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“Quantitative Implications of a Debt-Deflation Theory of Sudden Stops and Asset Prices”

(joint with Enrique Mendoza, University of Maryland, IMF, NBER)

Journal of International Economics, September 2006

“Sudden Stops” experienced during emerging markets crises are characterized by large reversals of capital inflows and the current account, deep recessions, and collapses in asset prices.  This paper proposes an open-economy equilibrium asset-pricing model in which financial frictions cause Sudden Stops.  Margin requirements impose a collateral constraint on foreign borrowing by domestic agents and trading costs distort asset trading by foreign securities firms.  At equilibrium, margin constraints may or may not bind depending on portfolio decisions and equilibrium asset prices.  If margin constraints do not bind, productivity shocks cause a moderate fall in consumption and a widening current account deficit.  If debt is high relative to asset holdings, the same productivity shocks trigger margin calls forcing domestic agents to fire-sell equity to foreign traders.  This sets off a Fisherian asset-price deflation and subsequent rounds of margin calls.  A current account reversal and a collapse in consumption occur when equity sales cannot prevent a sharp rise in net foreign assets.

“The Composition of Capital Inflows When Emerging Market Firms Face Financing Constraints”

(joint with Diego Valderrama, Federal Reserve Bank of San Francisco)

Journal of Development Economics, Forthcoming

The composition of capital inflows to emerging market economies tends to follow a predictable dynamic pattern across the business cycle. In most emerging market economies, total inflows are pro-cyclical, with debt and portfolio equity flowing in first, followed later in the expansion by foreign direct investment (FDI). To understand the dynamic composition of these flows, we use a small open economy (SOE) framework to model the composition of capital inflows as the equilibrium outcome of emerging market firms' financing decisions. We show how costly external financing and FDI search costs generate a state contingent cost of financing such that the cheapest source of financing depends on the phase of the business cycle. In this manner, the financial frictions are able to explain the interaction between the types of flows and deliver a time-varying composition of flows, as well as other standard features of emerging market business cycles. If, as this work suggests, flows are an equilibrium outcome of firms' financing decisions, then volatility of capital inflows is not necessarily bad for an economy. Furthermore, using capital controls to shut down one type of flow and encourage another is certain to have both short- and long-run welfare implications.

“Can Financing Constraints Explain the Asset Pricing Puzzles in Production Economies?”

General Equilibrium asset pricing models have a difficult time simultaneously delivering a sizable equity premium, a low and
counter-cyclical real risk free rate, as well as cyclical variation in return volatility. To explain these stylized facts, this paper introduces occasionally binding financing constraints that impede producers' ability to invest in an otherwise standard real business cycle model. These financing constraints increase the marginal cost of investing without altering the marginal rate of substitution directly, generating a sizable equity premium as well as other standard business cycle quantity and price moments. The financial frictions drive a wedge between the marginal rate of substitution and firms' internal stochastic discount factors so that the shadow value of capital is no longer tied to the average price of capital serving to increase asset price volatility.

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