Focuses of Research
My research focuses on impacts of international financial frictions on
international capital flows and risk-sharing and sovereign defaults. Other
research interests include structural change in open economies, firm financing
and growth patterns across countries, and impacts of financial crisis on firm
behavior and exporting decisions.
Solving the Feldstein-Horioka Puzzle with Financial Frictions, joint with Yan Bai, forthcoming, Econometrica.
Unlike the prediction of a frictionless open economy model, long-term average savings and investment rates are highly correlated across countries---a puzzle first identified by Feldstein and Horioka (1980). This paper quantitatively investigates the impact of financial frictions on this correlation. We consider two financial frictions. One is limited enforcement, where contracts are enforced by the threat of default penalties. The other is limited spanning, where the set of available assets is restricted to noncontingent bonds. We find that the calibrated model with both frictions produces a savings-investment correlation and a volume of capital flows close to the data. For the limited enforcement friction to solve the puzzle, we need implausibly lenient default penalties, under which capital flows are too low compared to those found in the data. For the limited spanning friction to solve the puzzle, we need to exogenously restrict the volume of capital flows to the level in the data. The two frictions have an important interaction which endogenously reduces capital flows. Limited enforcement generates endogenous debt limits to ensure that countries have an incentive to repay. When limited enforcement is combined with limited spanning, these debt limits become more restrictive since (i) they ensure repayment even under the worst contingency and (ii) the repayment incentive is low when only noncontingent bonds are traded. As a result, the two-friction model generates a volume of capital flows and a savings-investment correlation like those in the data.
Technical Appendix 1 Technical Appendix 2
Working Papers:
1. Firm Dynamics and Financial Development, joint with Cristina Arellano and Yan Bai, December 2008, submitted
This paper studies how financial development in an economy influences firms' financing and growth. We first document empirically the debt financing and growth patterns of firms with a large and comprehensive dataset from 22 European countries. We find that in less financially developed economies, small firms grow faster and have lower debt to asset ratios than large firms. We then develop a quantitative model where financial development drives firm growth and debt financing through the availability of credit. We parameterize the model to the firms' financial structure in the data and show that financial development can rationalize the difference in growth rates between firms of different sizes across countries.
2. Duration of Sovereign Debt Renegotiation, joint with Yan Bai, March 2009
The structure of sovereign debt has evolved over time from illiquid bank loans toward liquid bonds that are traded on the secondary market in the past two decades. This change in the debt structure is accompanied with a reduction in the duration of sovereign debt renegotiation; it takes on average 9 years to restructure bank loans, but only 1 year to restructure bonds. In this work, we argue that the secondary market plays an important role --- information revelation --- in reducing the renegotiation length. We construct a dynamic bargaining game between the government and the creditors with private information on the creditors' reservation value. The government uses costly delays as a screening device for the creditors' type, and so the delays arise in equilibrium. Moreover, the more severe is the private information, the longer the delays are. When we introduce the secondary market, the equilibrium delays are greatly reduced. This is because the secondary market price conveys information about the creditors' reservation and lessens the information friction. We also find that bond financing is more friendly to the debtor country; it increases ex-ante borrowing and investment and ex-post renegotiation welfare of the government.
3. Financial Integration and International Risk Sharing, joint with Yan Bai, May 2009, submitted
Conventional wisdom suggests that financial liberalization can help countries insure against idiosyncratic risk. There is little evidence, however, that countries have increased risk sharing despite recent widespread financial liberalization. This work shows that the key to understanding this puzzling observation is that conventional wisdom assumes frictionless international financial markets, while actual international financial markets are far from frictionless. In particular, financial contracts are incomplete and enforceability of debt repayment is limited. Default risk of debt contracts constrains borrowing, and more importantly, it makes borrowing more difficult in bad times, precisely when countries need insurance the most. Thus, default risk of debt contracts hinders international risk sharing. When countries remove their official capital controls, default risk is still present as an implicit barrier to capital flows; the observed increase in capital flows under financial liberalization is in fact too limited to improve risk sharing. If default risk of debt contracts were eliminated, capital flows would be six times greater, and international risk sharing would increase substantially.
4. Structural Transition in Open Economies, joint with Kei-Mu Yi, May 2009, upcoming soon
We study the impact of international trade on structural change. We employ a three-sector Ricardian trade model with neoclassical growth. We show that the presence of international trade generates two key predictions. First, even if manufacturing is the fast growing sector, it is possible for the manufacturing employment share to have a hump pattern. Second, the rate of structural transformation is faster, the more open the economy. We calibrate our model to match initial conditions in a "representative" emerging market economy. We then reduce trade costs and examine the implications for structural change. We find that our model can help resolve anomalies from closed economy models in a quantitatively important way.
5. Decentralized Borrowing and Decentralized Default, joint with Yun Jung Kim, May 2009, upcoming soon