Essays on International Debt and the Macroeconomics of Small Open Economies

Abstract

The business cycle of small open economies is extensively influenced by external factors, particularly by the access to and the cost of international borrowing. The essays in this dissertation are concerned with the macroeconomic effects of foreign debt and the design of optimal macroprudential policies.

Chapter 1 analyzes the interaction between banks and the government, when the government has limited commitment to provide bailouts in situations of financial distress. In the model, banks obtain funding from foreign lenders, and a liquidity mismatch in their balance sheets opens the door to speculative runs. The financial strength of the government and the capitalization of banks determine whether the government’s promise to insure banks is credible and can therefore rule out such panics. There is a strategic complementarity between bank and government debt that operates through bond prices and leads to the existence of multiple equilibria. Bank recapitalization and the imposition of leverage limits can preclude the panics, but they do not necessarily imply Pareto welfare improvements.

Chapter 2 explores the time variation of interest rate volatility in emerging markets, and its relationship with sudden stops in external funding. By estimating a multi-country regime-switching VAR model, we learn that periods of high volatility are associated with increases in interest rates and declines in economic activity. High volatility regimes tend to be contemporaneous with sudden stops, and they forecast these episodes six and twelve months ahead. Sudden stops are associated with persistent increases of interest rates and

sharp declines in output.

Chapter 3 studies optimal capital account policy for borrowing-constrained small open economies in the presence of time-varying external volatility. In the model, sudden stops arise endogenously and they are caused by adverse shocks to output and interest rates, consistent with the evidence of Chapter 2. The social planner, by considering the pecuniary externalities derived from external borrowing, restricts capital flows in response to output and interest rate shocks. His intervention is not necessarily larger when external volatility increases: his policy is shaped by weighing the future incidence of sudden stops against the size of pecuniary externalities. This chapter is coauthored with Ricardo Reyes-Heroles.