fiscal cyclicality and currency risk premia

41
Fiscal Cyclicality and Currency Risk Premia Zhengyang Jiang * November 12, 2018 Government surpluses load on a common factor, but to different degrees. In the cross-section, countries whose government surpluses are more cyclical with respect to the common factor tend to have higher nominal interest rates and higher currency returns. Their currency returns are also more exposed to a common risk factor, leading to a correspondence between the factor structure in government surpluses and the factor structure in currency returns. In a frictionless model, I show these results are consistent with the idea that currencies are priced as the claims to government surpluses. * Department of Finance, Kellogg School of Management, Northwestern University. 2211 Campus Drive, Evanston, IL 60208. Email: [email protected]. This paper is a part of my PhD thesis. I acknowledge with deep gratitude the mentorship of John Cochrane and Hanno Lustig as my advisors, and the guidance of Adrien Auclert, Svetlana Bryzgalova, Sebastian Di Tella, and Darrell Duffie on my dissertation committee. For helpful comments, I thank Torben Andersen, Samuel Antill, Jonathan Berk, Shai Bernstein, YiLi Chien, Jesus Crespo Cuaresma (discussant), Peter DeMarzo, Ian Dew-Becker, Xiang Fang, Steven Grenadier, Benjamin H´ ebert, Robert Hodrick, Oleg Itskhoki, Patrick Kehoe, Peter Koudijs, Arvind Krishnamurthy, Ye Li, Edith X. Liu (discussant), Matteo Maggiori, Konstantin Milbradt, Sergio Rebelo, Rob Richmond, Dimitris Papanikolaou, Cheng Peng, Paul Pfleiderer, Jesse Schreger, Kenneth Singleton, Ilya Strebulaev, Viktor Todorov, Christopher Tonetti, Victoria Vanasco, Adrien Verdelhan, Jonathan Wallen, Yi David Wang, Rui Xu, Mindy Xiaolan Zhang, and seminar participants at Northwestern Kellogg, UW Foster, NYU Stern, Imperial College Business School, LSE, New York Fed, USC Marshall, Chicago Booth, Wharton, WFA, Vienna Symposium on Foreign Exchange Markets, and Cubist Systematic Strategies. I thank Daojing Zhai for excellent research assistance. 1

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Page 1: Fiscal Cyclicality and Currency Risk Premia

Fiscal Cyclicality and Currency Risk Premia

Zhengyang Jiang∗

November 12, 2018

Government surpluses load on a common factor, but to different degrees. In the cross-section,

countries whose government surpluses are more cyclical with respect to the common factor

tend to have higher nominal interest rates and higher currency returns. Their currency

returns are also more exposed to a common risk factor, leading to a correspondence between

the factor structure in government surpluses and the factor structure in currency returns.

In a frictionless model, I show these results are consistent with the idea that currencies are

priced as the claims to government surpluses.

∗ Department of Finance, Kellogg School of Management, Northwestern University. 2211 Campus Drive,Evanston, IL 60208. Email: [email protected]. This paper is a part of my PhDthesis. I acknowledge with deep gratitude the mentorship of John Cochrane and Hanno Lustig as my advisors,and the guidance of Adrien Auclert, Svetlana Bryzgalova, Sebastian Di Tella, and Darrell Duffie on mydissertation committee. For helpful comments, I thank Torben Andersen, Samuel Antill, Jonathan Berk, ShaiBernstein, YiLi Chien, Jesus Crespo Cuaresma (discussant), Peter DeMarzo, Ian Dew-Becker, Xiang Fang,Steven Grenadier, Benjamin Hebert, Robert Hodrick, Oleg Itskhoki, Patrick Kehoe, Peter Koudijs, ArvindKrishnamurthy, Ye Li, Edith X. Liu (discussant), Matteo Maggiori, Konstantin Milbradt, Sergio Rebelo,Rob Richmond, Dimitris Papanikolaou, Cheng Peng, Paul Pfleiderer, Jesse Schreger, Kenneth Singleton, IlyaStrebulaev, Viktor Todorov, Christopher Tonetti, Victoria Vanasco, Adrien Verdelhan, Jonathan Wallen, YiDavid Wang, Rui Xu, Mindy Xiaolan Zhang, and seminar participants at Northwestern Kellogg, UW Foster,NYU Stern, Imperial College Business School, LSE, New York Fed, USC Marshall, Chicago Booth, Wharton,WFA, Vienna Symposium on Foreign Exchange Markets, and Cubist Systematic Strategies. I thank DaojingZhai for excellent research assistance.

1

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2

I. Introduction

I find a high level of commonality in the changes in government surplus-to-debt ratios.

Across 11 developed countries, the first principal component explains 43% of their variations

from 1991 to 2017, and this fraction rises to 55% in the subsample starting from 2007. All

countries are exposed to this common factor, but to different degrees. A country has a

higher government surplus cyclicality if its government surplus-to-debt ratio is more exposed

to this factor. In this paper, I show how government surplus cyclicalities explain currency

risk premia in the cross-section.

To see this point, consider a model in which each country’s government only issues local

currency debt, and the debt is the claim to the government’s surpluses. Then, the real value

of the government debt reflects the present value of government surpluses, which fluctuate

across business cycles. On the other hand, since the notional payment of the government

debt is fixed in the unit of the local currency, the value of the local currency must adjust in

response to changes in government surpluses.

Therefore, currencies that are associated with more cyclical government surpluses tend to

depreciate more when the common factor in government surpluses declines. To compensate

investors for bearing this risk, these currencies have to offer higher risk premia. Notice,

however, their risk premia are not compensation for government default. In this model,

governments never default because they can always inflate away their local currency debt.

Currencies with higher risk premia can compensate investors by either raising nominal

interest rates or promising future appreciation. If each country’s monetary policy is set

so that its nominal exchange rate does not permanently drift upwards or downwards with

respect to other currencies, the country’s nominal interest rate must reflect its government

surplus cyclicality. So, a country with a higher government surplus cyclicality not only has

a higher currency return but also has a higher nominal interest rate.

Finally, the common variation in government surpluses also generates a factor structure

in currency returns. Lustig, Roussanov and Verdelhan (2011) define each currency’s carry

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3

beta as the exposure of its excess return with respect to the carry trade return, which is

the return differential between high interest rate currencies and low interest rate currencies.

They find currencies with higher carry betas tend to have higher returns. My model offers

an economic explanation for this factor structure: Currency returns load on a common risk

factor because their government surpluses are exposed to a common shock. The carry trade

bets on currencies whose government surpluses are more cyclical, and is therefore correlated

with the common factor in currency returns.

In summary, my model connects currency risk premia to the fiscal side of the economy. I

derive closed-form characterizations and test them in the sample of 11 developed economies.

Figure 1 summarizes the main result. A country with a higher government surplus cyclicality

tends to have a higher nominal interest rate, a higher currency expected return, and a higher

carry beta. Government surplus cyclicalities explain 62% of the cross-country variation in

average quarterly nominal interest rates, 78% of the variation in average quarterly currency

excess returns, and 52% of the variation in carry betas. This result is robust after I account

for the fact that government surplus cyclicalities are estimated.

1 2 3 4 5

−0.

6−

0.2

0.2

0.6

Government Surplus Cyclicality

Nom

inal

Inte

rest

Rat

e D

iffer

entia

l (%

)

Australia

CanadaDenmark

Germany

Japan

New ZealandNorway

Sweden

Switzerland

United Kingdom

United States

1 2 3 4 5

0.0

0.2

0.4

0.6

0.8

Government Surplus Cyclicality

Cur

renc

y E

xces

s R

etur

n (%

)

Australia

Canada

Denmark

Germany

Japan

New Zealand

Norway

Sweden

Switzerland

United Kingdom

United States

1 2 3 4 5

−0.

6−

0.2

0.2

0.6

Government Surplus Cyclicality

Cur

renc

y R

etur

n’s

Car

ry B

eta

Australia

Canada

DenmarkGermany

Japan

New ZealandNorwaySweden

Switzerland

United Kingdom

United States

Fig. 1.—Government surplus cyclicality explains currency risk premia. I plot each country’s government

surplus cyclicality against its currency’s quarterly average nominal interest rate differential with respect to

the U.S. dollar, quarterly average excess return with respect to the U.S. dollar, and carry beta. Data are

quarterly, 1980Q2—2017Q4. I use the longest sample possible for each currency. The dashed line is the best

fitting straight line from ordinary least squares.

Page 4: Fiscal Cyclicality and Currency Risk Premia

4

Moreover, the government surplus-to-debt ratio can be decomposed into a GDP-to-debt

component, a tax-to-GDP component, and a spending-to-tax component. It is mainly the

spending-to-tax component that drives government fiscal shocks and determines government

surplus cyclicalities. This result suggests that currency risk premia are mainly influenced by

government fiscal policies rather than underlying economic conditions.

Finally, I construct a currency portfolio sorted by conditional government surplus cycli-

calities, which are estimated from rolling window regressions. The cross-country strategy

takes a long position in currencies whose conditional government surplus cyclicalities are

higher than the cross-country median, and a short position in other currencies. The return

of this strategy is strongly correlated with the carry trade return, and offers a Sharpe ratio

similar to that of the carry trade. Because conditional government surplus cyclicalities are

estimated from data available ex-ante, this approach is an out-of-sample evaluation of the

fiscal condition’s return predictability. This result confirms that the carry trade is profitable

because it loads on currencies whose government surpluses are cyclical.

This paper proceeds as follows. Section II formulates the model and derives its predictions.

Section III describes the data. Sections IV, V, and VI report the main empirical results. Sec-

tion VII concludes. The Appendix contains proof and data sources. The Internet Appendix,

available on my personal website, contains additional empirical results.

A. Literature review

This paper connects the currency literature with the fiscal literature. The currency liter-

ature has documented the carry trade anomaly (Brunnermeier, Nagel and Pedersen (2008);

Lustig and Verdelhan (2007); Lustig, Roussanov and Verdelhan (2011); Burnside, Eichen-

baum and Rebelo (2011); Engel (2014)) and found a factor structure in currency returns

(Lustig, Roussanov and Verdelhan (2014); Fourel et al. (2015); Verdelhan (2018)). Hassan

and Mano (2014) shows that this factor structure is related to the cross-sectional component

of currency risk premia. I offer a fiscal explanation for these patterns.

My model is closest to Gourio, Siemer and Verdelhan (2013); Colacito et al. (Forthcoming)

Page 5: Fiscal Cyclicality and Currency Risk Premia

5

that explore heterogeneous loadings on global shocks as the key determinant of currency risk

premia, to Engel and West (2005); Gourinchas and Rey (2007, 2014); Farhi and Gabaix

(2016) that derive exchange rates as present values, and to Maggiori and Gabaix (2015) that

model risk-averse international investors.

On the other hand, the fiscal literature studies how fiscal conditions affect domestic and in-

ternational prices. Burnside, Eichenbaum and Rebelo (2001, 2003); Corsetti and Mackowiak

(2001); Daniel (2001a) show how fiscal shocks affected exchange rates during currency crises.

The fiscal theory of the price level connects fiscal conditions to domestic price levels (Sargent

and Wallace (1984); Leeper (1991); Woodford (1994); Sims (1994); Cochrane (2001, 2005,

2018, 2017); Dupor (2000); Daniel (2001b)). My paper extends this link to study currency

risk premia.

Outside the currency crisis literature and the fiscal theory, Aguiar et al. (2013, 2015); Du,

Pflueger and Schreger (2016) study how fiscal commitment interacts with inflation and debt

crisis. Aguiar, Amador and Gopinath (2005); Farhi, Gopinath and Itskhoki (2013) study

fiscal policies and real allocations. Obstfeld (2011); Farhi, Gourinchas and Rey (2011);

Caballero and Farhi (2013) explore the fiscal production of safe assets. My paper provides

a novel mechanism for determining international asset returns through the risk exposures of

fiscal processes.

In addition, my fiscal explanation of currency risk premia takes each country’s government

surplus cyclicality as given. Deeper economic rationales are required to explain why some

countries have more cyclical government surpluses. These rationales are beyond the scope

of this paper, but they can be motivated by previous studies that find commodity-exporting

countries (Powers (2015); Ready, Roussanov and Ward (2016, 2017)), peripheral countries

in the international trade network (Richmond (2016)), and net debtor countries (Corte,

Riddiough and Sarno (2016); Wiriadinata (2018)) have higher currency risk premia.

Finally, my model assumes that governments do not default. Default is possible if gov-

ernments have real liabilities, in which case their fiscal conditions affect both their default

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6

probabilities and their exchange rates (Chernov, Schmid and Schneider (2016); Bolton and

Huang (2017); Della Corte et al. (2016); Du and Schreger (2016); Augustin, Chernov and

Song (2018)). My model mutes this channel in order to focus on the connection between

fiscal conditions and currency risk premia.

II. Model

A. Environment

This section develops a simple model. There is only one type of consumption goods, which

is traded internationally at zero transportation cost and has a flexible price.

There are N countries, indexed by i ∈ {1, . . . , N}. Each country has a local currency. Let

Qit denote its value, which is the amount of consumption goods each unit of currency can

buy.

Each country also has a government, which collects tax and has government spending. Let

τ it denote the tax revenue, and let git denote the government spending. Both quantities are

in the unit of the consumption goods. Government surplus is defined as their difference:

sitdef= τ it − git.

The government issues debt denominated in the local currency. I make two simplifying

assumptions about the government debt. First, the government only issues one-period debt;

that is, each unit of the government debt pays 1 unit of the local currency in next period.

Let Bit denote the nominal quantity of the government debt issued in period t, which is the

amount of the local currency that the government pays in period t+ 1.

Second, the government does not default. Let Rf,it denote the nominal interest rate of the

government debt issued in period t. Then, this debt is worth (1 + Rf,it )−1Bi

t units of the

local currency. As this model does not distinguish between a country’s monetary authority

and its government, the nominal interest rate is set by the government.

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7

In sum, the government has the following intertemporal budget condition:

τ it + (1 +Rf,it )−1Bi

tQit = git +Bi

t−1Qit. (1)

On the left-hand side, the government collects tax revenue and receives the proceeds from

new debt issuance. On the right-hand side, it spends and pays out for expiring debt. Debt

quantities Bit and Bi

t−1 are converted to real values by a factor of Qit, the currency value.

B. International Investor

There is a representative international investor who has access to the complete market. In

period t, his consumption is ct and his utility is

u (ct) =c1−γt

1− γ.

He receives endowment yt. He pays tax τ it to country i’s government, and receives govern-

ment spending git from it. He also trades government debt. By market clearing conditions,

since he is the only non-government agent, he holds all government debt in equilibrium. His

budget constraint is

yt +∑i

git +∑i

Bit−1Q

it −∑i

(1 +Rf,it )−1Bi

tQit = ct +

∑i

τ it , (2)

where all Arrow-Debrew securities with zero supply are omitted.

Then, the Lagrangian for the international investor’s optimization problem is

∑t

e−δtu (ct) + Λt

(yt +

∑i

sit − ct +∑i

Bit−1Q

it −∑i

(1 +Rf,it )−1Bi

tQit

).

Page 8: Fiscal Cyclicality and Currency Risk Premia

8

The first-order condition implies

1 = Et[

Λt+1

Λt

(1 +Rf,it )

Qi+t+ 1

Qit

], (3)

where Λt+1/Λt is the international investor’s real pricing kernel:

Λt+1

Λt

= e−δu′ (ct+1)

u′ (ct)= exp(−δ − γ∆ log ct+1).

Next, assume the present value of future government surpluses grows slower than the

discount rate:

ASSUMPTION 1:

limT→∞

Et

[Λt+T+1

Λt

(∞∑k=0

Λt+T+1+k

Λt+T+1

sit+T+1+k

)]= 0.

Then I can iterate the intertemporal government budget condition Eq. (1) and obtain the

following present value relationship.

LEMMA 1: Currency value equals the present value of real government surpluses divided

by the nominal quantity of government debt:

Qit =

1

Bit−1

∞∑k=0

Et[

Λt+k

Λt

sit+k

]. (4)

Let ei,jt denote the nominal exchange rate between country i’s currency and country j’s cur-

rency. Because the law of one price holds for the consumption goods, the nominal exchange

rate between the two currencies equals the ratio between their purchasing powers:

ei,jt = Qit/Q

jt .

Page 9: Fiscal Cyclicality and Currency Risk Premia

9

C. Shocks and Processes

Now I specify the processes of the real pricing kernel, government surpluses, and interest

rate targets. All shocks are standard normal variables, mutually independent across countries

and across time.

The international investor’s endowment loads on a global consumption shock εct+1:

yt+1

yt= exp(σεct+1).

The government budget condition Eq. (1) and the international investor’s budget con-

straint Eq. (2) imply that his real pricing kernel is

Λt+1

Λt

= exp(−δ − γσεct+1).

The log growth rate of country i’s government surplus is exposed to the same global

consumption shock εct+1:

∆ log sit+1 =

(µ− 1

2(ϕi)2σ2 − 1

2ω2

)+ ϕiσεct+1 + ωεs,it+1,

where the exposure ϕi is defined as the country’s government surplus cyclicality. This value

is fixed for each country, but can vary across countries. In addition, the log growth rate

of government surplus is also exposed to a country-specific shock εs,it+1. The terms in the

bracket are set so that the expected growth rate of government surplus is the same for all

countries:

Et[sit+1/sit] = eµ.

Finally, the government in country i sets the nominal interest rate Rf,it according to the

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10

following rule:

log(1 +Rf,it ) = rf,i + ηεf,it , (5)

where rf,i is a country-specific constant and εf,it is an idiosyncratic shock.

With these assumptions, the currency value equals the government surplus-to-debt ratio

times a function of the government surplus cyclicality:

LEMMA 2: The currency value is

Qit =

sitBit−1

F (ϕi),

where the function F is defined as

F (ϕi) =∞∑k=0

Et[

Λt+k

Λt

sit+ksit

].

D. Characterizations

When the international investor invests one unit of consumption goods in country i’s

government debt, he earns (1 +Rf,it )Qi

t+1/Qit unit of consumption goods in the next period.

Define the log currency excess return of currency i against currency j as the difference in

their log returns from the international investor’s perspective:

ri,jt+1def= log

(Qit+1

Qit

(1 +Rf,it )

)− log

(Qjt+1

Qjt

(1 +Rf,jt )

).

Alternatively, we can take the perspective of a hypothetical investor in country j. The

log currency excess return can also be expressed as the log return of country i’s government

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11

debt in the unit of country j’s currency minus country j’s log nominal interest rate:

ri,jt+1 = log

(ei,jt+1

ei,t(1 +Rf,i

t )

)− log

(1 +Rf,j

t

).

PROPOSITION 1 (Currency Risk Premium): The expected log currency excess return of

currency i against currency j is

Et[ri,jt+1] = (γϕiσ2 − γϕjσ2)−(

1

2(ϕi)2σ2 − 1

2(ϕj)2σ2

).

For any country i, its expected log currency excess return has two components. The

first component γσ2ϕi reflects the currency risk premium, which is increasing in country

i’s government surplus cyclicality ϕi. The second component −(1/2)(ϕi)2σ2 is the Jensen’s

inequality term that comes from the expectation of a log-normal process. When risk aversion

γ is larger than government surplus cyclicality ϕi, the currency’s expected log excess return

is increasing in ϕi.

The next proposition shows that the risk premium term γϕiσ2 also manifests itself in the

currency’s nominal interest rate.

PROPOSITION 2 (Nominal Interest Rate): (a) The log nominal interest rate in country i

satisfies

log(1 +Rf,it ) = γϕiσ2 +

(δ − 1

2γ2σ2

)+ ∆ logBi

t − µ.

(b) The log expected exchange rate movement is

logEt

[ei,jt+1

ei,jt

]=

(γϕiσ2 − rf,i − ηεf,it

)−(γϕjσ2 − rf,j − ηεf,jt

).

If the log expected exchange rate movement has an unconditional mean of 0, the nominal

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12

interest rate target rf,i must reflect the currency risk premium:

rf,i = γϕiσ2.

Proposition 2(a) states that besides the risk premium term, the nominal interest rate

contains two additional terms. δ − (1/2)γ2σ2 is the log real interest rate implied from the

international investor’s pricing kernel:

Et[

Λt+1

Λt

· eδ−12γ2σ2

]= 1,

and ∆ logBit − µ is the inverse of the expected change in currency value:

logEt[Qit+1

Qit

]= logEt

[sit+1/s

it

Bit/B

it−1

]= −∆ logBi

t + µ;

since this expected change in currency value does not affect risk premium, the currency has

to offer a higher nominal interest rate if it is expected to depreciate.

Proposition 2(b) states that if exchange rates have no permanent drifts, currencies with

higher government surplus cyclicalities must also have higher nominal interest rates. Pro-

ceeding with this assumption, I set rf,i = γϕiσ2.

Lastly, I define the carry trade strategy as a long position in currencies whose nominal

interest rates are above the cross-country median plus a short position in currencies whose

nominal interest rates are below the median. The average log return of its holdings is

rcarryt+1def=

1

N

(∑i∈Ht

ri,jt+1 −∑i∈Lt

ri,jt+1

), (6)

Ht ={i : Rf,i

t ≥ median({Rf,kt }k)

},

Lt ={i : Rf,i

t < median({Rf,kt }k)

}.

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13

Fix a base currency j. I define a currency’s carry beta βicarry as the exposure of its excess

return against the base currency j with respect to the carry trade return (Lustig, Roussanov

and Verdelhan (2011)), obtained from the following regression:

ri,jt+1 = αi + βicarryrcarryt+1 + εit+1.

For tractability, I make the following assumption.

ASSUMPTION 2: There is a large number N of countries, and their government surplus

cyclicalities ϕi are normally distributed with a mean of ϕ and a standard deviation of ρ.

Then, the following proposition characterizes the carry beta.

PROPOSITION 3 (Factor Structure in Currency Returns): Currency returns loads on the

carry trade return to different degrees. Each currency’s carry beta βicarry equals its govern-

ment surplus cyclicality ϕi up to a linear transformation:

βicarry =1

C2

ϕi − ϕj

C2

,

where C2 = 2√2π

ρ2√1+(

η

γσ2ρ

)2is a positive constant.

This last proposition shows a correspondence between the factor structure in currency re-

turns and the factor structure in government surpluses. A currency with a higher government

surplus cyclicality also has a higher carry beta.

E. Discussions of Assumptions

This model makes the following assumptions to derive simple characterizations of nominal

currency returns and nominal interest rates.

No Government Default

In my model, governments never default. The local currency debt is like equity, and the

currency value is like its stock price. Whenever the present value of government surpluses

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14

declines in real terms, the local currency depreciates so that the government surplus is still

sufficient to honor the debt’s nominal payment.

However, if the government also issues real debt or foreign currency debt, the government

defaults whenever its surplus falls below the required debt payment in real terms or in

foreign currency terms. Governments can also default strategically (Arellano (2008)). In

these cases, a country’s fiscal condition affects both its default probability and its currency

value. Because there is one more degree of freedom, additional layers are required to pin

down the entire dynamics. These layers are abstracted away in my paper.

In the Internet Appendix, I document that government surplus cyclicality explains a large

fraction of variation in currency risk premia among developed countries, and a smaller frac-

tion of variation among developing countries. Sovereign CDS premium has the opposite

pattern: It explains no variation in currency risk premia among developed countries, and

a large fraction of variation among developing countries. Since government default mainly

happens in developing countries, it is reasonable to expect my fiscal explanation of currency

risk premia to work better for developed countries.

Constant Real Exchange Rate

In this frictionless model, a single type of consumption goods implies constant real exchange

rates. This assumption allows me to characterize currency returns in closed forms. In reality,

real exchange rates are not constant, and their movements are highly correlated with nominal

exchange rate movements (Mussa (1986)). In Jiang (2018), I develop a New Keynesian model

with differentiated goods and sticky prices. This model has two ex-ante symmetric countries,

and each country’s price level is determined by the present value of government surpluses

as in Eq. (1). Because prices are sticky, real and nominal exchange rates have to comove

in response to fiscal shocks, while inflation adjustment is sluggish and shaped by monetary

policy.

Local Currency Debt

This model assumes that governments only issue local currency debt. The Bank for In-

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15

ternational Settlements discloses the currency compositions of central government debt in

different countries. With the exception of Argentina, most government debt issued in recent

years is denominated in its local currency, with a large fraction of debt having fixed rates

(See Internet Appendix).

Negative Government Surplus

If the present value of all future government surpluses is negative, the currency should have

a negative value. However, current government deficits do not necessarily imply a negative

present value of future government surpluses, if government surpluses will turn positive in

the long run. In support of this view, Bohn (1998) documents that the U.S. government

tends to increase government surpluses when the debt-to-GDP ratio is high.

III. Data

A. Sample

I focus on 11 developed economies: Australia, Canada, Denmark, Germany, Japan, New

Zealand, Norway, Sweden, Switzerland, the United Kingdom, and the United States.

Data are quarterly, covering the period from 1980Q1 to 2017Q4. The sample is unbalanced,

but after each country’s time series starts, there is no missing observation. The Appendix

provides a detailed description of the data source.

B. Estimation of government surplus cyclicality

By the law of large numbers, the average log growth rate of the government surplus-to-debt

ratio in my model equals the global consumption shock εct+1 up to a linear transformation:

1

N

N∑i=1

(log

sit+1

Bit

− logsitBit−1

)=

1

N

N∑i=1

(−1

2(ϕi)2σ2 − 1

2ω2 + δ − 1

2γ2σ2

)+

(1

N

N∑i=1

ϕi

)σεct+1.

Therefore, each country’s government surplus cyclicality ϕi can be recovered by regressing

Page 16: Fiscal Cyclicality and Currency Risk Premia

16

the log growth rate of its government surplus-to-debt ratio on the average log growth rate:

logsit+1

Bit

− logsitBit−1

= ai + bi · 1

N

N∑k=1

(log

skt+1

Bkt

− logsktBkt−1

)+ εit+1, (7)

and the regression coefficient bi is a scaled version of the government surplus cyclicality:

bi =1

1N

∑Nk=1 ϕ

k· ϕi.

To estimate bi from this regression, I encounter two empirical issues. First, there are

seasonal effects in quarterly government surpluses and government debt. To control for

these seasonal effects, I use the four-quarter change in the government surplus-to-debt ratio

instead. Then Eq. (7) becomes:

logsit+1

Bit

− logsit−3

Bit−4

= ai + bi · 1

N

N∑j=1

(log

sjt+1

Bjt

− logsjt−3

Bjt−4

)+ εit+1. (8)

My model implies that bi from Eq. (8) is still equal to government surplus cyclicality ϕi

up to a linear transformation (See the Internet Appendix).

Second, government surpluses can be negative, in which case their logarithm log sit+1 is

undefined. This issue reflects my model’s trade-off between tractability and reality: While

the assumption of log-normal shocks allows me to derive closed-form results, it cannot match

observed government deficits. Since the focus of this paper is on the change in the government

surplus-to-debt ratio, I use the following approximation to derive testable implications:

logsit+1

Bit

− logsit−3

Bit−4

≈Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

, (9)

where Snom,it+1 is the nominal government surplus and P it+1 is the price level. The proof is in

Page 17: Fiscal Cyclicality and Currency Risk Premia

17

the Appendix. Under this approximation, Eq. (8) becomes

Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

= ai + bi · ft+1 + εit+1, (10)

where ft+1 is the common surplus factor:

ft+1def=

1

N

N∑j=1

(Snom,jt+1

Bjt

P jt−3

P jt+1

−Snom,jt−3

Bjt−4

).

Since not all countries have government surplus data available at the start of the sample,

the common surplus factor is the equal-weighted average over countries that have data.

IV. Commonality in Government Fiscal Shocks

A. Exposures to the common surplus factor

Table 1 reports the estimation result of Eq. (10). All countries have positive and statisti-

cally significant loadings on the common surplus factor. Although the loadings vary across

countries, the common surplus factor explains large fractions of variations in all countries

except Japan and Germany. For example, United States’ coefficient is 0.35 while Norway’s

coefficient is 1.85, but the common surplus factor explains about the same fraction of the

variation in both countries.

Table 1

Loadings on the Common Surplus Factor

Japan US Switzerland Canada Germany Denmark UK Sweden Norway Australia New Zealand

bi 0.20 0.35 0.37 0.41 0.50 0.77 0.80 0.81 1.85 1.99 3.07

s.e. (0.05) (0.03) (0.05) (0.05) (0.18) (0.08) (0.08) (0.08) (0.18) (0.21) (0.30)R2 9.71 41.45 27.08 35.54 5.29 38.63 38.69 40.29 42.20 43.35 49.65

Note: I report the coefficient bi, its standard error, and the R2 of Eq. (10) in the time series of each country.

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18

B. Principal component analysis

Alternatively, I use the principal component analysis to confirm the existence of a common

factor in the fiscal shocks across countries. I rescale all countries’ time series of the changes in

government surplus-to-debt ratios so that they all have unit variance. Under this approach,

a country with a volatile government surplus-to-debt ratio does not necessarily have a higher

loading on the common factor.

Figure 2 reports the result. The left panel shows the fraction of variance explained by each

principal component. The first principal component explains 43% of the variation in gov-

ernment surplus-to-debt ratios, while the remaining principal components explain much less

variation. In the subsample starting from 2007, this fraction rises to 55%. For comparison,

the first principal component of GDP growth rates explains 54% of the variation.

The right panel shows the loading of each country’s time series on the first principal

component. All countries have positive loadings on the first principal component. Since

2 4 6 8 10

010

2030

40

Principal Components

Prop

ortio

n of

Var

ianc

e

Ger

man

y

Japa

n

New

Zea

land

Aus

tral

ia

Switz

erla

nd

Nor

way

Den

mar

k

Swed

en

Uni

ted

Stat

es

Uni

ted

Kin

gdom

Can

ada

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

Fig. 2.—Principal component analysis of the changes in government surplus-to-debt ratios. Each country’s

time series is rescaled so that it has a unit variance. The left panel shows the fraction of variance explained

by each principal component. The right panel shows each country’s loading on the first principal component.

Data are quarterly, from 1991Q1 to 2017Q4. This sample is shorter because some countries contain missing

data points in the 1980s.

Page 19: Fiscal Cyclicality and Currency Risk Premia

19

each country’s time series is normalized by its volatility, the rank of countries by their

loadings is different from the rank in Table 1.

The first principal component is highly correlated with the common surplus factor ft+1

with a correlation of 0.95. Because the common surplus factor is easier to construct and has

a longer sample period, I focus on the common surplus factor in my remaining analysis.

C. What drives the common surplus factor

To examine what explains the variation in the common surplus factor, I regress the common

surplus factor ft+1 on concurrent variables xt+1:

ft+1 = α + βxt+1 + εt+1.

The explanatory variables xt+1 fall into three categories. First, government surpluses are

tax minus spending, and ultimately come from the production of goods. I include the average

log growth rates of GDP, tax revenue and government spending across all countries.

Second, Lustig, Roussanov and Verdelhan (2011, 2014) and Verdelhan (2018) show that

the carry factor and the dollar factor are systematic risk factors in currency returns. The

dollar factor is the holding return of the U.S. dollar against the equal-weighted portfolio of

foreign currencies in my sample. If government surplus-to-debt ratios affect currency risk

premia, the common surplus factor might comove with these currency factors.

Third, stock market performance also reflects economic fundamentals and government

policies. I use the MSCI world equity cum-dividend return in US dollar and the VIX index

to represent the fluctuations in the stock market.

Table 2 reports the regression results. The average log GDP growth rate is positively cor-

related with the common surplus factor, and explains 26% of the variation in the common

surplus factor. The common surplus factor is also positively correlated with the average

growth rate of tax revenue and negatively correlated with the average growth rate of gov-

ernment spending. Therefore, the common movements in tax revenue and in government

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20

Table 2

Drivers of the Common Surplus Factor

(1) (2) (3) (4) (5) (6) (7) (8) (9)

GDP Growth 0.168∗∗

(0.070)

Tax Revenue Growth 0.231∗∗∗

(0.014)Govt Spending Growth −0.224∗∗∗

(0.025)Carry Factor 0.198∗ 0.199∗ 0.133∗∗∗

(0.103) (0.102) (0.051)

Dollar Factor −0.002 0.011 0.060∗∗

(0.051) (0.037) (0.029)

MSCI World Return 0.098∗∗∗ 0.127∗∗∗ 0.114∗∗∗

(0.029) (0.017) (0.019)VIX −0.047∗∗ −0.002 −0.002

(0.020) (0.011) (0.012)

Observations 147 147 133 133 133 147 112 112 112

R2 0.264 0.837 0.144 0.00004 0.145 0.271 0.139 0.350 0.403

Note: I regress the common surplus factor on fundamental variables, currency factors and stock marketperformance. Because the common surplus factor is the average 4-quarter change in government surplus-to-debt ratios, all explanatory variables except VIX are growth rates or cumulative returns over the same 4-quarter periods. The constant is not reported. The standard errors are heteroskedasticity and autocorrelationconsistent. ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01.

spending both contribute to the variation in the common surplus factor.

The common surplus factor also comoves with the carry trade factor. The common surplus

factor is not correlated with the dollar factor in the univariate regression, but it is positively

correlated with the dollar index once the MSCI world stock return index is controlled for.

Finally, the common surplus factor is higher when the stock market performs well. In

univariate regressions, the common surplus factor is positively correlated with the MSCI

world equity return and negatively correlated with the VIX index. The VIX index no longer

explains the common surplus factor once the MSCI world equity return is controlled for.

The last column in Table 2 regresses the common surplus factor on currency risk factors

and stock market performance. These financial variables explain 40% of the variation in the

common surplus factor.

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21

V. Currency Risk Premia in the Cross-Section

A. Main results

Having established the existence of the common factor in government surplus-to-debt ra-

tios, I test my model’s key predictions. Proposition 1 and 2 predict that a currency with a

higher government surplus cyclicality has a higher average excess return and a higher average

nominal interest rate. As discussed in Section III, I use the regression coefficient bi from

Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

= ai + bi · ft+1 + εit+1

as a proxy for the government surplus cyclicality ϕi.

In Figure 1 in the introduction, I have shown that the regression coefficient bi is positively

associated with the average nominal interest rate differential and the average currency excess

return with respect to the U.S. dollar. I run 4 tests to quantify this relationship.

The first test is ordinary least squares (OLS). I regress each country’s average nominal

interest rate differential or average currency excess return with respect to the U.S. dollar on

its regression coefficient bi:

1

T

T∑t=1

(logRf,i

t − logRf,USt

)or

1

T

T∑t=1

ri,USt+1 = λ0 + λbi + ei. (11)

I regard each currency’s regression coefficient bi as a known constant, and run a linear

regression in the cross-section of countries. Table 3 reports the results. A one-standard

deviation increase in a country’s regression coefficient bi is associated with a 0.32% higher

nominal interest rate and a 0.24% higher currency excess return per quarter. The government

surplus cyclicality explains 62% of the cross-country variation in the average nominal interest

rate and 78% of the cross-country variation in the average currency excess return.

The next three tests recognize the fact that the regression coefficient bi is estimated from

a regression. The second test corrects for the estimation errors in bi using the generalized

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22

Table 3

Currency Risk Premia in the Cross-Section

Dependent Variable Test #Quarters λ Std Error R2 (%) α Test p Value

Nominal Interest Rate OLS 152 35.40 (9.20) 62.19

Nominal Interest Rate GMM 108 47.35 (9.88) 7.48 0.68Nominal Interest Rate Shanken 108 32.53 (1.21) 1220.22 0.00

Nominal Interest Rate Fama-Macbeth 137 45.85 (5.40) 645.18 0.00

Currency Excess Return OLS 152 26.83 (4.80) 77.64Currency Excess Return GMM 108 38.21 (19.48) 3.40 0.97

Currency Excess Return Shanken 108 31.33 (18.12) 2.91 0.97

Currency Excess Return Fama-Macbeth 137 17.38 (21.11) 6.06 0.73

Note: I report the estimates of the risk premium parameter λ from the four tests. The estimates λ are scaledto express the change in the dependent variable in basis points for a unit increase in the government surpluscyclicality. #Quarters is the number of quarters used in each test. OLS and the Fama-Macbeth test allowsome countries to have missing observations. α Test is the test statistics against the null that all pricingerrors are jointly zero. Under the null, it follows a Chi-squared distribution, and I also report its p value.The standard errors from the GMM, the Shanken test, and the Fama-Macbeth test are heteroskedasticityand autocorrelation consistent.

method of moments (GMM). The moment conditions are

(Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

)− ai − bift+1 = 0,((

Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

)− ai − bift+1

)ft+1 = 0,(

logRf,it − logRf,US

t

)− λbi − λ0 = 0 or ri,USt+1 − λbi − λ0 = 0.

The first two moment conditions estimate the proxy bi for government surplus cyclicality.

The last moment condition estimates the relationship λ between government surplus cycli-

cality and currency risk premia. In order to estimate the covariance matrix of residuals, all

countries’ time series should have the same length. So, in this procedure I use the subsample

that contains no missing observation, which starts from 1991.

I report the first-stage GMM result in Table 3. The estimate λ is consistent with the

OLS results, suggesting a positive relationship between government surplus cyclicality and

currency risk premia.

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23

The third test uses the Shanken (1992) correction. The sample is shorter because this pro-

cedure also requires that the sample contains no missing observation. When the dependent

variable is the currency excess return, the estimate λ and its standard error are similar to

those from the GMM.

The fourth test follows the Fama and MacBeth (1973) procedure. I estimate the regression

coefficient bi from the entire time series, and then estimate the coefficient λ from Eq. (11)

using the cross-section in each quarter. I only require that there are at least four countries

with non-missing observations to admit a quarter into my sample, and report the sample

average of the estimate λ in each quarter. When the dependent variable is the currency

excess return, the estimate λ is smaller than the estimates from the other tests.

B. The source of government surplus cyclicality

The government surplus-to-debt ratio can be decomposed into 3 components:

sit+1

Bit

≡GDP i

t+1

Bit

·τ it+1

GDP it+1

·τ it+1 − git+1

τ it+1

.

The GDP-to-debt ratio measures the quantity of domestic production per unit of govern-

ment debt, reflecting the country’s underlying economic condition. The tax-to-GDP ratio

measures the quantity of tax revenue per unit of domestic production, reflecting the govern-

ment’s tax policy. The surplus-to-tax ratio measures the quantity of government spending

per unit of tax revenue, reflecting the government’s spending policy.

Take the four-quarter log difference,

∆4 logsit+1

Bit

≡ ∆4 logGDP i

t+1

Bit

+ ∆4 logτ it+1

GDP it+1

+ ∆4 logτ it+1 − git+1

τ it+1

,

where ∆4 = (I − L4) takes the difference between the variable and its value 4 quarters ago.

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24

On the left-hand side, I use the approximation formula Eq. (9):

∆4 logsit+1

Bit

≈Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

.

On the right-hand side, because the government surplus τ it − git can be negative, I use the

spending-to-tax ratio git/τit to represent log((τ it − git)/τ it ).

Then, I can examine which component explains the variation in the government surplus-

to-debt ratio. To do so, I regress the change in the government surplus-to-debt ratio on its

three components:

Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

= a+ c1∆4 logGDP i

t+1

Bit

+ c2∆4 logτ it+1

GDP it+1

+ c3∆4 git+1

τ it+1

+ εit+1.

Table 4 reports the regression results. All three components are correlated with the change

in the government surplus-to-debt ratio. However, the spending-to-tax ratio alone explains

69% of the variation, and drives out the explanatory power of the other two components.

This result suggests that the variation in the government surplus-to-debt ratio is mainly

driven by the government’s fiscal policy rather than the country’s economic condition.

Table 4

Decomposition of Government Fiscal Shock

(1) (2) (3) (4)

∆ log(GDP it+1/Bit) 0.034∗∗∗ −0.004

(0.010) (0.004)∆ log(τ it+1/GDP

it+1) 0.211∗∗∗ −0.0001

(0.019) (0.018)∆(git+1/τ

it+1) −0.245∗∗∗ −0.246∗∗∗

(0.009) (0.012)

Observations 1,578 1,578 1,578 1,578

R2 0.027 0.205 0.693 0.693

Note: I regress the change in government surplus-to-debt ratio on its three components. It is a panelregression across all countries and quarters. The constant is not reported. Standard errors are clustered byquarter. ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01.

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25

Now that the spending-to-tax ratio drives the variation in the government surplus-to-debt

ratio, can its cyclicality explain currency risk premia? To answer this question, I repeat the

same tests in Table 3, but replace the government surplus-to-debt ratio with the spending-

to-tax ratio and other components.

For example, in the OLS test, I regress each of the three components on the common

surplus factor in each country’s time series:

∆ logGDP i

t+1

Bit

= ai1 + bi1 · ft+1 + εi1,t+1,

∆ logτ it+1

GDP it+1

= ai2 + bi2 · ft+1 + εi2,t+1,

∆gitτ it

= ai3 + bi3 · ft+1 + εi3,t+1,

and then regress each country’s average currency excess return with respect to the U.S. dollar

on one of the coefficients bi1, bi2, and bi3.

I also repeat the GMM, the Shanken test and the Fama-Macbeth for each of the components

of the government surplus-to-debt ratio. Table 5 reports the test results. The association

between the spending-to-tax ratio’s cyclicality and the currency excess return is the strongest:

It has the highest R2 and the highest t statistics, and the null that all pricing errors are jointly

zero is not rejected in its GMM test.

This result suggests that the cross-country variation in currency risk premia is mostly

due to the governments’ fiscal policies. In the Internet Appendix, I also report the results

using the nominal interest rate differential as the dependent variable. The cyclicality of

the spending-to-tax ratio also explains the cross-country variation in nominal interest rate

differentials.

VI. The Factor Structure of Currency Returns

Lustig, Roussanov and Verdelhan (2011) show that the carry trade factor explains the

Page 26: Fiscal Cyclicality and Currency Risk Premia

26

Table 5

Decomposition of Government Surplus Cyclicality

Explanatory Variable Test #Qtrs λ Std Error R2 (%) α Test p Value

GDP-to-Debt Ratio OLS 152 6.59 (5.33) 14.53

GDP-to-Debt Ratio GMM 108 45.56 (47.61) 488.98 0.00GDP-to-Debt Ratio Shanken 108 7.26 (9.35) 11.04 0.27

GDP-to-Debt Ratio Fama-Macbeth 137 6.70 (9.15) 10.72 0.30

Tax-to-GDP Ratio OLS 152 8.78 (8.93) 9.71Tax-to-GDP Ratio GMM 108 48.93 (36.03) 44.11 0.00

Tax-to-GDP Ratio Shanken 108 16.56 (14.88) 4.39 0.88

Tax-to-GDP Ratio Fama-Macbeth 137 17.11 (13.88) 12.43 0.19Spending-to-Tax Ratio OLS 152 −9.98 (4.78) 32.60

Spending-to-Tax Ratio GMM 108 −26.80 (16.88) 4.32 0.93

Spending-to-Tax Ratio Shanken 108 −13.51 (9.11) 7.80 0.55Spending-to-Tax Ratio Fama-Macbeth 137 −17.48 (8.74) 14.94 0.09

Note: I report the estimates of the risk premium parameter λ from the four tests described in Table 3.The dependent variable is currency excess return. The estimates λ are scaled to express the change in thedependent variable in basis points for a unit increase in the explanatory variable. #Quarters is the numberof quarters used in each test. α Test is the test statistics against the null that all pricing errors are jointlyzero. Under the null, it follows a Chi-squared distribution, and I also report its p value. The standard errorsfrom the GMM, the Shanken test, and the Fama-Macbeth test are heteroskedasticity and autocorrelationconsistent.

cross-section of currency risk premia, and Fourel et al. (2015); Verdelhan (2018) show that it

also explains currency returns. Proposition 3 offers a fiscal explanation: Currency loadings

on the carry trade return have a factor structure because government surpluses are exposed

to the common surplus factor to different degrees. In this section, I examine the extent

to which the factor structure in currency returns corresponds to the factor structure in

government surpluses.

A. Government surplus cyclicality and currency return beta

As in Proposition 3, a currency’s carry beta βicarry is defined as the exposure of its excess

return in dollar with respect to the carry trade factor:

ri,USt+1 = αi + βicarryrcarryt+1 + εit+1. (12)

The last panel of Figure 1 in the introduction plots each country’s regression coefficient

Page 27: Fiscal Cyclicality and Currency Risk Premia

27

bi against its carry beta. This figure confirms Proposition 3: A currency with a higher

government surplus cyclicality tends to be more exposed to the carry trade factor.

Table 6 provides a detailed analysis. Panel A reports each currency’s carry beta from

from Eq. (12). Countries with higher government surplus cyclicalities, such as Australia and

New Zealand, have positive carry betas, whereas countries with lower government surplus

cyclicalities, such as Japan and Switzerland, have negative carry betas. The R2 is higher for

countries whose carry betas are greater in absolute values. Compared with Table 1, the carry

trade factor explains a smaller fraction of variation in currency returns than the common

surplus factor does for the variation in government fiscal shocks.

By Proposition 3, since bi measures the government surplus cyclicality of country i, country

i’s carry beta has the following functional form:

βicarry = ζ0 + ζbi.

Panel B tests this relationship in two ways. The first test regards each currency’s carry beta

βicarry and government surplus cyclicality bi as known constants, and runs a linear regression

Table 6

Factor Structure in Currency Returns

Panel A: Carry Beta

Japan Switzerland Germany Denmark US UK Canada Sweden Norway New Zealand Australiaβicarry −0.65 −0.29 −0.17 −0.10 0.00 0.31 0.34 0.40 0.41 0.63 0.71

s.e. (0.15) (0.15) (0.14) (0.14) (0.00) (0.13) (0.08) (0.14) (0.14) (0.13) (0.13)

R2 12.80 2.88 1.09 0.38 - 4.25 11.31 5.70 6.45 15.02 18.14

Panel B: Carry Beta vs. Government Surplus Cyclicality

Test #Quarters ζ Std Error R2 (%)

OLS 152 0.34 (0.10) 54.95GMM 108 0.49 (0.21)

Note: Panel A reports the coefficient βicarry, its standard error, and the R2 of Eq. (12) for each country.

Panel B reports the test statistics. #Quarters is the number of quarters used in each test. The standarderrors from the GMM are heteroskedasticity and autocorrelation consistent.

Page 28: Fiscal Cyclicality and Currency Risk Premia

28

in the cross-section of countries:

βicarry = ζ0 + ζbi + ei.

The OLS results suggest that a one-standard deviation increase in government surplus

cyclicality is associated with a 0.30 increase in slope beta, and government surplus cyclicality

explains 55% of the cross-country variation in the slope beta.

The second test corrects for the estimation errors using the generalized method of moments

(GMM). The moment conditions are

Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

− ai − bift+1 = 0,(Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

− ai − bift+1

)ft+1 = 0,

ri,USt+1 − (ζ0 + ζbi)rcarryt+1 − ci = 0,(ri,USt+1 − (ζ0 + ζbi)rcarryt+1 − ci

)rcarryt+1 = 0.

The first two moment conditions estimate the regression coefficient bi, which proxies for

the government surplus cyclicality. The last two moment conditions estimate the carry beta

βicarry, imposing the functional form (ζ0 + ζbi). Consistent with the OLS result, ζ is positive.

A higher government surplus cyclicality bi corresponds to a higher carry beta βicarry. A

country with a more cyclical fiscal condition also has riskier currency returns.

B. Currency portfolios sorted by conditional government surplus cyclicality

Now that a country’s government surplus cyclicality also reflects its currency’s risk expo-

sure, I can construct the carry trade from the fiscal data. First, I estimate the conditional

government surplus cyclicality of country i in quarter t by running the regression Eq. (10)

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29

over a rolling window of T quarters:

Snom,ik+1

Bik

P ik−3

P ik+1

−Snom,ik−3

Bik−4

= ait + bitfk+1 + εi,tk+1, (13)

for k = {t− T, . . . , t− 1}.

In the earlier part of the sample, some countries’ government surpluses and debt quantities

are missing. I exclude a country/quarter observation (i, t) from panel the whenever there is

any missing variable in the entire rolling window from quarter t− T to quarter t− 1. I use

a look-back horizon of T = 4, 8, 20 or 40 quarters.

Then, I sort currencies into two quarterly-rebalanced portfolios based on their conditional

government surplus cyclicalities bit. Portfolio Low contains the currencies whose conditional

government surplus cyclicalities are below or equal to the cross-country median, and Portfolio

High contains those whose conditional government surplus cyclicalities are above the median.

The cross-country strategy invests a dollar in each currency in Portfolio High, and shorts a

dollar’s worth of each currency in Portfolio Low. The average log return of this strategy is

rxct+1def=

1

N

∑i∈Hxct

ri,USt+1 −∑i∈Lxct

ri,USt+1

,

where Hxct =

{i : bit > median({bjt}j)

}, Lxct =

{i : bit ≤ median({bjt}j)

}.

Table 7 reports the means, the Sharpe ratios, and the correlation matrix of the carry trade

return and the cross-country strategies’ returns. Regardless of the look-back horizon, the

Sharpe ratios of the cross-country strategies are slightly lower than that of the carry trade.

Surprisingly, a sample of four quarters is enough to estimate conditional government surplus

cyclicalities that predict currency returns in the cross-section.

Moreover, the cross-country strategies’ returns are positively correlated with the carry

trade return. I also report the alpha from regressing the carry trade return on the return

of each cross-country strategy. These strategies’ returns explain 24% to 52% of the average

Page 30: Fiscal Cyclicality and Currency Risk Premia

30

Table 7

Portfolios Sorted By Conditional Government Surplus Cyclicality

Avg Return (%) SR Correlation Matrix Alpha of Carry Trade (%)

Carry Trade 0.25 0.16 1.00 0.50 0.53 0.51 0.53 0.00

(0.15) (0.10) (0.00) (0.08) (0.09) (0.10) (0.08) (0.00)Cross-Country, T=4 0.13 0.12 0.50 1.00 0.66 0.46 0.32 0.16

(0.10) (0.10) (0.08) (0.00) (0.07) (0.08) (0.11) (0.14)

Cross-Country, T=8 0.18 0.16 0.53 0.66 1.00 0.67 0.56 0.12(0.11) (0.10) (0.09) (0.07) (0.00) (0.08) (0.12) (0.14)

Cross-Country, T=20 0.16 0.13 0.51 0.46 0.67 1.00 0.77 0.14

(0.11) (0.11) (0.10) (0.08) (0.08) (0.00) (0.09) (0.14)Cross-Country, T=40 0.08 0.07 0.53 0.32 0.56 0.77 1.00 0.19

(0.11) (0.10) (0.08) (0.11) (0.12) (0.09) (0.00) (0.13)

Note: I estimate each currency’s conditional government surplus cyclicality using a rolling window regressionEq. (13), and sort currencies based on this estimate. Avg return is the quarterly average return, and SR isthe quarterly Sharpe ratio. The standard errors are obtained from 10,000 rounds of bootstrapping. In eachround, I resample the quarters with replacement.

excess return of the carry trade.

VII. Conclusion

In this paper, I show how government surplus cyclicalities explain the cross-country vari-

ation in currency risk premia and give rise to a factor structure in currency returns. These

results are consistent with the asset pricing view that an asset’s risk premium is driven by

the systematic risk exposure of its cash flows.

This framework has broader implications. In this model, I assume constant real exchange

rates in order to focus on currency risk premia. In Jiang (2018), I show that if prices are

sticky but exchange rates are flexible, government fiscal conditions drive both nominal and

real exchange rates.

In this model, investors hold government debt for its cash flows. In Jiang, Krishnamurthy

and Lustig (2018), we assume that investors also derive convenience benefits from holding

the US government debt, and show how this extension explains the dollar’s exchange rate.

Page 31: Fiscal Cyclicality and Currency Risk Premia

31

Appendix

Appendix A: Proof

Proof of Lemma 1: Consider any country i. Combine the government budget condition Eq. (1) with Euler equation

Eq. (3),

sit + Et[

Λt+1

ΛtBitQ

it+1

]= Bit−1Q

it. (A1)

I iterate this equation forward, and obtain

Bit−1Qit = lim

T→∞

(T∑j=0

Et[

Λt+jΛt

sit+j

]+ Et

[Λt+T+1

ΛtBit+TQ

it+T+1

]). (A2)

If Assumption 1 holds, i.e.

limT→∞

Et

[Λt+T+1

Λt

(∞∑k=0

Λt+T+1+k

Λt+T+1sit+T+1+k

)]= 0, (A3)

then Eq. (4), reproduced below, is a solution to Eq. (A2):

Qit =

∞∑k=0

Et[

Λt+kΛt

sit+kBit−1

]. (A4)

Other solutions to Eq. (A2) create arbitrage opportunities: If the real value of the currency is

Qi∗t =

∞∑j=0

Et[

Λt+jΛt

sit+jBit−1

]+M i∗

t (A5)

for some positive M i∗t , then the international investor can short-sell one unit of this currency and trade Arrow-

Debreu securities to replicate the government’s budget from time t. This portfolio of Arrow-Debreu securities

requires the international investor to provide a stream of cash flows {sit+j}. This stream of cash flows costs∑∞j=0 Et[(Λt+js

it+j)/(ΛtB

it−1)] at time t. Therefore, the international investor makes a net profit of M i∗

t at time

t, which is an arbitrage opportunity. A similar argument also rules out the case of a negative M i∗t .

Proof of Lemma 2: Define

V T,itdef= Et

[ΛT s

iT

Λtsit

]

Page 32: Fiscal Cyclicality and Currency Risk Premia

32

which implies a boundary condition V T,iT = 1 and an intertemporal relationship:

V T,it = Et[

Λt+1

Λt

sit+1

sitV T,it+1

]. (A6)

Conjecture

V T,it = exp(fT−t(ϕi)),

with the boundary condition f0(ϕi) = 0.

Then f can be solved by iterating Eq. (A6):

efT−t(ϕi) = eµ−δ+12γ2σ2−γϕiσ2+fT−t−1(ϕi),

which confirms the functional form of f . Then, the currency value can be expressed as

Qit =

∞∑τ=0

Et[

Λt+τΛt

sit+τBit−1

]=

sitBit−1

∞∑τ=0

exp(fτ (ϕi)),

where the function F is defined as

F (ϕi)def=

∞∑τ=0

exp(fτ ((νit)2, ϕi)).

Proof of Proposition 1 and 2: From the Euler equation

Et[

Λt+1

Λt

Qit+1

Qit(1 +Rf,it )

]= 1,

the nominal interest rate satisfies

1

1 +Rf,it= Et

[Λt+1

Λt

Qit+1

Qit

]=

Bit−1

Biteµ−δ+

12γ2σ2−γϕiσ2

,

which simplifies to the formula in the proposition.

Page 33: Fiscal Cyclicality and Currency Risk Premia

33

Plug in the nominal interest rate rule,

logEt[Qit+1

Qit

]= logEt

[sit+1/s

it

Bit/Bit−1

]= −∆ logBit + µ

= γϕiσ2 +

(δ − 1

2γ2σ2

)− rf,i − ηεf,it .

The log currency excess return is

ri,jt+1def= log

(Qit+1

Qit(1 +Rf,it )

)− log

(Qjt+1

Qjt(1 +Rf,jt )

)

=

(γϕiσ2 − 1

2(ϕi)2σ2 + ϕiσεct+1 + ωεs,it+1

)−(γϕjσ2 − 1

2(ϕj)2σ2 + ϕjσεct+1 + ωεs,jt+1

).

So the expected log currency excess return is

Et[ri,jt+1] = (γϕiσ2 − γϕjσ2)−(

1

2(ϕi)2σ2 − 1

2(ϕj)2σ2

).

Proof of Proposition 3:

Plugging in the interest rate target rf,i = γϕiσ2, the log nominal interest rate is

log(1 +Rf,it ) = γσ2ϕi + ηεf,it .

Let φ denote the density function of the standard normal distribution. Then the distribution the log nominal

interest rate at time t is N (γσ2ϕ, (γσ2ρ)2 + η2). The median of this distribution is γσ2ϕ. By the Glivenko–Cantelli

theorem, the sample median converges to the population median almost surely. So, the carry trade return is

rcarryt+1 =

∫r≥γσ2ϕ

ri,jt+1 −∫r<γσ2ϕ

ri,jt+1

=

∫ϕi

∫εf,it

(2 · 1{γσ2ϕi+ηε

f,it ≥γσ2ϕ} − 1

)(γϕiσ2 − 1

2(ϕi)2σ2 + ϕiσεct+1 + ωεs,it+1

(ϕi − ϕρ

)φ(εct+1)dϕidεct+1

= C1 +

∫ϕi

∫εf,it

(2 · 1{γσ2ϕi+ηε

f,it ≥γσ2ϕ} − 1

)(ϕiσεct+1

(ϕi − ϕρ

)φ(εct+1)dϕidεct+1.

Page 34: Fiscal Cyclicality and Currency Risk Premia

34

Then

rcarryt+1 = C1 + σεct+1

∫ϕi

(2Φ

(γσ2(ϕi − ϕ)

η

)− 1

)ϕiφ

(ϕi − ϕρ

)dϕi

= C1 + C2σεct+1,

where

C2 =

∫ϕi

(2Φ

(γσ2(ϕi − ϕ)

η

)− 1

)ϕiφ

(ϕi − ϕρ

)dϕi

=2√2π

ρ2√1 +

γσ2ρ

)2> 0.

It then follows that currency i’s carry beta is

βicarry =cov(rcarryt+1 , ri,jt+1)

var(rcarryt+1 )

=ϕi − ϕj

C2.

Linear Approximation of the Change in Government Surplus-to-Debt Ratio:

The first step is to find a stationary time series. Let Snom,it denote the nominal government surplus, and let P it

denote the price level. Then, the government surplus-to-debt ratio can be written as

sit+1

Bit

def=

Snom,it+1 /Bit

P it+1

.

The numerator and the denominator of this fraction are not co-integrated: In the past 37 years, the numerator

Snom,it+1 /Bit fluctuates within a band, while the GDP deflator P it+1 has a strong trend. Figure A1 reports the time

series of their cross-country averages. The cross-country average of nominal surplus-to-debt ratios was −2.10% in

1980 and 0.00% in 2017; both values fall into the normal range of variation. In contrast, the cross-sectional average

of GDP deflators has increased from 0.51 in 1980 to 1.40 in 2017.

As a result, the government surplus-to-debt ratio sit+1/Bit has been declining. Economically, this pattern means

that the real government surplus backing each local currency unit of government debt has been decreasing, across all

countries.

On the other hand, the numerator Snom,it+1 /Bit is stationary. An augmented Dickey–Fuller test with 4 lags to

account for seasonal effects rejects the null hypothesis of a unit root at 5% level. Let si denote the average nominal

Page 35: Fiscal Cyclicality and Currency Risk Premia

35

1980 1990 2000 2010 2020

−0.

020.

000.

02

date

Ave

rage

Nom

inal

Sur

plus

−to

−D

ebt R

atio

0.0

0.4

0.8

1.2

Ave

rage

GD

P D

efla

tor

Nominal Surplus−to−Debt RatioGDP Deflator

Fig. A1.—The nominal government surplus-to-debt ratio Snom,it /Bi

t−1 and the GDP deflator, averaged

across countries. The GDP deflator in each country is normalized so that its value in 2000Q1 is 1.

surplus-to-debt ratio in country i:

sidef= Snom,it+1 /Bit.

Assuming the average nominal surplus-to-debt ratio si is positive, I can linearize the change in government surplus-

to-debt ratio around si/P it−3:

logsit+1

Bit− log

sit−3

Bit−4

def= log

Snom,it+1 /Bit

P it+1

− logSnom,it−3 /Bit−4

P it−3

≈ 1

si/P it−3

(Snom,it+1 /Bit

P it+1

− si

P it−3

)− 1

si/P it−3

(Snom,it−3 /Bit−4

P it−3

− si

P it−3

)

=1

si

(Snom,it+1

Bit

P it−3

P it+1

−Snom,it−3

Bit−4

). (A7)

Intuitively, Eq. (A7) takes the nominal surplus-to-debt ratio at quarter t+ 1, adjusts it for the price level change

in the previous 4 quarters, and then compares it to the nominal surplus-to-debt ratio 4 quarters before. It accounts

for both the change in the nominal government surplus and the change in the price level.

Lastly, the average nominal surplus-to-debt ratio si may vary across countries, which affects the magnitude of Eq.

(A7). However, as the government surplus-to-debt ratio is highly persistent, its long-run average is very difficult to

estimate. For parsimony, I assume si is the same across all countries.

Page 36: Fiscal Cyclicality and Currency Risk Premia

36

Appendix B: Data Source

Spot exchange rates and 3-month forward rates are closing rates at the end of each quarter, and they come from

three sources: WM/Reuters, Barclays Bank International and Thomson Reuters, all downloaded from Datastream.

For each currency and each quarter, I make sure the spot exchange rate and the 3-month forward rate come from

the same data source. Data from WM/Reuters take priority over data from Barclays Bank International, which take

priority over data from Thomson Reuters.

Following Du and Schreger (2016), I construct nominal interest rate differentials and currency returns based on

currency forward premia, which do not contain sovereign default risk. For robustness, I repeat my empirical analysis

in the Internet Appendix, using currency returns based on treasury yields.

The nominal government surplus, the nominal quantity of government debt, and the nominal GDP are downloaded

from Oxford Economics via Datastream. These nominal quantities are denominated in the unit of the local currency.

The GDP deflator is also downloaded from Oxford Economics via Datastream. Each country’s GDP deflator is

normalized so that its value in 2000Q1 is 1. Oxford Economics seasonally adjusts some, but not all, of these variables.

*

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