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Private Sector Risk and Financial Crises in Emerging Markets

  • Betty Daniel

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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File URL: http://www.albany.edu/economics/research/workingp/2008/PrivateDefault121908.pdf
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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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Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.

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  1. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  2. Aaron Tornell & Frank Westermann & Lorenza Martínez, 2004. "The Positive Link Between Financial Liberalization, Growth, and Crises," CESifo Working Paper Series 1164, CESifo Group Munich.
  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, vol. 70(1), pages 82-114, September.
  4. Joshua Aizenman & Nancy P. Marion, 2002. "International Reserve Holdings with Sovereign Risk and Costly Tax Collection," NBER Working Papers 9154, National Bureau of Economic Research, Inc.
  5. Roberto Chang, 2005. "Financial Crises and Political Crises," NBER Working Papers 11779, National Bureau of Economic Research, Inc.
  6. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  7. 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.
  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. Romain Rancière & Aaron Tornell & Frank Westermann, 2002. "Systemic crises and growth," Economics Working Papers 854, Department of Economics and Business, Universitat Pompeu Fabra, revised Nov 2004.
  10. 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.
  11. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
  12. 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.
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