Financial fragility in emerging market countries: firm balance sheets and the

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Niveau: Supérieur, Doctorat, Bac+8
Financial fragility in emerging market countries: firm balance sheets and the productive structure Yannick Kalantzis ? (ENPC, PSE) May 2005 Abstract We build an overlapping generation model to study financial fragi- lity in a two-sector small open economy. Firms are subject to a borrow- ing constraint and there is a currency mismatch in the balance sheets of the non-tradable sector. As a consequence, at a given point in time, multiple equilibria may arise, which makes self-fulfilling balance of payments crises possible. This state of financial fragility requires that firms producing non-tradable goods are sufficiently leveraged and that the relative size of the non-tradable sector is sufficiently large with regards to the tradable sector. We study under what conditions the endogenous evolution of these two structural factors, firm balance sheets and the productive struc- ture, along an equilibrium path eventually leads to a financially fragile state. Keywords: balance of payments crises, financial fragility, foreign cur- rency debt, borrowing constraint, multiple equilibria. JEL Classification Numbers: E44, F32, F34, F43, O41 ?Paris-Jourdan Sciences Economiques. Unite mixte de recherche CNRS-EHESS-ENPC- ENS. 48, bd Jourdan 75014 Paris. France. E-mail: . I would like to thank Robert Boyer and Philippe Martin for their useful comments and advice, as well as participants at a seminar in PSE.

• tradable sector


• fulfilling crises


• balance sheet


• account liberalization


• bust cycle story


• real exchange


• has increasing


• self

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• Documents
• Education
• Internship reports
• Martin
• Science
• Balance sheet

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• Language: English

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Financialfragilityinemergingmarket
countries:firmbalancesheetsandthe
productivestructure
YannickKalantzis
∗
(ENPC,PSE)
May2005

Abstract
Webuildanoverlappinggenerationmodeltostudyfinancialfragi-
lityinatwo-sectorsmallopeneconomy.Firmsaresubjecttoaborrow-
ingconstraintandthereisacurrencymismatchinthebalancesheets
ofthenon-tradablesector.Asaconsequence,atagivenpointin
time,multipleequilibriamayarise,whichmakesself-fulfillingbalance
ofpaymentscrisespossible.Thisstateoffinancialfragilityrequires
thatfirmsproducingnon-tradablegoodsaresufficientlyleveragedand
thattherelativesizeofthenon-tradablesectorissufficientlylargewith
regardstothetradablesector.
Westudyunderwhatconditionstheendogenousevolutionofthese
twostructuralfactors,firmbalancesheetsandtheproductivestruc-
ture,alonganequilibriumpatheventuallyleadstoafinanciallyfragile
state.
Keywords
:balanceofpaymentscrises,financialfragility,foreigncur-
rencydebt,borrowingconstraint,multipleequilibria.
JELClassificationNumbers
:E44,F32,F34,F43,O41

∗
Paris-JourdanSciencesEconomiques.Unite´mixtederechercheCNRS-EHESS-ENPC-
ENS.48,bdJourdan75014Paris.France.
E-mail:
[e-mail]
.
IwouldliketothankRobertBoyerandPhilippeMartinfortheirusefulcommentsand
advice,aswellasparticipantsataseminarinPSE.Ofcourse,alltheremainingerrorsare
myown.

1

Theopeningofdevelopingeconomiestointernationalfinanceinthelast
threedecadeshasledinanumberofcasestobalanceofpaymentscrises.The
SouthernConecrisesatthebeginningoftheeighties,theMexicancrisisof
1994,theAsiancrisesof1997andtheArgentinecrisisof2001alltookplace
afterthecapitalaccounthadbeenliberalized.
Thesuddennessofthesecrisisepisodes,thefactthatsomeofthemwere
triggeredbycontagionphenomenaandtheabsenceofapparentchangesin
fundamentalsbeforethemhaveledmanyanalyststoconcludethattheywere
ofaself-fulfillingnature.
Modelswithmultipleequilibriaseemtobetheproperanalyticaltoolto
addresstheissue.Inthesemodels,thetriggeringofacrisisisanexogenous
andarbitraryevent,oftenrepresentedbyachangeinthevalueofa
sunspot
variable.However,ifthetriggeringofacrisismaybeindependentoffunda-
mentals,the
possibility
ofacrisisisnot:fundamentalshavenotdisappeared,
theyhavejuststeppedbackwardfromfinancialcrisestofinancialfragility.
Multipleequilibriamodelscanthusbeusedtoidentifythestructuralchar-
acteristicsthatmakecrisespossible.
AfirsthintwasgivenbyKrugman(1999):inastaticmodelofasmall
openeconomy,heshowedthatself-fulfillingcrisesarepossiblewhenthefor-
eigncurrencyexternaldebtislargeenoughrelativetoexports.Butthese
possiblestructuralcharacteristicsareendogenousandevolveovertime,espe-
ciallyafteraneconomyhasopeneditscapitalaccount.Therefore,adynamic
frameworkisneededtogiveafullaccountoffinancialfragilityinadeveloping
economyopenedtointernationalfinance.
Thispaperaimsatprovidingsuchaframework.Wedevelopanover-
lappinggenerationmodelwhereintermediatesectorsproducetwokindsof
inputs:tradableandnon-tradable.Awithin-periodsunspotequilibriumis
possiblewhenthedebtrepaymentsoffirmsproducingnon-tradablegoods
arehighenoughrelativetotheircash-flowand/orifthesectorproducing
non-tradablegoodsislargeenoughrelativetothesectorproducingtradable
goods.Financialfragilitythusdependson
bothfinancialandreal
factors:the

2

firm-levelfinancialstructurewithinthenon-tradablesectorandthecross-
sectorialproductivestructure.Bothofthesecharacteristicsevolvealong
equilibriumpaths.Thedynamicpartofthemodelallowsustodetermine
whethertheirevolutioninevitablyleadstoasituationoffinancialfragility.
Wefindthatthisisthecaseforsufficientlylowlevelsofinternationalinterest
rates,asufficientdegreeoffinancialopennessandsufficientlyhighgrowth
rates.
Theprecisemechanismunderlyingtheexistenceofmultipleequilibriain-
volvesaself-reinforcinglinkbetweentherealexchangerateandthelevelof
investmentexpenditures.First,becauseofmoralhazardandimperfectmoni-
toringofloans,firmsaresubjecttoaborrowingconstraint.Theamountthey
areabletoborrowislimitedbytheircash-flows,whichyieldsafinancialaccel-
eratoreffect.Second,theeconomyissubjectto
originalsin
andfirmscannot
contractdebtindomesticcurrency,whichgeneratesacurrencymismatchin
thebalancesheetsoffirmsproducingnon-tradablegoods.Together,these
twomarketimperfectionscreateabalancesheeteffectinthenon-tradable
sector,wherebymovementsintherealexchangerateaffectfirm’sbalance
sheets,theircapacitytoraiseexternalfundsandtheirlevelofinvestment.
Third,investmentpartlyconsistsofexpendituresinnon-tradablegoodsso
thatanincreaseininvestmentprovokesarealappreciation.Thus,areal
appreciationincreasesthecash-flowofnon-tradablefirmsandloosenstheir
borrowingconstraintsothattheycaninvestmore;thehigherlevelofinvest-
mentreinforcestherealappreciationuntiltheborrowingconstraintdoesnot
bindanymore.Onthecontrary,arealdepreciationhasanegativeimpact
ontheirbalancesheets,whichlimitstheinvestmentexpenditurestheycan
financeandfurtherdepreciatestherealexchangerateuntilthenon-tradable
firmseventuallydefaultontheirloans.Tobepossible,thisreinforcingmech-
anismrequiresasufficientlystrongfinancialacceleratoreffect.
Anicefeatureofourmodelisthatitenablesustostudywhetherthe
steadystateofthedynamicsissubjecttofinancialfragility.Whenthis
isthecase,financialfragilityisacharacteristicofanyequilibriumpath,

3

independentlyoftransitoryshocks.Wearethusabletoassessthelong-run
effectofcapitalaccountliberalizationwhereasmostoftheexistingliterature
onthesubjectanalyzesboom-bustepisodes
1
andhavelittletosayabout
financialfragilityinthelongrun.
2

Thestylizedfactsreproducedbythemodelarequalitativelyconsistent
withtheempiricalevidencethathasbeendocumentedinseveralpapers.Our
modelpredictsthatanincreaseintherelativesizeofthenon-tradablesector
withregardstothetradablesectorisoneofthekeyfactorsinducingfinan-
cialfragility.Tornell&Westermann(2002)indeedobserveanasymmetrical
evolutionofthetwosectorsinaneventstudyoftwincrises:therelative
sizeofthenon-tradablesectorincreasesbeforethecrisesanddecreasesaf-
ter.Accordingtoourmodel,anincreaseinthisrelativesizeshouldgoalong
witharealappreciation.Arealappreciationisindeedobservedinthephase
ofhighgrowthprecedingacrisis(Kaminsky&Reinhart1999,Gourinchas,
Valde´s&Landerretche2001,Tornell&Westermann2002).Themodelalso
emphasizesthecentralroleplayedbyinvestmentinthecrisismechanism.
ThisisconsistentwiththefactthatinvestmentisthecomponentofGDP
displayingthelargestvariabilityinthecrisisepisodes,growingrapidlybe-
foreandfallingabruptlyduringthecrisis(Gourinchasetal.2001,Tornell&
Westermann2002).Atlast,thecrisesareoftensudden,afactaccountedfor
byourmultipleequilibriastory.

Thereareanumberofotherpaperstryingtomodeltheinstabilityof
emergingmarketcountries,beginningwiththeseminalpaperofKrugman
(1999)whichprovidesaself-fulfillingcrisismechanismbasedonabalance
sheeteffect,fromwhichourowncrisismechanismisinspired.Whereasthis
modelisstaticandhasonlyonedomesticgood,wemodelatwo-sectorecon-
omyandprovideacompletedynamicframework.Inthesamevein,Jeanne&
1
AnotableexceptionisRancie`re,Tornell&Westermann(2003).Seeourreviewofthe
literaturebelow.
2
Basedonempiricalevidence,Kaminsky&Schmukler(2003)arguethatthelarge
amplitudeofboom-bustcyclesinthestockmarketfollowingfinancialliberalizationmight
beatransitoryphenomenonanddisappearinthelongrun.

4

Zettelmeyer(2002)proposeasimpleandunifiedframeworkthatencompasses
bothKrugman’screditcrunchmodelandotherbalancesheetapproaches
basedonmaturitymismatchesandbankruns.
OurworkismostlyrelatedtoSchneider&Tornell(2004)whichbuilt
adynamicmodelwithmultipleequilibriaandsectorialeffects.Wetryto
explainthesamesetofstylizedfactsastheseauthors.Themaindifference
betweentheirmodelandoursisthattheirexplanationisbasedonaboom-
bustcyclestory.Thedynamicspossiblyleadingtoacrisisneedanexpected
exogenousshocktooccuratsomepointinthefuturetostart.Iftheeconomy
succeedsinreachingthisfinalpointwithoutfallingintoacrisis,itwillremain
safe.Onthecontrary,inourmodel,financialfragilitycanbeastructural
featureoftheeconomy,eveninthelongrun.Inadditiontothat,weexplicitly
modelthetwosectorsinasymmetricway.Inparticular,bothsectorscan
besubjecttoaborrowingconstraint(whetherthisconstraintbindsornotis
anendogenousoutcomeofthemodel)whereasintheirmodeltheborrowing
constraintonlyexists(andalwaysbinds)inthenon-tradablesector.
Rancie`reetal.(2003)developagrowthmodelwhereself-fulfillingcrises
arepossibleinthelongrun.Thisworkdiffersfromoursinthemodeling
details.Intheirsetting,thetradablesectorhasastandardproductionfunc-
tionwithconstantreturnstoscaleandnoborrowingconstraintwhereas
thenon-tradablesectorhasincreasingreturnsandissubjecttoaborrowing
constraint.
3
Inourwork,bothsectorsaretreatedsymmetricallyandany
differencebetweenthemendogenouslyariseasaresultofthemodel.Also,
thecrisismechanismtheyuseisdifferentfromours.
Aghion,Bacchetta&Banerjee(2004
a
)constructadynamicmonetary
modelwithmultipleequilibriawhereaself-fulfillingcrisisispossibleinthe
firstperiodifthesubsequentproductivityissufficientlylarge.Therefore,
theirpaperdonotaddresstheissueoflong-runfinancialfragility.Inanother
3
Contrarytotheassumptionmadebytheseauthors,itseemstousmorenatural,if
onewantstotreatthetwosectorsinanasymmetricalway,toassumeincreasingreturns
inthetradablesectoralone.Increasingreturnsareindeedmorelikelytobeobservedin
industrialsectorsthaninconstructionandservices.SeevanWijnbergen(1984)foran
two-sectoropen-economymodelwithlearning-by-doinginthetradablesector.

5

paper(2004
b
),thesameauthorsdevelopamodeloffinancialinstabilitywhere
endogenouscyclesariseinthelongrunbecauseofabalancesheeteffect.
Theyhavethesameperspectiveastheonewefollowinthispaper,inthat
theyseektodeterminethestructuralconditionsofthiscyclicalinstability
buttherearenocrisisintheirmodelandtheydonotdiscusstheeffectof
changesinthesectorialstructure.
Inpreviousworks(Kalantzis2004,2005),wehaveconstructedadynamic
two-sectorgrowthmodelwhereself-fulfillingcrisescouldoccurinthelong-
run.Thedynamicpartofthatmodelreliedonincreasingreturnsandthe
crisismechanisminvolvedamyopicinvestmentbehaviorofentrepreneurs
whereasthepresentmodelhasconcaveproductionfunctionsandrational
expectations.
Ourworkisalsorelatedtofinancialacceleratormodelsinclosedeconomies
andtheliteratureonborrowingconstraints(Bernanke&Gertler1989,Kiy-
otaki&Moore1997,Holmstrom&Tirole1996,Holmstrom&Tirole1998),
aswellastotheliteratureon
originalsin
(Eichengreen&Hausmann1999,
Eichengreen,Hausmann&Panizza2003
c
).

Thepaperisorganizedasfollows.Wepresentthemodelinsection1.In
section2,wesolvethewithin-periodequilibriumandshowthatasunspot
equilibriummayexist.Insection3,westudythesteadystateofthedynamics
andshowtowhatconditionitdisplaysfinancialfragility.Wecalibratethe
modelinsection4withdatafromArgentinainthenineties.Insection5,we
examinetheeffectsofdifferentunexpectedshocksandrelatethemwiththe
conditionoflong-runfinancialfragility.Section6concludes.

1Themodel

Weconsiderasmallopeneconomywithoverlappinggenerations.There
arefivekindsofagents:households,firmsproducingafinalgoodforcon-
sumption,entrepreneursproducingtradableornon-tradableinputsanddeep-
pocketexternalinvestors.Timeisdiscrete.Agentslivetwoperiods.There

6

isonesourceofuncertainty:ateachperiod,asunspotvariable
S
t
takesthe
value1withprobability
ω
and0withprobability1
−
ω
(
ω<
1).Whenthere
aremultipleequilibria,
S
t
=0willcorrespondtocrisistimes.
Financialopenness
Thereisaninternationalfinancialmarketwithdeep-pocketandrisk-neutral
externalinvestorswhereone-periodbondsaretradedwithaninternational
risklessinterestrate
R
∗
(intermsoftradablegoods).Duetothesmall
economyassumption,
R
∗
isexogenous.
Weassumethatallagentsintheeconomyhaveaccesstothismarket.
However,thereisanicebergcost
τ
≥
0tointernationalfinancialtransactions.
Whenaninternationalinvestorlends1+
τ
unitsoftradablegoodstoa
domesticagent,thedomesticagentonlygets1unit,and
viceversa
.As
internationalinvestorsarerisk-neutral,theinternationalrisklessratefaced
byadomesticagent
borrowing
abroadis
R
D
=(1+
τ
)
R
∗
.Likewise,the
internationalratefacedbyadomesticagent
lending
abroadis
R
∗
/
(1+
τ
).
τ
isameasureoffinancialopenness.Thecase
τ
=0correspondstoan
economyentirelyopenedtointernationalfinance.
Thehouseholds
Householdslivetwoperiods.Theyareendowedwithoneunitoflaborin
theirfirstperiodoflifeandtheyconsumefinalgoods.
L
t
isthenumberof
householdsbornattime
t
.Weassumeaconstantpopulation
L
t
=
L
.
yDenote
c
t
theconsumptionlevelofayounghouseholdbornattime
t
and
c
to
+1
theconsumptionlevelofthesamehouseholdattime
t
+1.Preferences
arelogarithmic:
¤¢¡£U
=log(
c
ty
)+
βE
t
log
c
to
+1
(1)
where
β
∈
]0
,
1[isadiscountfactorand
E
t
[
∙
]denotestheexpectedvalueat
time
t
.
Totransferconsumptionfromtheirfirsttotheirsecondperiodoflife,
householdscanbuythreedifferentkindsofassets:theycanbuybondsonthe

7

internationalmarketortheycanlendfundstothedomesticentrepreneursof
eitherthetradableorthenon-tradablesector.Theychoosethetotalamount
ofsavingsandthecompositionoftheirportfoliotomaximizeintertemporal
utilitysubjecttotheirbudgetconstraint.Wewillsolvethismaximization
programlater,withthehelpofasimplifyingassumption.

Thefinalgoodsector
Attime
t
,thefinalgood
C
t
isproducedbyacompetitivesectorusinglabor
L
t
=
L
andtwotypesofintermediategoods:tradableinputs
T
tC
andnon-
tradableinputs
N
tC
.TheproductionfunctionisaCobb-Douglasfunction
withconstantreturnstoscale:
¤£αC
t
=(
N
tC
)
µ
(
T
tC
)
1
−
µ
L
1
−
α
(2)
with
α,µ
∈
]0
,
1[.Profitmaximizationbyfirmsgivetheusualfirstorder
conditions.Respectivelydenoting
p
t
,
p
tC
and
w
t
thepriceofthenon-tradable
input,thepriceoftheconsumptiongoodandthewage,alloftheminterms
oftradablegoods,onegets:

(1
−
α
)
p
tC
C
t
=
w
t
L
(3)
αµp
tC
C
t
=
p
t
N
tC
(4)
α
(1
−
µ
)
p
tC
C
t
=
T
tC
(5)
Remarkthat
p
isameasureoftherealexchangerate(ahighvalueof
p
correspondstoanappreciatedrealexchangerate).

Theintermediatesectors
Therearetwokindsofintermediategoods:tradableandnon-tradable.The
tradableinputisproducedbythetradablesector(sectorT)butcanalsobe
imported.Likewise,anyexcessproductionofthissectorcanbeexported.We
assumethattheinternationaldemandfortradableinputsisinfinitelyelastic.

8

Thenon-tradableinputisexclusivelyproducedbyadomesticnon-tradable
sector(sectorN)andthewholeproductionhastobeuseddomestically.
Eachsectoriscomposedbyacontinuumoffirmsofmeasureone.Each
firmproducesanintermediategoodusingthetwokindsofinputsascapi-
tal.AfirmofthesectorNproducesattime
t
+1aquantity
N
t
+1
ofnon-
tradableintermediategoodsusingacapitalof
K
tN
tradablegoodsand
J
tN
non-tradablegoods.
4
TheproductionfunctionisaCobb-Douglasfunction
withdiminishingreturns:
"µ
N
¶
1
−
η
µ
N
¶
η
#
δ
N
t
+1
=
A
tN
+1
K
t
J
t
(6)
ηη−1with
η,δ
∈
]0
,
1[.Bothtypesofcapitalarefullydepreciatedfromoneperiod
tothenext.
Likewise,theproductionfunctionforafirmofthesectorTis:
#"µ
K
T
¶
1
−
η
µ
J
T
¶
ηδ
T
t
+1
=
A
tT
+1
tt
(7)
ηη−1Thereisanexogenousandhomogenousgrowthtrendintheproductivityof
bothsectors:
A
i
=
A
i
£
(1+
g
)
1
−
δ
¤
t
i
=
N,T
(8)
0tInthefollowing,
g
willbethesteady-stategrowthrateoftheeconomy.
Eachfirmintheintermediatesectorsisrunbysuccessivegenerations
ofrisk-neutralentrepreneurs.Weassumethattheydonotconsumeduring
theirfirstperiodoflifeandthattheyspendsomefixedfraction
γ
∈
]0
,
1[
oftheirprofitstoconsumefinalgoodsintheirsecondperiodoflife.Thus,
anentrepreneurofthesector
i
bornattime
t
investsherinternalfunds
W
ti
inthefirstperiodoflife,getsthereturnΠ
ti
+1
inthesecondperiodoflife,
keepsafraction
γ
forherownconsumptionandgivestheremainingpro-
ceeds
W
ti
+1
=(1
−
γ
)Π
ti
+1
tohersuccessor.Moreover,attime
t
,ayoung
4
K
tN
mainlyconsistsofmachinery,transportation,....
J
tN
representsbuildingsbut
alsoallpossiblenon-tradablegoodsandservicesnecessarytotheinstallationoftradable
capital.

9

entrepreneurcanborrowsomeadditionalexternalfundstodomestichouse-
holdsorinternationallendersandpaythembackinthefollowingperiod.

Themarketforcorporatedebt
Wenowintroducetwomarketimperfections.First,weassumethatthe
economyissubjecttotheso-called
originalsin
:thereisnomarketfordebt
denominatedinnon-tradablegoods.
5
Therefore,theentrepreneurscanonly
issuedebtdenominatedintradablegoods.Inparticular,entrepreneurspro-
ducingnon-tradablegoodscannotinsureagainstrealexchangeraterisk.
6
Second,becauseofmoralhazardandimperfectmonitoring,anentrepreneur
mightbesubjecttoaborrowingconstraint.WefollowSchneider&Tornell
(2004)andAghion,Banerjee&Piketty(1999)forthedetailedmicrofounda-
tionofthisborrowingconstraint.
iBLet
t
+
i
1
denotetheexternalfundslenttoanentrepreneurofthesector
Rti
attime
t
.Theentrepreneurhastorepayattime
t
+1anamount
B
ti
+1
in
itradablegoods.
R
t
mayincludeariskpremiumduetopossibledefaults.As
inSchneider&Tornell(2004),theentrepreneurhasthepossibility,attime
t
+1,ifthefirmissolvent(cf
infra
),torunawaywiththeproductionwithout
repayingitsdebt
B
ti
+1
.This,however,requiressomespecialeffortandcosts
ihiBheradisutility
dW
ti
+
t
+1
proportionaltothetotalfundsofthefirm.If
iRtshechoosestodothis,thelendercantrytofindherandforcehertorepay
5
SeeEichengreenetal.(2003
c
)foranempiricalinvestigationontherelevanceofthis
concept.AccordingtoEichengreen,Hausmann&Panizza(2003
b
),originalsinmightbe
theresultoftransactioncostsininternationalfinancewhichsetafinitenumberofcurren-
ciesintheworld’sportfolio:thecosttodetainthemarginalcurrencyshouldcompensate
thebenefitderivedfromriskdiversification.Aslargecountriesoffermorediversification
thansmallones,theyarguethatoneshouldexpectthecurrenciesoflargecountriestobe
dominantininternationalportfolios.
6
Severalauthorshaveproposedargumentstoexplainwhydomesticfirms
choose
totake
ariskypositionbyissuingdebtdenominatedinforeigncurrency:moralhazardinduced
byexpectedbail-outs(Schneider&Tornell2004),borrowingconstraintsinthedomestic
financialsystem(Caballero&Krishnamurthy2000),commitmentproblems(Jeanne2000)
orthelackofcredibilityofthedomesticmonetarypolicy(Jeanne2003).Inthispaper,we
considerthatfirms
couldnot
issuedomesticcurrencydebt,eveniftheywantedto.Fora
moredetaileddiscussiononthedifferencebetweenoriginalsinandcurrencymismatches,
refertoEichengreen,Hausmann&Panizza(2003
a
).

01