Bond Finance, Bank Credit, and Aggregate Fluctuations. in an Open Economy

Transcription

1 Bond Finance, Bank Credi, and Aggregae Flucuaions in an Open Economy Prepared for he Spring 2016 Carnegie Rocheser NYU Conference on Public Policy Robero Chang Andrés Fernández Adam Gulan March 14, 2016 Absrac Corporae secors in emerging marke economies have increased noiceably heir reliance on foreign financing, presumably reflecing low global ineres raes. This rend has largely refleced increased bond issuance by emerging economies firms, in conras o he bank loans ha dominaed capial flows in he pas. To shed ligh on hese developmens, we develop a sochasic dynamic model of an open economy in which he levels of direc versus inermediaed finance are deermined endogenously. The model embeds he saic, parial equilibrium model of Holmsröm and Tirole (1997) ino a dynamic general equilibrium seing. I generaes an increase in boh bonds and loans following an exogenous drop in world ineres raes; also, he raio of bonds o loans increases because bank credi becomes relaively more expensive, reflecing he scarciy of bank equiy. These implicaions are in line wih empirical observaions and highligh he role of equiy in he adjusmen process. More generally, he model is suiable for sudying he ineracion beween modes of finance and he macroeconomy, and is of independen ineres. Conference Draf. We hank Andrea Ferrero and Maria Pía Olivero for useful discussions. We have also benefied from conversaions wih Julian Caballero, Luis Caão, Pablo D Erasmo, Markus Haavio, Beng Holmsröm, Enrique Mendoza, Guillermo Ordoñez, Vincenzo Quadrini, Ani Ripai, Cirad Slavík, Chrisian Upper, Jaume Venura, Mirko Wiederhol and paricipans of seminars a Bank of Ausria Research Workshop on Macro-Financial Linkages and Curren Accoun Imbalances, Bank of Finland, CEF Taipei 2015, Finnish Economic Associaion Annual Meeing Pori 2016, Goehe Universiy Frankfur, HMRAD 2015, 9h Join French Macro Workshop, LACEA Sana Cruz 2015, Midwes Macro Meeings Rocheser Fall 2015, PIER-ITAM-UPenn Conference on Macroeconomics 2015, U. of Houson and U. of Jyväskylä. Chang acknowledges he hospialiy of CREI. Saniago Téllez provided excellen research assisance. Furher commens will be mos appreciaed. Rugers Universiy and NBER. chang@econ.rugers.edu Iner-American Developmen Bank. andresf@iadb.org Bank of Finland. adamgulan@gmail.com 1

2 1 Inroducion In recen years, he corporae secor in emerging marke economies has increased is reliance on foreign financing considerably. This rend became more marked during he period of low global ineres raes following he global financial crisis, and has generaed a lively debae regarding is inerpreaion and policy implicaions. An opimisic view is ha he increase in corporae liabiliies is a naural response o favorable ineres raes and relaively favorable invesmen prospecs in emerging counries. A less sanguine view is ha larger foreign liabiliies are dangerous and place emerging economies in a precarious posiion. Undersanding his phenomenon has been complicaed by he observaion ha i has largely refleced increased bond issuance by emerging economies firms, in conras o he bank loans which dominaed capial flows in he pas. 1 To illusrae, Figure 1 2 reproduces a char from IADB (2014), describing he evoluion of foreign corporae liabiliies in Brazil, Chile, Colombia, Mexico, and Peru, as well as an average (LAC-5). The figure shows a clear acceleraion in he amoun of boh bonds and loans owed by Lain American firms. I also shows ha he relaive imporance of bonds has increased since he sar of he cenury and, more emphaically, since he global crisis. For he ypical counry in he figure, he share of bonds in he sock of inernaional corporae deb increased from 22% in 2000 o 43% in This process has aken place while, simulaneously, deb-o-oupu raios have increased in emerging economies. In 2005 deb-o-gdp for LAC-5 was abou 30%, while by he end of 2013 i had almos doubled, jus below 60%. 3 Figure 2 shows ha he surge of exernal borrowing has been accompanied by a drop in he ineres raes faced by emerging economies. This drop was parly relaed o he low global ineres raes since he onse of he crisis, here measured by real U.S. T-bill raes. However, since he early 2000s i was also accompanied by he low spreads ha hese counries are charged 1 Noe also ha hese developmens have been dominaed by corporae deb raher han sovereign deb, which was prevalen in earlier periods. 2 Figures and ables are gahered a he end of he paper. 3 The Online Appendix reproduces Figure 1 by scaling he amoun of deb by GDP 2

3 on op of he riskless rae. 4 Low spreads coninued despie he shor-lasing jump following he panic of This paper sheds ligh on he inerpreaion and implicaions of hese evens by developing a sochasic dynamic equilibrium model of an open economy in which he quaniies of direc versus inermediaed finance are deermined endogenously. Our model embeds he saic, parial equilibrium model of Holmsröm and Tirole (1997, henceforh HT) ino an oherwise sandard dynamic seing. As in HT, he producion of capial goods requires finance from ouside invesors. Due o moral hazard problems, a fracion of his producion can be financed direcly from he ousiders, while anoher porion can be financed only wih he paricipaion of moniors or "banks". In each period, herefore, he amouns of bank loans and direc finance are endogenous and depend on variables such as he price of capial goods and he equiy capial of invesmen producing firms and banks. The laer are deermined in a dynamic general equilibrium, in conras o HT. Hence our model allows for a sudy of he ineracion beween modes of finance and he macroeconomy, and is of independen ineres. As a main finding, he model yields an inuiive economic explanaion of he join dynamics of bonds, bank loans, and ineres raes summarized by Figures 1 and 2. In he model, an exogenous drop in world ineres raes leads o an increase in he demand for capial goods and a corresponding increase in heir relaive price. The laer raises he profiabiliy of invesmen goods producion; given exising corporae equiy, his raises pledgeable value and allows for increases in boh corporae bonds and bank loans. A he same ime, however, he reurn o he equiy of he banking secor goes up, reflecing ha such equiy is scarce and slow o adjus. Hence bank finance becomes relaively more cosly han direc finance and, accordingly, he raio of corporae bonds o bank loans goes up. These implicaions are all in line wih he empirical observaions menioned above, and reflec he crucial roles of corporae equiy and bank equiy in he adjusmen process. The model also generaes rich and realisic dynamics ha express he inerplay beween 4 These favorable borrowing condiions have been enjoyed no only by sovereign borrowers (EMBIG spread) bu also by non-financial corporaions (CEMBI spread). 3

4 invesmen supply and demand, financial fricions, and he evoluion of equiy. In paricular, he responses of corporae bonds and bank loans o lower ineres raes reflec he adjusmen of invesmen as well as of he reurns o bank equiy and corporae equiy. The laer, in urn, are deermined by he dynamics of he price of capial goods and he raes of accumulaion of boh kinds of equiy. We sudy hese feaures of he model in a calibraed version. The model is suiable o ackle several relaed quesions. In paricular, i has been conjecured ha he observed increase in direc finance relaive o indirec finance in emerging counries may reflec changes in he underlying echnology of finance which, a he same ime, may have made hose counries more vulnerable o exernal shocks. Our model provides a less pessimisic perspecive: as we show, permanen changes in moral hazard parameers or monioring coss can indeed resul in an increase in he raio of commercial bonds o loans, bu also imply smooher responses o ineres rae shocks. This is inuiive, reflecing ha he mode of finance provides an addiional margin of adjusmen, and suggess ha he recen increase in corporae liabiliies is a naural response o low ineres raes and relaively favorable invesmen prospecs in emerging counries. 5 Finally, we exend he model o allow for an expors commodiy secor, and analyze he impac of shocks o world commodiy prices. This is of ineres because many emerging economies, including he ones feaured in Figures 1 and 2, rely heavily on commodiy expors whose prices have experienced large flucuaions since he millennium. In he exended model, a favorable shock o he prices of expor commodiies causes an increase in he demand for capial goods, raising heir price. This, in urn, leads o increased producion of capial goods, larger quaniies of boh direc and indirec finance, and an increase in he bonds o loans raio, jus as in he baseline model and because of he same reasons. The exended model hus confirms ha insighs of he baseline model as o he mechanism by which exernal shocks may explain he dynamics of bonds and loans. I also indicaes ha, in realiy, favorable commodiy 5 In conras, Shin (2013) and ohers have argued ha larger foreign liabiliies are dangerous and place emerging economies in a precarious posiion. Shin (2013) has emphasized ha he increase in commercial deb can be problemaic because of he possibiliy of exacerbaing currency mismach problems, which we do no address in his paper. 4

5 prices may have aced in conjuncion wih lower ineres raes in generaing such dynamics. Our work is relaed o several srands of lieraure. One is a se of empirical sudies ha have documened recen inernaional rends in corporae deb issuance and analyzed he deerminans of corporae deb choice. Shin (2013) and Turner (2014) repor he considerable increase in foreign currency borrowing in inernaional bond markes by emerging marke corporaions, par of which has been done by heir offshore affi liaes and mos of i in dollars. IADB (2014) carefully documens his phenomenon for Lain American economies while Caballero e.al. (2015) shows evidence for emerging economies in Asia and Easern Europe. Our model can be seen as a heoreical explanaion of hese empirical findings. In developing our model, we build upon HT and oher basic conribuions ha have provided microfoundaions for he choice beween bank and marke finance under moral hazard. 6 Our work exends his line of research by endogenizing he choice beween bank finance and marke finance embedding HT s dual moral hazard problem wihin a dynamic, general equilibrium conex of a small open economy. Our approach emphasizes he role of corporae equiy and bank equiy as deerminans of he demand for credi, like HT. We go beyond HT, however, in exploring dynamics as well as macroeconomic implicaions. Chen (2001), Aikman and Pausian (2006), and Meh and Moran (2010) have also embedded HT ino dynamic equilibrium seings. A crucial difference wih our paper, however, is ha none of hese forerunners modeled he endogenous deerminaion of direc finance versus inermediaed finance, which is he cenral concern of our paper. Perhaps he closes aneceden of our sudy is he recen paper by De Fiore and Uhlig (2015) 7. They develop a model in which firms choose o finance producive projecs eiher direcly or wih he help of financial inermediaries; he laer can draw a signal abou he probabiliy of projec success, which helps avoiding bankrupcy. De Fiore and Uhlig (2015) 6 Repullo and Suarez (2000) also endogenize he choice beween bank finance and marke finance wihin an environmen where firms are heerogeneous in he amoun of available ne worh. See also Diamond, 1991; Rajan, 1992; Besanko and Kanaas, 1993; and Bolon and Scharfsein, De Fiore and Uhlig (2011) firs develops he model in De Fiore and Uhlig (2015), providing seady sae analysis and focusing on long run differences beween he US and he Euro area. 5

6 hen argue ha heir model can accoun for a simulaneous fall in bank loans o and increase in bond issuance by US firms during he Grea Recession; his is he case if firm-level uncerainy and inermediaion coss of banks happen o increase a he same ime. Our paper coincides wih De Fiore and Uhlig s in modeling he endogenous deerminaion of direc finance versus bank finance in dynamic macro models, bu i is very differen oherwise. We sar from differen facs: in emerging economies, he amouns of bonds and bank loans have moved in he same direcion; in conras, De Fiore and Uhlig s objecive was o explain he observed fall in loans and increase in bonds in he US. More noably, our heoreical framework is quie differen from heirs: ours emphasizes he key role of corporae and bank equiy, which allows us o provide an economic explanaion of he links beween observable changes in world ineres raes and commodiy prices and he dynamic behavior of bonds and loans. Finally, De Fiore and Uhlig s model is a closed economy one, while we model an open economy in order o undersand he inernaional phenomena described above. The plan of he paper is as follows. Secion 2 presens he basic model, oulines is soluion, and discusses is heoreical implicaions. Secion 3 describes a baseline calibraion. Secion 4 examines dynamic implicaions of he calibraed model. Secion 5 exends he model o allow for a commodiy expors secor and discusses he implicaions. Final remarks are given in Secion 6. Some echnical issues are delayed o an Appendix. 2 The Model 2.1 Households and Final Goods Producion Our specificaion of he household secor and of he producion of final goods is sandard, so i will be brief. This is because, for our purposes, he main aspec of his par of he model o generae a dynamic demand for capial goods. Accordingly, we assume ha producing final goods requires capial, which is owned by domesic households, and ha he relaive price of capial is ime varying. 6

7 Time is discree and indexed by = 0, 1,... We focus on a small open economy. There is a freely raded final good ha will serve as numeraire. Compeiive domesic firms produce final goods wih capial and labor via a Cobb-Douglas funcion: Y = A K α H 1 α (1) wih Y denoing oupu of final goods, K capial inpu, H labor inpu, A oal facor produciviy (assumed o be exogenous), and 0 < α < 1 Compeiive facor markes yield he usual marginal condiions αy = r K K (2) (1 α)y = w H (3) where r K and w denoe he renal rae of capial and he wage rae. Households are he owners of producive facors, including capial. They can also borrow or lend in world markes a a gross ineres rae Ψ +1 R+1, where R+1 is he safe world ineres rae beween periods and Ψ +1 is a counry specific spread. The household s budge consrain in period is, hen, C + Q X + Ψ R D = w H + r K K + D +1 + ( 1 φ f) Π (4) where C denoes consumpion of he final good, X purchases of new capial, Q he price of new capial, and D +1 he amoun borrowed abroad. Finally, ( 1 φ f) Π denoes dividends from invesmen producing firms, which are ransferred o he household, as described below. The spread Ψ is exogenous o he household bu, as discussed by Schmi-Grohé and Uribe (2003), i depends on D, he aggregae value of D : Ψ = Ψ + Ψ(e D D 1) (5) 7

8 The represenaive household maximizes he expeced presen discouned uiliy of consumpion and labor effor. We assume GHH preferences (Greenwood, Hercowiz, and Huffman 1988) for which he marginal uiliy of consumpion is ) σ λ c = (C κ Hτ (6) τ where κ, τ, and σ are parameers. Opimal labor supply is hen given by: w = κh τ 1 (7) The opimal foreign borrowing-lending policy is given by 1 = β h λ c +1 E λ c Ψ +1 R+1 (8) where β h (0, 1) is he household s discoun facor and E (.) is he condiional expecaion operaor. Finally, capial accumulaion is subjec o adjusmen coss: K +1 = (1 δ)k + X ϕ 2 K ( ) 2 K+1 1 (9) K where 0 < δ < 1 is he depreciaion rae and ϕ > 0 is a parameer giving he degree of adjusmen coss. Then opimal invesmen is given by he dynamic equaion: ( )] K+1 Q [1 + ϕ 1 K (10) = β h λ c +1 E λ c [r+1 K + Q +1 (1 δ) + ϕ ( ) K+2 K+2 1 ϕ ( ) 2 K+2 1 ] K +1 K +1 2 K +1 where β h is he household s discoun facor. This equaion, as well as he previous ones, have 8

9 sandard inerpreaions. For a given process for he price of capial Q, and given a process for Π, he preceding wo equaions deermine he demand for invesmen. I is ofen assumed ha domesic oupu can be spli beween consumpion goods and new capial goods a no cos, so ha Q = 1 always, and ha invesmen producion yields no profis so ha Π = 0. In ha case, (1)-(10) is a sysem of en equaions ha suffi ces o deermine he res of he variables so far. 2.2 Finance and Producion of New Capial Goods To depar from he usual approach, we assume ha new capial goods X are produced via a process subjec o financial fricions. In equilibrium Q will be variable and invesmen will reflec he dynamic supply of invesmen as well as demand. More imporanly, hose dynamic forces will inerac wih he behavior of alernaive modes of corporae finance. New capial goods are produced by "holdings", each of which manages a coninuum of producive unis ("branches" for shor) indexed by i [0, 1]. The represenaive holding arrives o period wih some amoun of equiy K f, inheried from he previous period. A he beginning of he period, each branch i is charged wih financing and execuing a projec of he same size, which akes I unis of radables as inpu, and reurns a random amoun of new capial goods a he end of he period, as we will describe. The size of he invesmen projec, I, is chosen by he manager of he holding o maximize end of period profis. Also a he beginning of he period, he holding s equiy is spli randomly beween is branches (his may reflec some idiosyncrasies in sarup coss, for example). A branch i is given equiy A i = ZK i f, where Z i is a random variable wih mean one, disribued i.i.d. across periods and ime. The cdf of z i = log (Z) i will be denoed by Φ(z), and he corresponding densiy funcion by φ(z). This seing migh correspond o a siuaion in which here are naionwide corporaions (holdings) ha own unis (branches) in differen locaions. The holding chooses a projec design ha has o be implemened by all branches. Each branch is given he same iniial 9

10 amoun of equiy money, bu idiosyncraic shocks o equiy imply ha branches effecively sar projecs wih an equiy disribuion implied by K f and he disribuion of Z i Individual Projecs Consider he problem of a branch which sars period wih equiy A i. As menioned, he branch manager akes he projec size I as given. Assuming ha I > A i, she will need o seek exernal finance in order o implemen he invesmen projec. To allow for boh direc and inermediaed finance, here we borrow he assumpions of HT. Specifically, invesmen projecs are subjec o moral hazard. If he branch manager has secured a leas an amoun I of funds a he beginning of he period, she can inves hem ino a "good" projec ha yields RI unis of new capial wih probabiliy p H and zero wih probabiliy 1 p H. The manager can, alernaively, inves I in a "bad" projec, which reduces he probabiliy of he successful oucome o p L < p H bu gives he manager a privae benefi of size BI. Here R, B, p H and p L are some given consans. Branch managers can seek funds from ouside invesors. Because conracs are seled wihin a period, and he res of he world is included in he se of ouside invesors, i is appropriae o assume ha ouside invesors are risk neural and have a zero opporuniy cos for funds. However, assuming ha he good projec has posiive expeced value bu he bad projec does no, ouside invesors will agree o lend only under a conrac ha provides enough incenives o he branch manager no o underake he bad projec. Denoing by R f,i he payoff o he branch manager in case of projec success, he necessary incenive compaibiliy consrain can be wrien as or p H R f,i p L R f,i R f,i BI + BI wih = p H p L 10

11 Also, for he branch manager o be able o finance he projec enirely by borrowing from he ouside lenders, he amoun borrowed mus be I A i. Then, he expeced payoff o he lenders mus be a leas as large, ha is, p H (Q RI R f,i ) I A i Combining he las wo inequaliies, i follows ha he branch manager will be able o finance is projec direcly from ouside lenders only if i has enough equiy: A i Ā, where Ā = I [ 1 p H (RQ B ) ] (11) Given I, Ā depends naurally on invesmen parameers such as R, as noed by HT. In our seing, Ā also depends on he price of capial: i falls if Q increases. This will imply ha he supply of capial will increase wih Q, which is inuiive. Wha if A i < Ā? As in HT, we assume he exisence of financial inermediaries or "banks". Banks sar each period wih some equiy of heir own ha can be used for funding projecs. More imporanly, hey also own a monioring echnology ha allows hem o reduce he branch manager s privae benefi of he bad projec from B o b < B. However, using he monioring echnology enails a privae cos ci o a bank. This implies ha, for a branch j o secure exernal funding wih he paricipaion of a bank, he bank s payoff if he projec is successful, denoed by R m,j, has o provide enough incenives for he bank o monior: or p H R m,j ci p L R m,j R m,j ci Rm Also, for a branch j o convince a bank o paricipae in he projec, i mus offer he bank a reurn on is funds a leas as large as wha he banker would obain elsewhere. Denoing 11

12 he laer by β, and he bank s conribuion o he projec by I m,j, he condiion is ha p H R m,j β I m,j. As we will see, alhough he conrac is wihin a period, β will be, in general, greaer han he marke reurn (of one). This means ha banks will no be paid more han sricly necessary, so ha he condiion mus hold wih equaliy, which combined wih he previous relaion gives I m,j = p HR m β I m In his case, he paricipaion of ouside invesors implies he incenive compaibiliy consrain p H R f,j p L R f,j + bi, ha is, R f,j bi where R f,j denoes he payoff o he branch manager in case of projec success. Finally, for ouside invesors o recover he opporuniy cos of heir funds, heir expeced payoff mus be a leas as large as he amoun hey lend o he projec. This can be wrien as: p H (Q RI R f,j R m,j ) I I m,j A i As in he case of direc finance, one can show now ha a branch j will be able o finance is projec via moniored finance if i has enough equiy: A j A, where [ A = I 1 cp ( H β p H RQ b + c )] (12) Addiional commen on he deerminaion of he rae of reurn o bank equiy, β, may be useful for he analysis laer. In his seing, as in HT, he reurn o a banker for paricipaing in a projec mus be large enough o induce monioring. This requires ha he payoff o he banker, R m = ci /, exceed he opporuniy cos of he monioring cos, which is jus ci (since < 1 and he alernaive rae of reurn is he inraperiod reurn of zero). Therefore, bankers earn an excess reurn for paricipaing in invesmen projecs. The assumpion in HT, which we borrow here, is ha bankers compee for such excess reurns by providing equiy I m 12

13 o he projecs. The rae of reurn β hen adjuss so as o equae he aggregae amoun of bank equiy hus provided o he available sock a he beginning of he period, which will be denoed by K m. In our formulaion, K m is predeermined, so he rae of reurn on equiy β adjuss o reflec he scarciy of bank capial The Choice of Projec Size To proceed, le G (A i ) denoe he disribuion of equiy in period. This is a ime dependen funcion derived from A i = Z i K f and our assumpions abou he disribuion of Z i 8 One can show ha he profis of a ypical holding in period can hen be wrien as: Π f = p H Q RI (1 G (A )) + A ( I A i A 0 A i dg ( A i ) ) dg ( A i ) ph ci β ( G (Ā) G (A ) ) (β 1) (13) The firs line expresses he holding s end of period revenue, he sum of expeced payoff from invesmen projecs plus he (zero) reurn from funds from branches ha will no be able o finance projec. The firs erm in he second line summarizes he marke cos of exernal finance. Noing ha p H ci /β = I m, he las erm capures he excess reurn o bank equiy. The holding chooses invesmen size I o maximize profis subjec o (11) and (12), aking Q and β as given. Afer some manipulaion, he firs order opimaliy condiion can be wrien as: (p H RQ 1)(1 G (A )) [ cph (1 1 ] (G ) (Ā) G (A β ) ) = A g (A ) [p H RQ 1] + [ Ā g (Ā) A g (A ) ] p H c (1 1 β ) (14) where g (A) is he densiy funcion associaed wih G (.). 9 The preceding equaion ogeher wih (11) and (12) now deermine I, A, and Ā. The 8 G (A) = Pr { A i A } = Pr { log A i log A } = Pr{log Z i log A log K f } = Φ(log A log K f ) 9 g (A) = A G (A) = 1 A φ(log A log Kf ) 13

14 inerpreaion of his condiion is illuminaing. The LHS can be seen as he expeced increase in he surplus o he holding from a marginal increase in projec size I. Each addiional uni of iniial invesmen has expeced reurn p H RQ 1, and is underaken by 1 G (A ) branches. Par of ha gain, however, is appropriaed by he banks because he reurn on bank equiy exceeds he marke reurn (ha is, if β > 1): his is he second erm in he LHS. The RHS collecs erms associaed wih he impac of an increase in I on he disribuion of branches. A larger I implies an increase in A and, hence, a reducion of approximaely A g (A ) producing unis, implying a corresponding reducion in he holding s revenue of p H RQ 1 per los uni. Finally, Ā also increases, which means ha approximaely Āg (Ā) branches move from direc finance o bank finance. Since A g (A ) drop ou from producion, he number of branches resoring o bank finance increases by [ Ā g (Ā) A g (A ) ], wih each of hem shifing profi owards banks by (p H c/ )(1 1/β ). 2.3 Marke Clearing and Dynamic Equilibrium As discussed, he reurn on he bankers equiy, β, adjuss so ha he bankers paricipaion in invesmen projecs adds up o bank equiy, denoed by K m. This requires: K m = I m [ G (Ā) G (A ) ] = p HcI β [ G (Ā) G (A ) ] (15) In urn, he equilibrium price of new capial goods, Q, mus adjus o equae he demand for new capial goods o heir supply: X = p H RI [1 G (A )] (16) To finish specifying dynamics, we need o describe he laws of moion of he equiy variables K m and K f. As a firs approximaion, we simply assume here ha banks and holding company branches have fixed dividend raes 1 θ m and 1 θ f respecively. 14

15 Hence he law of moion of K m is K m +1 = θ m p H ci [ G (Ā) G (A ) ] (17) and he law of moion of K f is K f +1 = θ f Π f, which can be simplified o: K f +1 = θ f Π f = θ f {(p H RQ 1)I [1 G (A )] +K f p H ci (1 1 β ) [ G (Ā) G (A ) ] } (18) Now he eigh equaions (11)-(18) give I, A, Ā, β, Q, µ and he moion of K m and K f. Togeher wih (1)-(10) and an assumpion abou he process for exogenous shocks, hey complee he specificaion of he model. 2.4 The Choice Beween Direc versus Indirec Finance In spie of he complexiy of he model, one can exrac useful insigh abou he choice of direc versus indirec finance by sudying he equilibrium condiions. Specifically, consider an unexpeced increase of invesmen demand, which may be due o one of he shocks o be discussed in more deail laer. Inuiively, in equilibrium, boh he price and he quaniy of invesmen mus increase. Since he producion of invesmen goods requires exernal finance, and he equiy of boh invesmen branches and banks is slow o adjus, he oal amoun of credi raised by he invesmen secor mus increase, a leas in he shor run. Bu we can say more. Increasing he producion of invesmen goods in his model requires a combinaion of a larger invesmen projec size I and of adjusmens in he numbers of branches resoring o eiher direc or indirec finance. The laer is deermined by he hresholds Ā and A, given by (11) and (12). In his siuaion, for he model o generae an increase in direc finance relaive o indirec finance, as in he daa, i mus be he case ha (roughly speaking) he hreshold Ā fall relaive 15

16 o A. Bu such a fall mus reflec ha bank finance has become relaively more expensive, as given by an increase in he reurn o bank equiy β. More precisely, noe ha (11) and (12) imply ha Ā A = 1 p H (RQ B ) 1 cp H β p H ( RQ b+c An increase in invesmen demand raises he price of capial Q which, by iself, would raise ) he raio. 10 Increased invesmen demand also raises he reurn on bank equiy, β, and his mus be he dominan force if he raio is o fall. The inuiion is simple and illusraes he crucial roles of corporae equiy and bank equiy. As emphasized by HT, an invesmen branch will underake a projec of size I if and only if i has enough equiy o cover he shorfall beween he uni cos of invesmen, which is one, and he pledgeable income from he invesmen, which is p H (RQ B ) per uni. The cuoff Ā is he value of equiy which is jus enough o cover ha difference: ha is wha (11) says. Branches wih equiy less han Ā resor o heir nex bes opion, which is moniored finance. This reduces hose branches s moral hazard problem (refleced in he fall in he parameer B o b) bu enails wo addiional coss: monioring coss reduce pledgeable income direcly, as given by he erm c/ ; bu, also, banks appropriae par of he surplus if β > 1, ha is, if he rae of reurn on bank capial exceeds he (wihin period) marke reurn (of one). Hence, when he price of capial increases, he fac ha bank capial is scarce means ha β mus increase in equilibrium; his reduces pledgeable income for bank-moniored projecs (bu no for projecs wih access o direc finance). In his way, our model provides an economic explanaion of he observed increase of bond issuance relaive o bank loans in emerging markes: falling world ineres raes led o increased demand for invesmen, raising he profiabiliy of invesmen projecs; in response, producers of invesmen goods increased projec size (I, in our model) and adjused he number of acive branches and borrowing (Ā and A ); oal credi hen increased, predominanly hrough direc finance, since bank finance became more expensive (higher β ). 10 To see his, ake logs and noe ha ( log Ā/A ) / Q = p H R(1/A 1/Ā) > 0 16

17 The above argumen is somewha loose in ha refers o he hresholds Ā and A only. Under our assumpions, however, he measure of branches resoring o eiher direc or indirec finance depends also on he shape of he disribuion G (A). Also, as we have seen, he hresholds depend on projec size I. Therefore i will be useful o define measures of he oal amouns borrowed via bonds or bank loans. For bonds, a reasonable measure is CB = I A (I A i )G (da i ) CB is appropriae under he assumpion ha branches wih access o direc finance pu all heir equiy ino heir projecs, and ha branches wih excess equiy (hose wih A i > I ) do no issue bonds. The corresponding measure for bonds is BL = A A (I A i )G (da i ) This expressions emphasize ha he shape of G impacs boh measures and heir raio. If G were a Uniform cdf, of course, i would follow direcly from he reasoning given above ha an increase in invesmen demand would raise he bond measure relaive o he loans measure. I is more realisic o assume ha G is no Uniform, however, and we will need o resor o numerical mehods o examine he raio. Bu he inuiion given above remains valid. 3 Seady Sae and Calibraion We calibrae he model a he quarerly frequency. As we noed, our specificaion of households and producion of final goods is fairly sandard. Consequenly, values for associaed parameers are readily aken from he lieraure on small open economy models. Our choices for H, σ, τ and α, C, Y R, Ψ, and ϕ are aken from Fernández and Gulan (2015). We normalize he price of capial goods Q and he oal facor produciviy parameer A o 1. We hen choose β h and δ o qualiaively mach he empirical raios X = 0.2 and K = 8. Y Y 17

18 The las value ranslaes ino capial sock being worh wo years of oupu and is consisen wih he daa for Mexico colleced by Kehoe and Meza (2012). The volailiy and persisence parameers of he exogenous shocks o produciviy are se o sandard values as well. We calibrae he R shock o fi he ineres on en year US bonds deflaed by he Universiy of Michigan survey-based inflaion expecaions. All calibraed parameers, normalizaions and mached raios are summarized in Table 1. The second sep of he calibraion is more novel and involved. I concerns he parameers of he invesmen supply side, ha is, of he holding companies. Recall ha Φ(z) denoes he cdf of z i = log (Z) i.we assume ha is Normal wih sandard deviaion σ G and mean σ 2 G /2 (which is necessary o ensure ha he expecaion of Z i is one). This implies ha he disribuion of equiy wihin he holding, G (.) is log-normal, wih mean K f. Log normaliy is ofen assumed in macroeconomics (e.g. Bernanke, Gerler, and Gilchris 1999) and in line wih he lieraure on he size of firms (e.g., Axell 2001, Quand 1966). We se he quarerly rae of reurn o bank equiy β = , based on he World Bank s Global Financial Developmen Daabase (see Cihak e al. 2013) for he Unied Saes. 11 This auomaically gives he value of banks dividend parameer φ m = 1 β. We hen se p H = 0.99 following Meh and Moran (2010), which reflecs a quarerly bankrupcy rae of 1%. We hen manually se p L = 0.96, he minimum value saisfying β > p H p L. A his sage one is lef wih equaion (14), describing he firs-order condiion of he holding. Normalizing all erms by K f and simplifying, he equaion reduces o an expression in only 6 unknowns: c, b, B, σ G, i = I/K f and R. To pin down heir values, we use five more independen resricions: The raio of quarerly bank operaing coss-o-bank asses, which we se o 0.78 percen guided by recen observaions for he U.S. in he World Bank s WFDD. Because empirically monioring coss consiue only a par of all banks operaing coss, his number 11 Recall ha banks are foreign-based in he model because we aemp o explain he empirical dynamics of foreign bank loans. 18

19 consiues in fac an upper bound for monioring coss ha one would like o arge in he model. The raio of bank asses o bank equiy (i.e. bank leverage) where we arge he value 10.64, in line wih he evidence repored in he World Bank s WFDD for U.S. commercial banks. The ypical holding s leverage: Fernández and Gulan (2015) repor an average value of 1.71 for publicly-raded firms in EME-13. The median raio of gross exernal bank credi o quarerly GDP, repored in he BIS for 5 seleced Lain American counries (Brazil, Chile, Colombia, Mexico and Peru), approximaely equal o 6.28 percen. Using he same source as guidance as in he previous bulle, we se he fifh and final raio, gross foreign corporae bond issuance o GDP, o percen. In addiion o he six equaions jus lised, he unknowns c, b, B, σ G, i = I/K f and R mus saisfy some inequaliies 12. Hence we choose values for hose unknowns o minimize a weighed average of he differences beween he model-generaed and empirical raios subjec o he required inequaliies. Deails are given in he Appendix. Table 2 presens he empirical arges of he raios alongside hose in he calibraed model whereas Table 3 summarizes he financial parameers values ha deliver hese arges. The overall mach is saisfacory. We ge very close o he chosen arges for bank leverage and corporae bonds-o-gdp raio. We underesimae somewha he volume of bank loans, bu imporanly, hey are sill over wice as large in he model han bonds, as i is he case in he daa. We underesimae he bank operaing coss, however, as discussed previously, he empirical arge should be only inerpreed as an upper bound for bank monioring coss because 12 Specifically, i follows from HT ha, for he model o be well behaved, he parameers c, b, B and R mus saisfy: 0 < A < Ā < I Im < I, b + c > B > b. Also, he Lagrange mulipliers associaed wih (11) and (12) mus be posiive. Finally, here are naural resricions; for example, monioring coss canno be negaive and he rae of reurn R should be greaer han 1. 19

20 i reflecs all banks operaing coss. The one dimension in which he mach is no as close is he leverage of he holding: he arge is 1.71 whereas he bes we can generae wih he model parameers is Dynamic Implicaions 4.1 Implicaions of Lower Ineres Raes Figure 3 describes impulse responses o a one percenage poin drop in he world ineres rae R. This exercise is inended o explore he response of he model o he fall in real ineres raes observed since he sar of he millennium. As usual, lower world ineres raes raise boh he household s sochasic discoun facor and he marginal uiliy of consumpion. As a consequence, consumpion, oupu, and hours increase for several periods (abou 20 quarers in our calibraion), reflecing he persisence of he R shock. Also as a consequence, households increase heir demand for capial goods X. This is me, in equilibrium, wih boh an increase in he producion of new capial goods and he price of capial Q. The dynamic responses of invesmen and he mix of direc and indirec finance accord wih he inuiion presened earlier. Since he price of new capial increases, holding companies have an incenive o increase producion. To do his, he size of he ypical projec relaive o he holding s capial, i = I /K f, increases for several quarers. Since K f is predeermined, he projec size I iself increases on impac; aferwards, he response of I is hump shaped. To undersand he responses of he quaniies of bonds and loans, as argued earlier, he figure repors he responses of he hresholds Ā and A normalized by K f (hey are denoed by abar and aubar in he figure, respecively). From (11) we know ha he response of Ā is ambiguous, since he increase in I raises i bu he increase of Q lowers i. The laer dominaes in our calibraion: on impac, Ā /K f falls, and herefore Ā does oo, implying ha he number of branches resoring o direc finance increases (hese are labeled "Caegory 3" 20

21 branches). In conras, A increases. As discussed, his reflecs no only he impac of higher I and Q, bu also an increase in he supranormal reurn o bank equiy β ; he laer occurs, as discussed, because bank capial is predeermined. The figure shows ha boh bonds and loans increase on impac, alhough bonds increase by more, so ha he CB/BL raio goes up. Once more, a key reason is ha he increase in invesmen demand raises he relaive cos of bank finance, which reflecs he scarciy of bank capial. The CB/BL raio increases is seady sae level for abou a year and a half, and hen undershoos. This reflecs he dynamics impared by he accumulaion of profis, which leads o increases in boh he holding s equiy K f and bank equiy K m. Boh increase for abou wo years, which in urn suppors more invesmen producion and, herefore, bond financing and loan financing (i.e. he exensive margin expands). As a consequence, Q drops relaively quickly. Also, β also falls sharply, reflecing boh he fall in Q as well as he accumulaion of bank equiy. The fall in β means ha bank finance becomes more aracive; his is refleced in he fac ha BL has a hump shaped response, while CB is monoonic. This also explains why he CB/BL raio appears o be less persisen han invesmen. Over ime, he impac of he shock wanes, and all variables reurn o heir seady sae values. Overall, his experimen indicaes ha our model can replicae he recen observed increases in boh direc and indirec finance, as he economy reacs o a fall in he world ineres rae. In his sense, he model raionalizes he evidence presened in he inroducion. 4.2 A Simulaion As a complemen o he impulse response analysis of he previous subsecion, we examine implicaions of our calibraed model when hi by a sequence of shocks o real ineres raes akin o hose observed in he daa. To his effec, we obain he fied residuals from an AR(1) process ha we esimae on he real ex ane 10 year US TBill rae. Then we feed hese residuals as R shocks ino he model. The simulaion period goes from 3Q 2004 unil 4Q Figure 4 21

22 plos he resuls of his experimen. The lef panel plos he oal amoun of corporae exernal deb implied by he model, adding up bond sock CB as well as bank loans BL, and normalizing he oal sock of deb o 100 for he firs period of he simulaion. The righ panel plos he simulaed pahs of CB and BL separaely. Qualiaively, he process of oal deb racks well he one observed in Figure 4. Firs, he simulaion capures a rise of deb in he pre-lehman period, hen a reversal during he crisis in , followed by a vigorous recovery in he years I is also worh sressing ha he simulaion mimics a sronger recovery of bond issuance in he pos crisis, relaively o ha of loans, which is a disincive feaure in he daa presened in Figure 4. However, he simulaion counerfacually predics a considerable fall in he las wo years of he period considered, , whereas he daa displays only a sagnaion. This experimen is also consisen wih he model s view of how low ineres raes may help explaining he ouburs of corporae exernal deb in emerging markes. Evidenly, facors oher han low ineres raes may have also conribued o he considerable growh in deb in hese economies, and indeed one of hem, commodiy prices, will be he subjec of a laer secion. Bu before we urn o ha, we explore he role and impac of some of he deep parameers of he model. 4.3 The Impac of Financial Fricions Differen values for he parameers in he model, in paricular hose relaed o financial fricions, can be inerpreed as capuring he model s implicaions for counries a various levels of financial developmen. We focus on monioring coss and he privae benefi from moral hazard Monioring Coss Suppose ha monioring coss, c, are one hird higher han in he benchmark calibraion. The corresponding seady sae is repored repored in he hird column of Table 4. 22

23 Inuiively, a larger c reduces he supply of invesmen, so ha aggregae invesmen X should go down and he price of capial Q should go up. In urn, he seady sae levels of capial, oupu, and consumpion all should go down. The able shows ha all of hese implicaions are borne ou, alhough he magniudes are small. More noiceably, bank loans BL fall in he seady sae. This is no surprising, since a larger monioring cos no only induces less oal borrowing, bu also a swich away from bank finance. To pu i in erms of our previous discussion, a larger c is associaed wih a lower projec size I and a higher price of capial Q. Looking a (11) and (12), boh have he same effec on Ā and A, reflecing ha hey affec pledgeable income in he same way. However, he higher value of c have an addiional, direc effec on A, reflecing ha larger monioring coss reduce pledgeable income of moniored projecs. So i mus be he case ha, for given I, he difference Ā A mus fall. (I is worh comparing his argumen wih our previous discussion, which relied on changes in β : he seady sae value of β does no depend on c). The swich away from bank finance explains why corporae bonds, CB, increase in he seady sae. This reflecs ha more branches move o Caegory 3 (direc finance) which overcomes he fac ha each branch borrows less (since projec size I falls). In conras, he fall in BL is explained by he fall in projec size, since he measure of branches moving o Caegory 2 (bank finance) acually increases. To see how he model s dynamics change when c is higher, Figure 5 plos impulse responses o a one percenage drop in he world ineres rae R in he benchmark case (black) and he counerfacual case of higher c (red). In he counerfacual case, he response of he real variables is dampened relaive o he benchmark. In oher words, increasing he cos of monioring pus sand in he wheels of he mechanism by which financial shocks ranslae ino movemens in economic aciviy. This can be clearly seen he responses of aggregae invesmen X, which increases in he counerfacual by much less relaive o he benchmark, hus making he price of invesmen goods Q go upwards by more. The explanaion for he dampening can be raced back o he responses of he holding s 23

24 deb, paricularly ha channeled rough banks. Indeed, oal loans no only decrease in he seady sae (as argued before), bu heir response o a drop in ineres raes is less vigorous when c increases han in he benchmark. This comes inuiively from he fac ha bank credi is more cosly. Noe also ha he response of bond finance is sronger relaive o he benchmark, increasing he bond o loan raio. Anoher direc consequence of higher monioring coss and he associaed reducion of he demand for bank loans is he reducion of banks revenue. Consequenly, bank equiy accumulaion is relaively more sluggish han in he benchmark, which inhibis banks lending laer on. This has also negaive implicaions for equiy buildup of he holding companies which, likewise, experiences a relaively slower pace of equiy accumulaion. Lasly, household income is affeced by his slower equiy buildup of he holding insofar as he dividends as smaller han in he benchmark, reducing he exen o which consumpion rises following he shock Privae benefis Suppose now ha he privae benefi B associaed wih moral hazard is en percen smaller relaive o he benchmark. This may capure an increase in ransparency in he privae secor, less corrupion, or a sronger rule of law. The impac on he seady sae is given in he las column of Table 4. Inuiively, one should expec a lower B o lead o more invesmen, capial, oupu, and consumpion, as well as a lower price of invesmen goods. Again, hese predicions are confirmed by he able, alhough he magniudes are small. Lower privae benefis also favor direc finance over bank finance. The able shows ha, accordingly, he measure of branches obaining direc finance ( Caegory 3) increases, and so does he amoun of bonds CB. In conras, he measure of branches wih bank loans falls; his reflecs boh he increase in projec size I as well as he fall in he price of invesmen Q. As a consequence, bank loans BL fall in he seady sae. Figure 5 describes he impulse responses o a one percenage drop in he world ineres 24

25 rae R in he benchmark (solid/dark) and he counerfacual case (dashed/red) of lower B. Perhaps he mos remarkable feaure of he counerfacual dynamics is refleced in he evoluion of he holding s deb. The quaniy of bonds increases by more relaive o he benchmark while he opposie occurs wih bank loans. Consequenly, he bond-o-loan raio increases more on impac, (in addiion o he previously discussed increase in he seady sae). However, his change in he composiion of deb does no ranslae ino a sronger increase in he reacion of he real variables (e.g., oupu, invesmen, consumpion) following an ineres rae shock. If anyhing, he opposie occurs, i.e. he reacions of real variables are now dampened relaive o he benchmark case when B was higher. The key o undersand his is ha, even wih wih a lower B, he reacion of invesmen holdings o an increase in he price of capial is resriced by is equiy, and also by bank equiy (which deermines he cos of bank finance). The accumulaion of boh ypes of equiy is slower han in he benchmark, which dampens he impulse responses. The observaions in his subsecion and he previous one raise he ineresing possibiliy ha he observed increase in bond financing relaive o bank financing may reflec changes in he financial echnology, as given by an increase in c or a fall in B. Such changes, in urn, would be no increase he economy s sensiiviy o exernal shocks: here he responses of invesmen and aggregae demand o ineres rae shocks are, if anyhing, smooher when c is higher or B lower. This should no be oo surprising in he conex of our model, because invesmen holdings do ake advanage of an addiional margin of adjusmen when facing shocks. On he oher hand, his perspecive provides an inerpreaion of he daa reviewed in he inroducion ha is more opimisic han ha of Shin (2013) and ohers As menioned in a previous foonoe, Shin s (2013) perspecive is largely grounded on he possibiliy of currency mismaches. Our model does no feaure mismaches, so i is no suiable o evaluae such perspecive. On he oher hand, here is no obvious reason why mismaches should be worse for firms han for banks, and hence he increase of bond issue relaive o bank loans has no clear implicaions for our analysis. 25

26 5 Bonds, Loans, and Commodiy Prices While world ineres raes appear o be he obvious suspecs in accouning for he observed dynamics of bonds and loans, emerging economies have been hi by oher exernal shocks. Mos noiceably, drasic flucuaions in commodiy prices have been a cener sage, as illusraed by Figure 7. The lef panel of he figure plos he evoluion of he price index for he hree broades caegories of commodiy goods, raw agriculural producs, meals and fuels, since he 1990s. I shows a remarkable increase in he volailiy of he prices of all hree caegories since he mid 2000s. 14 The righ panel of Figure 7 uses counry-specific commodiy price indices compued for Brazil, Chile, Colombia, and Peru, all ne commodiy exporers, and compares he indices wih he Lain American EMBI spread. The plo shows ha he four price indices were srongly correlaed wih each oher, and also endured a marked increase in heir volailiy since he mid 2000s. A ha ime foreign financing hese counries also began increasing; his was expressed by a remarkable negaive comovemen beween commodiy prices and counry spreads, which is shown in he figure. Tha periods of booming commodiy prices have coincided wih low ineres rae spreads on counry deb has been observed no only for he four counries here bu for emerging economies in general. 15 These drasic flucuaions in he prices of commodiies expored by emerging economies has moivaed a recen lieraure on heir business cycle implicaions as well as he appropriae moneary and fiscal policy responses. 16 The lieraure, however, has largely ignored he relaed issue of how commodiy prices and financial flows may be relaed. Specifically, can favorable shocks o commodiy prices explain he sylized paerns of bond and bank financing in emerging 14 The hree price indices are compued by he IMF and are publiclly available on he web. The figure presens a smoohed ransformaion of he original series using a cenered rolling moving average of 6 monhs. 15 Counry-specific commodiy prices come from Fernández e.al (2015), who calculaed hem combining he spo prices of 44 disinc commodiy goods sold in inernaional markes wih counry-specific shares of each of hese commodiies in oal commodiy expors. This work compues counry-specific price indices for a large pool of emerging economies and quanifies he (srong) degree of comovemen beween hem. I also provides more sysemaic evidence beween counry-specific commodiy prices and measures of sovereign and corporae spreads of inernaional deb issued by emerging economies. 16 See e.g. Fernández e al. (2015) and he sudies in Capuo and Chang (2015). 26

27 economies? In his secion we ouline an exension of our basic model ha provides a posiive answer. More generally, he model suggess ineresing links beween commodiy prices and he ype of capial flows o emerging economies. 17 Doing full jusice o his issue would require a separae paper, in our view; our reamen here is inended only o illusrae he main connecions, as well as o reinforce he inuiion of our model of alernaive modes of finance. So, following Caao and Chang (2013), among ohers, we add a simple commodiy expor secor ("mining") of compeiive "mines" o he benchmark model analyzed before. The represenaive mine produces an expor commodiy ("copper") whose world price (relaive o raded final goods) is exogenous and denoed by P C. I is assumed ha P C follows an AR(1) process: P C = (1 ρ C ) P C + ρ C P C 1 + ε C where P C is he real seady sae price of copper and ε C are normally disribued iid shocks wih mean 0 and variance σ 2 C. Producion only akes capial, and he producion of he ypical mine is: Y C = A C ( K C ) αc where Y C denoes copper oupu and K C he copper mine s capial. In addiion, α C and A C are consans. The mine s only cos is invesmen X C, which governs he evoluion of mining capial. For simpliciy, assume adjusmen coss are similar o he household s, alhough wih possibly 17 Recen works have sudied he amplificaion mechanism of spreads ha reac o changes in commodiy prices wihin a quaniaive general equilibrium (see Fernandez e.al. 2015, and Shousha, 2016). Ohers have ried o provide microfoundaions of movemens in spreads following changes in commodiy prices wihin a financial acceleraor framework (Belran, 2015; González e.al, 2015). None of hese works, however, have sudied he ype of capial inflows ino emerging economies and commodiy prices. 27