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.
This paper argues that interest rates affect output through their impact on the cost of variable inputs such as materials and labor. The cost of variable inputs increases in the interest rate because of time lags in the production process. When a firm sets out to produce a good, first it has to acquire raw materials and put workers to work, and only after a period of time it is able to sell the finished good. In the interim, the firm foregoes interest income or incurs interest costs. If the interest rate goes up, the production process becomes more costly so that the firm optimally chooses to reduce its sales.
I exploit the following cross-sectional implication of the theory: industries that usually hold more inventories relative to their variable costs should react more strongly to changes in the cost of capital. The reason is that inventories account for the value of all variable inputs accumulated between the time of their acquisition and the sale of the corresponding output. As a consequence, the ratio between total inventories and variable costs captures the importance of the foregone interest rate income associated with the purchase of variable inputs.
Monetary economists have frequently expressed the view that the financial system is an important source of and propagation mechanism for cyclical fluctuations. Indeed, Keynes (1936), Simons (1948), Friedman (1960) and many others have argued that the free and unregulated operation of financial markets can lead to indeterminacy of equilibrium and "excessive economic fluctuations," even in the absence of shocks impinging on the rest of the economy. In modern terms, this argument claims that the financial system itself is a source of endogenously arising economic volatility.
This view has a long empirical foundation. Most of the pre-World War II recessions were associated with substantial transfers of resources out of the banking system and into other assets. For instance, most of the pre-World War II recessions described by Friedman and Schwartz (1963) were associated with increases in the currency-deposit ratio. Particularly severe recessions were associated with particularly sharp increases in this ratio (that is, with bank panics). And even in the last three decades, several recessions have been accompanied by phenomena termed "disintermediation" or "credit crunches." In all of these episodes the volume of bank-extended credit declined, and "credit crunches" have often been associated with the increased incidence of non-price rationing of credit.
