PDF Ebook International Financial Shocks in Emerging Markets: The Role of Liability Dollarization
In the present paper, we investigate the propagation and amplification mechanisms of an unanticipated adverse shock to the country risk premium on foreign-currency denominated funds in a dynamic stochastic general equilibrium model of a two-sector small open economy. The model incorporates a financial market friction in the form of an endogenous risk premium which depends on the economy’s level of external debt. This friction amplifies the initial financial shock, especially, when the economy is highly indebted and is subject to large currency mismatches.
Under a flexible exchange rate regime, the exchange rate depreciates immediately and the shock is enforced by two main channels: (1) the domestic value of outstanding debt rises (adverse balance sheet effect); and (2) the endogenous term of the risk premium increases with the higher debt burden. As a result, domestic consumption, investment, and capital inflows drop sharply. In this scenario of capital account dominance, the current account has to adjust to the capital account restrictions. The involved sudden stop is partly offset by a shift of resources from the non-tradable to the tradable goods sector and the associated export expansion counteracts the reduction in imports. The associated adjustment is most painful when liability dollarization is coupled with a small tradable goods sector.
During the last two decades, many emerging market(EM) economies suffered financial crises of severe magnitude. Most of these crises were triggered by systemic sudden stops (3S) in which large-scale capital outflows and skyrocketing EM bond spreads affected a wide range of EM economies at approximately the same time. In several instances, the financial crises coincided with deep recessions.
As Calvo, Izquierdo, and Talvi (2007) point out:
”Turmoil in EM world capital markets, coupled with country-specific vulnerabilities, such as the level of domestic liability dollarisation, i.e., foreign-exchange denominated debt contracts in the domestic capital market, and the size of the supply of tradable goods, appear to be key in explaining recent financial crises in EMs involving sudden interruptions in capital flows. Shocks at the heart of capital markets have typically been a triggering factor.behind these crises.”
In the present paper, we explain the associated adjustment to an unexpected, adverse shock to the costs of foreign funding in a dynamic stochastic general equilibrium model (DSGE) of a small open economy (SOE) that faces a financial market friction. The shock is incorporated exogenously in the risk premium on foreign-currency denominated funds of the corporate sector and is amplified as the associated currency depreciation increases both the domestic value of outstanding debt (adverse balance sheet effect) and the endogenous term of the risk premium. We simulate the model and compare the impulse responses of economies with different levels of foreign-currency denominated debt and different sizes of the tradable goods sector.
The model can be applied to study the effects of systemic financial shocks originating in international capital markets on EM economies. We calibrate the model by matching the implied theoretical impulse responses with the corresponding impulse responses of a structural panel vector autoregressive (SPVAR) model for a set of Latin American economies. Such systemic financial shocks have been at play during the Tequila crisis in 1994-95, the East Asian crisis of 1997, the Russian crisis of 1998, and the Argentine crisis of 2001-02 (for detailed analysis of the financial crisis in Latin America see Calvo (1998), Calvo, Izquierdo, and Talvi (2007), and Kaminski, Reinhart, and Vegh (2003)).1 In all cases, an initial shock stemming from a particular country, spread out to a variety of economies in terms of exchange rate systems, capital controls, fiscal stance, growth performance, or balance sheet mismatches. In most cases, the countries’ own structural weaknesses created the underlying vulnerability to the capital flight, but the initial shock originated at least partly in global capital markets.
Download
PDF Ebook International Financial Shocks in Emerging Markets: The Role of Liability Dollarization
Posted in :
