universiti putra malaysia financial intermediary ...psasir.upm.edu.my/5022/1/fep_2007_10.pdf ·...

of 25 /25
UNIVERSITI PUTRA MALAYSIA FINANCIAL INTERMEDIARY DEVELOPMENT, OUTPUT AND EXPORT UNDER CREDIT MARKET IMPERFECTIONS TANG KIN BOON FEP 2007 10

Author: hoangphuc

Post on 06-Jul-2018

219 views

Category:

Documents


0 download

Embed Size (px)

TRANSCRIPT

  • UNIVERSITI PUTRA MALAYSIA

    FINANCIAL INTERMEDIARY DEVELOPMENT, OUTPUT AND EXPORT

    UNDER CREDIT MARKET IMPERFECTIONS

    TANG KIN BOON

    FEP 2007 10

  • FINANCIAL INTERMEDIARY DEVELOPMENT, OUTPUT AND EXPORT UNDER CREDIT MARKET IMPERFECTIONS

    By

    TANG KIN BOON

    Thesis Submitted to the School of Graduate Studies, Universiti Putra Malaysia, in Fulfilment of the Requirements for the Degree of Doctor of Philosophy

    December 2007

  • DEDICATION

    To My Father, Mother and Sook Sin

    ii

  • Abstract of thesis presented to the Senate of Universiti Putra Malaysia in fulfilment of the requirement for the degree of Doctor of Philosophy

    FINANCIAL INTERMEDIARY DEVELOPMENT, OUTPUT AND EXPORT

    UNDER CREDIT MARKET IMPERFECTIONS

    By

    TANG KIN BOON

    December 2007

    Chairman : Associate Professor Tan Hui Boon, PhD Faculty : Economics and Management This study examines the long-run relationship between financial intermediary

    development, output and export under three credit market imperfections role of

    financial intermediaries, financial accelerator and currency mismatch. In particular,

    this study has (1) examined the direct relationship between financial intermediary

    development and output fluctuations (2) examined the dampening and magnifying

    effects of financial intermediaries on output fluctuations via the propagation of real

    and monetary shocks, (3) examined the impact of exchange rate movements on

    exports under the condition of foreign currency borrowing and credit constraint and

    (4) evaluated the impact of external finance premium on various sectorial

    productions and aggregate outputs growth. An aggregate data panel is constructed

    for the countries under study and the cointegration hypothesis among the variables

    is verified using Pedronis and Westerlunds panel cointegration tests. The

    idiosyncratic, individual and group-mean panel cointegrating vectors are then

    estimated using FMOLS and DOLS developed by Pedroni.

    iii

  • Using data from 17 countries at different income levels in East Asia-Pacific, the

    empirical results indicate that (1) strong and robust evidence for dampening effect

    of real shocks, (2) somewhat weak evidence for magnifying effect of monetary

    shocks, (3) financial intermediary development to some extent have direct impact on

    output fluctuations if countries are bank-dependent, (4) the larger the level of

    countrys foreign debt and credit constraint results more negative response of

    exports to currency depreciation, (5) countrys export with high foreign currency

    denominated debt are more vulnerable to negative exchange rate shocks and (6) the

    negative relationship between the external finance premium and the aggregate

    output growth seems to be strengthened in middle income than in the sectorial

    production growth.

    iv

  • Abstrak tesis yang dikemukakan kepada Senat Universiti Putra Malaysia sebagai memenuhi keperluan untuk ijazah Doktor Falsafah

    PEMBANGUNAN PENGANTARA KEWANGAN, HASIL KELUARAN DAN

    EKSPORT DI BAWAH KETIDAKSEMPURNAAN PASARAN KREDIT

    Oleh

    TANG KIN BOON

    Disember 2007

    Pengerusi : Profesor Madya Tan Hui Boon, PhD Fakulti : Ekonomi dan Pengurusan Penyelidikan ini mengkaji hubungan jangka panjang di antara pembangunan

    pengantara kewangan, hasil keluaran dan eksport di bawah tiga ketidaksempurnaan

    pasaran kredit peranan pengantara kewangan, pemecut kewangan dan

    ketidakpadanan mata wang. Secara khususnya, penyelidikan ini telah (1) mengkaji

    hubungan langsung di antara pembangunan pengantara kewangan dan

    ketidakstabilan hasil keluaran, (2) mengkaji kesan-kesan pelembapkan and

    pembesaran pengantara kewangan ke atas ketidakstabilan hasil keluaran melalui

    pembeluasan kejutan-kejutan asli dan kewangan, (3) mengkaji kesan tekanan kadar

    tukaran asing ke atas eksport di bawah syarat peminjaman mata wang asing dan

    kekangan kredit, (4) menilai kesan tekanan premium kewangan luar ke atas indeks

    pengeluaran and hasil keluaran berjumlah. Data panel dibina untuk negara-negara di

    bawah kajian dan hipotesis hubungan integrasi antara faktor-faktor telah disahkan

    dengan menggunakan ujian-ujian panel hubangan integrasi yang direka oleh Pedroni

    dan Westerlund. Vektor-vektor individu dan kumpulan rata ditaksir dengan

    menggunakan teknik FMOLS and DOLS yang direka oleh Pedroni.

    v

  • Dengan menggunakan data dari 17 negara-negara di Asia-Pacific Timur yang

    separas dengan tingkat pendapatan yang berlainan, hasil-hasil empirik menunjukkan

    (1) bukti yang kukuh dan konsisten mengenai kesan pelembapkan oleh kejutan asli,

    (2) bukti yang lemah mengenai kesan pembesaran oleh kejutan kewangan, (3) pada

    tahap tertentu pembangunan pengantara kewangan menunjukkan kesan langsung ke

    atas ketidakstabilan hasil keluaran di negara-negara yang sangat bergantung kepada

    bank, (4) hutang luaran dan kekangan kredit negara yang tinggi akan mengakibatkan

    balasan negatif eksport, (5) hutang mata wang asing negara yang tinggi juga akan

    mengakibatkan eksportnya lebih mudah diserang oleh kejutan-kejutan negatif

    tukaran asing dan (6) hubungan premium kewangan luar dengan perkembangan

    hasil keluaran berjumlah adalah lebih kukuh di negara-negara berpendapatan tengah

    berbanding dengan hubungannya dengan perkembangan indeks pengeluaran.

    vi

  • ACKNOWLEDGEMENTS I am deeply grateful to my supervisor, Associate Professor Dr. Tan Hui Boon, for

    the confidence she has shown in me. I would like to express my deepest

    appreciation to her for generous supervision, advice and patience throughout the

    completion of this thesis. She has continued her valuable assistance by giving

    suggestions and insights.

    Valuable comments of two members of the supervisory committee, Associate

    Professor Dr. Zulkornain Yusop and Dr. Zaleha Mohd Noor are greatly appreciated.

    Without their support, this thesis would likely not have matured.

    I have also benefited from valuable comments, suggestions and helps from Joakim

    Westerlund, Peter Pedroni, Nasri Harb and Thorsten Beck.

    vii

  • I certify that an Examination Committee has met on 12th December 2007 to conduct the final examination of Tang Kin Boon on his Doctor of Philosophy thesis entitled Financial Intermediary Development, Output and Export under Credit Market Imperfections in accordance with Universiti Pertanian Malaysia (Higher Degree) Act 1980 and Universiti Pertanian Malaysia (Higher Degree) Regulations 1981. The Committee recommends that the student be awarded the degree of Doctor of Philosophy. Members of the Examination Committee were as follows: Law Siong Hook, PhD Senior Lecturer Faculty of Economics and Management Universiti Putra Malaysia (Chairman) Taufiq Hassan, PhD Lecturer Faculty of Economics and Management Universiti Putra Malaysia (Internal Examiner) Zulkarnain Muhamad Sori, PhD Associate Professor Faculty of Economics and Management Universiti Putra Malaysia (Internal Examiner) Mansor Hj. Ibrahim, PhD Professor Kulliyyah Ekonomi dan Sains Pengurusan Universiti Islam Antarabangsa Malaysia (External Examiner) _______________________________

    HASANAH MOHD. GHAZALI, PhD Professor and Deputy Dean School of Graduate Studies Universiti Putra Malaysia Date: 29 January 2008

    viii

  • This thesis was submitted to the Senate of Universiti Putra Malaysia and has been accepted as fulfilment of the requirement for the degree of Doctor of Philosophy. The members of the Supervisory Committee were as follows: Tan Hui Boon, PhD Associate Professor Faculty of Economics and Management Universiti Putra Malaysia (Chairman) Zulkornain Yusop, PhD Associate Professor Faculty of Economics and Management Universiti Putra Malaysia (Member) Zaleha Mohd Noor, PhD Lecturer Faculty of Economics and Management Universiti Putra Malaysia (Member) _______________________________

    AINI IDERIS, PhD Professor and Dean School of Graduate Studies Universiti Putra Malaysia Date: 21 February 2008

    ix

  • DECLARATION I hereby declare that the thesis is based on my original work except for quotations and citations which have been duly acknowledged. I also declare that it has not been previously or concurrently submitted for any other degree at UPM or other institutions.

    ________________ TANG KIN BOON Date: 1 January 2008

    x

  • TABLE OF CONTENTS

    Page DEDICATION iiABSTRACT iiiABSTRAK vACKNOWLEDGEMENTS viiAPPROVAL viiiDECLARATION xLIST OF TABLES xivLIST OF FIGURES xviLIST OF ABBREVIATIONS/NOTATIONS/GLOSSARY OF TERMS xvii CHAPTER 1 INTRODUCTION

    1.1. Background 11.1.1. External Finance Premium and Output Fluctuations 81.1.2. Balance Sheet Effects 121.1.3. Bank Lending Effects 151.1.4. Monetary Policy, Currency Mismatch and Exchange Rate

    Movements 20

    1.1.5. Asian Exports and Exchange Rate Movements During the Crisis

    24

    1.1.6. Credit Boom-Bust Cycle and Economic Growth 281.2. Problem Statement 30

    1.2.1. Do Financial Intermediary Developments affect Output Fluctuations?

    30

    1.2.2. Do Credit Market Imperfections Amplify or Dampen Output Fluctuations?

    31

    1.2.3. Why East Asian Exports Stagnated or Fell after the Currency Crisis?

    33

    1.2.4. Does Agency Cost Reduce or Increase Output Growth? 351.2.5. Financial Constraints: Are SMEs more Credit Constrained

    than LMs? 36

    1.3. Objectives of the Study 381.4. Significance of the Study 39

    2 LITERATURE REVIEW 43

    2.1. Financial Intermediary Development and Output Fluctuations 442.1.1. Financial Accelerator 442.1.2. Credit Market Imperfections and Output Fluctuations 472.1.3. Do Intermediaries Dampen or Magnify Shocks? 552.1.4. Financial Accelerator and Macroeconomic Fluctuations:

    Empirical Evidence 65

    xi

  • 2.1.5. Monetary Policy as an Exogenous Shock to Agency Costs 682.1.6. Extensions of the Credit Market Imperfections 69

    2.2. Credit Market Imperfections and the Impact of Exchange Rate Movements on Exports

    73

    2.2.1 Exchange Rate Movements and International Trade under Foreign Currency Borrowing

    73

    2.2.2 Related Empirical Evidence of Foreign Currency Borrowing 762.2.3 Exchange Rate Movements and International Trade under

    Credit Constraint 77

    2.2.4 The Complimentary Effect of Foreign Currency Borrowing and Credit Constraint

    80

    2.3. Credit Channel 832.3.1 Balance Sheet Channel 832.3.2 Bank Lending Channel 872.3.3 Predictability of External Finance Premium 942.3.4 Balance Sheet Effects and Firms Size 96

    2.4. Financial Intermediary Development and Growth 982.4.1. How does Financial Intermediary Development affect

    Economic Growth? 98

    2.4.2. Related Empirical Literature 101 3 THEORETICAL MODELING AND METHODOLOGY 107

    3.1. Theoretical Models 1073.1.1. A Model of Financial Development and Output Fluctuations

    based on Beck, Lundberg and Majnoni (2006) 107

    3.1.2. Testable Hypotheses 1153.1.3. A Model of Agency Costs based on Bernanke, Gertler and

    Gilchrist (1996) 116

    3.1.4. Implications of External Finance Premium 1203.1.5. A Model of Export Functions based on Goldstein and Kahn

    (1978) 122

    3.2. Empirical Models 1253.2.1. Direct Effect of Financial Intermediary Development on

    Output Fluctuations 126

    3.2.2. Indirect Effect of Financial Intermediary Development on Output Fluctuations

    128

    3.2.3. Credit Market Imperfections and the Impact of Exchange Rate Movements on Exports

    129

    3.2.4. Testing for Amplification Effects 1333.2.5. Financing Opportunities Across Sectors 134

    3.3. Panel Data Model 1353.4. Panel Unit Root Tests 135

    3.4.1. Im, Pesaran and Shin (2003) test 1363.4.2. Fisher ADF and PP tests 137

    3.5. Panel Cointegration Tests 1383.5.1. Pedroni Heterogeneous Panel Tests 139

    xii

  • 3.5.2. Westerlund Panel Invariance Tests 1433.5.3. Westerlund Panel CUSUM Test 1473.5.4. Westerlund Panel Structural Break Test 1483.5.5. Contribution of the Current Methods 150

    4 RESULTS AND DISCUSSIONS 152

    4.1. Financial Intermediaries Development and Output Fluctuations 1524.1.1 Direct Impact of Financial Intermediary Development on

    Output Fluctuations 157

    4.1.2 Dampening and Magnifying Effects of Financial Intermediary Development on Output Fluctuations

    163

    4.2. The Effects of Foreign Currency Borrowing and Financial Development on Export

    177

    4.2.1 Traditional Competitiveness Effect 1874.2.2 Effect of Foreign Currency Borrowing 1884.2.3 Effect of Financial Development 1894.2.4 Amplification Effect of Financial Development 1914.2.5 Amplification Effect of Exchange Rate 1924.2.6 Results based on ASEAN-5 196

    4.3. The Effects of External Finance Premium on Sectorial Production Index and Aggregate Output

    199

    5 CONCLUSION AND POLICY IMPLICATIONS 218

    5.1. Discussion and Conclusion 2185.1.1 Financial Development and Output Fluctuations 2195.1.2 Financial Development, Foreign Currency Borrowing and

    Exports 220

    5.1.3 External Finance Premium and Output Growth 2225.2. Policy Implications 224

    5.2.1 Monetary Policy, Financial Development and Output Fluctuations

    224

    5.2.2 Foreign Debt Management 2265.2.3 Choice of Exchange Rate Regime Under Imperfect Credit

    Markets 227

    5.2.4 Credit Effects and Macroeconomic Policies 229 REFERENCES 232APPENDICES 244BIODATA OF THE AUTHOR 277

    xiii

  • LIST OF TABLES

    Table Page 1-1 Gross flow of financial liabilities of non-financial corporate

    sector (in percentage)

    15

    1-2 Estimated total NPLs (in percentage of all loans)

    16

    3-1 Reduced-form coefficients

    124

    3-2 Pedroni panel cointegration statistics

    140

    4-1a Panel unit root tests

    161

    4-1b Panel cointegration test results (Direct relationship between financial development and output fluctuations)

    162

    4-1c Panel cointegration test results (Indirect relationship between financial intermediary development and output fluctuations)

    165

    4-1d Group-mean FMOLS estimates of the indirect effect of financial intermediary development on output fluctuations

    169

    4-1e Individual DOLS estimates of the indirect effect of financial intermediary development on output fluctuations via the propagation of real shocks

    174

    4-1f Individual DOLS estimates of the indirect effect of financial intermediary development on output fluctuations via the propagation of monetary shocks

    175

    4-2a Panel unit root tests

    183

    4-2b Pedronis heterogeneous panel cointegration test results (Aggregate relationship between exports, foreign liability and financial development)

    185

    4-2c Pedronis heterogeneous panel cointegration test results (Segmented relationship between exports and foreign liability or financial development)

    186

    4-2d FMOLS and DOLS estimates of export, foreign liability, financial development and the amplification effects

    194

    xiv

  • 4-2e DOLS estimates of export, foreign currency borrowing and financial development for ASEAN-5

    198

    4-3a Pedronis heterogeneous panel cointegration test results (Sectorial effects)

    205

    4-3b Pedronis heterogeneous panel cointegration test results (Aggregate effects)

    206

    4-3c Westerlunds panel cointegration test results (Sectorial effects)

    207

    4-3d Westerlunds panel cointegration test results (Aggregate effects)

    208

    4-3e FMOLS and DOLS estimates of the impact of external finance premium on sectorial production growth

    214

    4-3f FMOLS and DOLS estimates of the impacts of external finance premium on aggregate output growth

    216

    xv

  • LIST OF FIGURES

    Figure Page 1-1 Changes in external finance premium and GDP growth

    11

    1-2 Changes in external finance premium and the ratio of gross fixed capital formation to stock indexes

    14

    1-3 Evolution of intervention rates

    17

    1-4 Changes in external finance premium and domestic credit

    19

    1-5 Evolution of exchange rates

    21

    1-6 External debt in foreign currency (in US$)

    22

    1-7 Debt service in foreign currency (% of GNP)

    23

    1-8 Monthly East Asian exports

    24

    1-9 Credit boom-bust cycle

    29

    2-1 Balance sheet channel

    85

    2-2 Bank lending channel

    88

    2-3 Adverse consequences of increases in interest rates 89

    xvi

  • xvii

    LIST OF ABBREVIATIONS/ NOTATIONS/ GLOSSARY OF TERMS

    ADF Augmented Dickey-Fuller

    DGP Data Generating Process

    DOLS Between-dimension Dynamic OLS

    FD Financial intermediary development

    FMOLS Between-dimension Fully Modified OLS

    GMM Generalized Method of Moment

    H-P filter Hodrick-Prescott filter

    IFS International Financial Statistics

    IPS Im, Pesaran and Shin

    IV Instrumental Variable

    PP Phillips-Perron

    PZ Parametric Statistic

    SPR External Finance Premium (Interest Rate Spread)

    SZ Semi-parametric Statistic

    TFP Total Factor Productivity

    VRG Group-Mean Ratio Statistic

    VRP Panel-Variance Ratio Statistic

    WBES World Business Environment Survey

    WDI World Development Indicators

  • CHAPTER 1

    INTRODUCTION

    1.1. Background

    Standard macroeconomic models typically assume that credit markets are perfect. In

    recent years, however, a body of theoretical work has challenged the key

    assumptions required for perfect credit markets. 1 The current work on the

    mechanics of credit market imperfections suggests that output and trade are

    interrelated with private credit and foreign debt. The financial crisis in East Asia has

    rekindled economists interest in the reasons and consequences of intervention in

    the financial markets. A lesson seems to have emerged from the issue of financial

    crisis, the role of financial intermediaries, bank failures and balance of payment

    problems. It seems that holding of excessive foreign currency liabilities by firms

    and banks have played havoc in East Asia. The external debt that many Asian

    countries accumulated to finance their development was almost strictly denominated

    in foreign currencies which are external to the region. 2 Besides, the crisis has

    highlighted the role financial development in propagating negative shocks to the

    economy. This is naturally led to an interest in the determinants of these frictions

    and their effects on the macroeconomy, particularly on output fluctuations and

    export. In light of that, credit market imperfections that based on asymmetric

    information, agency costs and other credit frictions in financial markets, is one of

    the theories that has been advanced in an attempt to provide a plausible explanation

    for the propagation of cyclical fluctuations.

    1 See Bernanke (1983), Bernanke and Gertler (1989) and Bernanke et al. (1998). 2 See Bordo and Meissner (2006) for the role of foreign currency debt in financial crises.

  • Over the last two decades, East Asian economies have experienced accelerate

    financial development, periods of rapid credit expansion, associated with high level

    foreign borrowing and rapid economic growth.3 Concerns have been raised on the

    role of excessive credit growth in the previous financial crises in Asian markets.

    These problems are associated with low investment, sharp increases in insolvencies

    and bankruptcies, rising debt burdens, collapsing equity prices, bank failures, high

    rate of defaults and output contraction. The third generation crises models have

    considered credit market imperfections as key fundamentals. According to this

    view, deteriorating credit market conditions are not simply passive reflections of a

    declining real economy, but are in themselves a major factor depressing economic

    activity. The key elements described above are based on borrowers credit

    worthiness, supply of loans by commercial banks, unwarranted non-performing

    loans and companies with excessive foreign currency-denominated debt. These

    factors are among the most important elements in explaining both the credit and

    output fluctuations in the region. This third generation model is particularly well

    suited to analyze the case of economies like in East Asia, where the source of

    currency crises lied primarily in the deteriorating balance sheets of private domestic

    firms and commercial banks rather than in uncontrolled budget deficit policies by

    local governments (e.g., see Mishkin, 1999).

    3 The main stylized facts on credit expansion and output cycles are described in Schneider and Tornell (2004).

    2

  • The idea that credit market imperfections play a central role in the propagation of

    cyclical fluctuations has a long-standing tradition in macroeconomics. Since Irving

    Fishers debt-deflation theory of Great Depression, many economists have argued

    that deteriorating credit market conditions are in themselves a major factor

    depressing real economic activity. Beginning with Bernanke and Gertler (1989) and

    Kiyotaki and Moore (1997) balance sheet effects were the initial efforts to introduce

    such effects into mainstream economic models in a formal way. In particular,

    endogenous developments in credit markets may work to propagate and amplify

    shocks to the economy (Bernanke and Gertler, 1995). More recently, Beck et al.

    (2006) has developed a theoretical model to assess the dampening effect of real

    shocks and magnifying effect of monetary shocks on output fluctuations.

    Under credit market imperfections, output relates to the net effect of the procyclical

    movements in borrowers net worth (i.e. balance sheet effects) and countercyclical

    movements in the external finance premium (i.e. the difference between the cost of

    funds raised externally and the opportunity cost of funds generated internally). Such

    a mechanism tends to constrain profitable investment opportunities and to produce

    inefficient decline in output. Within this context, balance sheets of some economic

    agents are highly vulnerable to adverse demand shocks because of the liabilities

    accumulated during the credit boom periods. These balance sheet exposures can be

    the sources of amplification and propagation during the downturn. One can define

    that the degree of credit market imperfections are depending on the magnitudes of

    these balance sheets exposures to negative aggregate shocks.

    3

  • The traditional credit channel literature examines the impact of asymmetric

    information via the changes in agency costs on real spending and economic activity.

    Literature of credit channel is divided into two schools of thought, balance sheet and

    bank lending channels. The bank credit channel analyses the impact of shocks on

    the supply of loans by depository institutions, whereas the balance sheet channel

    focuses on the potential impact of shocks on firms balance sheets and their ability

    to borrow. Both channels emphasize on the asymmetric information between the

    borrowers and lenders which alter the costs of financing that have significant

    consequences on output fluctuations. Although both channels theoretically quite

    different, we do not intend to distinguish them empirically.

    Nevertheless, both channels are based on one key fundamental, the financial

    accelerator. 4 The financial accelerator hypothesis says that credit market

    distortions magnify economic fluctuation. Accordingly, small credit distortions may

    lead large and persistent fluctuation in output. In other words, credit market

    distortions create a financial accelerator which destabilizes the economy. While in

    some cases the distortions destabilize the economy, they sometimes stabilize the

    economy. 5 Many empirical studies are unable to distinguish between financial

    accelerator and stabilizer. In order to fill the gap in the literature, this study attempts

    to distinguish them empirically by considering various macroeconomic shocks.

    4 The term financial accelerator was first introduced by Bernanke and Gertler (1989). 5 See a recent study by House (2006) where the stabilizing forces are closely related to forces that cause overinvestment in static models.

    4

  • In a world of imperfect credit market, financial intermediaries are important because

    of information and transactions costs that arise from imperfect information between

    the borrowers and lenders. This information asymmetry is opening up the possibility

    of an interesting interaction between financial intermediary development and output

    fluctuations. As a result, questions have been raised on the dampening and

    amplifying effect of financial development on output fluctuations. Numerous studies

    have focused on financial development and economic growth (e.g. Rajan and

    Zingales, 1998; Levine et al., 2000; Beck et al., 2000b),6 however, the indirect

    effect of financial development on output fluctuations has not been studied

    thoroughly yet. 7 This study examines on both the direct and indirect effects of

    financial intermediary development on output fluctuations.

    The credit market imperfections can also affect the way in which an economy reacts

    to exchange rate movements through different channels. For example, after the large

    exchange rate depreciations following the 1997 East Asian crisis, export volumes

    from East Asian countries did not increase with respect to the large currency

    depreciations.8 Two main explanations for this phenomenon have been proposed,

    excessive foreign currency borrowing affected firms balance sheets and contraction

    in domestic credit affected supply of exports.

    6 Rajan and Zingales (1998) argue that financial development facilitates economic growth as it reduces external costs of finance to firms. 7 See a latest study by Beck et al. (2006). 8 See Duttagupta and Spilimbergo (2004) for a survey of Asian exports during the crisis.

    5

  • The first channel related to this view is foreign currency borrowings where share of

    firms liability is denominated in foreign currency, thus exchange rate depreciation

    will increase the amount of this debt. This will deteriorate firms balance sheets and

    thus decrease the amount of their production.9 The second channel that can be

    observed is the presence of credit constraints where depreciation can decrease the

    amount of firms cash flow if their assets are denominated in domestic currency; if

    this cash flow determines firms net worth, investment will decrease after

    depreciation and if this investment is necessary to produce and export, trade will

    decrease too. The complementary of these two channels is called the currency

    mismatch. The effects would be the same if countries have large debt denominated

    in foreign currency to finance their development while the cash flow that serve

    those debts are denominated in domestic currency, a depreciation of currency

    exacerbating debt-service difficulties and increasing the likelihood of default of

    domestic banks and firms and consequently economic collapsed.

    This view is argued by Eichengreen and Hausmann (1999) that the danger of

    exchange rate fluctuations in the face of foreign currency borrowing might force

    many countries to adopt hard currency pegs. They coined the term original sin

    because they argued foreign currency denominated debt was imposed by

    international capital markets. Nations with poor reputations, and even nations with

    ostensibly good reputations or solid fundamentals, are obliged to issue debt in key

    international currencies. In other words, domestic policies or problems were not the

    only reason countries could not borrow in their own currencies. 9 See for example, Deardorff (2000), Jeanne (2002) and Cespedes et al. (2004).

    6

  • This study considers three literatures of credit market imperfections credit channel

    (or the role of financial intermediaries), financial accelerator and currency mismatch

    focusing on the selected countries in East Asian and Pacific region. In particular,

    this study is related to four different stands of literature. First, this study is based on

    a large empirical literature on the relationship between financial development and

    output fluctuations. A second relevant stand of literature is the accelerating effects

    of credit market imperfections on the propagation of various economic shocks. A

    third related literature is the effect of exchange rate movements on export when

    foreign currency borrowing and the level of credit constraint are considered. A

    fourth related line of work is the literature on the credit channel of monetary

    transmission mechanism where monetary policy impacts on real economy through

    the balance sheet and bank lending channels.

    In the following sections, a descriptive analysis of how credit market imperfections

    at work with respect to the changes in various financial market indicators is

    reviewed. Such indicators are the role of credit constraints in output fluctuations,

    the importance of bank loans for bank-dependent borrowers, the balance sheet

    effects with or without the foreign currency denominated debt and the rapid

    expansions of guaranteed debt by the public entities. Based on the descriptive

    analysis, three hypotheses are proposed in which will be examined in the later parts

    of this study.

    7