Contrarian Opinion and Its Predictability: Application to Exchange Rates

Unpublished, 2018

Although exchange rates exhibit trends, they are difficult to predict out-of-sample. Puzzlingly when trends end, speculators behave overly-optimistically (overly-pessimistically). We formalize a novel mechanism for generating trends, where this contrarian-pattern arises in equilibrium. News are impounded into exchange rates via trending bubblypaths, which informed-speculators ride until trend-reversals approach. When informed-speculators exit, trends continue because uninformed-speculators trade more optimistically (pessimistically) with hedgers. We estimate these switching-times and forecast trend-reversals using COT-speculator-position data. Our directional-forecasts achieve 53%-72% success-ratios over 1-to-12-month horizons, outperforming the random-walk for most currency-horizon pairs using the Binomial test and a new test weighting directional-forecasts by subsequent exchange rate changes.


Eurozone Architecture and Target2: Risk-sharing and the Common-pool Problem

Unpublished, 2018

The introduction of the Euro has brought about an implicit risk-sharing mechanism across members of the Eurozone, which works via the Target2 system: when a country is hit by a negative shock, it automatically receives a transfer via the ECB. On the one hand, this risk-sharing mechanism has proved to be welfare-improving, as it smooths the effects of the shock on consumption and output. On the other hand, it has led to lending booms, excessive national debt accumulation and capital flight. In this paper, we present some stylized facts that illustrate these two effects and develop a dynamic political-economy model, in which both effects are part of an internally consistent mechanism. In this model, we analyze the interaction of systemic bailout guarantees with two common-pool problems: an inter-country and a within-country common-pool problem. In equilibrium, risk-premia on interest rates fall–which is good for investment and growth–but also a voracity effect arises, under which a greater ability of national central banks to support distressed banks during crises leads to a dynamic path, which features unsustainable national debt over the long-run, coexisting with private capital flight. Possibly, introducing an explicit risk-sharing mechanism in combination with other reforms may keep the good aspects of the Eurozone architecture, while ameliorating these common-pool problems.


Economic Recessions and Wildfires I: The Exponential Region

Unpublished, 2017

Data describing the preceding two centuries reveals that the frequency of recessions larger than a given depth satisfies, with remarkable precision, an exponential distribution, up to a very large depth cut-off. Beyond that, the recession depth data exhibits a power-law distribution. To understand what may generate such exponentiality, we
analyze a typical recessionary episode and find that it is composed of a sequence of statistically independent annual decline events, the depth of which conforms to a gamma probability density distribution. Using formal probabilistic analysis we show that these two empirical properties generate the exponential complementary distribution function observed in the cross-section of recessions. Furthermore, we show this result approximately holds for general density distribution functions. The implication is that non-catastrophic recessions are simply sequences of negative growth draws, which are independent, so a recession today does not imply a greater risk of recession next year.


The Euro Area’s Common Pool Problem Revisited: Has the Single Supervisory Mechanism Ameliorated Forbearance and Evergreening?

Unpublished, 2017

The Single Supervisory Mechanism was introduced to eliminate the common-pool problem and limit uncontrolled lending by national central banks (NCBs). We analyze its effectiveness. Second, we model how, by forbearing and providing refinancing credit, NCBs avoid domestic resolution costs and, instead, share potential losses within the Euro Area. This results in “evergreening” of bad loans. Third, we construct a new evergreening index based on a large worldwide survey administered by the ifo institute. Regressions show evergreening is significantly greater in the Euro Area and where banks are in distress. Finally, greater evergreening accompanies higher growth of NCB-credit and Target2-liabilities.


The Principle of Contrarian Opinion and Its Implications for Exchange Rate Forecasts

Unpublished, 2015

We develop a minimal model where the principle of contrarian opinion is a property of equilibria in markets with heterogeneous agents, some of which are less informed and so chase price trends. It allows us to construct an internally consistent mechanism for endogenous amplification cycles of appreciation and depreciation of the price. Based on the empirical implication of the model, we propose a forecasting strategy by using the structural break estimations in the bivariate process followed by exchange rates and the net positions of speculators. We use several econometric tests to compare these forecasts against the random-walk by constructing the directional forecasts based on the structural break estimations. According to the weighted directional test proposed by Kim, Liao and Tornell (2014) and the standard binomial test, these directional forecasts outperform the random walk over forecasting horizons from 1 months to 12 months.


Why Do Reforms Occur in Crises Times?

Unpublished, 2015

Structural reforms, whereby organized groups lose their power to extract rents, tend to occur in bad times rather than during prosperous times. We present a model where rent-seeking leads to economic decline, which, in turn, will make a future reform inevitable when times will be bad enough. Furthermore, we show that in the case of trade liberalization–a prime example of structural reform–there is strong empirical evidence that reforms are induced by severe crises.


Exchange Rates Under Robustness: The Forward Premium Puzzle and Momentum

Unpublished, 2015

We characterize conditions under which a desire for robustness against model misspecification may account for the forward premium puzzle. We consider a setup where optimizing agents, who hold no misperception about the model, distort their forecasts to attain robustness against potential misspecification. In general, the robust forecast distortion is data-dependent. However, a clear bias arises in an empirically relevant case to the major currency markets. We prove that, with probability approaching one, there is forecast under-reaction if the interest rate differential is close to a random-walk and there is structured uncertainty about the volatility of the differential. Using approximate analytical solutions we show that in equilibrium, this forecast under-reaction translates into a delayed response of the exchange rate to interest rate shocks, which gives rise to a negative unconditional correlation between interest rate differential shocks and exchange rate changes, i.e., a negative Fama coefficient. We calibrate our model with empirical estimates of key parameters and generate a negative Fama coefficient under sufficient uncertainty aversion.


Asset Price Support Policy During Crises: How Aggressive Should it Be? 

Unpublished, 2015 

Should a Central Bank (CB) aim at smoothing out all asset price volatility in crisis times? What trade-offs does it face? To address this question we consider an economy where leverage is endogenously determined by the CB asset price support policy during crises. By keeping the price of distressed assets above a critical level, the CB can induce a high-leverage equilibrium with high output but with infrequent financial crises. But how agressively should the Central Bank support the price of distressed assets? The optimal CB policy depends on whether the interventions necessary to support the high-leverage equilibrium are costly or not. If the CB does not require any net wealth to credibly promise the minimal intervention that will keep asset prices above the critical level, it is optimal to commit all its wealth to intervention—this seems to be the case in the US in the aftermath of the 2008 crisis. In contrast, if interventions are costly, there is a tradeoff between enjoying higher leverage and output now, but withstanding a lower number of crises before falling into a low-leverage low-output trap, and a more prudent policy that can keep the economy longer in the high-leverage equilibrium. We solve the Central Bank problem in closed-form by converting it into a linear HBJ equation. Key determinants of the shape of policy functions is the number of future crises the Central Bank can withstand and the net expected social value of leverage. We find that more prudent policies tend to be optimal when leverage is more socially valuable or the Central Bank has more wealth.


Speculators Positions and Exchange Rate Forecasts: Beating Random Walk Models

Unpublished, 2014

Speculators' positions in futures markets contain useful information to forecast exchange rates. We extract such information by fitting a microfounded regime switching model, and forecast whether speculators will be increasing or decreasing their positions. We use this predicted state to form both directional and point exchange rate forecasts for the six most traded currency pairs. Over forecasting horizons from 6 to 12 months, our directional forecasts have a 58 percent average success ratio and most of our point forecasts are more accurate than those implied by the random walk models. Forecasting evaluation tests show that our empirical findings are significant.


The Dynamic Tragedy-of-the-Commons in the Eurozone and Target2

Unpublished, 2013

What are the mechanisms by which the Target2 liabilities of Southern Eurozone countries have been generated? Why have Southern Eurozone countries not implemented adjustment policies fast enough? To address these issues we document a set of stylized facts that characterize the patterns observed in the Eurozone, and present a political-economy model that accounts for these patterns and that allows us to interpret the Target2 mechanism as a systemic bailout guarantee.


Systemic Risk-Taking and the U.S. Financial Crisis

Unpublished, 2009

The recent macroeconomic experience of the U.S. resembles the boom-bust cycles of emerging markets more so than the tame postwar US business cycles. We present a model in which a feebdack loop between credit and prices generates the boom and the bust, and accounts for several stylized facts that characterize of the U.S. experience. We then use this framework to analyze the dynamics of external imbalances and to evaluate post-crisis stabilization policy. 


Concentrated Ownership and Bailout Guarantees

Unpublished, 2005

This paper studies the effect of bailout guarantees in an economy where ownership of firms is concentrated. In contrast to standard models of deposit insurance, bailout guarantees need not generate excessive risk taking, but may instead alleviate underinvestment. While the economy can experience wasteful lending booms, such booms often end in a self-correcting soft landing, as in the data. However, an economy that operates efficiently can also relapse into episodes of inefficient over- or underinvestment. Financial development has unintended consequences as it provides markets with tools to better exploit the bailout guarantee.


Crises and Growth: A Re-evaluation

Unpublished, 2003

We address the question of whether growth and welfare can be higher in crisis prone economies. First, we show that there is a robust empirical link between per-capita GDP growth and negative skewness of credit growth across countries with active financial markets. That is, countries that have experienced occasional crises have grown on average faster than countries with smooth credit conditions. We then present a two-sector endogenous growth model in which financial crises can occur, and analyze the relationship between financial fragility and growth. The underlying credit market imperfections generate borrowing constraints, bottlenecks and low growth. We show that under certain conditions endogenous real exchange rate risk arises and firms find it optimal to take on credit risk in the form of currency mismatch. Along such a risky path average growth is higher, but self-fulfilling crises occur occasionally. Furthermore, we establish conditions under which the adoption of credit risk is welfare improving and brings the allocation nearer to the Pareto optimal level. The design of the model is motivated by several features of recent crises: credit risk in the form of foreign currency denominated debt; costly crises that generate firesales and widespread bankruptcies; and asymmetric sectorial responses, where the nontradables sector falls more than the tradables sector in the wake of crises.


Credit Market Imperfections in Middle Income Countries

Unpublished, 2003


The Credit Channel in Middle Income Countries

Unpublished, 2002

Credit market conditions play a key role in propagating shocks in middle income countries (MICs). In particular, shocks to the spread between domestic and international interest rates have a strong effect on GDP, and an even stronger effect on domestic credit. This strong credit channel is associated with a sharp sectorial asymmetry: the output of the bank-dependent nontradables (N) sector reacts more strongly than tradables (T) output. This asymmetry, in turn, is associated with a strong reaction of the real exchange rate —the relative price between N and T goods. We present a model that reconciles these facts and leads to a well speci- fied estimation framework. From the equilibrium we derive structural VARs that allow us to identify shocks to credit market conditions and trace their effects on the economy. We estimate these structural VARs for a group of MICs and find evidence of a strong credit channel. We argue that at the heart of the MIC credit channel are a deep asymmetry in financing opportunities across N and T sectors, and a severe currency mismatch. This makes movements in the real exchange rate the driving element in the amplification of shocks. Finally, we show that the model’s key assumptions are consistent with evidence gleaned from both firm level and aggregate data.


Soft Landings

Unpublished, 2000

A country experiencing a lending boom goes through a period of unusually fast growth in credit. This paper proposes a theory of lending booms that incorporates two distortions which are prevalent in emerging markets: the imperfect enforceability of contracts and government bailout guarantees. The first of distortion implies that there may be an underinvestment problem and that shocks are propagated through their effect on borrower wealth. The second distortion amplifies shocks since it encourages excessive risk taking and overinvestment. Although they appear to affect borrowing in opposite ways, the tow distortions do not neutralize each other. They combine to rationalize the gradual buildup of lending booms, the excess volatility of credit and asset prices and the slow recovery if a lending boom ends in a financial crisis. The interaction also introduces a nonlinearity in the response to shocks. This explains why most lending booms do not require a large negative shock to end, but rather come to a ’soft landing’. In addition to accounting for the main characteristics of a typical lending boom episode the model also surprising policy implications.


The Role of Bank Restructuring in Recovering From Crises: Mexico 1995-1998

Unpublished, 1999