Bank of England Working Papers -
Abstracts 2004 (no. 211-245)
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Working
Paper No 245
Horizontal and vertical integration in securities trading
and settlement by Jens Tapking and Jing Yang
(376k)
This paper addresses a very European issue, the consolidation
of securities trading and settlement infrastructures. In a two-country
model, we analyse welfare implications of different types of consolidation.
We find that horizontal integration of settlement systems is better
than vertical integration of exchanges and settlement systems,
but vertical integration is still better than no consolidation.
These findings have clear policy implications with regard to the
highly fragmented European securities infrastructure.
Working Paper
No 244
Long-horizon equity return predictability: some new evidence
for the United Kingdom
by Anne Vila Wetherilt and Simon Wells
(342k)
This paper revisits the issue of long-horizon equity return predictability
for the United Kingdom in the context of the dynamic dividend
discount model of Campbell and Shiller. This model attributes
predictable variation in equity prices to predictable variation
in expected returns. The model is supported by the theoretical
asset pricing literature, which shows how the variation in expected
returns can be related to investors' time-varying preferences
for risk. The paper considers various empirical specifications
that are consistent with the Campbell and Shiller model and finds
that they are supported by UK equity data. In particular, there
is weak evidence that the dividend yield has predictive ability
for long-horizon excess returns. The paper also examines some
of the econometric issues brought up by recent research, in particular
the small-sample bias, and applies appropriate statistical corrections.
It further shows that the model's predictive ability depends greatly
on the sample period over which the model is estimated.
Working
Paper No 243
Long-term interest rates, wealth and consumption
by Roy Cromb and Emilio Fernandez-Corugedo
(573k)
This paper examines the sensitivity of the level of consumption
to interest rates in a standard partial equilibrium theoretical
framework with no uncertainty. Using a multi-period framework,
the consumption function is derived and interest rate effects
are decomposed into substitution, income and wealth effects. Drawing
on parallels with the finance literature, the paper illustrates
two key implications of the theory that are not typically emphasised
in the economics literature. First, it shows that wealth effects
mean that consumption is much more likely to be negatively related
to interest rates than the simple two-period textbook model might
suggest. Second, it demonstrates that long-term interest rates
are more important than short-term rates - the sensitivity of
consumption to interest rate changes depends crucially on how
long these are expected to persist. Numerical calibrations provide
an indication of the sensitivity of the results to key parameters.
Working Paper
No 242
Core inflation: a critical guide
by Alan Mankikar and Jo Paisley
(320k)
The term 'core inflation' is widely used by academics and central
bankers. But despite its prevalence, there is neither a commonly
accepted theoretical definition nor an agreed method of measuring
it. The range of conceptual bases is potentially confusing, and
can make the large number of available measures of core inflation
difficult to interpret, particularly when they display different
trends. Nevertheless, measures of core inflation can be helpful
if they increase the signal to noise ratio in measured inflation.
This paper examines a range of measures of core inflation for
the United Kingdom, both conceptually and empirically, setting
out their motivation and highlighting their potential limitations.
No single measure performs well across the board, but a compromise
conclusion on the usefulness of measures of core inflation is
that each one may provide a different insight into the inflation
process. There can be value in looking at a range of measures,
as long as one bears in mind what information each type of indicator
is best at providing. When all measures are giving the same message
then, in a sense, monetary policy makers can reasonably consider
that these measures are providing a reliable guide to inflationary
pressures. It is when the measures start to diverge that policymakers
need to take a much closer look at the reasons for those divergences.
Working Paper
No 241
Anticipation of monetary policy in UK financial markets
by Peter Lildholdt and Anne Vila Wetherilt
(399k)
This paper examines the question of whether the ability of market
interest rates to predict future policy rate changes in the United
Kingdom has changed markedly over the period 1975-2003. Such improvements
in predictability could arise from greater transparency in the
monetary policy process, together with greater credibility of
the Bank of England. Empirical tests, using a simple term structure
model, show that predictability has indeed improved over the sample
period as a whole, and most markedly after the introduction of
inflation targeting in 1992. But closer inspection of the data
reveals that predictability did not rise smoothly over time, nor
is it possible to generalise this result across maturities. Furthermore,
attempts to identify structural breakpoints in a formal way were
on the whole unsuccessful. Nonetheless, the paper concludes that,
over the longer sample period, the data show a clear improvement
in the ability of market participants to predict policy rate changes
by the Bank of England.
Working Paper
No 240
Price-setting behaviour, competition, and mark-up shocks
in the New Keynesian model
by Hashmat Khan
(196k)
Recent research and policy discussions have noted that the potentially
increased competition among firms since the 1990s may affect inflation
and economic activity. This paper considers the implications of
this structural change on short-run inflation dynamics, and for
assessing shocks to inflation and output. The importance of firms'
price-setting behaviour is highlighted in this context using a
standard New Keynesian model with microfoundations. It is well
known that both Rotemberg and Calvo price-setting assumptions
imply the same reduced-form New Keynesian Phillips Curve (NKPC).
Increased competition among firms, however, increases price flexibility
in the former, and has either no effect or decreases price flexibility
in the latter. The effects of mark-up shocks on inflation and
output are small when firms' price-setting behaviour incorporates
concerns about potential loss of market share. These effects are
further dampened in an environment of more intense competition.
Under the assumption of increased competition, both models lead
to unambiguous predictions about the direction of change in the
slope of the Phillips curve. Rolling estimates of the NKPC indicate
that the slope has declined or flattened for several countries
since the 1990s. This evidence is consistent with the prediction
of the Calvo model.
Working Paper
No 239
From tiny samples do mighty populations grow? Using the British
Household Panel Survey to analyse the household sector balance
sheet
by Victoria Redwood and Merxe Tudela
(223k)
This paper evaluates the reliability of specific variables in
the British Household Panel Survey (BHPS) by comparing grossed-up
variables from the BHPS with their corresponding national aggregates.
The paper focuses on those variables that provide the most information
on risks to financial stability stemming from households, particularly
household balance sheet variables relating to debt and assets,
and income. The results indicate that housing wealth and income
derived from the BHPS are broadly consistent with the aggregate
measures. But unsecured debt and financial wealth are substantially
under-recorded in the BHPS relative to the aggregate benchmark.
Working Paper
No 238
Estimating time-variation in measurement error from data
revisions; an application to forecasting in dynamic models
by George Kapetanios and Tony Yates
(200k)
Over time, economic statistics are refined. This means that newer
data are typically less well measured than old data. Time or vintage-variation
in measurement error like this influences how forecasts should
be made. Measurement error is obviously not directly observable.
This paper shows that modelling the behaviour of the statistics
agency generates an estimate of this time-variation. This provides
an alternative to assuming that the final releases of variables
are true. The paper applies the method to UK aggregate expenditure
data, and demonstrates the gains in forecasting from exploiting
these model-based estimates of measurement error.
Working Paper
No 237
Forecasting with measurement errors in dynamic models
by Richard Harrison, George Kapetanios and Tony Yates
(306k)
This paper explores the effects of measurement error on dynamic
forecasting models. It illustrates a trade-off that confronts
forecasters and policymakers when they use data that are measured
with error. On the one hand, observations on recent data give
valuable clues as to the shocks that are hitting the system and
that will be propagated into the variables to be forecast. But
on the other, those recent observations are likely to be those
least well measured. The paper studies two classes of forecasting
problem. The first class includes cases where the forecaster takes
the coefficients in the data-generating process as given, and
has to choose how much of the historical time series of data to
use to form a forecast. We show that if recent data are sufficiently
badly measured, relative to older data, it can be optimal not
to use recent data at all. The second class of problems we study
is more general. We show that for a general class of linear autoregressive
forecasting models, the optimal weight to place on a data observation
of some age, relative to the weight in the true data-generating
process, will depend on the measurement error in that observation.
We illustrate the gains in forecasting performance using a model
of UK business investment growth.
Working Paper
No 236
The effects of stock market movements on consumption and
investment: does the shock matter?
by Stephen Millard and John Power
(320k)
This paper uses a simple model to examine the links between equity
price movements and consumption and investment. Generally, the
effect of a given movement in equity prices on consumption depends
on the underlying source of the shock to equity prices, and some
empirical evidence is presented that supports this. Furthermore,
in the model the effect of a given movement in equity prices on
investment does not depend on the source of the shock. However,
some theoretical arguments and empirical evidence are provided
to suggest that it might in the real world.
Working Paper
No 235
Rule-based monetary policy under central bank learning
by Kosuke Aoki and Kalin Nikolov
(276k)
This paper evaluates the performance of three popular monetary
policy rules where the central bank is learning about the parameter
values of a simple New Keynesian model. The three policies are:
(1) the optimal non-inertial rule; (2) the optimal history-dependent
rule; (3) the optimal price level targeting rule. Under rational
expectations rules (2) and (3) both implement the fully optimal
equilibrium by improving the output/inflation trade-off. When
imperfect information about the model parameters is introduced,
the central bank makes monetary policy mistakes, which affect
welfare to a different degree under the three rules. The optimal
history-dependent rule is worst affected and delivers the lowest
welfare. Price level targeting performs best under learning and
maintains the advantages of conducting policy under commitment.
These findings are related to the literature on feedback control
and robustness. The paper argues that adopting integral representations
of rules designed under full information is desirable, because
these rules deliver the beneficial output/inflation trade-off
of commitment policy, while being robust to implementation errors.
Working Paper
No 234
Intertemporal substitution and household production in labour
supply
by Guillermo Felices and David Tinsley
(188k)
The demands on a person's time vary over their working life, so
that the years in which they might be expected to devote most
time to work may also be the period when other commitments, such
as bringing up children, are most pressing. Estimates of the intertemporal
labour supply elasticity that do not take this possibility into
account are likely to be biased. Recent research that uses US
data from three time-use surveys has found evidence for a large
downward bias to the labour supply elasticity. This paper uses
a large UK survey to test this hypothesis. It finds convincing
evidence for a similar downward bias in estimates of the UK labour
supply elasticity for males. The analysis is extended by differentiating
by sex, marital status, skill and business cycle. The bias appears
in every case, but is less evident for married men. The labour
supply elasticity for single women is, interestingly, similar
to that for single men.
Working Paper
No 233
The efficient resolution of capital account crises: how to
avoid moral hazard
by Gregor Irwin and David Vines
(253k)
This paper presents a model of capital account crises and uses
it to study resolution mechanisms for both liquidity and solvency
crises. It shows that liquidity crises should be dealt with by
a standstill combined with IMF lending into arrears, whereas solvency
crises should be resolved by debt write-downs. Dealing with solvency
crises by lending would require a subsidy and this creates moral
hazard, such as incentives for excessive borrowing, for too little
equity financing and for investment in projects that are inefficient.
The analysis underlines the importance of accurately assessing
whether a crisis is rooted in a liquidity or a solvency problem.
Working Paper
No 232
Evolving post-World War II UK economic performance
by Luca Benati
(472k)
This paper uses tests for multiple structural breaks at unknown
points in the sample period, and band-pass filtering techniques,
to investigate changes in UK economic performance since the end
of World War II. Empirical evidence suggests that the most recent
decade, associated with the introduction of an inflation-targeting
regime, has been significantly more stable than the previous post-WWII
era. For real GDP growth, and for three measures of inflation,
break dates are identified at around the time of the introduction
of inflation-targeting, in October 1992. For all four series,
the estimated innovation variance over the most recent subperiod
has been the lowest of the post-WWII era. The volatility of the
band-pass filtered macroeconomic indicators considered has been,
after 1992, almost always lower than either during the Bretton
Woods regime or the 1971-92 period; often, as in the cases of
inflation and real GDP, markedly so. The Phillips correlation
appears to have undergone significant changes over the past 50
years, from being unstable in the 1970s, to slowly stabilising
from the beginning of the 1980s onwards. After 1992, the correlation
has exhibited by far the greatest degree of stability during the
post-WWII era.
Working Paper
No 231
Real exchange rate persistence and systematic monetary policy
behaviour
by Jan J J Groen and Akito Matsumoto
(339k)
This paper estimates forward-looking monetary policy rules for
Germany over the 1979-98 period and for the United Kingdom for
the periods 1979-90 and 1992-98. The estimation results indicate
that there were substantial differences between systematic monetary
policy in Germany and in the United Kingdom, as well as shifts
in systematic monetary policy in the United Kingdom, over this
period. The paper analyses the implications of these estimated
policy rules for real exchange rate behaviour in an open economy
dynamic stochastic general equilibrium model. The analysis shows
that real exchange rate persistence could be attributed to the
persistence of real shocks and interest rate smoothing behaviour
of central banks. However, the observed cross-country asymmetry
in systematic monetary policy behaviour elevates real exchange
rate persistence to realistic levels, whereas changes in asymmetric
policy behaviour alter the character of real exchange rate persistence.
Working Paper
No 230
Financial interlinkages in the United Kingdom's interbank
market and the risk of contagion
by Simon Wells
(257k)
A well functioning interbank market is essential for efficient
financial intermediation. But interbank exposures imply the possibility
of direct contagion: the insolvency of a single institution may
trigger multiple bank failures due to direct credit exposures.
The complete network of interbank exposures that gives rise to
this channel of contagion is not observable, making it difficult
to assess the systemic risk it poses. This paper uses data on
loans and deposits between UK-resident banks to estimate the distribution
of bilateral exposures. The potential for contagion is examined
by assuming the sudden failure of each individual bank and estimating
the losses incurred to other banks as a result of the initial
shock. This study suggests that, while a single bank failure is
rarely sufficient to trigger the outright failure of other banks,
it does have the potential to weaken substantially the capital
holdings of the banking system. And, when the failure of a single
bank does result in knock-on effects, their severity depends greatly
on the maintained assumptions about the distribution of interbank
loans and the level of loss given default. But data constraints
mean that drawing definitive conclusions is difficult.
Working Paper
No 229
On the resolution of banking crises: theory and evidence
by Glenn Hoggarth, Jack Reidhill and Peter Sinclair
(236k)
This paper reviews the merits of the various techniques used by
authorities when resolving individual or widespread bank failures
in developed and emerging market economies. In particular, the
various banking crisis resolution techniques available to the
authorities are classified and then compared with the techniques
that have been used in practice, drawing on both the available
evidence and our own analysis. With individual bank failures the
authorities usually first seek a private sector solution. Any
losses are passed on to existing shareholders, managers and sometimes
uninsured creditors, and not to taxpayers. But policy options
are more limited in systemwide crises. In most recent systemwide
crises, early on central banks have provided liquidity to failing
banks and governments have given blanket guarantees to depositors.
In nearly all cases, investor panics have been quelled but at
a cost to the budget and increasing the risk of future moral hazard.
Open-ended central bank liquidity support seems to have prolonged
crises, thus increasing rather than reducing the output costs
to the economy. Bank restructuring has usually occurred through
mergers, often government assisted, and some government capital
injection or increase in control. Bank liquidations have been
rare and creditors - including uninsured ones - have rarely made
losses. In systemwide crises, resolution measures have been more
successful in financial restructuring than in restoring banks'
ongoing profitability or credit to the private sector. In most
cases bank lending has remained subdued for years after a banking
crisis.
Working Paper
No 228
The UK labour force participation rate: business cycle and
trend influences
by Mark Schweitzer and David Tinsley
(336k)
In this paper the extent to which recent patterns in UK labour
force participation have been influenced by trend and business
cycle factors is investigated. A modelling strategy is proposed
that pools the available micro and aggregate-level data, to produce
a mutually consistent model of the trend and cyclical components
of participation. A significant procyclical pattern is established,
but some distinct trend influences on the participation rate are
also identified. The approach allows for the construction of forecasts,
which would be a useful input into the sort of macroeconometric
models used by policymakers. The model outperforms some conventional
macroeconometric forecasts in out-of-sample forecast tests.
Working Paper
No 227
The Phillips curve under state-dependent pricing
by Hasan Bakhshi, Hashmat Khan and Barbara Rudolf
(251k)
This paper is related to a large recent literature studying the
Phillips curve in sticky-price equilibrium models. It differs
in allowing for the degree of price stickiness to be determined
endogenously. A closed-form solution for short-term inflation
is derived from the dynamic stochastic general equilibrium (DSGE)
model with state-dependent pricing originally developed by Dotsey,
King and Wolman. This generalised Phillips curve encompasses the
New Keynesian Phillips curve (NKPC) based on Calvo-type price-setting
as a special case. It describes current inflation as a function
of lagged inflation, expected future inflation, and current and
expected future real marginal costs. The paper demonstrates that
inflation dynamics generated by the model for a broad class of
time and state-dependent price-setting behaviours are well approximated
by the popular hybrid NKPC (with one lag of inflation) in a low-inflation
environment. This provides an explanation of why the hybrid NKPC
performs well in describing inflation dynamics across industrial
countries. It implies, however, that the reduced-form coefficients
of the hybrid NKPC may not have a structural interpretation.
Working Paper
No 226
Corporate capital structure in the United Kingdom: determinants
and adjustment
by Philip Bunn and Garry Young
(811k)
In this paper three contributions are made. First, empirical support
is provided for the 'trade-off' model of corporate capital structure
where companies borrow to take advantage of the tax benefits of
debt, which they set against possible costs of overindebtedness.
Second, it is shown empirically how companies adjust their balance
sheets when borrowing is out of equilibrium, through adjustments
to dividend payments, new equity issues and to a lesser extent
capital investment. Third, these factors are incorporated within
an aggregate model that quantifies the process and speed of balance
sheet adjustment in the economy as a whole.
Working Paper
No 225
Exploring the relationship between credit spreads and default
probabilities
by Mark J Manning
(370k)
Contrary to theory, recent empirical work suggests that changing
default expectations can explain only a fraction of the variability
in credit spreads. This paper takes a fresh look at this question,
relating credit spreads for a sample of investment-grade bonds
issued by UK industrial companies to default probabilities generated
by the Bank of England's Merton model of corporate failure. For
the highest quality corporate issues, where the probability of
default is low, this factor explains relatively little of the
variation in credit spreads. For such bonds, common market factors
- perhaps related to liquidity conditions - appear to be of greater
importance. This is consistent with previous empirical work. For
lower-rated investment-grade bonds, however, the probability of
default is found to be a more important determinant of credit
spreads, explaining around a third of variability in a pooled
regression. When coefficients are allowed to vary at the level
of the individual issue, explanatory power rises to 50% for this
group. This is much higher than previous studies have found, reflecting
both the more direct application of the Merton model and the recognition
that idiosyncrasies in factors such as liquidity conditions and
expected recovery rates are likely to undermine results from pooled
estimation.
Working Paper
No 224
The informational content of empirical measures of real interest
rate and output gaps for the United Kingdom
by Jens D J Larsen and Jack McKeown
(426k)
In many economies, the monetary policy instrument is the level
of short-term nominal interest rates, but the monetary policy
stance might be better characterised by the
ex-ante real
interest rate that this nominal rate implies, relative to some
'neutral' or 'natural' real rate of interest. In this paper, the
natural rate of interest and the real interest rate gap - the
difference between the actual and the natural real rate of interest
- are estimated by applying Kalman filtering techniques to a small-scale
macroeconomic model of the UK economy. In this model, the real
interest rate gap, the output gap and inflation are related via
IS-curve and Phillips-curve relationships. The natural rate of
interest is defined as the level of (
ex-ante) real interest
rates that is consistent with an output gap of zero, that is output
at its natural level, in the medium term. Based on these estimates,
the paper examines whether empirical measures of the real interest
rate gap are a useful tool for policymakers - do they contain
additional information relative to the estimated output gap, and
does the real rate gap have leading indicator properties for the
output gap and inflation? Are these gap estimates of practical
use in a policy setting? The paper finds that the real rate gap
has leading indicator properties for both the output gap and inflation.
Importantly, these properties have varied considerably over time:
breaking the sample into four subsamples, it appears that the
leading indicator properties for both the output and real rate
gap were substantially stronger for the subsample that covers
most of the 1980s. After the introduction of the inflation target,
post 1992, the relationship between the real interest rate gap
and the output gap strengthens, but the leading indicator properties
of these gaps for inflation diminish, as might be expected under
an inflation-targeting regime.
Working Paper
No 223
Real exchange rates and the relative prices of non-traded
and traded goods: an empirical analysis
by Jan J J Groen and Clare Lombardelli
(528k)
This paper provides an empirical analysis of the decomposition
of UK real exchange rates into the relative price of traded goods
and the ratio of the relative price of non-traded to traded goods,
and tests the prediction that deviations from the law of one price
in tradable goods dominate real exchange rate variability only
in the short run. UK bilateral real exchange rates are examined
relative to a sample of six main OECD partners. The existence
of a long-run relationship between real exchange rates and these
corresponding relative price ratios is analysed using cointegrated
vector autoregressive models. These show only limited evidence
of a cointegrating relationship. The paper quantifies the severity
of the deviations from the law of one price, and shows that these
deviations are persistent relative to the length of the sample
period. This motivates the use of a multi-country panel cointegration-testing
framework, which produces evidence of a long-run relationship
between the real exchange rate and the non-tradable component.
Working Paper
No 222
The roles of expected profitability, Tobin's Q and cash flow
in econometric models of company investment
by Stephen Bond, Alexander Klemm, Rain Newton-Smith, Murtaza
Syed and Gertjan Vlieghe
(409k)
Evidence that cash flow has a significant effect on company investment
spending, after controlling for Tobin's average Q, has often been
interpreted as suggesting the importance of financing constraints.
Recent work on measurement error in the Q model casts doubt on
this interpretation. It is possible that the Q model may not be
identified if there are 'bubbles' in stock market valuations that
are both persistent over time and that are correlated with fundamental
values. Cash flow may then provide additional information about
expected profitability that is not captured by a poorly measured
Tobin's average Q variable. This hypothesis is explored empirically
using UK panel data on companies for which analysts' earnings
forecasts are available from the IBES database. The results point
to a severe measurement error in average Q. The paper finds that,
controlling for expected profitability using analysts' earnings
forecasts, cash flow becomes insignificant. Both sales growth
and cash-stock variables do provide additional information, which
could either be capturing expectations of profitability at longer
horizons, or reflect misspecification of the basic Q model. Results
for subsamples do not suggest financing constraints as a likely
explanation for these findings.
Technical
Appendix 1 to accompany Working Paper No. 222
(224k)
Technical
Appendix 2 to accompany Working Paper No. 222
(228k)
Working Paper
No 221
Female labour force participation in the United Kingdom:
evolving characteristics or changing behaviour?
by Maria Gutiérrez-Domènech and Brian Bell
(151k)
The working-age female participation rate in the United Kingdom
increased by 7 percentage points between 1984 and 2002. The purpose
of this paper is to quantify how much of the rise reflects changes
in the socio-demographic structure of the female population and
how much can be attributed to changes in behaviour or other uncontrolled
factors. The paper uses a time series of cross-sections from the
Labour Force Survey, and applies a method of growth accounting.
The results show that, between 1984 and 2002, changes in the structure
of the female population contributed to two thirds of the growth
in female participation, whereas one third is explained by changes
in behaviour or other factors.
Working Paper
No 220
Does job insecurity affect household consumption?
by Andrew Benito
(283k)
This paper confronts implications of precautionary saving models
with microdata on British households. The results provide support
for the central proposition that job insecurity depresses household
consumption levels. A one standard deviation increase in unemployment
risk for the head of household is estimated to reduce household
consumption by 2.7%. Interpreting the spread of the distribution
across workers in job insecurity levels as consisting of four
standard deviations, this implies that moving from the bottom
to the top of the distribution gives rise to a reduction in consumption
of 11%, ceteris paribus. This effect is estimated to be greater
for the young, those without non-labour income and manual workers,
a pattern also consistent with the predictions of precautionary
saving models. The paper then studies the propensity for households
to purchase durable goods and finds durables purchases to be delayed
significantly by higher unemployment risk. The paper therefore
demonstrates that job insecurity affects aggregate demand through
both non-durable and durable expenditure, controlling for other
influences including estimated permanent income.
Working Paper
No 219
Bail out or work out? Theoretical considerations
by Andrew G Haldane, Gregor Irwin and Victoria Saporta
(280k)
This paper assesses various crisis resolution proposals using
a theoretical model of (liquidity and solvency) crisis. The model
suggests that payments standstills and last-resort lending are
equally efficient means of dealing with liquidity crises, while
coordinated lending through creditor committees is second best.
Debt write-downs are preferred to subsidised IMF financing when
dealing with solvency crises, because of the negative moral hazard
implications of the latter tool. Finally, the model suggests that
international bankruptcy court proposals may be superior to existing
contractual approaches in securing such write-downs.
Working Paper
No 218
Health, disability insurance and labour force participation
by Brian Bell and James Smith
(166k)
Over half a million men of working age left the labour market
over the course of the 1990s. In this paper this remarkable decline
is explored, and the roles played by the interaction of skills,
long-term sickness and the disability benefit system are highlighted.
The analysis shows that the decline in participation was almost
exclusively among unskilled males and that this same group reported
increasing long-term illness. The generosity of the disability
insurance system relative to that of the unemployment insurance
appears to have encouraged such workers to exit the labour market.
Strong evidence is presented of sizable labour supply responses
to disability insurance benefits, which would support that hypothesis.
But it seems unlikely that this 1990s' experience will be repeated
as disability benefits are now much less generous than they were
at that time.
Working Paper
No 217
International financial rescues and debtor-country moral
hazard
by Prasanna Gai and Ashley Taylor
(346k)
In this paper the question of whether recent international policy
initiatives to facilitate financial rescues in emerging market
countries have influenced debtors' incentives to access official
sector resources is examined. A country's systemic importance
is highlighted as a key characteristic that drives access to official
sector finance. The effect of these policy initiatives on IMF
programme participation is estimated using a pooled probit model.
The safety net implied by policy changes to permit exceptional
access is shown to have a greater marginal impact on the use of
official sector resources, the more systemically important the
debtor country is. The paper's results can be interpreted as offering
some support for the presence of debtor-country moral hazard.
Working Paper
No 216
IMF lending and creditor moral hazard
by Andrew G Haldane and Jörg Scheibe
(492k)
Existing empirical evidence on the effects of IMF intervention
on debtor and creditor incentives - so-called moral hazard - is
mixed. A new test of creditor moral hazard is developed which
uses some new data and some more stringent identifying restrictions.
The test examines the response of the market valuation of UK banks
to IMF loan packages. It finds a significant positive response
for UK banks, with abnormal returns of over 1% in a number of
cases. These excess returns are greater, the larger is the IMF
package and the larger is the size of the creditor banks' emerging
market portfolio. This effect is significant even once the potentially
welfare-enhancing effect of IMF loans in offsetting overpricing
problems in international capital markets is controlled for. In
short, concrete evidence is found of creditor-side moral hazard
associated with IMF support.
Working Paper
No 215
How can the IMF catalyse private capital flows? A model
by Adrian Penalver
(427k)
This paper presents a model to explain how IMF programmes can
catalyse private capital flows following a financial crisis, a
concept that was at the heart of the IMF's strategy for dealing
with capital account crises in the late 1990s. In the model, the
IMF lends funds below the prevailing market interest rate and
it is this subsidy that induces the borrowing country to exert
adjustment effort to avoid default. By preventing default, future
marginal rates of return on investment are kept high, thereby
encouraging private capital flows. The IMF may also have a signalling
role if it has superior information about debtor type and can
affect the interest rate charged in the immediate aftermath of
a crisis. In practice, however, IMF programmes based on the catalytic
approach have been disappointing and actual private capital flows
have been considerably below those projected. Therefore, the paper
also considers how capital flows derived from the model are sensitive
to the assumptions made. The paper concludes by discussing the
policy implications of the analysis for IMF programme design.
Working Paper
No 214
An empirical model of household arrears
by John Whitley, Richard Windram and Prudence Cox
(325k)
Household arrears on payment obligations are one of the most direct
measures of household sector financial stress. In this paper a
time series approach is used to model two of the key components
of aggregate UK household arrears: those on mortgages and credit
cards. Mortgages are the main component of secured borrowing by
households and credit cards are a key element in unsecured borrowing.
Recent data show that both secured and unsecured debt have risen
substantially, both absolutely and as a proportion of income since
1997. Unsecured debt has increased more rapidly over this period
and so has become more important in overall household debt. During
this period of rapid debt accumulation, the proportion of mortgage
loans in arrears has fallen but the value of credit card arrears
relative to the value of active card balances has risen. These
differences in the behaviour of arrears are explained by reference
to the underlying driving forces identified in previous empirical
work. In particular the level of housing equity appears to be
more important in explaining mortgage arrears, and the role of
supply factors is highlighted for credit card arrears. Although
the estimated models confirm that both income and interest repayments
(and therefore income gearing) are important factors in explaining
both forms of arrears, unemployment only plays an additional role
for mortgage arrears. Joint testing of the two models suggests
a role for the ratio of the value of the mortgage loan to the
value of housing equity for both kinds of arrears, but with opposing
effects. In the case of mortgage arrears this might reflect the
lenders' perceptions of the quality of the borrower. Credit card
arrears appear to contain some information about future mortgage
arrears although the reverse does not hold. Both equations adjust
relatively quickly to any shocks, typically in around two years.
The significance of the income-gearing term for both types of
arrears underlines the importance of the path of interest rates
for the financial position of the UK household sector.
Working Paper
No 213
Investment-specific technological change and growth accounting
by Nicholas Oulton
(214k)
Greenwood, Hercowitz and Krusell have claimed that the Jorgenson
form of growth accounting is conceptually flawed and severely
understates the role of technological progress embodied in new
capital goods ('embodiment') in explaining US growth. To the contrary,
in this paper it is shown that in its technology aspects their
model is a special case of the Jorgensonian growth-accounting
model. What they call investment-specific technological change
is shown to be closely related to the more familiar concept of
TFP growth: statements about the one can be translated into statements
about the other. Empirically, they claim that the proportion of
US growth accounted for by embodiment is about twice as large
as estimated by conventional growth accounting. But the difference
between these estimates is found to be due more to data than to
methodology.
Working Paper
No 212
Crisis spillovers in emerging market economies: interlinkages,
vulnerabilities and investor behaviour
by Michael Chui, Simon Hall and Ashley Taylor
(386k)
Many emerging market economy (EME) financial crises in the 1990s
quickly spread to other countries. By contrast, spillovers from
the Argentina crisis in 2001-02 appear to have been much more
limited. Why do some crises spread widely and others do not? In
this paper the joint importance of intra-EME linkages, related
country-specific vulnerabilities and investor behaviour are stressed.
This framework provides insights into some potential reasons behind
the differing extent of spillovers in two case studies - Asia
1997-98 and Argentina 2001-02. It also highlights the need for
further analysis of the less easily measurable elements of the
framework, in particular changes in investor behaviour.
Working Paper
No 211
An empirical analysis of the dynamic relationship between
investment-grade bonds and credit default swaps
by Roberto Blanco, Simon Brennan and Ian W Marsh
(337k)
In this paper the behaviour of credit default swaps (CDS) are
analysed for a sample of firms and support found for the theoretical
equivalence of CDS prices and credit spreads. When this is violated,
the CDS price can be viewed as an upper bound on the price of
credit risk, while the spread provides a lower bound. It is shown
that the CDS market is the main forum for credit risk price discovery
and that CDS prices are better integrated with firm-specific variables
in the short run. Both markets equally reflect these factors in
the long run, and this is primarily brought about by bond market
adjustment.
