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Private Sector Risk and Financial Crises in Emerging Markets

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  • Betty Daniel

Abstract

Investment necessary for growth is risky and often requires external financing. For an emerging market, access to international credit markets is volatile and interest rates reflect risk of default. We present a theoretical model in which emerging market agents have access to a profitable two-period investment project of fixed size greater than their endowment. Credit market imperfections can magnify a small solvency problem into a financial crisis with widespread default and/or currency devaluation. In equilibrium, creditors o¡èer single-period debt up to a ceiling based on expected future output. News about a negative productivity shock reduces the debt ceiling imposed by creditors, creating a sudden stop of capital floows. The sudden stop can be severe enough to trigger a debt crisis, when agents prefer default over debt repayment, and/or a currency crisis, as agents attempt to maintain desired consumption by swapping domestic currency for foreign currency to purchase goods. We also show that there are critical thresholds for parameters governing credit market imperfections that separate countries into a safe credit club with low interest rates and steady access and a risky club with high interest rates and volatile access.

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Paper provided by University at Albany, SUNY, Department of Economics in its series Discussion Papers with number 08-10.

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Date of creation: 2008
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Handle: RePEc:nya:albaec:08-10

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Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
Phone: (518) 442-4735
Fax: (518) 442-4736

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Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
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  1. Aizenman, Joshua & Marion, Nancy P., 2003. "International Reserve Holdings with Sovereign Risk and Costly Tax Collection," Santa Cruz Center for International Economics, Working Paper Series, Center for International Economics, UC Santa Cruz qt9s7978n1, Center for International Economics, UC Santa Cruz.
  2. Romain Ranciere & Aaron Tornell & Frank Westermann, 2002. "Systemic Crises and Growth," Working Papers 190, Barcelona Graduate School of Economics.
  3. Mendoza, Enrique G. & Smith, Katherine A., 2006. "Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices," Journal of International Economics, Elsevier, Elsevier, vol. 70(1), pages 82-114, September.
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  5. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, American Economic Association, vol. 94(4), pages 1183-1193, September.
  6. Charles T. Carlstrom & Timothy S. Fuerst, 1996. "Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis," Working Paper 9602, Federal Reserve Bank of Cleveland.
  7. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  8. Reinhart, Carmen & Kaminsky, Graciela, 1999. "The twin crises: The causes of banking and balance of payments problems," MPRA Paper 14081, University Library of Munich, Germany.
  9. Reinhart, Carmen & Calvo, Guillermo, 2000. "When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options," MPRA Paper 6982, University Library of Munich, Germany.
  10. Aaron Tornell & Frank Westermann & Lorenza Martínez, 2004. "The Positive Link Between Financial Liberalization, Growth, and Crises," CESifo Working Paper Series 1164, CESifo Group Munich.
  11. Roberto Chang, 2002. "Financial Crises and Political Crises," Departmental Working Papers, Rutgers University, Department of Economics 200229, Rutgers University, Department of Economics.
  12. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries," IMF Working Papers 06/229, International Monetary Fund.
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