Do Credit Market Imperfections and Balance Sheet Effects Explain why Emerging Markets React so Sharply to Negative Shocks?

This paper develops a fully microfounded two-sector DGE model for a small open economy subject to credit market imperfections (CMIs) and balance sheet problems (due to the presence of a currency mismatch). Specifically, some agents in this economy face credit constraints to finance investment due to information asymmetries and, while their assets are denominated in the domestic currency, their liabilities are denominated in the foreign currency. The article investigates whether these two factors rationalize why emerging markets (EMs) react more sharply to negative shocks relative to developed economies and if, at the same time, these frictions may explain why EMs face a countercyclical credit spread to finance investment. The model’s behavior is studied while considering an unexpected increase in the foreign interest rate under a floating and a fixed exchange rate regime. The paper shows that CMIs and balance sheet problems can generate amplification relative to a case in which financial markets work perfectly, but at most it is moderate. Nonetheless, the degree of amplification strongly depends on the exchange rate that prevails in the economy, being always larger under a floating regime. It is also shown that the model provides a good account of why it is more expensive to finance investment when a negative shock hits the economy, a fact observed in many EMs. JEL Classification: F32, F39, F41.