Ebook The Impact of Financial Frictions on a Small Open Economy: When Current Account Borrowing Hits a Limit
The evidence of consumption and output collapses in emerging markets is associated with rapid reversals in the current account and thus suggests limited access to international credit. During the 1980s most Latin American countries were essentially excluded from international capital markets after the Mexican debt crisis of 1981. Economic activity, growth and consumption stalled. Beginning in the late 1980s and continuing through the 1990s there was a strong effort to reintegrate Latin American markets into the world economy.
Emerging markets again faced unfavorable problems with external financing in the 1990s. Mexico, in 1994, and Asia, in 1997, experienced rapid reversals in the current account (Milessi-Ferretti and Razin, 1997, 1998; Edwards, 1998). More over, for emerging markets the periods of current account reversals (balance-of-payments crises) were also associated with deep recessions. Calvo (1998) has termed this phenomenon the “sudden stop”.
From a statistical point of view, the conditional distribution of gross domestic product (GDP) and the current account across several emerging markets deviates significantly from the Normal distribution and exhibits important non linearities in that it displays conditional volatility. The statistical properties of these time series characterize economic phenomena studied in the international macroeconomics literature. For example, excess volatility corresponds to time series that display either conditional volatility or high kurtosis, and the sudden current account reversals correspond to time series that display skewness. This paper presents evidence that macroeconomic aggregates for seven emerging markets significantly deviate from Normality and display conditional volatility, particularly GDP, private investment, and the current account. This paper also shows that a small open economy (SOE) model with financial frictions can quantitatively reproduce these properties of the times series, using Mexico as a case study.
The model presented here features agents of an SOE who borrow at an internationally set interest rate to smooth consumption. The key assumption of the model is the introduction of a financial friction. Domestic agents face an international financial friction that limits the current account deficit as a percentage of GDP. Specifically, the current account deficit cannot exceed a given fraction of the GDP. One can think of this constraint as arising either from international lenders perceiving a this current account deficit as the maximum sustainable deficit or from a government imposing capital controls to target a maximum current account deficit.
The financial constraint is occasionally binding. This results in simulated time series that exhibit periods of relative stability along with periods of crisis, when the conditional volatility will be high. In the model presented here the constraint is on the flow of assets. Agents cannot self-insure by accumulating buffer stocks of international assets, although the maximum current account deficits are limited.
The frequency of crisis in this framework is dependent on how “tight” the constraint is. Periods of crisis can be very frequent if the constraint is tight enough, although the largest deficit will not be as large so the reversal will be smaller. The constraint is more binding when the domestic economy faces a negative shock. Moreover, the constraint limits current account deficits and not surpluses, potentially leading to asymmetries in the time series.
Posted in :
