Domestic Financial Participation and External Vulnerability in Emerging Economies

Victoria Nuguer

2019-09-10 - The Global Financial Crisis (GFC) of 2008-2009 highlighted the role of the banking system as an important propagation mechanism of U.S. financial shocks to emerging economies (EMEs). Evidence shows that compared to advanced economies (AEs), EMEs exhibit considerably lower shares of firms that participate in the domestic banking system, leading several EMEs to promote greater firm domestic financial participation. What are the implications of this greater firm participation in the banking system for the response to external financial shocks, such as those experienced by EMEs during the GFC? First, we show VAR evidence on the difference between countries with high and low costs of creating a business; when creating a firm is cheaper, and firm financial participation is higher, credit and consumption fall less after a shock that resembles the financial crisis. We build a two-country RBC model with banking frictions, firm heterogeneity in participation in the domestic banking system, and endogenous firm entry that resembles these results. We show that greater firm financial participation on the extensive margin in EMEs limits the effect of adverse external financial shocks on EME financial and macro aggregates, with endogenous firm entry playing a critical role in the volatility-reducing effects of greater firm financial participation in EMEs.