Over the last two decades major emerging market (EM) economies have experienced deep economic crises. Many of them appear to have been triggered by financial turmoil on international capital markets, because a wide range of EM economies has been affected at approximately the same time. Figure 1 shows country risk premiums (EMBI+ spreads) for seven major Latin American economies. The financial spreads are highly correlated, increasing sharply during the crisis periods of 1994-95, 1998 and 2001-02. The global financial crisis of 2007-08 has most adversely affected Ecuador that faces a risk premium of more than 40 percentage points.
The fact that country risks increase recurrently and simultaneously across borders indicates that these countries are, from time to time, vulnerable to sudden and systemic deteriorations in external financial conditions, although this has improved since 2002 (decoupling hypothesis). The financial spreads reveal the unsettled nature of capital markets in which investors recurrently shy away from securities and investments in these countries. There is also some country variation, indicating that the depth of the financial turmoil depends on country fundamentals.
Calvo, Izquierdo, and Talvi (2006) emphasize that external shocks can be followed by a painful adjustment or become a minor recession. The outcome depends ultimately on local financial and economic conditions and fiscal and monetary policy responses. Domestic weaknesses such as currency mismatches and high levels of external short-term debt have been the major source of financial fragility in EM economies. Similar high levels of public debt have tied hands of many local governments to counteract crises by expansive fiscal policies. In countries where fundamentals are sound, as in Chile, country risk is much less volatile and dependent on external shocks.
The theoretical literature on external financial shocks in EM economies typically incorporates financial market frictions in the form of a borrowing constraint on external debt (Arellano and Mendoza (2003), Christiano, Gust, and Roldos (2004), and Mendoza (2006)) or in the form of a risk premium that depends on an economy’s net worth (Cespedes, Chang, and Velasco (2004), Gertler, Gilchrist, and Natalucci (2007), and Cook and Devereux (2005)). In these models a crisis is set in motion when an adverse shock triggers a binding borrowing constraint or an increase in the risk premium. In response the economy is forced to repay parts of its external debt (financial deleveraging). When liabilities are largely denominated in units of tradables and assets in units of non-tradables, the deleveraging causes a real depreciation. The depreciation in turn increases an economy’s liabilities relative to assets (adverse balance sheet effect) and the associated reduction in net worth worsens the access to external finance (adverse risk premium effect). This mechanism tends to end up in a circle of amplification.
In the present paper we investigate the impact of external financial shocks on real sectors. Our contribution to the literature is twofold. First, we estimate the impact of adverse shocks to the country risk premium on fundamentals of major Latin American economies. As frame work serves a structural panel vector-autoregression (VAR) of GDP, investment, trade balance, domestic credits and the country risk premium payed on external debt. We find that adverse financial shocks have been followed by persistent drops in investments, credits and GDP in these countries. The financial deleveraging has forced in turn a current account reversal. Second, we investigate the transmission of risk premium shocks to the real economy in a dynamic stochastic general equilibrium model (DSGE) of a small open economy. The financial shocks are incorporated in a debt-related risk premium of external foreign-currency funds and are amplified by currency depreciation.
The model is most related to the limited participation model of Christiano, Gust, and Roldos (2004). There are, however, four important differences. On the empirical side our focus is set on Latin America instead of Asia. On the theoretical side we do not model the financial shock in form of a binding borrowing constraint, rather we incorporate the shock in the risk premium. Not only the household’s deposit decision is made prior to the shock as in classical limited participation models, but also the firm’s decision on production and finance. And finally we estimate structural parameters by impulse response matching. The results suggest that the proposed model fits the observed dynamics of the considered economies very well and that it may be applied to study optimal monetary policy responses to international financial turmoil.
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