Global imbalances,cross-market linkages,and the financial crisis: A multivariate Markov-switching analysis

Based on multivariate Markov-switching models, this paper presents new results on the interactions between global imbalances, credit spreads, housing markets, macroeconomic variables, commodities and equities during Q1-1987/Q1-2011. We show that rising global imbalances and the uncontrolled development of the US mortgage and housing markets have been deeply destabilizing the economy, with various shocks impacting subsequently equity markets and macroeconomic variables. But we also uncover, surprisingly, that the cross-market linkages with the commodity markets are strong. Finally, we identify that the US housing market lies at the epicenter of the crisis through its multiple and highly significant interactions with the other variables in the system (including the global imbalances). Sub-samples and alternative time series estimates are provided to check the statistical congruency of the various models.     

Macroeconomic Fluctuations and Bank Lending: Evidence for Germany and the Euro Area

Abstract. This paper analyzes the dynamic response of loans to the private sector and of economic activity to aggregate supply, demand and monetary policy shocks in Germany and the euro area based on a standard macroeconomic VAR using sign restrictions to identify the structural shocks. The main results of this analysis are that (i) with the exception of the response to the supply shock in Germany, the response of loans to the three macroeconomic shocks is rather weak and in most cases insignificant; (ii) the 2000–05 credit slowdown and weak economic performance in Germany were primarily driven by adverse supply shocks; and (iii) the marked slowdown in credit creation in Germany over this period actually represents a realignment of the outstanding stock of loans with its deterministic level. In order to assess the role of bank lending in the transmission of macroeconomic shocks, we further perform counterfactual simulations and analyze the dynamic responses of German loan subaggregates in order to test the distributional implications of potential credit market frictions. These exercises do not indicate that credit market frictions play an amplifying role in the transmission of macroeconomic fluctuations.     

The impact of the Interaction between institutional quality and aid volatility on growth: theory and evidence

We analyze both theoretically and empirically, the effect of aid volatility and its interaction effect with institutional quality on per capita economic growth. Our theoretical model, in which an aid-recipient government, operating in an institutional environment of some given quality (making choices over the distribution of aid), predicts that a negative effect of aid volatility on growth is mitigated by stronger institutional quality. We use panel data covering the period 1984–2004 for 78 countries to test this theoretical prediction. Using Generalised Methods of Moments (GMM) we find the relationship between growth and aid volatility is significantly negative and depends on institutional quality. Our baseline results are robust to various computations of aid volatility and foreign aid, time periods, sub-samples and additional covariates.     

Sudden stops,sectoral reallocations,and the real exchange rate

A sudden stop of capital flows into a developing country tends to be followed by a rapid switch from trade deficits to surpluses, a depreciation of the real exchange rate, and decreases in output and total factor productivity. Substantial reallocation takes place from the nontraded sector to the traded sector. We construct a multisector growth model, calibrate it to the Mexican economy, and use it to analyze Mexico's 1994–95 crisis. When subjected to a sudden stop, the model accounts for the trade balance reversal and the real exchange rate depreciation, but it cannot account for the decreases in GDP and TFP. Extending the model to include labor frictions and variable capital utilization, we still find that it cannot quantitatively account for the dynamics of output and productivity without losing the ability to account for the movements of other variables.     

Emerging market sovereign spreads,global financial conditions and U.S. macroeconomic news

We investigate the impact of global financial conditions, U.S. macroeconomic news and domestic fundamentals on the evolution of EMBI spreads for a panel of 18 emerging market (EM) countries using daily data. To this end, we consider not only the conventional panel cointegration procedures but also the recent common correlated effects method to tackle cross-section dependence that may stem from common global shocks such as contagion. The results suggest that the long-run evolution of EMBI spreads depends on global financial conditions, crises contagion and domestic fundamentals proxied by sovereign ratings. The results from panel equilibrium correction models suggest that EMBI spreads respond substantially also to U.S. macroeconomic news and changes in the Federal Reserve's target interest rates. The magnitude and the sign of the effect of the U.S. news, however, crucially depend on the state of the U.S. economy, such as the presence of inflation dominance.     

Maturity mismatch and financial crises: Evidence from emerging market corporations

Substantial attention has been paid in recent years to the risk of maturity mismatch in emerging markets. Although this risk is microeconomic in nature, the evidence advanced thus far has taken the form of macro correlations. We evaluate this mechanism empirically at the micro level by using a database of over 3000 publicly listed firms from fifteen emerging markets. We measure the risk of maturity mismatch by estimating, at the firm level, the effect on investment of the interaction of short-term exposure and aggregate capital flight. This effect is (statistically) zero, contrary to the prediction of the maturity-mismatch hypothesis. This conclusion is robust to using a variety of different estimators, alternative measures of capital flows, and controls for devaluation effects and access to international capital. We do find evidence that short-term-exposed firms pay higher financing costs, and have lower equity valuations, but not that this reduction in net worth translates into a drop in investment or sales.     

Equilibrium real interest rates and the financial cycle: Empirical evidence for Euro area member countries

We estimate the equilibrium real interest rate for nine Euro area member countries and the Euro area as a whole using quarterly data from 1995 to 2015. We expand the standard model of estimating real equilibrium interest rates to incorporate the financial cycle for the private sector. We show that adding the financial cycle indeed alters the equilibrium real interest rate estimates and, in line with previous studies, that there is a fall in the equilibrium real interest rate over time. Our results indicate that in most member countries the real rate is lower than its equilibrium level. Hence, they should not worry about secular stagnation now. This is because secular stagnation is likely to occur when real interest rates are higher than their equilibrium levels. This result can serve as a starting point for further research in this field, e.g. by adding public sector financial cycles or disentangling the roles of households, corporations and the government.     

Re‐vitalizing money demand in the Euro area. Still valid at the zero‐lower bound

The analysis of monetary developments has always been a cornerstone of the ECB's monetary analysis and, thus, of its overall monetary policy strategy. In this respect, money demand models provide a framework for explaining monetary developments and assessing price stability over the medium term. It is a well‐documented fact in the literature that, when interest rates are at the zero‐lower bound, the analysis of money stocks become even more important for monetary policy. Therefore, this paper re‐investigates the stability properties of M3 demand in the euro area in the light of the recent economic crisis. A cointegration analysis is performed over the sample period 1983 Q1 and 2015 Q1 and leads to a well‐identified model comprising real money balances, income, the long‐term interest rate and the own rate of M3 holdings. The specification appears to be robust against the Lucas critique of a policy dependent parameter regime, in the sense that no signs of breaks can be found when interest rates reach the zero‐lower bound. Furthermore, deviations of M3 from its equilibrium level do not point to substantial inflation pressure at the end of the sample. Excess liquidity models turn out to outperform the autoregressive benchmark, as they deliver more accurate CPI inflation forecasts, especially at the longer horizons. The inclusion of unconventional monetary policy measures does not contradict these findings.     

Financial liberalization,financial sector development and growth: Evidence from Malaysia

The objective of this paper is to examine whether financial development leads to economic growth or vice versa in the small open economy of Malaysia. Using time series data from 1960 to 2001, we conduct cointegration and causality tests to assess the finance-growth link by taking the real interest rate and financial repression into account. The empirical evidence suggests that financial liberalization, through removing the repressionist policies, has a favorable effect in stimulating financial sector development. Financial depth and economic development are positively related; but contrary to the conventional findings, our results support Robinson's view that output growth leads to higher financial depth in the long-run.     

Internal finance and growth: Microeconometric evidence on Chinese firms

Using a panel of 79,841 Chinese firms over the period 2000-2007, we examine the extent to which liquidity constraints affect firms' assets growth. We find that state owned enterprises are not affected, while the availability of internal finance represents a binding constraint for the growth of private firms, especially those operating in coastal regions, with negligible foreign ownership. Thanks to their high productivity, cash flow is, however, so abundant for these firms that they are able to grow at a very fast rate, despite being discriminated against by financial institutions. Hence, well developed external capital markets may not always be needed for fast economic growth.     

The Interaction of Financial Fragility and the Business Cycle in Determining Banks’ Loan Losses: An Investigation of the Italian Case

The Basel II capital accord and the recent crises have fostered the debate over the financial stability of the aggregate banking sector. Because loan losses are an important factor for banking stability, this paper aims to gauge the impact of real and financial fragility on default losses of Italian banks. To this end the ratio of non‐performing loans to total loans is regressed on the business cycle and indebtedness. In addition, to capture the joint effect of real and financial fragility, the analysis considers an interaction term, which to our knowledge has never been applied before to Italian default data. Based on the interaction model, results show that the actual impact of financial fragility on default losses depends not only on the business cycle phase but also on the firm's size, whereby in adverse economic conditions, small firms are more significantly affected by financial fragility.     

Financial market participation and the developing country business cycle

I explore the implications of limited participation in financial markets on a standard small open economy business cycle model. Despite its parsimony, the limited participation model developed in this paper improves over the standard model in terms of explaining two important features of business cycle facts of developing countries: high volatility of consumption, and high negative correlation between the trade balance and output. Limited participation model is then used to inspect the effects of financial development and integration on macroeconomic volatility. Under a standard calibration, limited participation model leads to the conclusion that financial development and integration are associated with higher investment and output volatility. Effect of more participation on consumption volatility is dependent on the specification of the risk premium function.     

Exchange rate movements and monetary policy in Brazil: Econometric and simulation evidence

The literature on monetary economy has aroused growing interest in macroeconomics. Due to computational advancements, models have become increasingly more complex and accurate, allowing for an in-depth analysis of the relationships between real economic variables and nominal variables. Therefore, using a dynamic stochastic general equilibrium (DSGE) model, based on Gali and Monacelli (2005), we propose and estimate a model for the Brazilian economy by employing Bayesian methods so as to assess whether the Central Bank of Brazil takes exchange rate fluctuations into account in the conduct of monetary policy. The most striking result of the present study is that the Central Bank of Brazil does not directly change the interest rate path due to exchange rate movements. A simulation exercise is also used. Our conclusion is that the economy quickly accommodates shocks induced separately on the exchange rate, on the terms of trade, interest rate, and global inflation.     

Does financial liberalization improve the allocation of investment?: Micro-evidence from developing countries

Using firm level panel data from 12 developing countries we explore whether financial liberalization improves the efficiency with which investment funds are allocated. A summary index of the efficiency of investment allocation that measures whether investment funds are going to firms with a higher marginal return to capital is developed. We examine the relationship between this and various measures of financial liberalization and find that liberalization increases the efficiency with which investment funds are allocated. This holds after various robustness checks and is consistent with firm level evidence of a stronger association between investment and fundamentals after financial liberalization.     

Non-linear causality between the stock and real estate markets of Western European countries: Evidence from rank tests

Using the non-parametric rank tests proposed by Breitung (2001), we set out in this study to determine whether any non-linear long-run equilibrium relationship exists between the stock and real estate markets of Western European countries. We go on to adopt the threshold error-correction model (TECM) to determine whether a similar relationship is discernible possibly non-linear functions of the log-price of these two markets. The findings clearly point to the existence of long-run unidirectional and bidirectional causality between the real estate market and the stock market in regions both above and below the threshold level. Finally, we find the existence of both wealth and credit price effects in the real estate markets and stock markets of Western European countries, which thereby offer financial institutions and individual investors in their construction of long-term investment portfolios within these two asset markets.     

Stability, global dynamics and Markov equilibrium in models of endogenous economic growth

This paper studies the local and global dynamics of two-sector models of endogenous growth with economy-wide external effects and taxes on capital and labor. The local analysis classifies the parameter space depending on the number of stationary solutions and local stability of equilibria. The global analysis shows that if taxes are within certain bounds and the size of the external effects on the average level of human capital is smaller than the share of physical capital, the equilibrium path is monotone and therefore a continuous Markov equilibrium can be constructed.     

Financial liberalization,private investment and portfolio choice: Financialization of real sectors in emerging markets

Using firm level panel data, we analyze the impacts of rates of return gap between financial and fixed investments under uncertainty on real investment performance in three emerging markets, Argentina, Mexico and Turkey. Employing a portfolio choice model to explain the low fixed investment rates in developing countries during the 1990s, we suggest that rather than investing in irreversible long-term fixed investments, firms may choose to invest in reversible short-term financial investments depending on respective rates of returns and the overall uncertainty in the economy. The empirical results show that increasing rates of return gap and uncertainty have an economically and statistically significant fixed investment reducing effect while the opposite is true with respect to financial investments.     

Sudden stops, financial frictions, and labor market flows: Evidence from Latin America

While the aggregate effects of sudden stops and international financial crises are well known, the disaggregated channels through which they work are not well explored yet. In this paper, using job flows from a sectoral panel dataset for four Latin American countries, we find that sudden stops are characterized as periods of lower job creation and increased job destruction. Moreover, these effects are heterogeneous across sectors: we find that when a sudden stop occurs, sectors with higher dependence on external financing experience lower job creation. In turn, sectors with higher liquidity needs experience significantly larger job destruction. This evidence is consistent with the idea that dependence on external financing affects mainly the creation margin and that exposure to liquidity conditions affects mainly the destruction margin. Overall, our results provide evidence of financial frictions being an important transmission channel of sudden stops and in the restructuring process in general.     

Asset bubbles,banking stability and economic growth

This paper examines the relationships between the asset bubble and the banking stability from both theoretical and empirical perspectives. The theoretical analysis demonstrates that the moral hazard caused by the deposit insurance and limited liability might facilitate the banks to hold bubble assets for the purpose of risk premium. Meanwhile the supervisory intensity, leverage ratio and credit spread provide the conditions for banks to hold bubble assets through their effects on risk premium. Once the banks hold the bubble assets, their stability will deteriorate because of four types of effects, namely internal leverage, cash withdrawal, credit friction and network effects. This paper also utilizes the BMA-PVAR model to test the theoretical findings by employing the data from 26 representative economies for a period between 2000 and 2014. The empirical evidences are consistent with the theoretical findings that the equity bubbles will lower the banking stability. The empirical evidences also suggest that the banking instability will be detrimental to the economic growth.     

Housing and credit market shocks: Exploring the role of rule-based Basel III counter-cyclical capital requirements

This paper examines the extent to which the Basel III bank capital regulation attenuates fluctuations in housing and credit markets and fosters financial and macroeconomic stability. We use a positive housing demand shock to mimic a housing market boom and a negative financial shock for credit squeeze and economic meltdown. The results show that the rule-based Basel III counter-cyclical capital requirement effectively attenuates fluctuations in housing and credit markets and prevents bubbles. In the case of a negative financial shock, it significantly reduces the magnitude of economic meltdown. Our analysis of the transition from Basel II to Basel III suggests that it is the counter-cyclical capital buffer that effectively mitigates the pro-cyclicality of its predecessor, while the impact of the conservative buffer is marginal. In contrast to the credit-to-GDP ratio, the optimal policy analysis suggests that the regulatory authority should adjust the capital requirement to changes in credit and output when implementing the counter-cyclical buffer. Future research could extend the study by comparing the effectiveness of the rule-based Basel III with other macroprudential tools in achieving financial and macroeconomic stability.