The current financial turmoil reminds us that the financial sector can be a transmitter of shocks to the economy rather than a shock absorber. Furthermore, in contrast with most crises in the past three decades, this turmoil has its centre in the core markets, not in developing or emerging markets. It is tempting to argue that lack of development and sophistication of financial markets helps to insulate emerging and developing countries from the financial turmoil. However, one should resist this temptation. One of the main reasons for the resilience so far shown by emerging countries is that, thanks to the easing of US monetary policy, they have not yet suffered from a significant increase in the cost of foreign borrowing, as the decline in interest rates in the United States has more than counterbalanced the increase in spreads faced by emerging economies. In summary, the shock to emerging markets has yet to come, and it is likely to materialise when the Fed begins tightening monetary policy. When it does, countries with less developed financial markets are likely to suffer from sharp drops in output.
Output contractions and financial development
In a recent study with Isabelle Roland, we have found compelling evidence that output falls tend to be much larger in countries with less developed credit markets (Coricelli and Roland, 2008). We extend the influential work of Rajan and Zingales (1998), who showed a strong impact of financial development on long run growth, by studying the impact of financial development on the magnitude of output falls in a large sample of countries and industrial sectors from 1963 to 2003.
Figure 1 links the decline in real value added (measured in absolute value, thus positive values imply larger decline) relative to the average value added decline in the whole sample with financial development. Countries are grouped in quartiles on the basis of their financial development, summarised by the ratio of domestic credit to the private sector to GDP, with the first quartile composed of the countries with the lowest level of financial development. The figure clearly shows that countries with less developed financial sectors display output falls well above the average, in contrast with countries with the most advanced financial sectors, which belongs to the fourth quartile.
Figure 1 Falls in real value added and financial development
Note: CPS/GDP= domestic credit to the private sector in percent of GDP.
This phenomenon is confirmed by our econometric results, which control for specific characteristics of countries and sectors, such as incomes per capita or specialisation in declining sectors. Therefore, the relationship suggested by Figure 1 is not merely a product of structural characteristics of poorer countries, which, in addition to having less developed financial sectors, are potentially affected by larger shocks in their terms of trade and tend to display larger output drops. By controlling for country effects, our analysis identifies the independent effect of financial development. Similarly, the econometric analysis permits us to control for sector-specific effects and thus ensures that the effect of financial development on output does not simply reflect idiosyncratic sector shocks.
Financial development as shock absorption
In summary, our analysis shows that the underdevelopment of the financial sector is one of the reasons why poorer countries tend to show much larger falls in output than more advanced economies. This effect is particularly strong in episodes of sharp output contractions. By contrast, in periods of output recovery and growth, financial development does not seem to play a significant role. How can we explain such a phenomenon? Traditionally, economists, focusing on the long-run relationship between financial development and economic growth, have argued that financial sector development fosters growth by inducing a more efficient allocation of resources and by financing innovative activities. We emphasise a different, possibly complementary, channel that highlights the role of the financial sector as a shock absorber in periods of adverse shocks. A more advanced financial sector tends to reduce the risks of magnification of shocks.
We argue that the financial sector acts through different channels in periods of adverse shocks than periods of favourable conditions, and this difference is particularly relevant in countries at lower levels of development. During good times, firms in developing and emerging countries typically finance their activity with sources alternative to the official banking sector: mainly trade credit and retained earnings. Outside finance does not seem to be a major constraint on the expansion of firms during such good times. However, these forms of finance, especially trade credit, increase the risk of chain effects, with shocks to individual firms transmitted to the rest of the system. Bank loans reduce these chain effects by reducing the dependence of the financial position of a firm from that of its customer-firms, as argued by Kiyotaki and Moore (1997). Such chain effects induce a sudden and sharp fall in output, as not only credit chains but also production chains break down.
The negative effects of financial underdevelopment go beyond the periods of output contraction. Indeed, recent studies have shown that the implications of sharp output falls are long-lasting, as the long term growth of an economy tends to decline following episodes of sharp output contraction (Cerra and Saxena, 2008). Our study concludes that credit markets are one of the main suspects for explaining why the output declines tend to be larger in emerging markets than in advanced market economies. Thus, building a deep domestic banking sector is a priority for developing and emerging markets, as deeper banking sectors help to avoid not only sharp output falls but also the long-term decline of growth rates induced by such falls.
Financial shock absorbers and emerging market crises
Our results might be indirectly linked to recent findings in the literature on systemic crises and sudden stops in emerging markets. First, our findings on the more important role played by financial development in determining the magnitude of output contractions rather than output expansions can be associated with the “Phoenix miracles” identified by Calvo, Izquierdo, and Talvi (2006). They argue that, following sharp output contractions associated to systemic crises, emerging markets quickly recover their previous level of output without much use of bank credit. Second, Calvo, Izquierdo, and Mejia (2008) analyse whether international financial integration reduces the probability of sudden stops in capital inflows and their attendant adverse effects on the real economy – with financial integration defined as the sum of stocks of international assets and liabilities of a country. They find that the probability of sudden stops is lower only at very high levels of financial integration, not at the levels typical of emerging markets. Drawing on our findings, a possible interpretation is that international financial integration does not shield emerging markets from the risk of sudden stops because emerging markets still display low levels of domestic financial development. In other words, higher integration in international credit markets is not a substitute for domestic financial development. Without a strong domestic financial market, financial integration may sharply increase the vulnerability of emerging markets to external shocks.
Calvo, G. A. , A. Izquierdo, and E. Talvi (2006), "Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crises", NBER Working Papers 12101, National Bureau of Economic Research.
Calvo, G. A., Izquierdo, A. and L. F. Mejia (2008), “Systemic Sudden Stops: The Relevance of Balance Sheet Effects and Financial Integration”, NBER Working Papers 14026, National Bureau of Economic Research.
Cerra, V. and S. Chaman Saxena (2008), "Growth Dynamics: The Myth of Economic Recovery", American Economic Review, Vol.98, No.1, pp.439-57.
Coricelli, F. and I. Roland, “Finance and Growth: When Does Credit Really Matter?”, CEPR Discussion Papers 6885, Centre for Economic Policy Research, London.
Kiyotaki, N. and J. Moore (1997) "Credit Chains", mimeo, London School of Economics.
Rajan, R. and L. Zingales (1998), "Financial Dependence and Growth", American Economic Review, Vol.88, No.3 559-586.