Shocks to Balance Sheets and Emerging Market Crises

• Author: R. Gaston Gelos
• Pages: 2-3

Page 2

Shocks to Balance Sheets and Emerging Market Crises

Models of the interaction between macroeconomics and finance-such as Bernanke and Gertler's (1989) financial accelerator model-have strongly influenced the way economists think about the propagation of shocks, and IMF researchers have sought to incorporate their insights into models of emerging market crises. ¹

Building on various existing models, Jeanne and Zettelmeyer (2002) derive a stylized framework to analyze currency crises. ²

The common theme is that currency and maturity mismatches in private sector balance sheets constrain the capacity of macroeconomic policies to deal with self-fulfilling capital account crises, generating a role for international lending. Christiano, Gust, and Roldós (forthcoming) discuss economic policies during crises in open economy models with collateral constraints: they find that the desirability of interest rate cuts during crises depends on the degree of short-term flexibility in the economy. ³

Disyatat (2001) develops a model in which countries with healthy banks are less likely to suffer a contraction following an unexpected depreciation. ⁴

Céspedes, Chang, and Velasco (2000, 2002) formalize the trade-offs faced by the monetary and exchange rate policy authorities in the presence of foreign-currency liabilities. ⁵

In a dynamic general equilibrium model, Choi and Cook (2002) show that a fixed exchange rate rule stabilizing bank balance sheets is preferable to an interest rate rule targeting inflation. ⁶

Catão and Rodríguez (2000) explore credit channel mechanisms in an economy where the nontradables sector is dependent on bank credit. ⁷

Allen and others (2002) extensively review sources of balance sheet vulnerabilities and their implications for surveillance and policies. ⁸

IMF researchers have pursued theoretical and empirical approaches to understanding the role of currency mismatches. Why do companies in emerging markets borrow in foreign currency? Jeanne (2000) discusses two different but related possibilities. In one explanation, dollar debt is more risky, but good entrepreneurs use it to signal their type. In the other, dollar debt is a commitment device: entrepreneurs can commit to high effort levels by using dollar debt, which reduces the likelihood that they will be bailed out by the government through exchange rate policy. ⁹

More recently, Jeanne (2002) argues that monetary policy credibility lies at the heart of the problem: in an environment with high monetary policy variance, borrowing in dollars may minimize the probability of default from a company's perspective. ¹⁰

Using data on Mexican companies, Gelos (2003) finds that a firm's share of foreign-currency-denominated debt in total debt is positively correlated with its own size and firm-level imports and exports; in contrast to the predictions of the signaling hypothesis, companies with more dollar debt are less profitable on average. ¹¹

What incentives do banks have to borrow and lend in foreign currency? Ize and Levy-Yeyati (forthcoming) develop a model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank's balance sheet. Dollarization depends on the relative volatilities of inflation and real depreciation. ¹²

Similarly, Catão and Terrones (2000) present a banking model where the extent to which banks choose to lend in dollars depends on devaluation risk, foreign interest rates, the availability of tradable collateral, and credit market...