Ebook Financial fragility in emerging markets: firm balance sheets and the sectoral structure
The opening of developing economies to international finance in the last three decades has led in a number of cases to severe balance-of-payments crises with large real costs. The Southern Cone crises at the beginning of the nineteen eighties, the Mexican crisis of 1994, the Asian crises of 1997, and the Argentine crisis of 2001, to mention but a few of them, all took place after the capital account had been liberalized. The literature dedicated to the empirical analysis of these events (Kaminsky & Reinhart 1999, Tornell & Westermann 2002, Calvo, Izquierdo & Mej?a 2004, among others) has identified a consistent set of stylized facts: the balance-of-payments crises go together with a real depreciation, a sharp drop of investment and a current-account reversal. Financial factors play a crucial role, and a lot of these currency crises were coupled with banking crises.
Some authors have also pointed to the role played by sectoral factors in these crisis episodes. Tornell & Westermann (2002) show that the relative size of the non-tradable sector usually increases before twin crises in middle-income countries. Calvo et al. (2004) find that the probability of a sudden stop is higher in economies where the absorption of tradable goods is small compared to the pre-crisis current-account deficit, a proxy for the size of a possible sudden stop. The rationale behind these findings is that any shock resulting in a lower demand for non-tradable goods has to be accommodated by a real depreciation in the short run. When the demand for non-tradable goods stemming from the tradable sector is large compared to the size of the non-tradable sector, it acts as a stabilizing buffer, so that the real exchange rate needed to close the gap is not very depreciated.
But the sectoral structure of an economy is endogenous and the size of both the tradable and non-tradable sectors evolves over time. Therefore, in order to fully understand these crisis episodes, one has to explain the sectoral dynamics of emerging economies. A first account of the link between financial crises and sectoral dynamics is provided by Schneider & Tornell (2004). Using a finite time model, they study the growth of the non-tradable sector during a transitory lending boom and show that it can lead to a self-fulfilling crisis.
This paper extends Schneider & Tornell’s (2004) framework and builds a model to study how the allocation of resources between the tradable and non-tradable sectors evolves over an infinite time horizon and how it affects the possibility of self-fulfilling balance-of-payments crises. It shows that the sectoral dynamics depends, among other factors, on external financing conditions, namely the financial openness and the international interest rate. In particular, a permanent increase in the supply of international liquidity can lead to a reallocation of resources towards the non-tradable sector. The paper studies whether this sectoral change is sufficient to make balance of-payments crises possible.
The paper models a two-sector small open economy with an overlapping generation structure. It embeds a static mechanism of self-fulfilling crisis which can produce multiple equilibria within a single time period, including a crisis equilibrium with a depreciated real exchange rate and defaults in the non-tradable sector. The within-period crisis equilibrium exists when (a) the debt repayments of firms producing non-tradable goods are high enough relative to their cash-flow and (b) the non-tradable sector is large enough relative to the tradable sector. Financial fragility thus depends on both a financial factor, the firm-level financial structure within the non-tradable sector, and a real factor, the sectoral structure of the whole economy. Both factors evolve along dynamic equilibrium paths. Starting from a closed economy, a country slightly opened to external finance reallocates resources towards the tradable sector in the long run in order to pay its external debt.
In more opened economies however, this is compensated by capital inflows which finance a higher demand for non-tradable goods, thus increasing the weight of the non-tradable sector in the long run. I show that for a sufficient degree of financial openness or equivalently a low enough world interest rate, this sectoral evolution leads to financial fragility in the long run so that equilibrium paths experience episodes of self-fulfilling balance-of-payments crises. Since this result is valid along stationary equilibrium paths, the model is well suited to assess the effect of capital account liberalization over time independently of boom-bust cycles induced by transitory shocks.
The precise mechanism underlying the existence of multiple equilibria within a single time period involves a self-reinforcing link between the real exchange rate and the level of investment expenditures, typical of balance-sheet approaches. First of all, firms are subject to a borrowing constraint. The amount they are able to borrow is limited by their cash-flows. Second, the economy is subject to Original Sin and firms cannot contract debt in domestic currency, which generates a currency mismatch in the balance sheets of the non-tradable sector. Together, these two market imperfections create a balance-sheet effect in the non-tradable sector, whereby movements in the real exchange rate affect firms’ balance sheets, their capacity to raise external funds, and their level of investment. Third, investment partly consists of expenditures in non-tradable goods so that an increase in investment provokes a real appreciation. Thus, a real appreciation increases the cash-flow of non-tradable firms and loosens their borrowing constraint so that they can invest more. The higher level of investment reinforces the real appreciation until the borrowing constraint does not bind any more. On the contrary a real depreciation has a negative impact on their balance sheets, which limits the investment expenditures they can finance and further depreciates the real exchange rate until the non-tradable firms eventually default on their loans. To make this reinforcing mechanism possible, the borrowing constraint has to be sufficiently weak.
The crisis equilibrium only exists when the relative size of the non-tradable sector is high enough for the following reason. When the tradable sector is large compared to the non-tradable sector, a large fraction of the demand for non-tradable goods stems from the tradable sector. Suppose firms in the non-tradable sector stop investing. The residual demand for non-tradable goods, stemming from the tradable sector, can be large enough to sustain an appreciated real exchange rate, so that firms in the non-tradable sector do not default on their loans. Then, these firms had no reason to stop investing in the first place and the crisis equilibrium is impossible. This argument supposes that the demand for non-tradable goods stemming from the tradable sector increases with the size of the tradable sector. In the setting of this paper, this is in part the consequence of a borrowing constraint.
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