Financial crises in emerging markets arise not from fraud and greed but from the downside of risky business investment projects financed by short-term debt in relatively weak financial markets. That is the idea explored in research by Professor Betty Daniel, published in the June 2012 issue of the Economic Journal.
Her analysis shows that when entrepreneurs must borrow in relatively weak financial market, bad news about the aggregate profitability of investment reduces the quantity of loans that creditors are willing to provide, creating a sudden stop in foreign lending, debt renegotiation and private sector default.
The study also demonstrates that wealth and the strength of financial markets divides countries into three ‘credit clubs’:
· Entrepreneurs in rich countries with strong financial markets have stable access to foreign capital without risk premia.
· Those in countries with intermediate levels of wealth and financial market strength have unstable access to foreign capital with volatile risk premia.
· And those in countries with little wealth and weak financial markets have no access.
There is good news in this result. As emerging economies become wealthier and strengthen their financial markets, they should be able to join the club with stable access to capital.
What causes financial crises? Professor Daniel begins by noting that after a crisis, such as the Asian crises in 1997-98, the public seeks a scapegoat:
‘We want to attribute the crisis to something like fraud, greed, cronyism, misbehaviour of some kind. We want to think that if we can control misbehaviour, we can eliminate crises.’
Her study considers a very different hypothesis about the cause of a private sector financial crisis. Business investment is risky. Risk means that some projects will be less profitable than expected. Financial crises can be the downside of that risk when accompanied by the type of financial market imperfections, which are likely to exist in emerging market economies.
Professor Daniel develops a theoretical analysis of risky long-term investment financed by short-term debt. Entrepreneurs have access to risky long-term investment projects, but they have insufficient wealth to finance them internally.
External financing takes the form of debt instead of equity because emerging markets are less likely than industrial countries to have the laws and reporting mechanisms in place to communicate information about firm profitability reliably. Debt is short-term instead of long-term to give creditors the opportunity to adjust financing based on new information.
The research measures financial market strength by the fraction of assets that creditors are able to claim after they incur the expenses of taking a defaulting entrepreneur to bankruptcy court.
A stronger financial market, such as those in developed countries, has stronger creditor protection in the form of larger bankruptcy awards. With debt financing supported by bankruptcy awards in the event of default, creditors limit the quantity of loans they are willing to provide.
Limits are necessary because whenever repayment of debt and principle exceeds the value of assets entrepreneurs would lose in bankruptcy court, they prefer default to repayment. Finally, interest rates have risk premia, reflecting loss to creditors in the event of default.
Professor Daniel considers whether her analysis can match quantitative aspects of the 1997-98 crisis in South Korea. She embeds the model in a general equilibrium framework with overlapping generations of two types of economic agents: entrepreneurs who have access to risky investment projects; and others who earn a safe, small income. She calibrates parameters to match data for South Korea prior to the crisis.
The quantitative analysis confirms the ability of the model to explain the crisis. It demonstrates that a crisis with observed magnitudes could have been the downside of risky investment projects, which were financed in markets with imperfections likely to characterise emerging market economies.
‘Private Sector Risk and Financial Crises in Emerging Markets’ by Betty Daniel is published in the June 2012 issue of the Economic Journal.