Working Paper Series no. 704: Real Interest Rates and Productivity in Small Open Economies

In emerging market economies (EMEs) capital inflows typically lead to output and asset price booms, appreciating real exchange rates, and excessive credit growth (Blanchard et al. 2016). Capital inflows, however, are not only a story of emerging markets. With the onset of the euro, large capital inflows in the European periphery have been associated to current account imbalances, loss of competitiveness, and a slowdown in productivity.

In this paper we study the effects of capital flows on business cycles, in both EMEs and advanced economies (AEs). In particular, we focus our attention on the effects of capital flows on aggregate productivity. In our analysis, capital flow “shocks” are measured as exogenous variations in world real interest rates. We first provide VAR-based evidence that the effects of real interest rate shocks on productivity are starkly different in EMEs and AEs (exemplified by the euro periphery). We show that a positive innovation to the real interest rate causes on average a fall in productivity in EMEs, while the opposite holds for the euro-periphery countries.

The empirical difference across EMEs and AEs poses a theoretical challenge. We therefore build a unified theoretical framework which can rationalize the evidence on the link between real interest rates and productivity for both groups of small open economies. We build a model of a small open economy which extends the standard international RBC model (e.g. Mendoza, 1991) to allow for two main features, making productivity endogenous: (i) financial imperfections; and (ii) firms' heterogeneity in productivity.

Relative to a standard RBC setup, this model leads to two main findings: first, an exogenous rise (fall) in the real interest rate leads to a rise (fall) in productivity; second, the exit (entry) of marginally less productive firms - cleansing effect - dampens the effects of real interest rate shocks on output. This result can be explained as follows. Consider an exogenous rise in the world real interest rate. At the margin, and in the presence of borrowing frictions, this makes the opportunity cost of producing (i.e., the marginal benefit of saving) higher for less productive firms, inducing the latter to exit the market, thereby driving up average productivity. The endogenous positive effect on productivity dampens the standard contractionary effect of higher real interest rates on output stemming from intertemporal substitution. Furthermore, the dampening effect on output is increasing in the dispersion of new entrants in the production sector.

While this model captures AEs business cycle fluctuations, an additional feature is added to account for EMEs business cycle characteristics: the widespread inability of those countries to borrow in their own currency - original sin. This model can generate both amplification of output fluctuations and a negative (positive) effect of higher (lower) real interest rates on productivity. This is because higher (lower) real interest rates, via a real exchange rate depreciation (appreciation), decreases (increases) the opportunity cost of producing of less productive firms and the borrowing ability of the incumbent, marginally more productive firms. These effects lead to a decrease (increase) in average productivity.

Finally, we show that our model, despite its simplicity, is able to fit well some relevant features of the data. We estimate key structural parameters of the model for EMEs, as well as of the model for the AEs, and show that firms' heterogeneity and market concentration are crucial ingredients for the effects of capital inflows across countries.