Capital Inflows, Financial Development, and Credit Constraints at the Firm Level: Theory and Evidence
Armenta Reales, Armando Jose
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This dissertation is composed of two related essays on the effects of periods of large capital inflows on macroeconomic aggregates and financing constraints at the firm level, and the relationship of the differences in these effects among developed and emerging economies with the degree of financial development. In the first essay I conduct an empirical exploration of this topic. I show that periods of large capital inflow are associated with more volatile macroeconomic outcomes in economies with a low degree of financial development, relative to economies with more developed financial systems. Employing firm level data for 42 countries, I show that firms in economies with a low level of financial development exhibit a relatively larger loosening in the cost of borrowing and a larger appreciation in equity prices. I show that financing constraints are more prevalent in firms located in countries with a low degree of financial development. Moreover, periods of capital inflow booms relax these financing constraints. This decrease is significant regardless of the composition of capital inflows, stronger when coupled with domestic credit booms, larger for firms in the non-tradable sector and larger for firms that depend more heavily on internal funds to finance their investment opportunities. In the second essay, using a theoretical model, I explain the larger aggregate response around capital inflow booms, as arising from varying degrees of financial development, and their relation to the pervasiveness of credit constraints at the firm level. I propose a heterogeneous agents model in which the share of borrowing-constrained agents depends on the level of financial development. Agents in an economy characterized by a low degree of financial development can use a lower share of their assets, measured at their market value, as collateral to secure debt. I show that a period of large capital inflow causes an increase in the demand for capital for both unconstrained and constrained firms. At the initial valuation of capital, only unconstrained firms can freely adjust their demand for capital. However, the increase in the aggregate demand for capital increases its valuation and thus generates a loosening in financing constraints for ex-ante constrained firms, and an amplified response at the firm level and on macroeconomic aggregates.