Financial Frictions and Total Factor Productivity: Accounting for the Real Effects of Financial Crises pot

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Financial Frictions and Total Factor Productivity: Accounting forthe Real Effects of Financial Crises1Sangeeta Pratap Carlos UrrutiaHunter College & Graduate Center,City University of New YorkCIE & Dept. of Economics,ITAMJune 2010Abstract The financial crises or “sudden stops” of the last decade in emergingeconomies were accompanied by a large fall in total factor productivity. In this paper weexplore the role of financial frictions in exacerbating the misallocation of resources andexplaining this drop in TFP. We build a dynamic two-sector model of a small open economywith a cash in advance constraint where firms have to finance a part of their purchase ofintermediate goods prior to production. The model is calibrated to the Mexican economybefore the 1995 crisis and subject to an unexpected shock to interest rates. The financialfriction can generate an endogenous fall in TFP of about 3.5 percent and can explain 74percent of the observed fall in GDP per worker. Adding a cost of adjusting labor betweenthe two sectors and sectoral specificity of capital also generates the sectoral patterns ofoutput and resource use observed in the data after the sudden stop. The results highlightthe interaction between interest rates and allocative inefficiencies as an explanation of thereal effects of the financial crisis.1Email:, are grateful to Roberto Chang, Tim Kehoe and Kim Ruhl for helpful comments. We also appreciatecomments from participants at the Latin American Meetings of the Econometric Society, Econometric SocietyWinter Meetings, the meetings of the Society for Economic Dynamics, the Midwest Macro Meetings andthe Cornell-Penn State Macro Workshop. Seminar participants at Drexel University, ITAM and WesleyanUniversity also provided helpful feedback. Vicente Castañon, Lorenza Martinez, Jose Luis Negrin andJessica Serrano at the Banco de Mexico, and Reyna Gutierrez at the Secretaria de Hacienda y CreditoPublico provided invaluable help with the data. We are also grateful to Erwan Quintin and Vivian Yuefor making their computations available to us. Raul Escorza and Nate Wright provided excellent researchassistance. The paper was partly written while Pratap was a Fernand Braudel fellow at the EuropeanUniversity Institute and Urrutia was visiting the International Monetary Fund’s Institute. We gratefullyacknowledge the hospitality of these institutions. This work was supported in part by a grant from the CityUniversity of New York PSC-CUNY Research Award Program. We are responsible for all errors.1 IntroductionThe financial crises of the last decade in emerging economies have been accompanied by alarge fall in total factor productivity. As Calvo et. al. (2006) show, GDP in these suddenstop episodes declined on average by 10 percent, the bulk of which can be attributed to adrop in TFP.2Investigating the forces behind these movements in total factor productivityis central to understanding the real effects of financial crises.A decline in TFP of this magnitude must be a result of not merely a misallocationof resources, but a misallocation that worsens during crises. In this paper we explore therole of financial frictions in exacerbating existing inefficiencies and explaining the drop inTFP. There is ample micro evidence that financial constraints and the increase in the costof credit affected the performance of firms during the crisis,3however their aggregate impacton output is unclear.We build a deterministic dynamic two-sector model of a small open economy with acash in advance constraint where firms have to finance a part of their purchase of intermediategoods prior to production. The economy consists of a traded and non traded goods sector,each of which use labor, capital and intermediate goods to produce output. The output ofboth sectors is combined to produce a final good and an intermediate good. The formeris used as both a consumption and an investment good and the latter for production. Theeconomy exports and saves in traded goods. Besides intertemporal adjustment costs forcapital, the financial constraint for intermediate goods is the only friction in the baselinemodel.An exogenous increase in interest rates has a twofold effect. First, it increases the wedgebetween the producer cost and the user cost of intermediate goods and worsens existingallocative inefficiency. The main objective of our paper is to quantify the impact of thischannel on TFP. Second, an increase in interest rates also increases the demand for tradedgoods, leading to an increase in their price and a real exchange rate depreciation.2The sudden stop episodes studied include the Latin American debt crises of the 1980s, the Mexican crisisof the first half of the 1990s and the East Asian and Russian crises of the late 1990s. On average, more than85 percent of the fall in output observed during these episodes can be attributed to the fall in TFP.3Aguiar (2005) and Pratap et. al (2003) show that the presence of dollar denominated debt depressedfirm investment during the 1994 crisis in Mexico. Pratap and Urrutia (2004) build a model that accountsfor most of the fall of investment in Mexico due to balance sheet effects of a real exchange rate depreciation.2We calibrate our model to the Mexican economy prior to the sudden stop of 1994 andintroduce the sequence of interest rates observed in Mexico during the sudden stop as anunexpected shock. The experiment delivers a reduction in TFP of about 3.5 percent whichaccounts for 52 percent of the TFP drop in the data and 74 percent of observed fall in GDPper worker. The model is also consistent with a current account reversal and a real exchangerate depreciation as observed in the data.However, the baseline model also predicts that the depreciation of the real exchangerate reallocates inputs from the non traded to the traded goods sector, leading to a largeincrease in the output of the latter and an equally large decline in that of the former. As weshow in the following section, this runs counter to the facts. No such immediate reallocationof labor or capital towards the traded goods sector took place in Mexico, and output fell inboth sectors. We therefore introduce two further frictions: a cost of adjusting labor betweenthe two sectors, and sectoral specificity for capital.4. We find that adding these frictions tothe model allows us to match the sectoral patterns of output and factor movements observedin the data, while we still obtain a large decline in TFP during the sudden stop. Moreover, weshow that labor and capital reallocation frictions on their own are not sufficient to generatea fall in GDP.Our paper borrows a key insight from Chari, Kehoe and McGrattan (2005) who showthat a sudden stop cannot generate a fall in output in a frictionless economy. They suggestthat financial constraints on the purchase of inputs can generate TFP effects and outputdrops only if they create a wedge between the user and producer price of these inputs. Webuild a fully fledged model with such constraints and quantitatively assess their plausibilityto explain the real effects of financial crises.We also contribute to a more general literature on financial frictions and sudden stopsin emerging economies. Models such as Mendoza (2010) and Mendoza and Yue (2009) usefinancial frictions as a device to amplify the economy’s response to a sequence of bad realiza-tions of exogenous TFP shocks. In contrast, we do not think of crises as regular business cyclephenomena. We show that in an economy with no productivity shocks, financial frictions can4Pratap and Quintin (2010) show that intersectoral movements of labor depreciate human capital duringthe Mexican crisis. Ramey and Shapiro (2001) show that there is a large degree of asset specificity in capitalgoods.3endogenously generate a large fall in TFP after an unexpected interest rate shock. In thissense, our paper complements the analysis in Kehoe and Ruhl (2009), who demonstrate thatdeterministic two-sector models of a small open economy can reproduce the current accountreversal and real exchange rate depreciation following a sudden stop. Without financialfrictions however, their model cannot generate an output drop.5Finally, our paper is also closely related to Neumeyer and Perri (2005) who also analyzethe role of a financial friction, modelled as a cash-in-advance constraint for firms, as apropagation mechanism for external interest rates shocks. However, unlike their model, ourfriction affects the purchase of intermediate goods instead of the wage bill, which allows usto obtain TFP effects. In their model, any output drop generated by an increase in interestrates is due to a decline in the labor supply and equilibrium employment. As discussedbefore, sudden stops in emerging economies are characterized by large falls in TFP andcomparatively minor reductions in labor so we simplify our model and consider labor supplyto be exogenous.The paper is organized as follows. The next section presents the empirical evidence onthe Mexican financial crisis. In section 3 we set out the baseline model with the financialfriction and calibrate it to the Mexican economy. We subject this economy to an increasein interest rates and show that, while our model can account for a large fraction of the fallin aggregate TFP and output, we cannot account for the patterns in sectoral reallocation ofoutput and factors of production observed in the data. In Section 4 we introduce the laborand capital friction and show that they are necessary to account for the fall in output in eachsector and the flows of labor and capital across sectors. Section 5 performs some robustnesschecks and Section 6 concludes.5Benjamin and Meza (2009) analyze the real effects of Korea’s 1997 sudden stop and attempt to generateTFP effects out of a purely financial crisis. Their mechanism is not financial frictions, but reallocation ofresources towards low-productivity sectors, which in their model correspond to non-tradable, consumptiongoods. We do not observe such a pattern in the Mexican data. Moreover the TFP effects of their reallocationmechanism are small.4801001201401601801988198919901991199219931994199519961997199819992000RER Price Ratio T/NReal Exchange Rate00.20.40.6198919901991199219931994199519961997199819992000Ex-post CETES rate in dollarsReal cost of credit for firmsReal Interest RateFigure 1: Real Exchange Rate and Real Interest Rate in Mexico2 DataExchange Rates and Interest Rates The main events associated with the Mexicancrisis of 1994 are well documented. On December 20 1994, the government devalued thepeso by 15 percent in response to capital outflows and a run on the currency. When thisproved insufficient to halt capital flight, the peso was allowed to float two days later. Between1994 and 1995, the real exchange rate depreciated by more than 55 percent.The left panel of Figure 1 shows the evolution of the multilateral, CPI based, realexchange rate (peso to the dollar), calculated by the Central Bank of Mexico using a basketof 118 currencies. The dotted line shows the ratio of the prices in the traded goods sectorto prices in the non-traded goods sector.6The increase in this price ratio due to the devalu-ation was 8 percent, a much smaller magnitude than the 58 percent depreciation of the realexchange rate. The subsequent trend however, mirrored the behavior of the real exchangerate and the series edged closer from 1998 onwards.Interest rates shot up simultaneously. The right panel of the same figure shows ameasure of the domestic interest rate in dollar terms based on the return on 28 day Mexican6While the precise definition of a traded or non traded good is sometimes contentious, we define thetraded goods sector as comprising of agriculture, manufacturing and mining, while the non traded goodssector consists of construction, and all services. The price index of each sector is calculated as the weightedaverage of the price indices of all the economic activities encompassed by it. The weights are calculated asthe share of the activity in sectoral value added.5treasury bills (CETES).7As observed, the interest rate fell steadily from 1988 to 1994, aperiod of financial liberalization in Mexico. During the sudden stop it increased to almost50 percent, from a level of 7 percent in 1994. In 1996 it fell slightly to 30 percent and slowlydeclined to pre-crisis levels. This is the change in interest rates that we will use for the crisisscenario. Its large magnitude reflects not only the perceived risk of default of the Mexicangovernment8but also the quantitative restrictions to borrowing implied by the sudden stopof foreign capital.It is hard to get a direct measure of the real cost of short run borrowing for businessesin Mexico during the crisis, but casual evidence suggests that it was not far off the 50 percentimplied by the ex-post CETES rate in dollars.9We also provide in Figure 1 an alternativemeasure based on firm level data of (arguably large) Mexican firms listed on the stock market.We calculate the cost of credit for the median firm as the ratio of the real value of interestpayments to the real value of the stock of bank debt. As observed in the figure, this realimplict interest rate increased from 17 percent in 1994 to 42 percent in 1995, and declinedto 30 percent the year after, very much in line with the ex-post CETES rate in dollars.Output and TFP The real effects of the devaluation and interest rate hike were imme-diate. The top left panel of Figure 2 shows that GDP, which had been growing at about 4percent per annum fell by over 6 percent in 1995. This decline was more pronounced in thenon traded goods sector than in the traded goods sector, as the second and third panels ofthe figure show.Using detrended data on sectoral value added, labor and capital we perform a standardgrowth accounting exercise to decompose the fall in GDP in 1995.10We use detrended data7In our model, all quantities, including the rate of interest will be expressed in terms of the traded good.The domestic interest rate in terms of dollars is the closest analog to this in the data. Ideally, we would liketo have an ex-ante interest rate in dollars, but the information to construct it is not available. Instead, weconstruct an ex-post short run rate as the difference between the interest rate in pesos and the devaluationrate over the next month.8For example, the return on the J.P. Morgan Emerging Markets Bond Index Plus (EMBI+) for Mexicoincreased from 5 to 15 percent from 1994 to 1995, and remained close to 10 percent till the end of 1996 (seeUribe and Yue 2006). This index captures the country specific risk of sovereign default.9In April 1995, the New York Times reported that entrepreneurs faced interest rates of over 100%. OnAugust 24 of the same year the Mexican government announced a $1.1 billion plan to guarentee interestrates at half their current level. Under the plan, the interest rate on the first $31,400 of business loans wouldbe reduced from about 60% to 25%.10Data for value added and employment comes form INEGI’s national income and product accounts. Data69. in the Traded Goods Sector8.88.999. TrendGDP in the Non Traded Goods Sector Total Factor Productivity8590951001051101151994199519961997199819992000Aggregate T Sector N SectorAggregate GDPFigure 2: Output and Total Factor Productivity in Mexico7Table 1: Growth Accounting for Mexican Economy - Detrended VariablesAnnual Growth Total Traded Non-tradedRate: 1994-95 Sector SectorGDP -9.2% -6.3% -10.2%Capital 0.3% 1.2% -0.6%Labor -4.8% -4.9% -4.7%TFP -6.7% -4.4% -7.2%to abstract from the long run growth rate of the total labor force and productivity, as thesefeatures are absent in our model.11Table 1 shows the results. As expected, TFP is themain driving force behind the output drop both at the economy-wide and sectoral levels,explaining 73 percent of the overall fall in GDP.The lower right panel of Figure 2 shows the evolution of aggregate and sectoral de-trended TFP during and following the Mexican crisis. The immediate collapse in TFP washigher in the non-traded sector. During the recovery TFP grew at a faster rate in the tradedsector (2.2 percent per year) than in the non-traded sector, where productivity staganatedfor the rest of the decade.Decline in Intermediate Inputs While output fell without a corresponding drop inmeasured labor and capital, there was a large decline in the use of intermediate inputs.From NIPA data, we estimate this fall to be around 4.8 percent in 1995. Moreover, theconsumption of energy, one of the most important intermediate goods, fell by over 10 percentin this period, as documented by Meza and Quintin (2006).The use of trade credit, which is typically used to finance intermediate good consump-tion also fell in this period. While macro data on trade credit is not available, data fromfirms listed on the Mexican stock exchange show that as a fraction of short term liabilities,the stock of trade credit outstanding fell from 24 percent in December 1994 to 20 percentby the end of 1995. Recovery to pre-crisis levels occurred only by 1997.for capital stock by sector is obtained from Banco de Mexico surveys. We use the factor shares αT= 0.48,αN= 0.36, and α = 0.4. The choice of these values will be discussed in detail in the calibration section.11Labor is detrended at the annualized rate of growth of total employment from 1988 to 2002 (n = 0.0195).Capital and GDP are detrended at the rate (1 + g) (1 + n)−1, where g = 0.0125 corresponds to the annualizedgrowth rate of per worker GDP in the same period. Finally, TFP is detrended at the rate (1 + g)1−α− 1.We use the same rates to detrend total and sectoral variables.8Share in Productive Factors0. CapitalShare in Output (GDP) 3: Share of Traded Goods in Output, Labor and CapitalInter-Sectoral Reallocation of Resources Figure 3 shows the share of the tradedgoods sector in GDP, labor and capital. In line with the experience of most industrial-ized economies, the long term process of structural transformation in Mexico saw a declinein the importance of the traded goods sector as services eclipsed manufacturing in impor-tance. The large devaluation in 1995, together with the passage of NAFTA the year before,reversed this trend in output and the share of traded goods in output increased by about0.8 percent in that year, consistent with the trends for sectoral TFP discussed before.12Interestingly, this was not accompanied by a similar increase in the share in labor andcapital. While the pace of the decline in the share of labor slowed, and the share of capitalincreased after about two years, no large and immediate reallocation of resources took place,as a standard frictionless model would predict after the devaluation. This suggests that costsof adjustment of labor and capital can be important in explaining the response of output inboth sectors.12Meza and Urrutia (2010) analyze the long run behavior of the real exchange rate in Mexico and linkedit to this process of structural transformation of the economy, together with a decline in the cost in foreignborrowing due to financial liberalization.93 The Baseline ModelIn this section we set up the baseline model with the financial friction. As mentionedearlier, the model economy is a small open economy which produces traded and non-tradedgoods. Both goods are combined to produce a final good which is consumed and invested.Traded and non traded goods are also combined to produce the intermediate good usedin their production. In addition, the traded good is exported and used for borrowing andlending. A representative firm in each sector produces according to a constant returns toscale production function using capital, labor and intermediate goods.We introduce the financial friction as a working capital requirement for production. Asin Mendoza and Yue (2009), intermediate goods must be purchased in advance of productionusing (short term) borrowing in traded goods.13In the small open economy, the interest rateon these loans is given by the world real interest rate. During the sudden stop, an increasein interest rates, through its effects on the purchase of intermediate goods, will increase thecost of production.A representative consumer supplies labor and rents capital to each sector, demandsfinal goods, invests in capital goods, and borrows or lends from abroad at the world interestrate. At each period, all factor and goods markets clear. The price of the final good is thenumeraire. We now describe this economy in detail.Consumers The representative consumer is endowed with one unit of labor which is sup-plied inelastically.14Each period, the consumer consumes the final good Ct, saves/borrowsin foreign bonds Bt+1valued at the price of traded goods pTt, and invests in capital Kt+1.The consumers problem can be written asmaxCt,Kt+1,Bt+1∞t=0βtC1−σt− 11 − σ13Schwartzman (2010) provides evidence that output reallocates from industries with high inventory tovariable cost ratios towards industies with lower ratios in times of interest rate increase, indicating thatholding these inventories in advance of production may be costly.14Since our main interest is understanding the movements in TFP and their contribution to a fall inoutput, we abstract from variations in factor use as an explanation for a fall in GDP.10[...]... significant fall in output and TFP, but it cannot account for the sectoral reallocation Including either one of the labor or capital frictions is not sufficient, since the other factor can always adjust to meet the increased demand for the traded good after the sudden stop Both these frictions are necessary to observe the drop in output and the sectoral patterns of reallocation observed in the data 27 Table... reallocation frictions actually 23 mitigate the misallocation of resources engendered by the financial friction This is because of the rate of growth of the price of tradable goods, which enters in the definition of the gross interest rate which governs the size of the wedge between the producer and user cost of intermediate goods: Rt+1 = (1 + rt+1 ) pT t+1 pT t With allocative frictions, the price of the traded... for the denominator gives us the first ratio.15 The second ratio comes from the NIPA data and is the ratio of gross output to total intermediate goods The product of these ratios gives us a value of κ = 0.7 This is lower than the value of κ = 1 used in Neumeyer and Perri (2005) and Uribe and Yue (2006) However, it is higher than the 10 percent value used in Mendoza and Yue (2009), who calibrate it to the. .. sector, following the real depreciation However the data does not support the reallocation of productive factors implied by the model Clearly if our model is to match the sectoral data, we need to understand the frictions that impede the reallocation of factors of production We introduce such frictions in the following section 20 Real GDP in the N Sector Real GDP in T Sector 120 115 110 105 100 95 90... (7) = wt + rt Kt + (Rt+1 − 1) κpM Mt t (8) using the value of final goods, the sum of all value added and the total income in the economy respectively The last term in equation (8) is the income of the intermediary in the current period and is equal to pM − pM Mt t t The current account balance can be derived by noting that the budget constraint of the consumer wt + rt Kt = Ct + Kt+1 − (1 − δ) Kt +... (57 percent) of the latter TFP also fell in both sectors, more in the non traded, than in the traded goods sector We see therefore that our model augmented with labor market frictions and capital specificity can account for about 40 percent of the decline in TFP and more than half the fall in aggregate output per worker In addition, it is consistent with the patterns of reallocation of labor and capital... using the equality between equations (6) and (8) on the left hand side and substituting equation (5) on the right hand side This implies that the balance of payments identity is ∗ pT Bt+1 − (1 + rt ) pT Bt − κpM Mt + Rt κpM Mt−1 = pT N Xt t t t t−1 t where the net foreign asset position of the country includes not only the stock of foregin bonds, but also (with a minus sign) the debt position of financial... value of the labor share below the steady state value, the share of labor increases till 21 Comparing the responses of the economy which starts with a non steady state level of capital to an economy at steady state is misleading since the former economy has less capital than the latter, and will have lower output for that reason 22 This type of convergence along the transitional path is key for the results... as before where interest rates are unexpectedly increased for two periods The aggregate effects of the sudden stop are shown in Figures 6 Aggregate output and TFP per worker falls by 2.5 percent, compared to 3.5 percent in the case without labor and capital frictions This accounts for more than half of the fall in output per worker and a third of the fall in TFP Somewhat counterintuitively, the reallocation... account for about one third of the decline in GDP in the data (as seen in Table 1), we compare its predictions to macroeconomic aggregates per worker The Real Exchange Rate and Current Account Since the economy saves in traded goods, the demand for traded goods also goes up as interest rates increase, putting upward pressure on the relative price of the traded good The lower left panel of Figure 4 shows the . listed on the stock market.We calculate the cost of credit for the median firm as the ratio of the real value of interestpayments to the real value of the stock. Financial Frictions and Total Factor Productivity: Accounting for the Real Effects of Financial Crises 1Sangeeta Pratap Carlos
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