Sector Heterogeneity and Credit Market Imperfections in Emerging Markets

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Sector heterogeneity and credit market

imperfections in emerging markets


Presented by- Liliana varela (July 2016)
Abstract:

Impact of country’s interest rate and its shocks on emerging markets,


association of economic activities with credit market imperfections.

This paper shows that increases in the cost of borrowing propagate


asymmetrically across sectors in emerging markets. It present that country’s
interest rate shocks are negatively correlated with output in non-tradable
activities, whilst present no significant relationship with tradable activities.

Importantly, this greater countercyclical co-movement between interest rate


and non-tradable output is at odds with the standard small open economy
model, in which interest rate shocks affect the tradable capital-intensive sector
the most. To rationalize the negative response of non-tradable output writer
develop a small open economy model and show that asymmetries in the access
to external finance can account for the distinctive and a priori counterintuitive
response across sectors. The greater downturn of non-tradable activities can be
explained by their higher reliance on domestic credit and, hence, by their
deeper exposure to local financial frictions.

A well-documented fact in international economics is that the emerging


economies. The larger impact of the borrowing cost on non-tradable activities is
remarkable, as these activities are labor-intensive. This paper sustains that the
greater exposure of non- tradable firms to domestic credit market imperfections
can account for this feature rate is countercyclical in emerging markets, but
cyclical in developed open economies. In the model, agents face heterogeneous
access to credit depending on the enforceability of debt contracts .Tradable
firms have perfect access to international capital markets, as foreign lenders
find.it easy to enforce their debt contracts by submitting them to foreign
courts. Non-tradable firms are instead subject to financial imperfections, as
there is no international authority that can enforce their debt contracts. In this
context, foreign lenders face the risk of debt repudiation and charge a risk
premium based on non-tradable firms’ default probability. This default
probability is endogenously determined and increases with the level of debt
repayment. In this way, an increase in the interest rate leads to a larger
increasing non-tradable firms’ borrowing costs, as it also raises their debt
repayments and default probability.

The larger impact of the borrowing cost on non-tradable activities is


remarkable, as these activities are labor-intensive. This paper sustains that the
greater exposure of non-tradable firms to domestic credit market imperfections
can account for this feature. In the model, agents face heterogeneous access to
credit depending on the enforceability of debt contracts. Tradable firms have
perfect access to international capital markets, as foreign lenders find it easy to
enforce their debt contracts by submitting them to foreign courts. Non-tradable
firms are instead subject to financial imperfections, as there is no international
authority that can enforce their debt contracts. In this context, foreign lenders
face the risk of debt repudiation and charge a risk premium based on non-
tradable firms’ default probability. This default probability is endogenously
determined and increases with the level of debt repayment. In this way, an
increase in the interest rate leads to a larger increase in non-tradable firms’
borrowing costs, as it also raises their debt repayments and default probability.
next turn to the empirics and assess the relationship between financing terms
and output growth in two steps. I first estimate a panel VAR, the impulse
response functions, and the variance decomposition for output growth to
domestic and foreign interest rate shocks for a set of thirty-five economies
(fifteen developed open economies and twenty emerging markets) at a quarterly
frequency over the period 1990q1-2015q4, and next evaluate the relationship
between domestic credit and output growth at sector level for emerging
markets.

The empirical results show, first, that one percent increase in the domestic
interest rate leads to a 7% decrease in emerging markets’ GDP. Second, non-
tradable and tradable activities respond asymmetrically to domestic interest
rate shocks. One percent increase in the domestic interest rate induces a 6.5%
decline in non-tradable output, while it has nonsignificant effect on tradable
activities. Notably, these results are driven by the increase in the country risk
premium. Third, the variance decomposition analysis demonstrates that
domestic interest rate shocks have a substantial impact on emerging markets’
business cycles, as they account for 14% of GDP fluctuations within business
cycle frequency (20 quarters). Fourth, the variance decomposition analysis also
reveals asymmetries in the source of fluctuations between tradable and non-
tradable activities, as domestic interest rate shocks account for larger declines
in non-tradable output.Fifth, these distinctive features observed in emerging
markets following interest rate shocks are absent in developed small open
economies. Finally, I construct a database on local credit and output at a
quarterly frequency for tradable and non-tradable activities for emerging
markets, and estimate a dynamic heterogeneous panel at sector level.
Empirical results show that non-tradable activities are more reliant on the
domestic credit market and, hence, more likely to be affected by local financial
imperfections. This paper is complementary to Tornell and Westermann (2005)
insofar as I provide a more comprehensive analysis of the relationship between
domestic credit conditions and sectorial output growth in emerging markets.

A SOE Model with Asymmetric Access to Finance

The standard small open economy (SOE) model states that increases in the
borrowing cost affect the capital-intensive tradable sector the most. She use a
SOE model with international borrowing to show that the presence of
heterogeneous access to external finance can explain the empirical patterns
observed in the data. Open economy model where the economy is composed by
two goods: tradable and non-tradable, and two factors of production: capital
and labor. Assume that the tradable and non-tradable sectors are perfectly
competitive, and the representative firm operates with a Cobb-Douglas
function: Yit=KtiiLti1-I, where i=Tradable, Non-tradable. The tradable sector is
capital-intensive and the non-tradable sector is labor-intensive.

Credit Market Imperfections

There is a broad consensus in the economic literature that credit markets


are subject to non-negligible financial frictions in emerging markets. The
equilibrium in the financial market imposes the arbitrage condition for the
foreign investor. This condition defines the supply curve for new capital for the
non-tradable sector. This supply curve is upward sloping and depends on
amount due by the non-tradable firm. As larger is the debt repayment of the
non-tradable firm, higher are its opportunity cost of default and its risk-
premium. In presence of credit market imperfections, non-tradable output is
negatively correlated with the domestic interest rate, whilst tradable output is
uncorrelated. It is the increase in the domestic risk premium affecting non-
tradable firms what accounts for this asymmetric response across sectors.

Output Responses to Interest Rate Shocks

This section analyzes the dynamic relationship between sectorial output,


interest rates for emerging markets and compares them with developed open
economies. She starts by employing panel VARs on tradable and non-tradable
output growth, and the domestic and foreign interest rates.
Sensitivity Analysis

To assess the robustness of the results, she conducts two further empirical
exercises. First analyze the sensitivity of the results for different classifications
of non-tradable activities, and test next whether results are robust to different
specifications of VAR.

Non-Tradable Activities

Results presented above considered a broad definition of non-tradable


activities that included all economic activities except for agriculture, fishing,
mining and manufacturing. More precisely, the non-tradable sector included:
utilities, construction, trade, transportation and accommodation, information and
communication, financial and real estate activities, professional activities, public
administration, education, health, arts and other private services.6 In this
section, I consider two robustness tests. I first exclude financial and real estate
activities from the analysis, and next I also exclude government regulated
activities, as utilities (electricity, gas and water supply), public administration,
education and health services, as these activities are subject to specific
regulations.

Domestic Credit and Sectorial Output Growth

Distinctive response across sectors is absent in open economies with


developed capital markets. Why do we observe this asymmetric response
between tradable and non-tradable activities in emerging markets? Previous
studies suggest that this heterogeneity could stem from differences in financial
opportunities between tradable and non-tradable firms in these economies. In
particular, Tornell and Westermann (2005) document those tradable firms see
easier access to international capital markets as -for instance- they can pledge
their exports as collateral, while non-tradable firms are typically smaller and
face greater obstacles to obtain international credit. This higher reliance on less
developed capital markets could account for the larger downturns observed in
non-tradable activities in emerging markets. Domestic credit and output
relationships at sector level in emerging markets. With this end, she estimates a
heterogeneous dynamic panel using a mean group estimators. Let the dependent
variable be sectorial output growth and the explanatory variable is sectorial
credit growth, and control for trade openness (export plus imports over GDP), real
exchange rate, country-fixed effects and currency and banking crisis

Mean Group Estimator


To study how sectorial credit and output relate, I compute a mean group
estimator that separately estimates the short- and long-term relationships for
each country, and averages the results across them.10 The advantage of the
mean group estimator to study emerging markets is that it estimates the
dynamic of each country individually. Given the heterogeneous pattern of
growth of emerging markets, jointly estimate their dynamic could induce to
measurement error problems and bias the estimators.

Conclusion

Interest rate shocks have a large impact on aggregate activities in emerging


markets. This paper has shown that this economic downturn stems from the
fall in non-tradable activities. Importantly, the asymmetric response between
tradable and non-tradable activities is characteristic of emerging markets and
absent in open economies with developed capital markets. This paper argues
that it is the heterogeneous access to external finance which can account for
this fact. In particular, as shown above, non-tradable activities are more reliant
on the local credit market and, thus, more exposed to the local financial
frictions predominant in these economies. It is the presence of local financial
imperfections that amplifies the initial increase in the borrowing cost and
affects those activities depending more intensively on local credits.

Traditionally, development policy has focused on credit access for tradable


firms, to aid the growth of a country’s exporting sector. Based on my findings,
countries with a well-developed export sector should also improve credit access
to domestically operating firms, so as to stabilize their economies in the face of
external shocks.

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