Regime-switching in emerging market business cycles: Interest rate volatility and sudden stops

Abstract

We document the presence of discrete regime-switching in emerging market business cycles, particularly in the volatility of interest rates at which countries borrow internationally, using a multi-country regime-switching vector autoregressive model. We study the statistical relationship of such business cycle regimes with episodes of sudden stops. Periods of high volatility tend to be persistent and are associated with high interest rates, the occurrence of sudden stops in external financing, and large declines in economic activity. Most strikingly, we show that regime switches drive the countercyclicality of interest rates in emerging markets documented in previous literature (Neumeyer and Perri, 2005) and that high-volatility regimes forecast sudden stops 6 and 12 months ahead.