External Debt in Emerging Economies: A Macrodynamical Model of Financial Fragility

Following both the balance-sheet approach to currency crises and the financial fragility literature, the paper presents an open economy macrodynamical monetary growth model with the aim of giving an endogenous characterisation to the process that, over time, leads an emerging economy to accumulate dangerously high levels of debt and to be vulnerable to macroeconomic instability. The model explores the nonlinear real and financial interaction at work, with the endogenously generated liquidity feeding back dynamically to firms’ investment, the level of output, the interest rate and the expected rate of return. The paper shows that the system may display instability if lenders and borrowers are not too concerned with firms’ degree of leverage, profitability expectations do not take adequately into account firms’ financial structure, and destabilising feedback mechanisms dominate, which go from debt accumulation and profitability expectations onto the rate of profit and the interest rate. As a result, the economy may incur in excessive foreign borrowing. The consequent worsening in firms’ balance sheets may turn into financial fragility, and over time bring about a fall in external lending. A prolonged recession may thus follow, possibly calling into question the currency arrangements; hence, a financial crisis may turn into a currency crisis.(This abstract was borrowed from another version of this item.)