Romain G. Rancière

Financial Development, Financial Fragility and Growth

The authors study the apparent contradiction between two strands of the literature on the effects of financial intermediation on economic activity. On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities (for example, Levine, Loayza, and Beck 2000). On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns (for example, Kaminski and Reinhart 1999). The authors account for these contrasting effects based on the distinction between the short- and long-run impacts of financial intermediation. Working with a panel of cross-country and time-series observations, they estimate an encompassing model of short- and long-run effects using the Pooled Mean Group estimator developed by Pesaran, Shin, and Smith (1999). Their conclusion from this analysis is that a positive long-run relationship between financial intermediation and output growth coexists with a mostly negative short-run relationship. The authors further develop an explanation for these contrasting effects by relating them to recent theoretical models, by linking the estimated short-run effects to measures of financial fragility (namely, banking crises and financial volatility), and by jointly analyzing the effects of financial depth and fragility in classic panel growth regressions.

The Optimal Level of International Reserves for Emerging Market Countries: A New Formula and Some Applications

We present a model of the optimal level of international reserves for a small open economy seeking insurance against sudden stops in capital flows. We derive a formula for the optimal level of reserves and show that plausible calibrations can explain reserves of the order of magnitude observed in many emerging market countries. The buildup of reserves in emerging market Asia can be explained only if one assumes a large anticipated output cost of sudden stops and a high level of risk aversion.

The Optimal Level of International Reserves for Emerging Market Countries: Formulas and Applications

We present a model of the optimal level of international reserves for a small open economy that is vulnerable to sudden stops in capital flows. Reserves allow the country to smooth domestic absorption in response to sudden stops, but yield a lower return than the interest rate on the countrys long-term debt. We derive a formula for the optimal level of reserves, and show that plausible calibrations can explain reserves of the order of magnitude observed in many emerging market countries. However, the recent buildup of reserves in Asia seems in excess of what would be implied by an insurance motive against sudden stops.

Income Inequality and Current Account Imbalances

This paper studies the empirical and theoretical link between increases in income inequality and increases in current account deficits. Cross-sectional econometric evidence shows that higher top income shares, and also financial liberalization, which is a common policy response to increases in income inequality, are associated with substantially larger external deficits. To study this mechanism we develop a DSGE model that features workers whose income share declines at the expense of investors. Loans to workers from domestic and foreign investors support aggregate demand and result in current account deficits. Financial liberalization helps workers smooth consumption, but at the cost of higher household debt and larger current account deficits. In emerging markets, workers cannot borrow from investors, who instead deploy their surplus funds abroad, leading to current account surpluses instead of deficits.

Crises and Growth: A Re-Evaluation

We address the question of whether growth and welfare can be higher in crisis prone economies. First, we show that there is a robust empirical link between per-capita GDP growth and negative skewness of credit growth across countries with active financial markets. That is, countries that have experienced occasional crises have grown on average faster than countries with smooth credit conditions. We then present a two-sector endogenous growth model in which financial crises can occur, and analyze the relationship between financial fragility and growth. The underlying credit market imperfections generate borrowing constraints, bottlenecks and low growth. We show that under certain conditions endogenous real exchange rate risk arises and firms find it optimal to take on credit risk in the form of currency mismatch. Along such a risky path average growth is higher, but self-fulfilling crises occur occasionally. Furthermore, we establish conditions under which the adoption of credit risk is welfare improving and brings the allocation nearer to the Pareto optimal level. The design of the model is motivated by several features of recent crises: credit risk in the form of foreign currency denominated debt; costly crises that generate firesales and widespread bankruptcies; and asymmetric sectorial responses, where the nontradables sector falls more than the tradables sector in the wake of crises.

The Optimal Level of International Reserves for Emerging Market Countries

We present a model of the optimal level of international reserves for a small open economy that is vulnerable to sudden stops in capital flows. Reserves allow the country to smooth domestic absorption in response to sudden stops, but yield a lower return than the interest rate on the countrys long-term debt. We derive a formula for the optimal level of reserves, and show that plausible calibrations can explain reserves of the order of magnitude observed in many emerging market countries. However, the recent buildup of reserves in Asia seems in excess of what would be implied by an insurance motive against sudden stops.

The Overhang Hangover

The authors revisit the debt overhang question. They first use nonparametric techniques to isolate a panel of countries on the downward sloping section of a debt Laffer Curve. In particular, overhang countries are ones where a threshold level of debt is reached in sample, beyond which (initial) debt ends up lowering (subsequent) growth. On average, significantly negative coefficients appear when debt face value reaches 60 percent of GDP or 200 percent of exports, and when its present value reaches 40 percent of GDP or 140 percent of exports. Second, the authors depart from reduced form growth regressions and perform direct tests of the theory on the thus selected sample of overhang countries. In the spirit of event studies, they ask whether, as the overhang level of debt is reached: (1) investment falls precipitously as it should when it becomes optimal to default; (2) economic policy deteriorates observably, as it should when debt contracts become unable to elicit effort on the part of the debtor; and (3) the terms of borrowing worsen noticeably, as they should when it becomes optimal for creditors to preempt default and exact punitive interest rates. The authors find a systematic response of investment, particularly when property rights are weakly enforced, some worsening of the policy environment, and a fall in interest rates. This easing of borrowing conditions happens because lending by the private sector virtually disappears in overhang situations, and multilateral agencies step in with concessional rates. Thus, while debt relief is likely to improve economic policy (and especially investment) in overhang countries, it is doubtful that it would ease their terms of borrowing or the burden of debt.

Country Insurance : The Role of Domestic Policies

This paper focuses on what countries can do on their own—that is, on the role of domestic policies—with respect to country insurance. Member countries are routinely faced with a range of shocks that can contribute to higher volatility in aggregate output and, in extreme cases, to economic crises. The presence of such risks underlies a potential demand for mechanisms to soften the blow from adverse economic shocks. For all countries, the first line of defense against adverse shocks is the pursuit of sound policies. In light of the large costs experienced by emerging markets and developing countries as a result of past debt crises, fiscal policies should seek to improve sustainability, taking into account that sustainable debt levels seem to be lower in emerging and developing countries than in advanced countries. Although much can be accomplished by individual countries through sound policies, risk management, and self-insurance through reserves, collective insurance arrangements are likely to continue playing a key role in cushioning countries from the impact of shocks.

Banks, Liquidity Crises and Economic Growth

How do the liquidity functions of banks affect investment and growth at different stages of economic development? How do financial fragility and the costs of banking crises evolve with the level of wealth of countries? We analyze these issues using an overlapping generations growth model where agents, who experience idiosyncratic liquidity shocks, can invest in a liquid storage technology or in a partially illiquid Cobb Douglas technology. By pooling liquidity risk, banks play a growth enhancing role in reducing inefficient liquidation of long term projects, but they may face liquidity crises associated with severe output losses. We show that middle income economies may find optimal to be exposed to liquidity crises, while poor and rich economies have more incentives to develop a fully covered banking system. Therefore, middle income economies could experience banking crises in the process of their development and, as they get richer, they eventually converge to a financially safe long run steady state. Finally, the model replicates the empirical fact of higher costs of banking crises for middle income economies.

Inequality, Leverage and Crises: The Case of Endogenous Default

The paper studies how high household leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of high-income households, a large increase in debt leverage of the remainder, and an eventual financial and real crisis. The paper presents a theoretical model where higher leverage and crises arise endogenously in response to a growing income share of high-income households. The model matches the profiles of the income distribution, the debt-to-income ratio and crisis risk for the three decades prior to the Great Recession.