Global Liquidity and Structural Change in Emerging Markets

During the past three decades, cross-border capital flows and increased financial globalization have figured prominently among the hot debated topics of economists and policy makers. On the one hand, this is a consequence of the rapid intensification of real and financial interlinkages, which prior to the Great Financial Crisis lead to a build-up of huge international asset and liability positions. On the other hand, it is a consequence of crisis resolution policies by the advanced economies’, which after the Great Financial Crisis have led to an environment of historically low interest rates. From the viewpoint of macroeconomics, this ease in global financing conditions is of particular relevance due to at least two reasons. First, the global nature of heightened financial integration susceptibly influences creditor and borrower relationships across borders and, by affecting the net present value of investment projects, abundant finance ultimately widens the investment panorama of local corporations. Second, considering the importance of global drivers behind cross-border capital flows, from the viewpoint of small open economies these international spill overs are possibly exogenous to the business cycle of small open economies. Taken together, the new environment of relaxed financing constraints warrants a reconsideration of the interaction between international financial capital and the local real economy. The following research project investigates the theoretical and empirical links between global financial conditions and structural change in small open economies. It comprises three chapters. -          The first essay empirically studies the interlinkages between global financial conditions, credit provision and aggregate productivity in a group of emerging market countries in the period 2000 – 2017. Employing a panel regression framework with fixed effects, it shows that gross, cross-border capital flows act as substantial drivers of local credit conditions. By including US dollar denominated debt securities into the regression framework, the results underline the importance of global bond markets for the intermediation of global liquidity. Furthermore, in a first attempt to understand the structural implications of large cross border capital flows, this chapter provides evidence on the negative association between credit booms and aggregate productivity. -          The second essay proposes an open economy, general equilibrium framework with credit frictions in order to assess the structural implications of large capital inflows periods. In this framework, a large interest rate differential between the world economy and the small open economy induces non-financial corporates to act as ‘surrogate’ financial intermediaries that provide credit to the otherwise credit constrained households of a small open economy. The ensuing boom in economic activity ultimately draws productive resources towards the non-traded sector of the economy. Short- run as well as long-run simulations demonstrate the structural implications of large capital inflows. -          The third essay develops a Vector Autoregressive Framework that builds on the structural implications of the theoretical model in Chapter 2. Using quarterly data of a group of 12 emerging market economies between 2000 and 2017, this chapter demonstrates how shocks to international financial conditions are transmitted to the local funding environment of small open economies. In this framework, the Federal Funds Rate, bond market spreads, and the balance sheet of the Federal Reserve System act as drivers of international liquidity. In line with the analytical prediction of the theoretical model in Chapter 2, the empirical model illustrates the asymmetric impact of large capital inflows on the economic structure of small open economies and is able to qualitatively reproduce key findings of the theoretical approach. The individual chapters of my thesis are self-contained and can be read on their own. However, given their common interest in the relationship between international finance and the real economy, Chapter 1 can be read as a motivational introduction to the theoretical model in Chapter 2, whereas Chapter 3 can be read as an empirical application of Chapter 2. Thus, the individual chapters can also be understood as variations of one common theme.