Financial conditions and the business cycles in emerging markets

ABSTRACT

This article assesses the role of financial conditions in business cycles in emerging markets. Evidence from nonlinear vector autoregression (VAR) model relating macroeconomic variables to a proxy of financial conditions suggests that (a) stressful times occur with considerable frequency, about 28$\mathrm{\%}$ of the time; (b) second moments of the main macroeconomic variables are regime-dependent, potentially more correlated with GDP and with larger volatility under financial distress conditions; (c) consumption is more volatile than GDP under both regular financial and financial distress condition; (d) duration of the financial instability period is estimated to be about 4.7 quarters; and (e) strong amplification effects exist, potentially related to the tightening of credit conditions.

KEYWORDS:

• Financial Conditions
• Bayesian Threshold VAR
• Emerging Markets Business Cycles

JEL CLASSIFICATION:

• E32
• E44
• F41
• F30
• F34

Acknowledgments

I would like to thank Ricardo Sabbadini and Paulo Lins for their helpful comments on an early version of the article.

Disclosure statement

No potential conflict of interest was reported by the author.

Supplementary Material

Supplemental data for this article can be accessed here.

Notes

¹ Throughout the article, we use the terms ‘financial distress’, ‘financial instability’, or ‘stressful times’ interchangeably.

² For a comparison, the so-called sudden stops are said to be rare events, occurring in less than $4\mathrm{\%}$ of time (see Calvo, Izquierdo, and Talvi 2006; Mendoza 2010). The methodology employed here treats such events as extreme realizations of financial distress.

³ The sub-indices are a banking sector stress index, a foreign market pressure index, two measures of equity market instability, and a sovereign debt stress index. For details, see the online appendix. However, we depart from the authors by estimating the FSI using the method proposed by Koop and Korobilis (2014), because it can deal with unbalanced series and can purge the macroeconomic shocks from the FSI so that it may reflect only financial shocks. Plots of the estimated FSI are available in the online appendix.