Sector Heterogeneity and Credit Market Imperfections in Emerging Markets

Interest rate shocks have a large impact on economic activities in emerging markets. This paper argues that this finding can be associated with credit market imperfections affecting principally non-tradable activities. Using a new database on sectoral output and credit markets in emerging economies, I present novel evidence documenting that tradable and non-tradable sectors respond asymmetrically to changes in credit conditions. In particular, I show that local credit conditions explain a significant proportion of the variation in output growth in non-tradable activities, but little of the variation in output growth in the tradable sector. Accordingly, interest rate shocks are amplified solely through nontradable activities. Importantly, I demonstrate that these distinctive features of emerging markets are absent in developed small open economies. To rationalize these findings, I introduce a simple small open economy model in which tradable and non-trabable sectors differ in their access to external finance. The model illustrates that credit market imperfections can reverse the predictions of the standard small open economy model, in which interest rate shocks affect the capital-intensive tradable sector most. In presence of financial frictions, these shocks can affect the labor-intensive non-tradable sector more. JEL Classification codes: E44, F34, F41, F43