Country Spreads as Credit Constraints in Emerging Economy Business Cycles

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1 Conférence organisée par la Chaire des Amériques et le Centre d Economie de la Sorbonne, Université Paris I Country Spreads as Credit Constraints in Emerging Economy Business Cycles Sarquis J. B. Sarquis s.j.sarquis@lse.ac.uk IRBr & FMG/LSE 2 June 2008 Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

2 Introduction Emerging economy business cycles are di erent (e.g. Agénor, McDermott and Prasad, 2000, Neumeyer and Perri, 2005) Higher macroeconomic volatility (Brazil s standard deviation of output twice that of US) Consumption is specially volatile relative to GDP Countercyclical trade balance (trade to GDP ratio) Higher and countercyclical real interest rates, R t (Brazil s standard deviation about twice that of US) Country spread is key component of R t R t S t due to both magnitude and variability Are country spreads part of the propagating mechanism over business cycles? Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

3 Motivation I: causation via country spreads as credit constraints Exogenous (global) credit shocks to real interest rates can explain some stylized facts of emerging economies: shocks have persistent e ects in output and consumption hump- or V-shaped (Calvo, Izquierdo and Talvi, 2006) responses regardless of the speed of recovery, negative growth persistence in line with recessions consumption - at least - as responsive as output to those shocks Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

4 Motivation II: causation via country spreads as credit constraints Signi cant shares (above 20%) of Y, C and I variability could be attributable to those shocks at realistic horizons despite productivity or domestic shocks, exogenous foreign credit shocks have lasting and signi cant implications exogenous international nancial factors have more relevant role than international trade e ects (eg. Canova, 2005) Countercyclical nature of interest rate mainly intertemporal, suggesting causal relationship so that: Corr(R t i, Y t ) < 0 and Corr(S t i, Y t ) for realistic i 0 Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

5 Theoretical developments Small Open Economy business cycle models: E ects of exogenous interest rate shocks are dominated by productivity shocks (Mendoza, 1991; Schmitt-Grohé and Uribe, 2003) Improvements with working capital constraints (Neumeyer and Perri, 2005, Uribe and Yue, 2006) countercyclical interest rates but with poor dynamics Collateral credit constraints (in the form of accumulating capital) to foreign borrowing (Sarquis, 2007) stronger propagation mechanism overall better dynamics and matching of stylized facts Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

6 Theoretical challenges addressed by the model To address country spreads, we require in a model: Strong propagation mechanism Endogenous connection between country spread and the macroeconomy moreover: Ability to distinguish shocks a ecting country spread (S) and those a ecting the benchmark interest rate (R ) Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

7 Next steps 1 Empirical evidence 2 Model 3 Calibration 4 Results 5 Conclusion Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

8 Empirical evidence to match Brazil - quarterly data - over 1994 to Second moments: typical business cycle statistics (standard deviations and correlations) 2 VAR impulse responses and variance decompositions 2 4 r t s t m t = C 4 r t 1 s t 1 m t u t. m =Vector representation of the macroeconomy= [output, hour, consumption, investment, trade/gdp] C 1,1 = 0 other (endogenous) variables not important to account for spread movements Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

9 VAR Responses to US interest rate shocks US real interest rate Country spread Output Consumption Note: dotted lines are 95% con dence interval Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

10 VAR Responses to exogenous country spread Exogenous shock to country spread Country spread Output Consumption Note: dotted lines are 95% con dence interval Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

11 VAR variance decompositions (%), at di erent quarters Variability attributable to exogenous shocks to US interest rate, country spread and macro variables Variable US interest rate Country spread Macro variables US int. rate Spread Output Hour Consumption Investment Trade ratio Overall in line with empirical ndings pointing out relevant role of US monetary and other global nancial variables. Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

12 Motivating the model Country spreads as propagating mechanisms (as credit constraints), why? Shocks to global liquidity, uncertainties and risk are transmitted to country spreads by causation in imperfect nancial markets Country spreads are determined by exogenous and endogenous variables; by endogenous factors, shocks propagate further into the macroeconomy via " nancial accelerator" (agency cost - Bernanke and Gertler, 1989; Gertler, Gilchrist and Natalucci, 2003; or collateral - Kiyotaki and Moore, 1997) Adverse exogenous credit shocks impair on consumption and investment by larger borrowing costs and also by the connection between country spreads and the macroeconomy: e.g. debt and economic performance (accumulation of capital) feedback, beyond exogenous credit forces. Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

13 Model Representative agent model and single good: subject to Max E t β s t (C t acht θ ) 1 η 1 s=t 1 η (1) C t F (K t 1, H t ) I t + B t R t B t 1 (2) F (K t 1, H t ) = Z t K α t 1H 1 α t (3) I t [1 G (I t /K t 1 )] = K t (1 δ)k t 1 (4) G ( ) : capital adjustment cost, with steady state values: G (δ) = G 0 (δ) = 0 and G 00 (δ) = π Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

14 Spread as credit constraint (Model II) Model is standard Business Cycle model plus constraint: S t = S σ t 1Rt τ 1 χ B d t 1 ɛ S t (5) Y t Persistence (σ) US interest rate (τ) (Endogenous) Debt to output ratio (d) Exogenous component of spread for instance, risk premia in US bonds (AAA-BAA corporate bonds) - Sarquis (2006) Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

15 Impatience hypothesis (Model III) Model is standard Business Cycle model plus: spread (credit) constraint impatience hypothesis βr < 1 Assuring both: Stationarity ("closing the SOE model") Limited borrowing (avoiding "Ponzi games") Permanent binding of the spread constraint ) dynamics of a credit constrained open economy Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

16 Model IV: Exogenous processes w t = Pw t 1 + ε t, (6) w t = z t r t e S t 2 P = 4 ρ z ρ r ρ e S 0, and zt = ln Z t, r t = ln R t and e S t = ln ɛ S t 3 5 ε t = ε z t ε r t ε s t 0 disturbances to the exogenous processes, N(ε, E (ε ε)) Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

17 First order conditions u H (C t, H t, ) = λ t F H (K t 1, H t ) + d(1 α)µ t S t H t (7) λ t = u C (C t, H t ) (8) λ t+1 = q t+1 1 G ( I t+1 K t ) I t+1 G 0 ( I t+1 ) K t K t (9) Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

18 First order conditions II λ t = βλ t+1 R t+1 + βdµ t+1 S t+1 B t (10) q t = β (λ t+1 F K (K t, H t+1 ) + q t+1 " 1 δ + It+1 K t #) 2 G 0 ( I t+1 ) K t +αβdµ t+1 S t+1 K t (11) µ t = λ t R t B t 1 + βσµ t+1 S t+1 S t (12) Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

19 Propagation in the Model From the Euler equations (10) and (11), corresponding to the rst order conditions in capital and debt: - abstracting from capital adjustment cost and - substituting out the multiplier µ βe λ t+1 λ t " FK (K t, H t+1 ) + 1 δ α B t K t R t+1 1 α B t K t # = 1 (13) From Equation (12), the relationship between the spread dynamics and the changes in the multiplier of the credit constraint µ t µ t+1 = λ tr t B t 1 µ t+1 + βσ S t+1 S t (14) Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

20 Calibration Parameters Symbol Value Rates real interest rate R 1.02 country spread S Preference discount factor β elasticity of labour supply = 1 1 θ θ 1 utility curvature η 2.5, 10 utility parameters a 2.39 Technology capital share α 0.38 depreciation rate δ capital adjustment cost π 1000 Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

21 Calibration II S t = S σ t 1Rt τ 1 χ B d t 1 ɛ S t Y t From S, B/Y (annually around 0.28) and τ and σ, given by the VAR estimates, using the steady state conditions of the constraint and of the FOC in S ) χ and d Country spread equation B/Y 0.07 S σ 0.5 d χ τ Note: quarterly values Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

22 Calibration III: alternative speci cations of independent shocks 2 P 1 = with P 1, 0.6% for ε z t, 1.0% for ε r t and 2.8% for ε e S t 2 P 2 = with P 2, 0.7% for ε z t, 1.3% for ε r t and 3.0% for ε e S t Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

23 Results: simulated responses to US interest rate shocks US real interest rate Country spread Country real interest rate Output Note: (green) triangles for P 1 with η = 2.5, (blue) squares for P 1 with η = 10, (red) diamonds for P 2 with η = 2.5, and (brown) circles for P 2 with η = Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

24 Simulated responses to US interest rate shocks (cont.) Hour Consumption Investment Trade / GDP Note: (green) triangles for P 1 with η = 2.5, (blue) squares for P 1 with η = 10, (red) diamonds for P 2 with η = 2.5, and (brown) circles for P 2 with η = Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

25 Simulated responses to spread shocks Exogenous shock to country spread Country spread Country real interest rate 0.05 Output Note: (green) triangles for P 1 with η = 2.5, (blue) squares for P 1 with η = 10, (red) diamonds for P 2 with η = 2.5, and (brown) circles for P 2 with η = 10. Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

26 Simulated responses to spread shocks (cont.) Hour Consumption Investment Trade / GDP Note: (green) triangles for P 1 with η = 2.5, (blue) squares for P 1 with η = 10, (red) diamonds for P 2 with η = 2.5, and (brown) circles for P 2 with η = 10. Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

27 Second moments Standard deviations % Real Simulated models data P 1 P 2 η = 2.5 η = 10 η = 2.5 η = 10 Output Consumption non durables Investment 5.5 mach. & equip Hour Trade balance Country inter. rate Country spread Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

28 Real data Simulated models P 1 P 2 η = 2.5 η = 10 η = 2.5 η = 10 Correlation with country interest rate Output Consumption Investment Hour Trade balance Correlation with country spread Output Consumption Investment Hour Trade balance Interest rate Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

29 Serial correlations between GDP and country spread Corr(s t j, y t ) Note: Solid (black) lines represent empirical unconditional correlations, with their 99% con dence intervals shown in dotted lines. The model s simulated correlations are marked with (green) triangles for P 1 and η = 2.5, (blue) squares for P 1 and η = 10, (red) diamonds for P 2 and η = 2.5, and (brown) circles for P 2 and η = 10. Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

30 Serial correlations between GDP and country interest rate Corr(r t j, y t ) Note: Solid (black) lines represent empirical unconditional correlations, with their 99% con dence intervals shown in dotted lines. The model s simulated correlations are marked with (green) triangles for P 1 and η = 2.5, (blue) squares for P 1 and η = 10, (red) diamonds for P 2 and η = 2.5, and (brown) circles for P 2 and η = 10. Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

31 Variance decompositions Accounting for (%) of standard deviation VAR variance Simulated model (P 1, η = 2.5) decomposition minimum maximum average Output Domestic shocks US rate shocks Spread shocks Consumption Domestic shocks US rate shocks Spread shocks Country spread Domestic shocks US rate shocks Spread shocks Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

32 Variance decompositions under di erent speci cations of shocks Accounting for (%) of standard deviation Estimated Simulated model, averages VAR P 1, η = 2.5 P 1, η = 10 P 2, η = 2.5 Output Domestic shocks US rate shocks Spread shocks Consumption Domestic shocks US rate shocks Spread shocks Country spread Domestic shocks US rate shocks Spread shocks Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

33 Note: Model s responses (P 1, with η = 10) are marked with squares. Estimated responses are (black) continuous lines. Dotted lines are 95% and 85% con dence interval. Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38 The reverse causation: responses of country spread to domestic shocks to output (productivity) and investment. Output 0.3 Investment

34 Conclusion Country spread can be a permanent credit constraint over business cycles frequencies, providing perhaps the bulk of the propagation mechanism of shocks leading to macroeconomic uctuations Matching of empirical regularities is overall good, although improvements are needed to address investment and trade dynamics In progress: distinguishing persistence in the spread arising from exogenous processes (such as global risk spread premia) Model can help bridging the country spread - business cycle disconnect (Mendoza and Uribe, 2008), at least from a business cycle model perspective Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

35 Responses of country spread and of output to shocks to the US rate, US risk and spread Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

36 Responses of consumption and investment to shocks to the US rate, US risk and spread Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

37 A note on forces leading the debt-capital ratio α B t K t = B t Y t F K (K t 1, H t ) Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

38 rt s t y t h t c t i t x t rt (0.084) (0.431) (0.189) (0.302) (0.228) (0.562) (0.166) [7.131] [1.912] [0.184] [-0.791] [1.294] [1.374] [-0.443] s t (0.109) (0.050) (0.079) (0.061) (0.148) (0.045) [6.570] [-3.002] [-0.945] [-4.461] [-3.426] [0.453] y t (0.442) (0.222) (0.346) (0.270) (0.653) (0.204) [-0.228] [3.266] [4.071] [2.428] [2.475] [0.079] h t (0.057) (0.028) (0.043) (0.034) (0.081) (0.025) [-0.696] [-0.906] [18.562] [-2.683] [-2.524] [4.197] c t (0.212) (0.106) (0.165) (0.128) (0.311) (0.120) [-0.179] [-0.330] [-2.470] [2.904] [-1.215] [-2.399] i t (0.103) (0.052) (0.081) (0.063) (0.152) (0.046) [0.311] [-1.318] [-2.449] [-1.339] [2.346] [-0.919] Sarquis (IRBr & FMG/LSE) Open Macro Spread 2 June / 38

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