Ebook Financial frictions, financial integration and the international propagation of shocks
This paper develops a two-country model featuring financial frictions on capital investment and nontrivial portfolio choices by agents under incomplete markets. This framework allows us to analyze the concept of international financial multiplier working through the balance sheets of cross-border levered investors, as postulated in the literature on international transmission through financial channels (e.g. Calvo (2000) and Krugman (2008) ), and study its effects for shocks propagation, as empirically documented e.g. by Kaminsky and Reinhart (2000) in the context of fundamentals-based “contagion” of financial shocks and crises.
These authors argue that the need to rebalance the overall risk of an investor’s cross-border asset portfolio and to deleverage following the losses after the initial shock can lead to a marked reversal in investment and asset prices across markets where the investor has substantial exposure. For instance, the latter paper finds that in the case of banks this helps explain cross-border spillovers of shocks, since if a bank is confronted with a marked rise in nonperforming loans in one country it is likely to be called upon to reduce the overall risk of its assets by pulling out of other high risk projects elsewhere. Furthermore, it will lend less (if at all), as it is forced to recapitalize and adjust to its lower level of wealth.
In our model economy “entrepreneurs/investors” in each country buy claims to capital stocks installed both domestically and abroad, to be used for production of a local, country-specific good which is then traded internationally for consumption and investment. Broadly motivated with financial frictions in the spirit of Bernanke et al. (1999), these investors are subject to a collateral constraint. Specifically, they finance their demand for capital investment by issuing debt in domestic currency, facing an external finance premium which is an inverse function of their net worth. Effectively, financial frictions thus impinge on the amount of savings that can be invested by a given economy into productive but risky activities, domestically and abroad, making these assets effectively illiquid in the sense that they cannot be readily purchased and sold.
This way we broadly capture the idea that the international financial multiplier works through the cross-border exposure of the balance sheet of leveraged agents. When asset prices (Tobin’s Q price of capital) fall heavily in one country, investors find themselves under capitalized, and have to restore their balance sheets by decreasing investment across-the-board, effectively selling off both domestic and foreign assets. This in turn puts pressure on the balance sheet of investors abroad, and so on, potentially enhancing cross border spillovers.
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