My recent research has dealt with issues related to financial globalization, and the accumulation of foreign assets and liabilities on external balance sheets. These include equity (foreign direct investment and stock) and debt (bonds and bank loans). Their amounts and composition differ between the emerging market economies and the advanced economies. The former generally hold assets in the form of foreign reserves, and issue equity to finance domestic investment. The latter nations hold the equity of the emerging economies and sell debt. In my work I have investigated the impact of the composition of the external balance sheets on economic performance as well as the determinants of the equity/debt liabilities mix, and this work has now been published.
In “External Liabilities, Domestic Institutions and Banking Crises in Developing Economies” (working paper here), my coauthors, Nabila Boukef Jlassi of the Paris School of Business and Helmi Hamdi of CERGAM EA 4225 Aix-Marseille University, and I examined the impact of foreign equity and debt liabilities on the occurrence of bank crises in 61 lower- and middle-income counties during the period of 1986-2010. We found that FDI liabilities lowered the probability of such crises while debt liabilities increased it. However, we also found that domestic institutions that decreased financial or political risk partially offset the impact of the debt liabilities on the probability of bank crises. A decrease in investment risk directly reduces the incidence of crises.
In “External Balance Sheets as Countercyclical Crisis Buffers” (working paper here), I investigated the claim that the composition of the external balance sheets of many emerging markets—“long debt and foreign exchange, short equity”—affected the performance of these countries during the global financial crisis of 2008-09. Using data from 67 emerging market economies, I showed that those economies that had issued FDI liabilities had higher growth rates during the crisis, fewer bank crises and were less likely to borrow from the IMF. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit.
Why do equity—and FDI in particular—and debt have such different impacts? First, equity represents a sharing of risk, whereas debt is a contractual commitment by the borrower. The equity premium is a compensation for the lower return incurred during a downturn. Second, debt is more likely to be reversed during a crisis than FDI, contributing to a “sudden stop.”. Third, FDI investors may be willing to provide more finance to keep their investment viable during a period of financial stress.
What determines the equity/debt mix of liabilities? In “Partners, Not Debtors: The External Liabilities of Emerging Market Economies” (working paper here), I studied the determinants of equity and debt liabilities on the balance sheets of 21 emerging market economies and 20 advanced economies over the period of 1981-2013. In the analysis I used a measure of domestic financial development that distinguished between financial institutions and financial markets. The results showed that the development of domestic financial markets is linked to an increase in equity liabilities, and in particular, portfolio equity. FDI liabilities, on the other hand, are more common when financial institutions are not well developed. Moreover, countries with higher growth rates are more likely to issue equity. Larger foreign exchange reserves are also associated with more portfolio equity.
The composition of assets and liabilities has other effects. Changes in the their values will impact a country’s net international investment position, which influences domestic spending and international solvency. In addition, they yield different income streams that determine net investment income, a component of the current account. In my current work I am looking at the income investment flows of advanced and emerging market countries. The flows in the advanced economies grew rapidly during the period of financial globalization leading up to the global crisis of 2008-09. In some cases, such as Japan and the United Kingdom, the net flows have become substantial and are a major determinant of the current account. The income flows of the emerging market economies did not have the same rapid growth, but their composition changed from payments to banks to payments on FDI and portfolio equity. I plan to write about these changes in future research papers.
