Discussion of “Could capital gains smooth a current account rebalancing?” by Cavallo and Tille
Akito Matsumoto (IMF)
This is my own view.

• scenario analysis of current account adjustment
• real side of the model – OR (2005)
– 3-region model
– Traded Goods – Non-Traded Goods
– LOOP holds
– GDP deflator targeting
– endowment economy
– no shocks
• more “realistic” adjustment scenario
– dynamic adjustment

• heroic assumption
– constant net asset position
• this pins down the adjustment length
• constant new portfolio allocation p
– simple and easy to understand
– requires CA=V -> constant net asset position
– gross position increases /not
– “exorbitant privilege” /not
• the US pays lower interest rate on its liability

• using the current portfolio for initial condition
– more realistic than mirror image model
• focusing on valuation effect from the (real) exchange rate movement
• simple model for policy circle

1. slow adjustment: half life of CA, RER 3 years. 10yrs for near “SS”.
2. almost same degree of adjustment as OR
3.
with “exorbitant privilege”
• in the LR, 30% real depreciations
• in the LR, net interest income >0 as gross position grows. TB<0
4.
w/o “exorbitant privilege”
• in the LR, 40% real depreciations
• standard result TB>0, NI<0

US Real Effective Exchange Rate
135
130
131.24
125
120
115
110
5 years
Jan 73-Oct 78
2 years
Feb 02-Jan 04
116.75
108.21
3 years
Mar 85-Jan 88
105
100
95
90
88.78
85
82.58
82.63
80
75
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

135
130
125
120
115
110
105
100
95
90
85
80
75
72 74 76
US Real Effective Exchange Rate and Current Account
78 80 82 84 86 88 90 92 94 96 98 00 02 04
-9.0
-8.0
-7.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
06
3.0

• maybe too slow adjustment
• Not enough RER change
– sensitivity analysis in other parameter
– q and h
• elasticity among tradable/ btw. T and NT may help

• are Japanese investors so stupid? why do they invest their assets in the US if r u <r w
– They might have been, but...
• possible explanations for having US asset
– Risk – Return trade-off? US asset is safe?
– vehicle currency > need to hold dollar?

• why r u <r w ?
• return on each asset group (bond, stock) was higher in the US than in Japan and
Europe for the last 15 years
– is it realistic for next ten years?
• if “exorbitant privilege” is true among developed country, it is probably asset compositions rather than return discount
• risk tolerance?

US Real Effective Exchange Rate
135
130
131.24
125
120
115
110
5 years
Jan 73-Oct 78
2 years
Feb 02-Jan 04
116.75
108.21
3 years
Mar 85-Jan 88
105
100
95
90
88.78
85
82.58
82.63
80
75
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

• probably emerging countries (or call Asia as emerging countries) to generate r u >r w and provide nice model; shocks
– risks in Asia are high?
• endogenous portfolio allocation with exogenous “r”
• better to have endogenous “r”
– Engel and Matsumoto (2006) Though our model is too simple in other dimensions
• FX as an asset

• valuation effect is important
– nice analysis for policy circle
– but need more analysis on portfolio choice
• remind me of the need to develop realistic
DSGE model with international portfolio choice