Capital accumulation and real exchange rate behavior in a small open economy with credit market frictions

Summary. We consider the nature of the relationship between the real exchange rate and capital formation. We present a model of a small open economy that produces and consumes two goods, one tradable and one not. Domestic residents can borrow and lend abroad, and costly state verification (CSV) is a source of frictions in domestic credit markets. The real exchange rate matters for capital accumulation because it affects the␣potential for investors to provide internal finance, which mitigates the CSV problem. We demonstrate that the real exchange rate must monotonically approach its steady state level. However, capital accumulation need not be monotonic and real exchange rate appreciation can be associated with either a rising or a falling capital stock. The relationship between world financial market conditions and the real exchange rate is also investigated. Received: October 3, 1997; revised version: October 23, 1997     

Financial crises,debt overhang,and firm growth in transition economies

ABSTRACT

We examine the effects of the global financial crisis of 2008 and the European debt crisis of 2011 on the relationship between capital structure, investments, and performance for Eastern European companies. While the existing literature documents how firms’ investments are sensitive to the availability of internal funds and to debt holdings, we further investigate whether this investment sensitivity also translates in different levels of performance, and document that capital structure indeed has both a direct and an indirect effect, mediated by the capital expenditure channel. We show that firms with higher financial flexibility experience higher investments and returns on capital. Over-levered firms instead suffer from a debt overhang condition, forcing them to curb investments, and consequently experiencing lower performance. Overall, we provide evidence on the importance of capital structure and financial flexibility on investments and performance, showing the real consequences of the debt overhang condition on firm value creation. Firms should therefore aim at maintaining adequate financial flexibility in order to be able to pursue future profitable investment opportunities, and avoid the under-investment problem arising from a debt overhang situation.     

Choosing sides in the trilemma: international financial cycles and structural change in developing economies

ABSTRACT

This paper analyzes the impact of international financial cycles on structural change in developing economies. It is argued that the impact of these cycles depends on the specific combination of macroeconomic and industrial policies adopted by the developing economy. The cases of Brazil and Argentina are contrasted with those of Korea and China. In the Asian economies, macroeconomic policy has been a complementary tool along with industrial policy to foster the diversification of production and capabilities. Inversely, in the case of the Latin American countries, long periods of real exchange rate (RER) appreciation, combined with the weaknesses (or absence) of industrial policies, contributed to the loss of capabilities and lagging behind.     

Why peg? The role of capital mobility and financial intermediation

Many economists argue that the growth of international capital mobility has made the maintenance of pegged exchange rates more costly, forcing developing states to choose alternative arrangements. But some states do not simply abandon pegged exchange rates as their exposure to capital mobility rises. Some states abandon pegs long before a crisis can erupt, while others maintain pegs until the speculative pressures became unbearable. Why, in an environment of growing capital mobility, do some states maintain pegs longer than others do? One reason is that the more that bank lending dominates investment in a country, the more likely that state is to hold on to a pegged exchange rate. When banks have accumulated significant amounts of foreign debt they lobby for exchange rate stability. In a bank‐dominated financial system, a concentrated banking sector can organize easily and use its crucial role in the economy to exert influence over economic policy. This article presents new evidence from statistical tests on 61 developing countries that confirm that states with deeper banking systems are more likely to peg their exchange rates, in spite of growing capital mobility.     

Inflation,growth and exchange rate regimes in small open economies

Summary. This paper compares the merits of alternative exchange rate regimes in small open economies where financial intermediaries perform a real allocative function, there are multiple reserve requirements, and credit market frictions may or may not cause credit rationing. Under floating exchange rates, raising domestic inflation can increase production if credit is rationed. However, there exist inflation thresholds: increasing inflation beyond the threshold level will reduce domestic output. Endogenously arising volatility may be observed independently of the exchange rate regime. Private information - with high rates of domestic inflation - increases the scope for indeterminacy and economic fluctuations.Received: 26 March 2002, Revised: 29 October 2002JEL Classification Numbers: E32, E44, F33.P.L. Hernandez-Verme: I would like to thank Leonardo Auernheimer, Valerie Bencivenga, Dean Corbae, Scott Freeman, Todd Keister, Beatrix Paal, and Maxwell Stinchcombe for very helpful comments and suggestions. Very special thanks are due to Bruce D. Smith. The paper also benefited from the discussions in the seminars in CIDE, the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Kansas City, Indiana University, ITAM, Purdue University, the Second Annual Missouri Economics Conference, Texas A&M, the University of Missouri and the University of Texas at Austin.     

Financial flows and economic growth in developing countries

This paper assesses the impact of financial flows and their composition on the real exchange rate and on economic growth for a sample of low- and middle-income countries over the period of 1980–2012. Financial flows can directly support economic growth by relaxing constraints on domestic resources, but can also indirectly weaken growth through appreciation of the real exchange rate. We use the generalized method of moments (GMM) for dynamic panel. Results show that net financial flows affect economic growth both directly and indirectly: (i) a one percent increase in total financial flows appreciates the real exchange rate by 0.5 percent; (ii) the real exchange rate appreciation effect of remittances is twice the effect of aid and ten times greater than the effect of Foreign Direct Investments; (iii) financial flows stimulate economic growth regardless of the development level. An increase of $10 per capita financial flows leads to a gain of 0.08 points of annual growth. This gain amounts to 0.15 when we control for the negative impact of the real exchange rate. Instability of market-oriented flows, such as FDI and portfolio investments, exacerbates instability of the economic growth rate.     

Bad loans,soft budget constraints and the political economy of financial market reform in transition economies

Financial market imperfections and especially the bad debt problem are among the most important factors impeding economic restructuring in transition economies. This paper analyses the implications of non-performing loans for the lending policy of banks and for the ensuing allocation of credit. It is shown that a lending bias exists in favour of old debtors, which not only impedes structural change but may also counteract policies intended to harden budget constraints and to promote restructuring. The paper also discusses from a political economy perspective, why despite these negative implications financial market reforms were not pursued more forcefully in most countries.     

Economic liberalization, capital mobility and informal wage in a small open economy: A theoretical analysis

Empirical evidence suggests that the size of the informal sector in the developing countries has increased considerably during the liberalized economic regime. The present paper purports to analyze the consequences of economic reforms on the wellbeing of the informal sector workforce using a three-sector general equilibrium model with two informal sectors. The theoretical analysis finds that different liberalized policies produce diverse effects on the informal wage and that these results are independent of the nature of capital mobility between the informal and the formal sectors. It also shows that labour market reforms, contrary to the common wisdom, are likely to produce favourable effects on the informal wage.