Economies with imperfect financial market access may experience crises that cause significant economic dislocation. These crises are characterized by the sudden stop of domestic or international credit flows and are associated with large declines in consumption, output, relative prices, and asset prices.
An important question for emerging-market economies is whether the likelihood and the severity of these crises is affected by excessive borrowing in normal times, when access to financial markets is unconstrained and plentiful. This question is important because the policy implications of alternative answers are very different. If there is excessive or inefficient borrowing in good times (i.e., “overborrowing”), policy should be geared primarily toward addressing the ex ante inefficiency that causes it; for example, by imposing a tax on capital flows or other forms of capital controls and prudential regulations to reduce the incentives to borrow excessively. In this case, policy should be less concerned about mitigating the consequences of the crisis, when one occurs, and instead strengthen the ex ante incentives to borrow efficiently in good times. In contrast, if there is no overborrowing in good times, policy should be geared primarily toward designing efficient ex post interventions mechanisms in bad times (such as bailout interventions financed nationally or multilaterally), trying to minimize the costs of the inevitable crises associated with imperfect access to financial markets. We emphasize here that, as Benigno, Chen, Otrok, Rebucci and Young (2009) discuss, there is an important link between ex-ante and ex-post policies: indeed full knowledge of ex-post policies might modify agents behavior in normal times and hence the required ex-ante intervention.
A fast growing literature has examined this issue in related work. In early contributions Fernandez-Arias and Lombardo (1998) and Uribe (2007) have examined the possibility of overborrowing in economies subject to exogenous (either individual or aggregate) debt limits. Lorenzoni (2008) and Korinek (2010) have explored the possibility of overborrowing qualitatively in models in which the debt limit is endogenous. Uribe (2007) and Bianchi (2009) have examined the issue quantitatively with contrasting results. While Uribe (2007) finds no overborrowing, Bianchi (2009) finds that overborrowing is quantitatively relevant and has significant welfare implications. In endowment economies, Korinek (2010) and Bianchi (2009) suggest that only macro prudential policies have scope for preventing and mitigating crises. In contrast, Benigno et al. (2009), based on a model with production similar to the one used in this paper, find that it is optimal (in Ramsey sense) to intervene mostly ex post, once a sudden stop actually occurs.
This paper analyzes quantitatively the extent to which there is overborrowing in a business cycle model for emerging market economies. We investigate overborrowing in small open economy model with production and imperfect access to international capital markets. Our occasionally binding credit constraint is embedded in a standard two-sector (tradable and non-tradable good) small open economy in which financial markets are not only incomplete but also imperfect, as in Mendoza (2002). In this model, for simplicity, production takes place only in the non-tradable sector of the economy. The asset menu is restricted to a one period risk-free bond paying off the exogenously given foreign interest rate. In addition to asset market incompleteness, we assume that access to foreign financing is constrained to a fraction of households’ total income. Thus, foreign borrowing is denominated in units of the tradable good but it is leveraged on income generated at different relative prices (i.e. the relative price of non-tradable good). The specification of the borrowing constraint thus captures “liability dollarization”, a key feature of emerging market capital structure (e.g., Krugman, 1999).4 As it is well known, however, pecuniary externalities like the one at work in our model can arise in much more general circumstances: namely, whenever a relative price enters the specification of a financial friction in a multiple good economy. (See Arnott, Greenwald, and Stiglitz, 1994 for a detailed discussion and a survey of the theoretical literature.)
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Revisiting Overborrowing and its Policy Implications
