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Balance Sheet Effects on Growth
& Capital Accumulation in
Emerging Markets
Liliana Castilleja – Vargas
BBVA - Bancomer
Economic Research Department
Mexico City
16th International Conference on Panel Data
Amsterdam (2- 4 July 2010)
Introduction

Empirical analysis

Panel data for 20 EMs & 13 developed countries

Annual data from 1985 to 2007

Relationships between capital flows, real depreciation,
growth & capital accumulation in EMs vs developed
countries

Is real depreciation contractionary in EMs through
valuation effects (balance sheet effects)?

Stylized facts: Influence of specific country’s fundamentals
(attenuate or magnify).
Introduction

EMs’ aftermath of “recent” financial crisis (before
the subprime mortgage crisis): Mexico in 19941995, Argentina 2001-2002, East Asia in 1997, Russia
in 1998, etc VS Mundell-Fleming model & developed
countries experience.

Common scenario: sudden stops, nominal & real
depreciation, deep contraction in M, financial distress,
output contraction. Balance of payments adjustment
was the result of liquidity & borrowing constraints.

EMs characteristic features tend to exacerbate
vulnerability to shocks: countercyclical current
accounts, high consumption volatility, sudden stops
coupled & current account reversals & sharp
depreciations (Aguiar & Gita, 2004; Calvo & Mishkin,
2003; Guidotti et al, 2004)
Literature Review: EMs syndromes

“Original sin” (Eichengreen & Hausmann, 1999):
high levels of liability dollarization because the
inability to borrow abroad in local currency causing
both currency and maturity mismatches.

“The cycle is the trend” (Aguiar & Gopinath, 2004):
permanent shocks to trend growth are the main
source of fluctuations in EMs vs transitory
fluctuations round a stable trend as in developed
countries.

“When-it-rains-it-pours” (Kaminsky, Reinhart &
Végh, 2004): observed procyclicality between the
capital flow cycle and macroeconomic cycle in EMs
(expansionary in good times & viceversa) reinforcing
each other.
Literature Review

Sudden stops & current account reversals:
Calvo (1998); Calvo, Izquierdo and Mejia (2004); Guidotti,
Sturzenegger and Villar (2004); Calvo and Mishkin (2003).

Domestic liability dollarization: Eichengreen and
Hausmann (1999); Calvo and Reinhart (2000).

Balance Sheet Effects: Frankel (2005); Guidotti,
Sturzenegger and Villar (2004), Izquierdo 2002, Calvo,
Izquierdo and Talvi (2003).

Influence of country fundamentals: Calvo and
Mishkin (2003); Calvo et al. (2004); Guidotti et al. (2004);
Edwards (2004); Frankel (2005).
Unexpected Liquidity
Constraint in EMs
a) No intervention by Central Bank
b) Reserve Depletion
c) Persistent sudden stop
Current Account
Reversals
Real Exchange
Rate Depreciation
High Domestic
Liability Dollarization
Adverse Effects on Investment
& Economic Growth
Negative Valuation Effects
(Balance Sheet Effects)
Data & Methodology

Panel of 20 EMs from 3 regions:
1. Latin America and Africa (areas rich in natural
resources): Argentina, Brazil, Chile, Colombia, Ecuador,
Mexico, Peru, Uruguay, Venezuela and South Africa.
2. East Asia: Indonesia, Korea, Malaysia, Philippines
and Thailand.
3. West and South Asia: India, Israel, Pakistan, Sri
Lanka and Turkey.

Panel of 13 Developed Economies:
Australia, Canada, Finland, France, Germany, Italy,
Japan, New Zealand, Spain, Sweden, Switzerland,
United Kingdom and United States.
Data & Methodology

A debt-weighted real effective exchange rate index to
focus on the real exchange rate between debtor and
creditor countries in EMs (Original contribution and a
better proxy than bilateral or trade-weighted rer).

Weighted arithmetic average of the bilateral real
exchange rates using the December CPI and the end-ofperiod nominal exchange against the US dollar, the euro
(incl. German mark and French franc before 1999) and
the Japanese yen.

The weights are derived from data on annual long-term
debt denominated in US dollars, euros (incl. German
mark and French franc before 1999) and Japanese yen
as given in the GFI of the World Bank.
Data & Methodology

Debt-weighted real effective exchange rate for EMs &
trade-weighted real exchange rate in developed countries
panel.

Financial account ratio (% of GDP): FDI, portfolio
investment and other investment (as referred by the IMF).

Country Fundamentals: Trade Openness (trade ratio to
GDP), Banking Development (Domestic credit by banks to
GDP) and Financial Openness (IMF’s AREAER’s dummy
for restrictions on capital flows).

Main data sources: WDI & GFI (World Bank) and IFM
(IMF).
Data & Methodology

Panel Data Methodologies: Fixed-Effects, First Difference
& System Generalized Method of Moments (GMM)
estimators with STATA.

As suggested by Roodman (2008), in the estimation of
GMM using STATA, the command “collapse” is used for
limiting instrument proliferation.

Whenever interaction terms with country fundamentals
are introduced, the constitutive terms are also included in
the specification (Brambor et al. 2005).

All constitutive terms in the interaction variables are mean
centred (de-meaned).

The results are subjected to robustness tests to account
for regional variation (incl. interaction terms) and outliers
(fundamentals).
Real Exchange Rate Model

Dynamic log-linear specification in differences

Dependent variable: Δ in ln real effective exchange rate

Explanatory variables:

Lag of dependent variable

Mean reversion term

Δ in ln terms of trade

Δ in capital lows

Lag of capital flows
Growth Rate Model

Specification in differences

Dependent variable: Δ in real growth rate (p.a. %)

Explanatory variables:

Mean reversion term

Δ World growth rate (p.a. %)

Δ ln terms of trade

Δ in capital flows

Δ in ln real exchange rate the current year

Δ in ln real exchange rate the previous year

Lagged ln of real exchange rate
Capital Accumulation Model

Specification in differences

Dependent variable: Δ in gross fixed capital formation
ratio (% of GDP)

Explanatory variables:

Mean reversion term

Δ in lagged growth rate (p.a. %)

Δ in lagged capital flows

Δ in ln real exchange rate the current year

Δ in ln real exchange rate the previous year

Lagged ln of real exchange rate
Results: RER Model for Developed Countries
Dependent variable: change in ln real exchange rate
Estimation method
(1)
Fixed-Effects
Estimator
(2)
First-Diff.
GMM Estimator
(3)
System
GMM Estimator
-0.246***
(-5.68)
0.202***
(3.66)
0.844***
(6.32)
0.003***
(2.65)
0.001
(1.12)
0.31
-0.233***
(-4.11)
0.224***
(3.60)
0.688***
(3.05)
0.003
(1.71)
0.0004
(-0.48)
-0.194***
(-3.68)
0.203***
(3.26)
0.674***
(3.27)
0.0002
(-0.30)
-0.001
(-1.37)
0.24
(0.80)
113.24
(0.10)
255
0.01
(0.99)
132.62
(0.02)
268
Explanatory variables
Lagged ln real exchange rate (LRERi,t-1)
Lagged change ln real exchange rate (∆LRERi,t-1)
Change in ln terms of trade
Lagged financial account ratio (FAi,t-1)
Change in financial account ratio (% of GDP) (ΔFAi,t)
ρ
Arellano-Bond test for AR(2) in first diff. or m2
(p-value)
Sargan test of overid. restrictions
(p-value)
Sample size
268
Results: RER Model for EMs
Dependent variable:
change in ln real exchange rate
Estimation method
Explanatory variables
Lagged ln real exchange rate
(LRERi,t-1)
Lagged change ln real exchange
rate (∆LRERi,t-1)
Change in ln terms of trade
Lagged financial account ratio
(FAt-1)
Change in financial account
ratio (% of GDP) (ΔFAi,t)
East Asia dummy interacted
with ΔFAi,t
West & South Asia dummy
interacted with ΔFAi,t
ρ
Arellano-Bond test for AR(2) in
first diff. or m2
(p-value)
Sargan test of overid. restrict.
(p-value)
Sample size
(1)
(2)
(3)
(4)
(5)
(6)
FixedEffects
Estimator
First-Diff.
GMM
Estimator
System
GMM
Estimator
FixedEffects
Estimator
First-Diff.
GMM
Estimator
System
GMM
Estimator
-0.336***
(-3.49)
-0.162
(-1.46)
0.027
(0.18)
0.008*
(1.95)
0.018***
(3.21)
-0.352***
(-5.89)
-0.144*
(-1.90)
-0.264
(-1.33)
0.006*
(1.80)
0.013**
(2.52)
-0.014
(-1.27)
-0.243***
(-3.14)
-0.228
(-1.00)
-0.002
(-0.58)
0.011*
(1.74)
-0.337***
(-3.48)
-0.164
(-1.45)
0.022
(0.15)
0.008*
(1.90)
0.018***
(2.55)
0.001
(0.13)
-0.006
(-0.82)
0.96
-0.360***
(-7.20)
-0.141*
(-1.74)
-0.223
(-1.26)
0.005*
(1.68)
0.011**
(2.17)
0.007
(1.25)
0.004
(0.67)
-0.012
(-1.18)
-0.247***
(-3.17)
-0.180
(-0.89)
-0.002
(-0.67)
0.011
(1.56)
0.002
(0.30)
0.002
(0.38)
0.39
(0.69)
0.94
(0.35)
0.41
(0.68)
85.14
(0.86)
383
100.20
(0.98)
363
98.49
(0.99)
383
0.96
383
0.79
(0.43)
86.01
(0.73)
363
383
Results: Growth Model for Developed Countries
Dependent variable: change in GDP growth rate (p.a. %)
Estimation Method
(1)
Fixed-Effects
Estimator
(2)
First-Diff.
GMM Estimator
(3)
System
GMM Estimator
-0.498***
(-7.33)
2.234
(0.52)
0.022
(0.61)
-2.414
(-1.07)
-3.458*
(-1.07)
-3.709***
(-2.96)
0.06
-0.502***
(7.59)
-0.881
(-0.21)
0.050
(1.05)
2.125
(0.54)
-4.882
(-1.44)
-1.849
(-1.40)
-0.528***
(8.53)
-1.718
(-0.38)
0.071
(1.50)
1.972
(0.45)
-4.653
(-1.29)
-2.681*
(-1.98)
-1.93
(0.05)
134.32
(0.005)
255
-1.81
(0.07)
142.3
(0.004)
268
Explanatory Variables
Lagged growth rate (p.a.%)
Change in ln terms of trade
Change in Financial Account (ΔFAi,t)
Change in ln real effective exchange rate (ΔRERi,t)
Lagged change in ln real effective exchange rate
(ΔRERi,t-1)
Lagged level of ln real effective exchange rate (RERi,t-1)
ρ
Arellano-Bond test for AR(2) in first diff. or m2
(p-value)
Sargan Test
(p-value)
Sample size
268
Results: Growth Model for EMs
Dependent variable: change in GDP growth rate (p.a. %)
Estimation Method
(1)
Fixed-Effects
Estimator
(2)
First-Diff.
GMM Estimator
(3)
System
GMM Estimator
-0.807***
(11.06)
1.240***
(5.91)
2.768
(0.99)
0.216***
(3.59)
3.338***
(2.90)
2.508**
(2.13)
2.585***
(2.83)
0.86
-0.781***
(-9.56)
0.281
(0.37)
5.317*
(1.92)
0.131
(1.41)
6.389**
(2.48)
3.598***
(2.88)
2.117*
(1.83)
-0.715***
(-7.86)
0.409
(0.51)
5.870**
(2.07)
0.138
(1.42)
5.397**
(2.20)
3.781***
(3.26)
-0.235
(-1.21)
0.29
(0.80)
112.80
(0.10)
366
0.64
(0.53)
128.22
(0.06)
383
Explanatory Variables
Lagged growth rate (p.a.%)
World growth rate (p.a %)
ln terms of trade
Change in Financial Account (ΔFAi,t)
Change in ln real effective exchange rate (ΔRERi,t)
Lagged change in ln real effective exchange rate
(ΔRERi,t-1)
Lagged level of ln real effective exchange rate (RERi,t-1)
ρ
Arellano-Bond test for AR(2) in first diff. or m2
(p-value)
Sargan Test of overid. restrictions
(p-value)
Sample size
383
Results: Growth Model for EMs & regional effects
Dependent variable:
change in the GDP growth rate (p.a. %)
Estimation Method
(1)
(2)
(3)
Fixed-Effects
Estimator
First-Diff.
GMM Estimator
System
GMM Estimator
-0.804***
(-11.27)
1.170***
(5.32)
4.121
(1.50)
0.216***
(3.72)
3.545***
(2.82)
1.272
(1.00)
2.729***
(2.96)
-2.402
(-0.95)
9.469**
(2.32)
10.15**
(3.23)
3.16
(0.75)
0.88
-0.767***
(-9.97)
0.996
(1.33)
3.644*
(1.49)
0.160*
(1.74)
6.249**
(2.28)
2.357**
(1.14)
1.761
(1.34)
0.763
(0.22)
11.316**
(2.13)
11.018***
(4.25)
2.546
(0.69)
-0.712***
(-8.55)
0.974
(1.18)
4.146*
(1.76)
0.174*
(1.75)
4.534*
(1.93)
2.369**
(2.31)
-0.205
(-1.09)
-0.492
(-0.17)
9.009*
(5.38)
10.906***
(4.39)
-1.220
(-0.38)
0.54
(0.59)
143.78
(0.21)
363
0.71
(0.48)
171.72
(0.05)
383
Explanatory Variables
Lagged growth rate (p.a.%)
Change in world growth rate (p.a %)
Change in ln terms of trade
Change in the financial account ratio (% of GDP)
(ΔFAi,t)
Change in ln real effective exchange rate (ΔRERi,t)
Lagged change in ln real effective exchange rate
(ΔRERi,t-1)
Lagged level of ln real effective exchange rate
(RERi,t-1)
ΔRERi,t interacted with East Asia dummy
ΔRERi,t interacted with West & South Asia dummy
ΔRERi,t-1 interacted with East Asia dummy
ΔRERi,t-1 interacted with West & South Asia
dummy
ρ
Arellano-Bond test for AR(2) in first diff. or m2
(p-value)
Sargan test of overid. restrictions
(p-value)
Sample size
383
Results: Growth Model for EMs & Fundamentals
Change in GDP growth rate (p.a. %)
Estimation method
(1)
First-Diff.
GMM
Estimator
(2)
First-Diff.
GMM
Estimator
(3)
First-Diff.
GMM
Estimator
(4)
First-Diff.
GMM
Estimator
-0.802***
(-12.57)
0.821
(0.95)
5.653**
(2.09)
0.140*
(1.86)
5.478**
(2.07)
2.476*
(1.80)
3.20*
(1.98)
3.413
(0.63)
-38.600
(-1.11)
-21.626
(-1.01)
-0.770***
(-9.64)
0.618
(0.85)
1.615***
(0.57)
0.170*
(2.00)
5.423**
(2.30)
3.141***
(3.14)
-0.616
(-0.48)
-0.786***
(-12.25)
1.073
(1.54)
0.534
(0.23)
0.130**
(2.29)
6.126***
(3.57)
1.589
(1.07)
1.434
(0.98)
-0.779***
(-12.35)
0.710
(0.90)
2.653
(1.18)
0.119*
(1.93)
6.465**
(2.60)
2.958**
(2.55)
3.756
(1.53)
Explanatory Variables
Lagged Growth rate (p.a. %)
Change in world growth rate (p.a %)
Change in ln terms of trade
Change in financial account ratio (% of GDP) (ΔFAi,t)
Change in ln debt-weighted real effective exchange rate
(ΔRERi,t)
Lagged change in ln debt-weighted real effective
exchange rate (ΔRERi,t-1)
Lagged ln debt-weighted real effective exchange rate
(RERi,t-1)
Lagged trade openness ratio (% of GDP)
Lagged trade openness ratio (% of GDP) times ΔRERi,t
Lagged trade openness ratio (% of GDP) times ΔRERi,t-1
-5.027*
(-1.85)
-22.564
(-1.64)
-9.148
(-0.93)
Lagged banking development ratio (% of GDP)
Lagged banking development ratio (% of GDP) times
ΔRERi,t
Lagged banking development ratio (% of GDP) times
ΔRERi,t-1
Lagged dummy for restrictions on capital account
transactions
Lagged dummy for restrictions on capital account
transactions times ΔRERi,t
Lagged dummy for restrictions on capital account
transactions times ΔRERi,t-1
-0.760
(-1.04)
-11.770***
(-3.57)
4.635
(1.16)
Lagged liability dollarization ratio (% of money)
Lagged liability dollarization ratio (% of money) times
ΔRERi,t
Lagged liability dollarization ratio (% of money) times
ΔRERi,t-1
Arellano-Bond test for AR(2) in first diff. or m2
(p-value)
Sargan test of overid. restrictions
(p-value)
Sample size
0.43
(0.67)
154.20
(0.10)
363
-0.01
(0.99)
142.17
(0.04)
358
1.58
(0.11)
136.79
(0.40)
363
7.198**
(2.44)
-32.195***
(-4.78)
-22.473
(-4.68)**
0.66
(0.51)
149.31
(0.16)
363
Results: Capital Accumulation Model for EMs & Fundamentals
Dependent variable: change in investment ratio
(% of GDP)
Estimation Method
(1)
(2)
(3)
Fixed-Effects
Estimator
First-Diff.
GMM Estimator
System
GMM Estimator
-0.201***
(-3.51)
0.109***
(3.69)
0.070**
(2.18)
-0.326
(-0.23)
0.245
(0.31)
0.563
(0.60)
0.48
-0.247***
(-2.86)
0.098***
(4.12)
0.065*
(1.74)
2.911
(1.73)
-0.497
(-0.70)
4.419
(1.65)
-0.150**
(-2.07)
0.109***
(3.95)
0.076*
(1.96)
0.576
(0.31)
0.463
(0.50)
0.013
(0.08)
0.65
(0.51)
95.41
(0.47)
371
0.44
(0.66)
121.01
(0.08)
391
Explanatory Variables
Lagged investment ratio (% of GDP)
Change in lagged growth rate (p.a.%)
Change in lagged financial account ratio (% of GDP)
ΔFAi,t-1
Change in ln real effective exchange rate (ΔRERi,t)
Lagged change in ln real effective exchange rate
(ΔRERi,t-1)
Lagged level of ln real effective exchange rate (RERi,t-1)
ρ
Arellano-Bond test for AR(2) in first diff. or m2
(p-value)
Sargan Test of overid. restrictions
(p-value)
Sample size
391
Conclusions
1.
Changes in credit constraints on the part of
international lenders and real exchange rate
adjustments are significantly positive correlated in
EMs.
2.
Real exchange rate depreciations (appreciations) in
EMs are associated with falls (increases) in growth
rates (at least the first two years).
3.
Capital account net outflows (inflows) are associated
with falls (increases) in capital accumulation.
4.
Real exchange rate adjustments are the channel by
which changes in credit constraints impact EMs’
business cycle, (in line with the literature on sudden
stops and balance sheet effects).
Conclusions
4.
Interestingly, having restrictions on capital
account transactions might act as shocks
absorber in EMs diminishing the adverse effects
of real depreciation on economic growth.
5.
We could not find concluding evidence
supporting the view that a higher level of trade
openness and banking development act as a
shock absorber.
6.
Results are robust to potential endogeneity,
regional variation in the real exchange rate
effects and outliers. There is evidence that these
effects are significantly larger in Emerging Asia.
Thank you so much!!