Global financial risk slows emerging market productivity growth

The paper estimates a panel state-space model for emerging and advanced small open economies from 1993 to 2019 to measure the effects of U.S. monetary policy uncertainty shocks.

Researchers found that a one-standard-deviation shock to U.S. interest rate uncertainty generates persistent declines in the estimated stochastic trend of economic activity in emerging market economies.

This shock lowers the level of the estimated trend in emerging markets by at least 25 basis points after three years, with no resulting make-up growth later.

In contrast, advanced economies exhibit a significantly smaller response, showing no comparable effect.

This result holds robust across multiple measures of global financial uncertainty and when conditioning on U.S. macroeconomic and credit conditions, underscoring the specific vulnerability of emerging markets to these external financial shocks.

The study develops a small open economy model to explain the differential responses, integrating endogenous productivity growth through innovation, occasionally binding collateral constraints, and stochastic volatility in world interest rates.

The core mechanism involves rising interest rate volatility, which depresses firm valuations.

This, in turn, tightens collateral constraints and slows innovation by firms, ultimately depressing productivity growth.

The mechanism's asymmetry is crucial: large positive interest rate shocks force deleveraging when borrowing constraints bind, amplifying the decline in firm valuations.

This creates a feedback loop between financial conditions and real activity, with stronger effects in economies that more frequently face these constraints.