Concerns about Government Guarantee Cost: Revisiting the Incentives Regarding the Issuance of Inflation-Linked Bonds (Job Market Paper)

I develop a dynamic model to analyze the effects of incentives and disincentives on a government’s decision whether or not to issue Inflation-linked Bonds (ILBs). I find that the potential government guarantee cost could serve as an important incentive for a government to issue this kind of bond. During a political decision or reform process, a government typically has to provide some form of compensation to avoid evasion and noncompliance, for example, a minimum benefit guarantee during social security privatization. The cost of this guarantee could be significant, and issuing ILBs instead of providing this guarantee would be a way for the government to avoid this cost. I show that the government is more likely to issue ILBs when (1) the potential guarantee cost is high, (2) government spending is low, and (3) people have higher inflation expectations, consistent with empirical findings. By applying this model to the OECD, BRIC countries as well as other countries which already issued ILBs, I find that the introduction of guarantee cost helps the model to match the countries’ timing of issuing ILBs (in particular, it provides a mechanism to explain why some countries issue ILBs when there is no fear of high inflation) and also justifies why countries typically only issue small amounts of ILBs compared to nominal bonds, neither of which practices is well explained by the previous literature. Finally, I compare the calibrated government guarantee cost and the estimate from Martingale pricing theory, and then discuss the possibility of reconsidering the ILBs issuance policy.


Life-Cycle Portfolio Choice with Ambiguous Labor Income (with Jianjun Miao)

The predictions derived from classical life-cycle investment models suggests that the allocation toward stocks should start high early in life and decline as a person ages. However, in recent years these models have been found to be inconsistent with the stylized facts documented by datasets like the Survey of Consumer Finances or the Panel Study of Income Dynamics, which show that the share of portfolio invested in risky assets tend to be “hump-shaped” in relation to age. To better explain these facts, we try to introduce ambiguity and learning into our account of labor income. The mechanism is as follows: when there exists ambiguity over labor income, the future flow of labor is better described as stock-like in contrast to the bond-like shapes assumed by the previous literature. Hence the agent will not invest so much in risky assets at the beginning of a working life. As the agent approaches retirement, there are two partially offsetting effects. First, the learning mechanism gradually solves the uncertainty and leads human capital to take on more bond-like features. Second, the residual value of future labor income shrinks, since the agent has fewer years left to work, and therefore the value of the bond position implicit in his human capital decreases. Eventually, this second effect prevails, and hence explains the hump-shaped stock allocation of his life-cycle profile.


China’s Pension Reform and Inflation-Linked Bonds

As the problem of an aging population becomes increasingly serious for China, the existing Chinese pension system has drawn increasing attention.  Besides the question on financial sustainability, some other problems like little protection against inflation and distorted incentives in the system still exist, which have led to the failure of previous pension reforms. This paper firstly reviews the current problems and options of China’s pension structure so as to find ways to improve the conditions of Chinese pensioners. In particular, I argue that the government could issue Inflation-Linked Bonds (ILBs). By a simulation using the actual Chinese macro and financial data, I first show that the ILBs will provide the investor with a significantly better risk-return trade-off and greatly reduce the investment risk with the objective of beating inflation. I also argue that ILBs will provide the correct incentive to avoid or at least mitigate evasion and noncompliance, which typically happen in the wake of pension reform.


Work in Progress

“Inflation Risk Premium and Liquidity Risk Premium: Evidence from US Treasury Market”

“Longevity Risk, Portfolio Choice and Retirement Decisions Over the Life Cycle” (with Zvi Bodie and Yuling Wang)