Interlinkages between external debt financing, credit cycles and output fluctuations in emerging market economies

This paper examines the role of external debt financing (EDF) in shaping the credit cycles and the joint implications of EDF flows and credit growth for the output volatility in ten major emerging economies. We find that extreme phases—known as surge and stop episodes—in EDF flows are significantly associated with credit surges and stop episodes as shown by a panel multinominal logit estimation. However, the association is asymmetric—EDF stop episodes are more likely to bring about a credit stop episode compared to the occurrence of credit surges due to EDF surges. The results suggest vulnerabilities of credit cycles of EMEs to the sharp movement in EDF flows which in turn is typically synchronized with global liquidity conditions. In the second part of our analysis, using the bias-corrected LSDV estimation for the dynamic panels, we find that EDF flows and credit jointly have a strong amplifying impact on the output volatility. Moreover, EMEs also face large output volatility when EDF stop and credit stop episodes occur together. The results implicate a broader welfare loss in the form of output fluctuations due to a strong synchronization between external debt financing and domestic credit conditions. Significant output fluctuations are also a cause of concern for policymakers in EMEs who seek to insulate their economies from external and domestic financial shocks.