Asset Bubbles, Investment, and Reserve Holdings in Emerging Economies

We build a general equilibrium model of investment and capital accumulation in emerging economies. The infinite horizon model features a financial friction, namely that entrepreneurs can only raise debt that they can credibly repay given an outside option such as an investment in the traditional sector of the emerging economy. We show that when lending rates are low, the pure market outcome can be improved upon by a rational asset bubble that relaxes entrepreneurs’ borrowing constraints and increases investment in physical capital. The forward looking nature of the no-default constraint establishes a link between the emergence of a bubble and current credit limits as well as the structure of capital advancement. A key role in spreading the bubble is played by the domestic banking sector that channels funds from investors to entrepreneurs. In bubble-like episodes, domestic investors hold less reserves as a fraction of total assets but are compensated by banks with higher rates of return on their investments in the booming domestic capital market. Loans financed by these deposits are channeled to firms, feeding a bubble, i.e. overvaluation of firms, which in turn validates the banks relaxed lending policy that drives an investment boom. Financial development, i.e. a better enforcement of debt repayments, causes bubbles to burst. However, the process of bubble-driven capital advancement with a crash can dominate economic development without bubbles and crashes. Bubbles may be fragile but they speed up capital advancement as long as financial frictions are binding. JEL classification: E32; E44; F32; F34.