Emerging Markets and Financial Intermediaries

Over the last fifteen years, emerging economies have experienced abrupt changes in bond spreads and large movements in capital flows. We propose a simple general equilibrium model where international investors hire fund managers to invest their capital either in the bonds of an emerging economy or in a riskless asset. We model the emerging economy as a small-open economy subject to an aggregate shock, populated by agents making decisions of consumption, borrowing and default. There is only an infinitesimal fraction of fund managers who have information on the fundamentals of the emerging country. This generates career concerns that distort the investment decision of uninformed fund managers. When the probability of default is sufficiently high, they prefer to invest in safe bonds even at a lower expected return to reduce the probability of being fired. This is what we define "reputational premium". As the economic and financial conditions change, the reputational premium can switch sign. This generates an overreaction of the market leading to excess volatility of spreads, capital flows and output.