The Role of External Shocks in Emerging Market Crises

Abstract

The dissertation attempts in three essays to contribute to the research on emerging market crises. A particular focus is set on problems associated with sudden stops of capital inflows, which appear to have been the cause of many recent emerging market crises. The main contributions to the existing literature are: (1) the empirical investigation of the effects of sudden stops and currency collapses using bank- and firm-level data, and (2) the development of micro-founded theoretical models which explain the transmission and amplification of unexpected external shocks in emerging market economies in an open economy framework.<br /> The first essay investigates in a cross-country study how domestic bank credits are affected during sudden stops. A particular focus is set on the asymmetric effects across individual banks. In the empirical investigation of 14 recent sudden stops that occurred in 11 Latin American and Asian countries, we find that sudden stops are associated with reductions in the domestic lending volume in the order of 10-15 % of GDP. The magnitude of this decline depends on the structure of the domestic banking sector, especially, on the degree of bank capitalization and foreign bank participation.<br /> The second essay investigates the channel between currency depreciations, liability dollarization, and income distributions. In the empirical investigation on recent currency collapses in Argentina, Brazil, and Mexico, we find that income and wealth transfers from borrowing firms to lenders increased substantially with the currency depreciations, especially in Argentina. Moreover, the currency depreciations had asymmetric effects on firms. Most affected were non-exporting firms with high fractions of foreign-currency denominated liabilities. The distributive issues of currency depreciations are further analyzed within a partial equilibrium model of firms with varying income and debt structures.<br /> Finally, the third essay develops a two-sector general equilibrium model of a small open economy to explore the transmission mechanisms of external financial shocks. We set up a cash-in-advance model with limited participation augmented with financial frictions in the form of a 'fundamentals-related' risk premium on external funds. The friction amplifies the economic effects of external financial shocks, especially, when the economy is highly indebted in foreign currency. For a set of Latin American economies, the theoretical model is calibrated to match the empirical impulse responses of output, investment, trade balance, and domestic credits in response to a shock to the country risk premium.