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UNIVERSITI PUTRA MALAYSIA FINANCIAL INTERMEDIARY DEVELOPMENT, OUTPUT AND EXPORT UNDER CREDIT MARKET IMPERFECTIONS TANG KIN BOON FEP 2007 10

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UNIVERSITI PUTRA MALAYSIA

FINANCIAL INTERMEDIARY DEVELOPMENT, OUTPUT AND EXPORT

UNDER CREDIT MARKET IMPERFECTIONS

TANG KIN BOON

FEP 2007 10

FINANCIAL INTERMEDIARY DEVELOPMENT, OUTPUT AND EXPORT UNDER CREDIT MARKET IMPERFECTIONS

By

TANG KIN BOON

Thesis Submitted to the School of Graduate Studies, Universiti Putra Malaysia, in Fulfilment of the Requirements for the Degree of Doctor of Philosophy

December 2007

DEDICATION

To My Father, Mother and Sook Sin…

ii

Abstract of thesis presented to the Senate of Universiti Putra Malaysia in fulfilment of the requirement for the degree of Doctor of Philosophy

FINANCIAL INTERMEDIARY DEVELOPMENT, OUTPUT AND EXPORT

UNDER CREDIT MARKET IMPERFECTIONS

By

TANG KIN BOON

December 2007

Chairman : Associate Professor Tan Hui Boon, PhD Faculty : Economics and Management This study examines the long-run relationship between financial intermediary

development, output and export under three credit market imperfections – role of

financial intermediaries, financial accelerator and currency mismatch. In particular,

this study has (1) examined the direct relationship between financial intermediary

development and output fluctuations (2) examined the dampening and magnifying

effects of financial intermediaries on output fluctuations via the propagation of real

and monetary shocks, (3) examined the impact of exchange rate movements on

exports under the condition of foreign currency borrowing and credit constraint and

(4) evaluated the impact of external finance premium on various sectorial

productions and aggregate outputs growth. An aggregate data panel is constructed

for the countries under study and the cointegration hypothesis among the variables

is verified using Pedroni’s and Westerlund’s panel cointegration tests. The

idiosyncratic, individual and group-mean panel cointegrating vectors are then

estimated using FMOLS and DOLS developed by Pedroni.

iii

Using data from 17 countries at different income levels in East Asia-Pacific, the

empirical results indicate that (1) strong and robust evidence for dampening effect

of real shocks, (2) somewhat weak evidence for magnifying effect of monetary

shocks, (3) financial intermediary development to some extent have direct impact on

output fluctuations if countries are bank-dependent, (4) the larger the level of

country’s foreign debt and credit constraint results more negative response of

exports to currency depreciation, (5) country’s export with high foreign currency

denominated debt are more vulnerable to negative exchange rate shocks and (6) the

negative relationship between the external finance premium and the aggregate

output growth seems to be strengthened in middle income than in the sectorial

production growth.

iv

Abstrak tesis yang dikemukakan kepada Senat Universiti Putra Malaysia sebagai memenuhi keperluan untuk ijazah Doktor Falsafah

PEMBANGUNAN PENGANTARA KEWANGAN, HASIL KELUARAN DAN

EKSPORT DI BAWAH KETIDAKSEMPURNAAN PASARAN KREDIT

Oleh

TANG KIN BOON

Disember 2007

Pengerusi : Profesor Madya Tan Hui Boon, PhD Fakulti : Ekonomi dan Pengurusan Penyelidikan ini mengkaji hubungan jangka panjang di antara pembangunan

pengantara kewangan, hasil keluaran dan eksport di bawah tiga ketidaksempurnaan

pasaran kredit – peranan pengantara kewangan, pemecut kewangan dan

ketidakpadanan mata wang. Secara khususnya, penyelidikan ini telah (1) mengkaji

hubungan langsung di antara pembangunan pengantara kewangan dan

ketidakstabilan hasil keluaran, (2) mengkaji kesan-kesan pelembapkan and

pembesaran pengantara kewangan ke atas ketidakstabilan hasil keluaran melalui

pembeluasan kejutan-kejutan asli dan kewangan, (3) mengkaji kesan tekanan kadar

tukaran asing ke atas eksport di bawah syarat peminjaman mata wang asing dan

kekangan kredit, (4) menilai kesan tekanan premium kewangan luar ke atas indeks

pengeluaran and hasil keluaran berjumlah. Data panel dibina untuk negara-negara di

bawah kajian dan hipotesis hubungan integrasi antara faktor-faktor telah disahkan

dengan menggunakan ujian-ujian panel hubangan integrasi yang direka oleh Pedroni

dan Westerlund. Vektor-vektor individu dan kumpulan rata ditaksir dengan

menggunakan teknik FMOLS and DOLS yang direka oleh Pedroni.

v

Dengan menggunakan data dari 17 negara-negara di Asia-Pacific Timur yang

separas dengan tingkat pendapatan yang berlainan, hasil-hasil empirik menunjukkan

(1) bukti yang kukuh dan konsisten mengenai kesan pelembapkan oleh kejutan asli,

(2) bukti yang lemah mengenai kesan pembesaran oleh kejutan kewangan, (3) pada

tahap tertentu pembangunan pengantara kewangan menunjukkan kesan langsung ke

atas ketidakstabilan hasil keluaran di negara-negara yang sangat bergantung kepada

bank, (4) hutang luaran dan kekangan kredit negara yang tinggi akan mengakibatkan

balasan negatif eksport, (5) hutang mata wang asing negara yang tinggi juga akan

mengakibatkan eksportnya lebih mudah diserang oleh kejutan-kejutan negatif

tukaran asing dan (6) hubungan premium kewangan luar dengan perkembangan

hasil keluaran berjumlah adalah lebih kukuh di negara-negara berpendapatan tengah

berbanding dengan hubungannya dengan perkembangan indeks pengeluaran.

vi

ACKNOWLEDGEMENTS I am deeply grateful to my supervisor, Associate Professor Dr. Tan Hui Boon, for

the confidence she has shown in me. I would like to express my deepest

appreciation to her for generous supervision, advice and patience throughout the

completion of this thesis. She has continued her valuable assistance by giving

suggestions and insights.

Valuable comments of two members of the supervisory committee, Associate

Professor Dr. Zulkornain Yusop and Dr. Zaleha Mohd Noor are greatly appreciated.

Without their support, this thesis would likely not have matured.

I have also benefited from valuable comments, suggestions and helps from Joakim

Westerlund, Peter Pedroni, Nasri Harb and Thorsten Beck.

vii

I certify that an Examination Committee has met on 12th December 2007 to conduct the final examination of Tang Kin Boon on his Doctor of Philosophy thesis entitled “Financial Intermediary Development, Output and Export under Credit Market Imperfections” in accordance with Universiti Pertanian Malaysia (Higher Degree) Act 1980 and Universiti Pertanian Malaysia (Higher Degree) Regulations 1981. The Committee recommends that the student be awarded the degree of Doctor of Philosophy. Members of the Examination Committee were as follows: Law Siong Hook, PhD Senior Lecturer Faculty of Economics and Management Universiti Putra Malaysia (Chairman) Taufiq Hassan, PhD Lecturer Faculty of Economics and Management Universiti Putra Malaysia (Internal Examiner) Zulkarnain Muhamad Sori, PhD Associate Professor Faculty of Economics and Management Universiti Putra Malaysia (Internal Examiner) Mansor Hj. Ibrahim, PhD Professor Kulliyyah Ekonomi dan Sains Pengurusan Universiti Islam Antarabangsa Malaysia (External Examiner) _______________________________

HASANAH MOHD. GHAZALI, PhD Professor and Deputy Dean School of Graduate Studies Universiti Putra Malaysia Date: 29 January 2008

viii

This thesis was submitted to the Senate of Universiti Putra Malaysia and has been accepted as fulfilment of the requirement for the degree of Doctor of Philosophy. The members of the Supervisory Committee were as follows: Tan Hui Boon, PhD Associate Professor Faculty of Economics and Management Universiti Putra Malaysia (Chairman) Zulkornain Yusop, PhD Associate Professor Faculty of Economics and Management Universiti Putra Malaysia (Member) Zaleha Mohd Noor, PhD Lecturer Faculty of Economics and Management Universiti Putra Malaysia (Member) _______________________________

AINI IDERIS, PhD Professor and Dean School of Graduate Studies Universiti Putra Malaysia Date: 21 February 2008

ix

DECLARATION I hereby declare that the thesis is based on my original work except for quotations and citations which have been duly acknowledged. I also declare that it has not been previously or concurrently submitted for any other degree at UPM or other institutions.

________________ TANG KIN BOON Date: 1 January 2008

x

TABLE OF CONTENTS

Page DEDICATION iiABSTRACT iiiABSTRAK vACKNOWLEDGEMENTS viiAPPROVAL viiiDECLARATION xLIST OF TABLES xivLIST OF FIGURES xviLIST OF ABBREVIATIONS/NOTATIONS/GLOSSARY OF TERMS xvii CHAPTER 1 INTRODUCTION

1.1. Background 11.1.1. External Finance Premium and Output Fluctuations 81.1.2. Balance Sheet Effects 121.1.3. Bank Lending Effects 151.1.4. Monetary Policy, Currency Mismatch and Exchange Rate

Movements 20

1.1.5. Asian Exports and Exchange Rate Movements During the Crisis

24

1.1.6. Credit Boom-Bust Cycle and Economic Growth 281.2. Problem Statement 30

1.2.1. Do Financial Intermediary Developments affect Output Fluctuations?

30

1.2.2. Do Credit Market Imperfections Amplify or Dampen Output Fluctuations?

31

1.2.3. Why East Asian Exports Stagnated or Fell after the Currency Crisis?

33

1.2.4. Does Agency Cost Reduce or Increase Output Growth? 351.2.5. Financial Constraints: Are SMEs more Credit Constrained

than LMs? 36

1.3. Objectives of the Study 381.4. Significance of the Study 39

2 LITERATURE REVIEW 43

2.1. Financial Intermediary Development and Output Fluctuations 442.1.1. Financial Accelerator 442.1.2. Credit Market Imperfections and Output Fluctuations 472.1.3. Do Intermediaries Dampen or Magnify Shocks? 552.1.4. Financial Accelerator and Macroeconomic Fluctuations:

Empirical Evidence 65

xi

2.1.5. Monetary Policy as an Exogenous Shock to Agency Costs 682.1.6. Extensions of the Credit Market Imperfections 69

2.2. Credit Market Imperfections and the Impact of Exchange Rate Movements on Exports

73

2.2.1 Exchange Rate Movements and International Trade under Foreign Currency Borrowing

73

2.2.2 Related Empirical Evidence of Foreign Currency Borrowing 762.2.3 Exchange Rate Movements and International Trade under

Credit Constraint 77

2.2.4 The Complimentary Effect of Foreign Currency Borrowing and Credit Constraint

80

2.3. Credit Channel 832.3.1 Balance Sheet Channel 832.3.2 Bank Lending Channel 872.3.3 Predictability of External Finance Premium 942.3.4 Balance Sheet Effects and Firms Size 96

2.4. Financial Intermediary Development and Growth 982.4.1. How does Financial Intermediary Development affect

Economic Growth? 98

2.4.2. Related Empirical Literature 101 3 THEORETICAL MODELING AND METHODOLOGY 107

3.1. Theoretical Models 1073.1.1. A Model of Financial Development and Output Fluctuations

based on Beck, Lundberg and Majnoni (2006) 107

3.1.2. Testable Hypotheses 1153.1.3. A Model of Agency Costs based on Bernanke, Gertler and

Gilchrist (1996) 116

3.1.4. Implications of External Finance Premium 1203.1.5. A Model of Export Functions based on Goldstein and Kahn

(1978) 122

3.2. Empirical Models 1253.2.1. Direct Effect of Financial Intermediary Development on

Output Fluctuations 126

3.2.2. Indirect Effect of Financial Intermediary Development on Output Fluctuations

128

3.2.3. Credit Market Imperfections and the Impact of Exchange Rate Movements on Exports

129

3.2.4. Testing for Amplification Effects 1333.2.5. Financing Opportunities Across Sectors 134

3.3. Panel Data Model 1353.4. Panel Unit Root Tests 135

3.4.1. Im, Pesaran and Shin (2003) test 1363.4.2. Fisher ADF and PP tests 137

3.5. Panel Cointegration Tests 1383.5.1. Pedroni Heterogeneous Panel Tests 139

xii

3.5.2. Westerlund Panel Invariance Tests 1433.5.3. Westerlund Panel CUSUM Test 1473.5.4. Westerlund Panel Structural Break Test 1483.5.5. Contribution of the Current Methods 150

4 RESULTS AND DISCUSSIONS 152

4.1. Financial Intermediaries Development and Output Fluctuations 1524.1.1 Direct Impact of Financial Intermediary Development on

Output Fluctuations 157

4.1.2 Dampening and Magnifying Effects of Financial Intermediary Development on Output Fluctuations

163

4.2. The Effects of Foreign Currency Borrowing and Financial Development on Export

177

4.2.1 Traditional Competitiveness Effect 1874.2.2 Effect of Foreign Currency Borrowing 1884.2.3 Effect of Financial Development 1894.2.4 Amplification Effect of Financial Development 1914.2.5 Amplification Effect of Exchange Rate 1924.2.6 Results based on ASEAN-5 196

4.3. The Effects of External Finance Premium on Sectorial Production Index and Aggregate Output

199

5 CONCLUSION AND POLICY IMPLICATIONS 218

5.1. Discussion and Conclusion 2185.1.1 Financial Development and Output Fluctuations 2195.1.2 Financial Development, Foreign Currency Borrowing and

Exports 220

5.1.3 External Finance Premium and Output Growth 2225.2. Policy Implications 224

5.2.1 Monetary Policy, Financial Development and Output Fluctuations

224

5.2.2 Foreign Debt Management 2265.2.3 Choice of Exchange Rate Regime Under Imperfect Credit

Markets 227

5.2.4 Credit Effects and Macroeconomic Policies 229 REFERENCES 232APPENDICES 244BIODATA OF THE AUTHOR 277

xiii

LIST OF TABLES

Table Page 1-1 Gross flow of financial liabilities of non-financial corporate

sector (in percentage)

15

1-2 Estimated total NPLs (in percentage of all loans)

16

3-1 Reduced-form coefficients

124

3-2 Pedroni panel cointegration statistics

140

4-1a Panel unit root tests

161

4-1b Panel cointegration test results (Direct relationship between financial development and output fluctuations)

162

4-1c Panel cointegration test results (Indirect relationship between financial intermediary development and output fluctuations)

165

4-1d Group-mean FMOLS estimates of the indirect effect of financial intermediary development on output fluctuations

169

4-1e Individual DOLS estimates of the indirect effect of financial intermediary development on output fluctuations via the propagation of real shocks

174

4-1f Individual DOLS estimates of the indirect effect of financial intermediary development on output fluctuations via the propagation of monetary shocks

175

4-2a Panel unit root tests

183

4-2b Pedroni’s heterogeneous panel cointegration test results (Aggregate relationship between exports, foreign liability and financial development)

185

4-2c Pedroni’s heterogeneous panel cointegration test results (Segmented relationship between exports and foreign liability or financial development)

186

4-2d FMOLS and DOLS estimates of export, foreign liability, financial development and the amplification effects

194

xiv

4-2e DOLS estimates of export, foreign currency borrowing and financial development for ASEAN-5

198

4-3a Pedroni’s heterogeneous panel cointegration test results (Sectorial effects)

205

4-3b Pedroni’s heterogeneous panel cointegration test results (Aggregate effects)

206

4-3c Westerlund’s panel cointegration test results (Sectorial effects)

207

4-3d Westerlund’s panel cointegration test results (Aggregate effects)

208

4-3e FMOLS and DOLS estimates of the impact of external finance premium on sectorial production growth

214

4-3f FMOLS and DOLS estimates of the impacts of external finance premium on aggregate output growth

216

xv

LIST OF FIGURES

Figure Page 1-1 Changes in external finance premium and GDP growth

11

1-2 Changes in external finance premium and the ratio of gross fixed capital formation to stock indexes

14

1-3 Evolution of intervention rates

17

1-4 Changes in external finance premium and domestic credit

19

1-5 Evolution of exchange rates

21

1-6 External debt in foreign currency (in US$)

22

1-7 Debt service in foreign currency (% of GNP)

23

1-8 Monthly East Asian exports

24

1-9 Credit boom-bust cycle

29

2-1 Balance sheet channel

85

2-2 Bank lending channel

88

2-3 Adverse consequences of increases in interest rates 89

xvi

xvii

LIST OF ABBREVIATIONS/ NOTATIONS/ GLOSSARY OF TERMS

ADF Augmented Dickey-Fuller

DGP Data Generating Process

DOLS Between-dimension Dynamic OLS

FD Financial intermediary development

FMOLS Between-dimension Fully Modified OLS

GMM Generalized Method of Moment

H-P filter Hodrick-Prescott filter

IFS International Financial Statistics

IPS Im, Pesaran and Shin

IV Instrumental Variable

PP Phillips-Perron

PZ Parametric Statistic

SPR External Finance Premium (Interest Rate Spread)

SZ Semi-parametric Statistic

TFP Total Factor Productivity

VRG Group-Mean Ratio Statistic

VRP Panel-Variance Ratio Statistic

WBES World Business Environment Survey

WDI World Development Indicators

CHAPTER 1

INTRODUCTION

1.1. Background

Standard macroeconomic models typically assume that credit markets are perfect. In

recent years, however, a body of theoretical work has challenged the key

assumptions required for perfect credit markets. 1 The current work on the

mechanics of credit market imperfections suggests that output and trade are

interrelated with private credit and foreign debt. The financial crisis in East Asia has

rekindled economists’ interest in the reasons and consequences of intervention in

the financial markets. A lesson seems to have emerged from the issue of financial

crisis, the role of financial intermediaries, bank failures and balance of payment

problems. It seems that holding of excessive foreign currency liabilities by firms

and banks have played havoc in East Asia. The external debt that many Asian

countries accumulated to finance their development was almost strictly denominated

in foreign currencies which are external to the region. 2 Besides, the crisis has

highlighted the role financial development in propagating negative shocks to the

economy. This is naturally led to an interest in the determinants of these frictions

and their effects on the macroeconomy, particularly on output fluctuations and

export. In light of that, credit market imperfections that based on asymmetric

information, agency costs and other credit frictions in financial markets, is one of

the theories that has been advanced in an attempt to provide a plausible explanation

for the propagation of cyclical fluctuations.

1 See Bernanke (1983), Bernanke and Gertler (1989) and Bernanke et al. (1998). 2 See Bordo and Meissner (2006) for the role of foreign currency debt in financial crises.

Over the last two decades, East Asian economies have experienced accelerate

financial development, periods of rapid credit expansion, associated with high level

foreign borrowing and rapid economic growth.3 Concerns have been raised on the

role of excessive credit growth in the previous financial crises in Asian markets.

These problems are associated with low investment, sharp increases in insolvencies

and bankruptcies, rising debt burdens, collapsing equity prices, bank failures, high

rate of defaults and output contraction. The third generation crises models have

considered credit market imperfections as key fundamentals. According to this

view, deteriorating credit market conditions are not simply passive reflections of a

declining real economy, but are in themselves a major factor depressing economic

activity. The key elements described above are based on borrowers’ credit

worthiness, supply of loans by commercial banks, unwarranted non-performing

loans and companies with excessive foreign currency-denominated debt. These

factors are among the most important elements in explaining both the credit and

output fluctuations in the region. This third generation model is particularly well

suited to analyze the case of economies like in East Asia, where the source of

currency crises lied primarily in the deteriorating balance sheets of private domestic

firms and commercial banks rather than in uncontrolled budget deficit policies by

local governments (e.g., see Mishkin, 1999).

3 The main stylized facts on credit expansion and output cycles are described in Schneider and Tornell (2004).

2

The idea that credit market imperfections play a central role in the propagation of

cyclical fluctuations has a long-standing tradition in macroeconomics. Since Irving

Fisher’s debt-deflation theory of Great Depression, many economists have argued

that deteriorating credit market conditions are in themselves a major factor

depressing real economic activity. Beginning with Bernanke and Gertler (1989) and

Kiyotaki and Moore (1997) balance sheet effects were the initial efforts to introduce

such effects into mainstream economic models in a formal way. In particular,

endogenous developments in credit markets may work to propagate and amplify

shocks to the economy (Bernanke and Gertler, 1995). More recently, Beck et al.

(2006) has developed a theoretical model to assess the dampening effect of real

shocks and magnifying effect of monetary shocks on output fluctuations.

Under credit market imperfections, output relates to the net effect of the procyclical

movements in borrowers’ net worth (i.e. balance sheet effects) and countercyclical

movements in the external finance premium (i.e. the difference between the cost of

funds raised externally and the opportunity cost of funds generated internally). Such

a mechanism tends to constrain profitable investment opportunities and to produce

inefficient decline in output. Within this context, balance sheets of some economic

agents are highly vulnerable to adverse demand shocks because of the liabilities

accumulated during the credit boom periods. These balance sheet exposures can be

the sources of amplification and propagation during the downturn. One can define

that the degree of credit market imperfections are depending on the magnitudes of

these balance sheets exposures to negative aggregate shocks.

3

The traditional “credit channel” literature examines the impact of asymmetric

information via the changes in agency costs on real spending and economic activity.

Literature of credit channel is divided into two schools of thought, balance sheet and

bank lending channels. The bank credit channel analyses the impact of shocks on

the supply of loans by depository institutions, whereas the balance sheet channel

focuses on the potential impact of shocks on firms’ balance sheets and their ability

to borrow. Both channels emphasize on the asymmetric information between the

borrowers and lenders which alter the costs of financing that have significant

consequences on output fluctuations. Although both channels theoretically quite

different, we do not intend to distinguish them empirically.

Nevertheless, both channels are based on one key fundamental, the “financial

accelerator”. 4 The financial accelerator hypothesis says that credit market

distortions magnify economic fluctuation. Accordingly, small credit distortions may

lead large and persistent fluctuation in output. In other words, credit market

distortions create a financial accelerator which destabilizes the economy. While in

some cases the distortions destabilize the economy, they sometimes stabilize the

economy. 5 Many empirical studies are unable to distinguish between financial

accelerator and stabilizer. In order to fill the gap in the literature, this study attempts

to distinguish them empirically by considering various macroeconomic shocks.

4 The term “financial accelerator” was first introduced by Bernanke and Gertler (1989). 5 See a recent study by House (2006) where the stabilizing forces are closely related to forces that cause overinvestment in static models.

4

In a world of imperfect credit market, financial intermediaries are important because

of information and transactions costs that arise from imperfect information between

the borrowers and lenders. This information asymmetry is opening up the possibility

of an interesting interaction between financial intermediary development and output

fluctuations. As a result, questions have been raised on the dampening and

amplifying effect of financial development on output fluctuations. Numerous studies

have focused on financial development and economic growth (e.g. Rajan and

Zingales, 1998; Levine et al., 2000; Beck et al., 2000b),6 however, the indirect

effect of financial development on output fluctuations has not been studied

thoroughly yet. 7 This study examines on both the direct and indirect effects of

financial intermediary development on output fluctuations.

The credit market imperfections can also affect the way in which an economy reacts

to exchange rate movements through different channels. For example, after the large

exchange rate depreciations following the 1997 East Asian crisis, export volumes

from East Asian countries did not increase with respect to the large currency

depreciations.8 Two main explanations for this phenomenon have been proposed,

excessive foreign currency borrowing affected firms’ balance sheets and contraction

in domestic credit affected supply of exports.

6 Rajan and Zingales (1998) argue that financial development facilitates economic growth as it reduces external costs of finance to firms. 7 See a latest study by Beck et al. (2006). 8 See Duttagupta and Spilimbergo (2004) for a survey of Asian exports during the crisis.

5

The first channel related to this view is foreign currency borrowings where share of

firms’ liability is denominated in foreign currency, thus exchange rate depreciation

will increase the amount of this debt. This will deteriorate firms’ balance sheets and

thus decrease the amount of their production.9 The second channel that can be

observed is the presence of credit constraints where depreciation can decrease the

amount of firms’ cash flow if their assets are denominated in domestic currency; if

this cash flow determines firms’ net worth, investment will decrease after

depreciation and if this investment is necessary to produce and export, trade will

decrease too. The complementary of these two channels is called the “currency

mismatch”. The effects would be the same if countries have large debt denominated

in foreign currency to finance their development while the cash flow that serve

those debts are denominated in domestic currency, a depreciation of currency

exacerbating debt-service difficulties and increasing the likelihood of default of

domestic banks and firms and consequently economic collapsed.

This view is argued by Eichengreen and Hausmann (1999) that the danger of

exchange rate fluctuations in the face of foreign currency borrowing might force

many countries to adopt hard currency pegs. They coined the term “original sin”

because they argued foreign currency denominated debt was imposed by

international capital markets. Nations with poor reputations, and even nations with

ostensibly good reputations or solid fundamentals, are obliged to issue debt in key

international currencies. In other words, domestic policies or problems were not the

only reason countries could not borrow in their own currencies. 9 See for example, Deardorff (2000), Jeanne (2002) and Cespedes et al. (2004).

6

This study considers three literatures of credit market imperfections – credit channel

(or the role of financial intermediaries), financial accelerator and currency mismatch

focusing on the selected countries in East Asian and Pacific region. In particular,

this study is related to four different stands of literature. First, this study is based on

a large empirical literature on the relationship between financial development and

output fluctuations. A second relevant stand of literature is the accelerating effects

of credit market imperfections on the propagation of various economic shocks. A

third related literature is the effect of exchange rate movements on export when

foreign currency borrowing and the level of credit constraint are considered. A

fourth related line of work is the literature on the credit channel of monetary

transmission mechanism where monetary policy impacts on real economy through

the balance sheet and bank lending channels.

In the following sections, a descriptive analysis of how credit market imperfections

at work with respect to the changes in various financial market indicators is

reviewed. Such indicators are the role of credit constraints in output fluctuations,

the importance of bank loans for bank-dependent borrowers, the balance sheet

effects with or without the foreign currency denominated debt and the rapid

expansions of guaranteed debt by the public entities. Based on the descriptive

analysis, three hypotheses are proposed in which will be examined in the later parts

of this study.

7