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Shifts in Portfolio Preferences of International Investors: An Application to Sovereign Wealth Funds

Reversals in capital inflows can have severe economic consequences. This paper develops a dynamic general equilibrium model to analyse the effect on interest rates, asset prices, investment, consumption, output, the exchange rate and the current account of a shift in portfolio preferences of foreign investors. The model has two countries and two asset classes (equities and bonds). It is characterized by imperfect substitutability between assets and allows for endogenous adjustment in interest rates and asset prices. Therefore, it accounts for capital gains arising from equity price movements, in addition to valuation effects caused by changes in the exchange rate. To illustrate the mechanics of the model, we calibrate it to analyse the conse- quences of an increase in the importance of Sovereign Wealth Funds (SWFs). Specifically, we ask what would happen if 'excess' reserves held by Emerging Markets were transferred from central banks to SWFs. We look separately at two diversification paths: one in which SWFs keep the same allocation across bonds and equities as central banks, but move away from dollar assets (path 1); and another in which they choose the same currency composition as central banks, but shift from US bonds to US equities (path 2). In path 1, the dollar depreciates and US net debt falls on impact and increases in the long run. In path 2, the dollar depreciates and US net debt increases in the long run. In both cases, there is a reduction in the 'exorbitant privilege', i.e., the excess return the US receives on its assets over what it pays on its liabilities. The model is applicable to other episodes in which foreign investors change the composition of their portfolios.

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File URL: http://www.econ.cam.ac.uk/research/repec/cam/pdf/cwpe1029.pdf
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Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 1029.

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Date of creation: 29 May 2010
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Handle: RePEc:cam:camdae:1029
Contact details of provider: Web page: http://www.econ.cam.ac.uk/index.htm

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  1. Jonathan Heathcote & Fabrizio Perri, 2007. "The international diversification puzzle is not as bad as you think," Staff Report 398, Federal Reserve Bank of Minneapolis.
  2. Pierre-Olivier Gourinchas & Hélène Rey, 2005. "From World Banker to World Venture Capitalist: US External Adjustment and the Exorbitant Privilege," NBER Working Papers 11563, National Bureau of Economic Research, Inc.
  3. Caballero, Ricardo J. & Farhi, Emmanuel & Gourinchas, Pierre-Olivier, 2008. "An Equilibrium Model of "Global Imbalances" and Low Interest Rates," Scholarly Articles 3229094, Harvard University Department of Economics.
  4. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers 5512, C.E.P.R. Discussion Papers.
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