The Impact of US Financial Uncertainty Shocks on Emerging Market Economies: An International Credit Channel

Abstract

I document that US financial uncertainty shocks, measured by an unexpected increase in VIX, have a substantial impact on the output of emerging market economies (EMEs) without material impact on US output during the last two decades. To understand this puzzling phenomenon, I propose an international credit channel - an outcome of financial frictions - as a propagation mechanism of US financial uncertainty shocks to EMEs. I augment a boom-bust cycle model of EMEs by Schneider and Tornell (2004) portfolio choice model of constrained international investors. As international investors pull their money from EMEs - to satisfy their Value-at-Risk constraints - in response to uncertainty shocks, borrowing costs increase and domestic credit falls as a consequence of credit market imperfections in EMEs. Higher borrowing costs, in turn, lead to a fall in investment that causes a real depreciation via currency mismatch and a decline in total output through sectoral linkages. The results of 18 EMEs from structural VARs, which are carefully identified using the equilibrium model, confirm the prediction of the model.