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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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Bibliographic Info

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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Web: http://www.albany.edu/economics/research/workingp/index.shtml

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  1. Aaron Tornell & Frank Westermann & Lorenza Martínez, 2004. "The Positive Link Between Financial Liberalization, Growth, and Crises," CESifo Working Paper Series 1164, CESifo Group Munich.
  2. Enrique G. Mendoza & Katherine A. Smith, 2004. "Quantitative Implication of A Debt-Deflation Theory of Sudden Stops and Asset Prices," NBER Working Papers 10940, National Bureau of Economic Research, Inc.
  3. Romain Rancière & Aaron Tornell & Frank Westermann, 2008. "Systemic Crises and Growth," The Quarterly Journal of Economics, MIT Press, vol. 123(1), pages 359-406, 02.
  4. Chang, Roberto, 2007. "Financial crises and political crises," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2409-2420, November.
  5. 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 qt9s7978n1, Center for International Economics, UC Santa Cruz.
  6. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  7. 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.
  8. Carlstrom, Charles T & Fuerst, Timothy S, 1997. "Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis," American Economic Review, American Economic Association, vol. 87(5), pages 893-910, December.
  9. Luis Felipe Cespedes & Roberto Chang & Andres Velasco, 2000. "Balance Sheets and Exchange Rate Policy," NBER Working Papers 7840, National Bureau of Economic Research, Inc.
  10. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
  11. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  12. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries: Formulas and Applications," IMF Working Papers 06/229, International Monetary Fund.
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