Focuses of Research

My current research focuses on impacts of international financial frictions on international capital flows and risk-sharing and sovereign defaults. Other research interests include long-run behavior of real exchange rates, the world income distribution and financial crisis.

Working Papers:

1.  Capital Structure and Contract Enforcement   Joint with Cristina Arellano and Yan Bai, February 2007

This paper studies how the degree of contract enforcement in a country influences firms' capital structures. We first document the capital structure for a new dataset of firms in two countries, Ecuador and the UK, that feature different degrees of contract enforcement. We find that capital structure is different in these two countries in terms of mean leverage and the leverage-size relation. In Ecuador leverage ratios are lower and smaller firms have smaller leverage ratios than large firms. In the UK leverage ratios are higher and bigger firms have smaller leverage ratios. We build a model of heterogeneous firms in an environment with lack of enforcement in debt contracts that delivers the observed capital structure in the data. In the model, the degree of contract enforcement acts like a tax or subsidy on the amount of borrowing for all firms. Weak contract enforcement corresponds to a tax that limits loans for all firms but hurts small firms more because their firm value relative to the tax is smaller and thus debt financing is more constrained. Strong contract enforcement corresponds to a subsidy on all firms that enables them to issue more debt but also helps disproportionately small firms given that the subsidy relative to their value is large. We quantify our mechanisms by calibrating our model to the firm datasets in the two countries and find that different degrees of enforcement can provide a unified rational for the differential capital structure observed in the data.

2.  Sovereign Debt Renegotiation: 1980s vs 1990s   Joint with Yan Bai, January 2007

Features of sovereign debts restructuring in 1980s and 1990s are quite different in two aspects. One is that the renegotiation periods are longer in 1980s than in 1990s, in spite of the fact that sovereign borrowing in 1980s is mainly bank loans with several big creditors, while in 1990s it is mainly bonds with a large number of small creditors. The other is that the overall haircut (debt discharge) rate is higher in 1990s than in 1980s. In this paper we study these features using a game-theoretical model with coordination problems and repeated renegotiations. The key difference between 1980s and 1990s is the existence of secondary markets for bonds in 1990s. The markets play two roles. First, the liquidity of bonds lowers the reservation values of current bondholders. Second, the prices offer higher precision of the signal on the reservation values of bondholders. The lower reservation value generates higher hair cut rates in the bond debt relative to the bank debt. The higher precision of signal produces a shorter period of renegotiation in the bond debt relative to the bank debt. There exists a unique equilibrium in the economy with a large number of small bondholders in that only a fraction of them choose to hold the bonds given the others accept the deal proposed by the government.

3. Solving the Feldstein-Horioka Puzzle with Financial Frictions   Joint with Yan Bai, July 2006

Contrary to the prediction of a frictionless open economy model, long-term averages of savings rates and investment rates are highly correlated across countries. This puzzle was first identified by Feldstein and Horioka in 1980. Updated data and predictions of a calibrated complete markets model confirm that the puzzle still exists. It can be solved by incorporating into a standard complete markets model two types of financial frictions: limited spanning, which restricts countries to trade only uncontingent bonds, and limited enforcement, which penalizes countries for reneging on debt contracts by excluding them from international financial markets. Each of these frictions, when added alone to the complete markets model, fails to solve the Feldstein-Horioka puzzle; each alone allows too much capital to flow across countries, which drives the savings-investment correlation close to zero. Together in the model, however the two frictions interact to greatly constrain capital flows to the level observed in the data and solve the puzzle.

4. Financial Integration and International Risk Sharing   Joint with Yan Bai, May 2005

In the last two decades, financial integration has increased dramatically across the world. At the same time, the fraction of countries in default has more than doubled. Contrary to theory, however, there appears to have been no substantial improvement in the degree of international risk sharing. To account for this puzzle, we construct a general equilibrium model that features a continuum of countries and default choices on state-uncontingent bonds. We model increased financial integration as a decrease in the cost of borrowing. Our main finding is that as the cost of borrowing is lowered, financial integration and sovereign default increases substantially, but the degree of risk sharing as measured by cross section and panel regressions increases hardly at all. The explanation, we propose, is that international risk sharing is not sensitive to the increase in financial integration given the current magnitude of capital flows because countries can insure themselves through accumulation of domestic assets. To get better risk sharing, capital flows among countries need to be extremely large. In addition, although the ability to default on loans provides state contingency, it restricts international risk sharing in two ways: higher borrowing rates and future exclusion from international credit markets.