Endogenous risk premium and terms of trade: evidence for developing countries*

1. Endogenous risk premium and terms of trade: evidence for developing countries* ARNOLDSHAIN SEMINAR XI. June 25-28, 2013. University of Antwerp, Beliguim. Sergio Barone Ricardo Descalzi

2. Presentation • Introduction • Theoretical Framework and Main Hyphotesis • Review of literature • Working hyphotesis • Empirical aplicaction • Estimation estrategy • Results • Conclutions

3. 1. Introduction GeographicalDistribution and incomelevel of capital flows 1970-2004. We can explain this direction of capital flow from differential between the interest rate paid by the rich and poor countries for theirs debts? , How do you explain this difference? GENERAL PROBLEM:scarce capital flowstopoorcountries. Why capital flowfrompoortorichcountries?

4. 1. Introduction More specifically: What the relation of the terms of trade and the risk premium?

5. 2. Theoretical Framework and WorkingHyphotesis Review of Literature: Lucas (1990): He points out three reasons : (a)The capital return (marginal product of capital in terms of capital per capita) is not equalize across countries by differences in human capital stock between rich and poor countries; (b)knowledgespillovers; (c)politicalrisk: due to the difficulty of the creditor country to ensure compliance with loan agreements (sovereign risk).

6. 2. Theoretical Framework and WorkingHyphotesis Alfaro, L., Kalemli-Ozcan, S., Volosovych, V. (2005)classifiy theoretical explanations of the Lucas paradox in two groups (a) differencesbetweenthefundamentals;(i)factors of production "lost" (specification problems in aggregate production function), (ii) government policies, (iii) institutional structure and theirs effects on TFP (Alfaro contribution) (b)Imperfections in the capital market; (i) sovereign risk; (ii)asymmetricinformation(a) ex-ante (adverse selection); (b) interim(moral hazard) Gertler and Rogoff (1990); (c) ex-post (expensiveverification of events);

7. units output with probability units output with probability 2. Theoretical Framework and WorkingHyphotesis Units of capital in period 1 yield in 2: • Two periods, one good, endowment • Two investing posibilities in order to utilize in 1. • Lend abrod at tisk-free rate • Invest in a risky technology: • Individual budget restriction in the first period is: • Where is the amount that the economy borrows from the rest of the world

8. 2. Theoretical Framework and WorkingHyphotesis • Withregardtotheinformationstructure , itissupposedthatthelenders are ableto observe endowments , theproductionfunction and theamountthatdebtor country borrows. • But, they can not observe whattheborrowerdoeswiththefunds he borrowfromabroad: thatis, creditors are notallowedtoobserved and theborrower, forexample, couldsecretlylendabroadratherthaninvest in theproyects. Finally, therealizedaoutputisfreelyobservedbylenders.

9. Capital stock with Funtion IC (Incentive Constraint): It equates the expected gain from investing with the country´s opportunity cost (given by the risk-free rate) of secretly holding assets abroad. If increases, then optimal fall because the expected profit from invested is reduced. Function MR (Market Return): This equation indicates that lenders must recieve the market rate of return. When increases, the poor economy increase her borrowing, then she has to offer to creditors a greater rate to get additional funds.

10. Given the uncollateralized borrow the risk-premium is endogenous. The economy must paid above the free-risk rate to financing capital above their Wealth or collateral. The rate of interest is: Terms of Trade Shocks and Risk-Premium

11. 3.Empirical Aplication: EstimationEstrategy

12. 3. EmpiricalAplication ExpectedResults Variable CoefficientExpectedSign Negative Positive Negative Positive Negative Negative Negative Negative No Significant

13. 3.Empirical Aplication Weestimeted POLS, RE, FGLS, FE y FEFGLS. Dependent variable logarithm of the risk premium (PR). TwoSamples: (i) N=75 t=30; variables incluided : logarithm of terms of trade (LNTOT), Ratio of dependency (RD), financialdeepness (M2GDP), inflation (INFL), TradeOpenness (AC) Growth (GROWTH). (ii) N=69 t=30; FinancialOpenness de Facto (APF)

14. 3. EmpiricalAplication : Results

15. 3. EmpiricalAplication : Results

16. 4. Conclusions The risk premium is negatively correlated with the Terms of Trade. That is, it checks the collateral effect of the terms of trade. The relationship between the terms of trade and the risk premium is higher for less developed countries. Inflation directly affects the risk premium. The anti-inflation policy is important to reduce country risk and reverse the shortage of funds to finance their development. Trade openness is significant only for upper middle income countries and high. Growth is not significantly different from zero for low income countries. For other categories of income is significant and negative. For low-income countries terms of trade improvement appear to be more relevant than the growth.