratzscher 2, Christian Saborowski 3 and Roland Straub 2

In 2009 all ECB publications feature a motif taken from the €200 banknote.

This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=1513205.

1 We would like to thank Jean Imbs, Robert Kollmann, Roberto Rigobon, John Rogers, Roberto de Santis, Lucio Sarno, Raf Wouters and seminar participants at ECARES of Université Libre de Bruxelles and the European Central Bank for helpful comments. The views expressed in this paper are solely our own and do not necessarily reflect those of the European Central Bank or the Eurosystem. 2 European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany; e-mail: [email protected] and [email protected] 3 University of Warwick, Coventry CV4 7AL, United Kingdom; e-mail: [email protected]

© European Central Bank, 2009 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Website http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily reflect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb.europa. eu/pub/scientific/wps/date/html/index. en.html ISSN 1725-2806 (online)

CONTENTS Abstract

4

Non-technical summary

5

1 Introduction

7

2 Decomposing net capital flows

10

3 The empirical model 3.1 Model specification 3.2 Identification of monetary policy shocks

12 12 14

4 Estimation results 4.1 The response and composition of capital flows 4.2 Variance decomposition 4.3 Robustness analysis

17

5 Conclusions

26

References

28

Appendix

32

European Central Bank Working Paper Series

47

17 22 24

ECB Working Paper Series No 1122 December 2009

3

Abstract The paper shows that monetary policy shocks exert a substantial effect on the size and composition of capital flows and the trade balance for the United States, with a 100 basis point easing raising net capital inflows and lowering the trade balance by 1% of GDP, and explaining about 20-25% of their time variation. Monetary policy easing causes positive returns to both equities and bonds. Yet such a monetary policy easing shock also induces a shift in portfolio composition out of equities and into bonds, implying a negative conditional correlation between flows in equities and bonds. Moreover, such shocks induce a negative conditional correlation between equity flows and equity returns, but a positive conditional correlation between bond flows and bond returns. The findings thus provide evidence for the presence of a portfolio rebalancing motive behind investment decisions in equities, but the dominance of what is akin to a return chasing motive for bonds, conditional on monetary policy shocks. The results also shed light on the puzzle of the strongly time-varying equitybond return correlations found in the literature. Keywords: monetary policy, trade balance, capital flows, portfolio choice, asset prices, United States, vector auto regressions, sign restrictions. JEL Classification: F4, E52, G1, F32.

4


Non-technical summary The current …nancial crisis has been preceded for several years by substantial global imbalances in trade and capital ‡ows. In particular, the United States has not only been the origin of the …nancial crisis, but it had been among the economies globally relying most heavily on capital in‡ows to …nance a large and growing trade de…cit. At the same time, a number of observers have argued that accommodative monetary policy over the past decade has been a key culprit behind these imbalances by inducing the build-up of excess liquidity, a rise in …nancial leverage and a boom in asset prices. This, in turn, may have contributed to a surge in private consumption, in part due to wealth e¤ects, and ultimately to a rising US current account de…cit (e.g. Taylor 2009). The role of monetary policy thus warrants closer scrutiny in order to understand how it may have contributed to the dynamics of capital ‡ows, both in terms of their size and their composition. Moreover, the focus on the e¤ect of monetary policy shocks on the direction and composition of capital ‡ows allows us to contribute to the debate on the determinants of portfolio choice, and how asset price movements are related to portfolio decisions of investors across countries as well as across …nancial asset classes. This paper tests empirically the e¤ect of US monetary policy shocks on the composition of US capital ‡ows and the US trade balance, and its channels. It employs a standard structural VAR speci…cation to identify monetary policy shocks, relying on sign restrictions imposed on the impulse response functions of a few macroeconomic variables. The empirical analysis yields two key …ndings. First, US monetary policy shocks exert a statistically and economically meaningful e¤ect on US capital ‡ows. An exogenous easing of US monetary policy by 100 basis points (b.p.) induces net capital in‡ows and a worsening of the US trade balance of around 1% of GDP after 8 quarters. The variance decomposition indicates that US monetary policy shocks over the period 1974 to 2007 explain about 20-25% of the variation in both the US trade balance and capital ‡ows at that horizon. As to the channels, it appears that wealth e¤ects play a central role. Equity returns rise on impact by about 6% in response to a 100 b.p. policy easing, while interest rates fall. Both of these responses in turn induce an increase in private consumption for about 8 quarters, and thus a deterioration in the trade balance. The second main …nding focuses on the e¤ect of monetary policy shocks on the composition of US capital ‡ows. The intriguing …nding is that an exogenous US monetary policy easing causes net in‡ows in debt securities, foreign direct investment (FDI) and other investment, while inducing net out‡ows in portfolio equities from the United States. Monetary policy shocks thus entail a conditional negative correlation between ‡ows in portfolio equity and debt. By contrast, monetary policy shocks induce a positive conditional correlation in equity returns and bond returns, as is well known in the literature. Moreover, they cause a negative conditional correlation between equity ‡ows and equity returns, but a positive conditional correlation between bond ‡ows and bond returns. The …ndings are robust to a battery of extensions and sensitivity


5

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6


1

Introduction

The current …nancial crisis has been preceded for several years by substantial global imbalances in trade and capital ‡ows. In particular, the United States has not only been the origin of the …nancial crisis, but it had been among the economies globally relying most heavily on capital in‡ows to …nance a large and growing trade de…cit. At the same time, a number of observers have argued that accommodative monetary policy over the past decade has been a key culprit behind these imbalances by inducing the build-up of excess liquidity, a rise in …nancial leverage and a boom in asset prices. This, in turn, may have contributed to a surge in private consumption, in part due to wealth e¤ects, and ultimately a rising US current account de…cit (e.g. Taylor 2009). At the same time, capital ‡ows to the United States have exhibited peculiar dynamics regarding their composition in recent years, with net in‡ows having become characterised by an ever heavier US dependence on in‡ows into US bonds, as opposed to equities. Figure 1 illustrates this point, underlining that in particular since 2001, in an environment of accommodative monetary policy, net in‡ows into US debt securities have surged to close to 6% of US GDP or about USD 800 billion per year, while net in‡ows into equities, FDI and other investment have been modest and even negative at times. The role of monetary policy thus warrants closer scrutiny in order to understand how it may have contributed to the dynamics of capital ‡ows, both in terms of their size and their composition. This is a …rst objective of the paper. More speci…cally, the paper focuses on the e¤ect of monetary policy shocks in the United States on the US trade balance and di¤erent types of capital ‡ows. Our analysis is in part motivated by the build-up of large trade and …nancial imbalances in recent years, which are now unwinding to some extent. Moreover, the focus on the e¤ect of monetary policy shocks on the direction and composition of capital ‡ows allows us to contribute to the debate on the determinants of portfolio choice, and how asset price movements are related to portfolio decisions of investors across countries as well as across …nancial asset classes. This is the second objective of the paper. An important strand of this literature analyses portfolio rebalancing versus return chasing as motives for investment decisions, in an environment of incomplete …nancial markets and imperfect substitutability of …nancial assets (e.g. Bohn and Tesar 1996, Hau and Rey 2006 and 2008, Albuquerque 2007, Devereux and Sutherland 2006, Tille and van Wincoop 2007). A related literature focuses on understanding asset price comovements, in particular the peculiar stock-bond return correlation, which are hard to explain with empirical models to date (e.g. Shiller and Beltratti 1992, Baele, Bekaert and Inghelbrecht 2008). The paper tests empirically the e¤ect of US monetary policy shocks on the composition of US capital ‡ows and the US trade balance, and its channels. It employs a standard structural VAR speci…cation to identify monetary policy shocks, relying on sign restrictions imposed on the impulse response functions of a few macroeconomic variables, following closely Canova and De Nicolo (2002), Uhlig (2005) and Fratzscher and Straub (2008). These identifying restrictions


7

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11

The …rst component on the right hand side of equation 4 captures what we denote the portfolio-rebalancing e¤ect, namely net purchases of asset k that are required to maintain constant portfolio weights. The second term captures the extent to which investors adjust portfolio weights as the portfolio is reoptimized over time. Given a …xed level of risk aversion and a constant variance-covariance matrix of returns, an investor adjusts portfolio weights only if his expectations of excess returns are revised over time. We therefore refer to this as the returnchasing e¤ect. The two e¤ects imply di¤erent correlation structures between the (expected) return on capital and capital ‡ows. If the portfolio rebalancing e¤ect dominates, an increase in the relative return on assets in country k should lead to a net capital out‡ow as indicated by the negative coe¢ cient on the local capital gain gkt : On the other hand, if the return chasing e¤ect dominates then changes in the investor’s expectation of excess returns in country k should dominate portfolio ‡ows. The latter implies a positive correlation between expected excess returns and net capital ‡ows. We emphasise that the purpose of this section is purely motivational in order to illustrate the implications of changes in returns for portfolio ‡ows, and vice versa. Our empirical exercise in the next sections will investigate which e¤ect dominates empirically when analysing net portfolio ‡ows of debt and equity following a monetary policy shock in the United States.

3

The Empirical Model

In this section, we present our empirical model and explain the implementation of our pure-sign restrictions approach. In Appendix 1 we de…ne further the variables that we use in the analysis and declare the respective data sources.

3.1

Model Speci…cation

We estimate a structural VAR model of the form yt = c +

p X

Ai yt

i

+B

1

"t

(5)

i=1

where B is an (n n) matrix of contemporaneous coe¢ cients, Ai is an (n n) matrix of autoregressive coe¢ cients, "t is an (n 1) vector of structural disturbances and yt an (n 1) vector of endogenous variables, and p is the number of lags in the VAR. The model we use is of dimension n = 8, where yt is de…ned as

yt = [ct

12


ct ; it

it ; cpit

cpit ; eqt

eqt ; nbt ; reert ; tbt ; capt ]

(6)

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