Financial Choice in a Non-Ricardian Model of Trade Katheryn N. Russ1

Diego Valderrama2

1 Department of Economics University of California – Davis 2 Economic Research Federal Reserve Bank of San Francisco

Board of Governors September 2009

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Stylized facts There are significant differences in the development of local corporate bond markets across countries

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Motivating question How do financial choice and trade interact in the open economy?

Policy recommendations in the aftermath of the 1997 Asian financial crisis Develop local bond markets to serve as a “spare wheel” Strengthen banking system Bond market development: An act of faith? Lack of a unified analytical framework Still nascent literature on finance, heterogenous firms and trade Financial choice is important as different policies (bank vs. bond finance) may affect firms differently (large vs. small)

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Financial Choice in the Open Economy

Financial choice: Combination of financial frictions faced by firms or investors Firms choose between different credit instruments. The market for each credit instrument has different transaction costs and risk characteristics. Firm characteristics and market conditions impact firms decision to use different credit instruments. Firm’s financial choice impacts their production and export decisions.

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Build a model to evaluate interaction between financial choice, production and trade We can not predict the effects of policies aimed at developing specific financial markets without modeling them in a small open economy. Ask questions: What are the impacts of specific financial policies on export behavior, the gains from trade, and the real exchange rate? Does trade openness affect the efficacy of policies aimed at a particular financial market? Three basic building blocks Endogenous number of heterogeneous, monopolistically competitive firms. Firms use both labor and capital as inputs for production, but must borrow funds to purchase capital. Firms choose between bank and bond financing, which are modeled very simply as “monitored” versus “unmonitored” lending. Russ, Valderrama (UC-Davis, FRBSF)

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Findings

Both bank and bond market development increase welfare I

But the relative welfare benefit of each policy depends on the level and type of trade barriers faced by exporters

The policies have opposite effects on the extensive margin and the real exchange rate I

I

Increasing bank efficiency increases the extensive margin of trade and appreciates the real exchange rate Reducing fixed costs of bond issuance reduces the extensive margin of trade and depreciates the real exchange rate

Increasing trade openness– by itself– increases the relative size of bank v. bond credit markets.

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Related literature I

Financial frictions and trade Chaney (2005): Exogenous liquidity constraints affect extensive margin of trade in heterogenous firm framework. Exogenous real exchange rate shocks ⇒ incomplete pass through. Manova (2008): Exogenously varies the degree to which externally financed purchases can be used as collateral by industry and the probability of default in heterogenous firm framework ⇒ explains observed bilateral trade flows. Antras and Caballero (2009): Exogenous liquidity constraint in a Heckscher-Ohlin/Mundell-Vanek framework ⇒ in financially underdeveloped countries, trade and capital flows can be complements rather than substitutes.

These models do not consider financial choice

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Related literature II

Firm financing choice in the open (macro) economy Russ (2009): There is a split between papers on financial choice which focus on financial flows and papers of trade. Razin and Sadka (2007): Financial choice from the point of view of a foreign investor, not the firm. Smith and Valderrama (2009): Financial choice by a representative firm in a small open economy.

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Outline 1

Introduction Motivation Our approach Related literature

2

Financial choice in a small open economy model of trade Domestic households Financial intermediaries Final goods production Intermediate goods production

3

Numerical results Reduction of financial frictions Reduction of trade costs

4

Conclusions

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Outline 1

Introduction Motivation Our approach Related literature

2

Financial choice in a small open economy model of trade Domestic households Financial intermediaries Final goods production Intermediate goods production

3

Numerical results Reduction of financial frictions Reduction of trade costs

4

Conclusions

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Domestic Households Provide labor and capital

Choose consumption C , labor L and savings K to maximize utility. max

S Ct ,Lt ,Kt+1

∞ X

β t U (Ct , Lt ),

(1)

t=0

subject to: Pt Yt = Pt Ct + Pt Kt+1 = wt Lt + rt Pt Kt + (1 − γ) Pt Kt + πtI + πtF .

(2)

In steady state: 1+r =

Russ, Valderrama (UC-Davis, FRBSF)

1 +γ β

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Financial intermediaries: bank and bond markets Transfer savings from households to firms

“bank lending is more flexible although more expensive than bond finance” Baumann, Hoggarth, and Pain (2005) on Bolton and Freixas (1998, 2000) Drawing from Russ and Valderrama (2009) Bank loans (“monitored lending”) Low fixed cost, fl , high interest rate rl Fraction δ of firm default. Must monitor defaulting firms with cost µ. Bonds (“unmonitored lending”) High fixed cost, fb , low interest rate rb Entry cost perfectly reveals productivity type and represents ex-ante monitoring (alternatively low cost monitoring µb )

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Participation constraint for financial intermediary:

Participation constraint Expected cost of monitoring nonperforming loans or defaulted bonds equals the expected gains from making loans to successful firms who repay loans or bond issues with no monitoring: δnj µj K (ϕ¯j ) = (1 − δ)nj (rj − r)K (ϕ¯j ), j ∈ l, b

(3)

Thus, we can obtain the equilibrium interest rate for each type of issuance rj = r +

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δµj . 1−δ

Financial Choice in a Non-Ricardian Model of Trade

(4)

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Yields spread between bond rate and bank rate Assuming µb < µl ⇒ rb < rl i.e., the bond issuance cost fb perfectly reveals firm type so that less monitoring occurs or, paying fb provides bond purchasers with insurance guaranteeing them full repayment of their investment, eliminating need for monitoring Since WWII, Moody’s seasoned AAA yield < prime rate by 16 basis points on average Without loss of generality, let µb ≡ 0 (5)

rb = r ⇒ Spread between bond rate and bank rate rl = rb +

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δµl . 1−δ

Financial Choice in a Non-Ricardian Model of Trade

(6)

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Final goods producers CES aggregate of domestically produced and imported bundles of intermediate goods.

Perfectly competitive final goods output ε  ε−1 ε−1  ε−1 Y = yd ε + ymε ,

(7)

Assumption: Imported bundle is a standardized unit and do not consider increasing or decreasing varieties of imports.

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Domestic intermediate goods

Imperfect competition. Firms use capital and labor to produce differentiated good, but must borrow from FI to finance capital expenditures. Firms have to pay an additional fixed cost fx to enter the export market.

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Intermediate goods production technology Firms draw a idiosyncratic productivity parameter ϕ from Pareto cumulative distribution H (ϕ). All firms use a Cobb-Douglas technology, yj (ϕ) = ϕALj (ϕ)α Kj (ϕ)1−α j ∈ {l, b}

(8)

⇒ Cost-minimizing input demand functions, Lj∗ (ϕ) = Kj∗ (ϕ) =

Russ, Valderrama (UC-Davis, FRBSF)

 

1−α α



1−α α



w rj

α−1

w rj

α

yj (ϕ) Aϕ

(9)

yj (ϕ) , Aϕ

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(10)

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Domestic goods bundle

Assembly of domestic intermediate good bundle by final goods producers: yd =

1 H (ϕb ) − H (ϕl )

Z

nl

Z

ϕb

yl (ϕ) 0

σ−1 σ

dH (ϕ)di

ϕl

1 + 1 − H (ϕb )

Z

nb

Z

σ ! σ−1

∞

yb (ϕ) nl

σ−1 σ

dH (ϕ)di

, (11)

ϕb

l : ϕ ∈ [ϕl , ϕb ), b : ϕ ∈ [ϕb , ∞).

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Intermediate input demands Given the CES technology structure, derive input demand curves by final goods producers for: domestically produced intermediate inputs, yj (ϕ) j ∈ {l, b} imports of intermediate inputs ym We also assume that there is an analogous foreign demand for domestically produced intermediate goods, yjx (ϕ) j ∈ {l, b}, which are the SOE’s exports. −σ   pj (ϕ) pd −ε yjd (ϕ) = Y, pd P  p −ε m ym = Y, P −σ yjx (ϕ) = (τ pj (ϕ)) Y ∗ . 

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(12) (13) (14)

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Domestic intermediate goods production Profits from intermediate goods production: 1 πjd (ϕ) = σ



pj (ϕ) pd

1−σ 

pd 1−ε PY − Pfj P

j ∈ {l, b}.

(15)

Prices are a constant markup over marginal cost, pj (ϕ) =

σ Wj σ − 1 Aϕ

(16)

where marginal costs Wj are Wj ≡

w α rj1−α (1 − α)

1−α

αα

.

(17)

Note that rb < rl ⇒ Wb < Wl ⇒ pb < pl

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Obtaining threshold productivity levels

Marginal producer will have non-negative profits πjd (ϕ) = 0 Marginal producer is a bank borrower as long as: fb > fl



rl rb

(1−α)(σ−1) .

(18)

We assume this condition holds. Thus, the following condition must hold for the marginal bank borrower: πld (ϕl ) ≡ 0.

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(19)

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Figure: Profit functions and productivity thresholds differ for bank borrowers and bond issuers Russ, Valderrama (UC-Davis, FRBSF)

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Exports Additional profits from exporting if pay fixed cost fx : πjx (ϕ) =

τ −σ 1−σ (pj (ϕ)) Y ∗ − Pfx . σ

(20)

Marginal exporter will be a bank borrower if the fixed cost of exporting fx is not “too large:” "  # (1−α)(1−σ) rl pdσ−ε P ε Y fb − fl ϕbx = · · 1 + (−σ) ∗ > 1. (21) ϕlx fl + fx r (1−α)(1−σ) − r (1−α)(1−σ) τ Y b

l

We assume that this condition holds. Then, the following condition must hold for the marginal bank exporter: πlx (ϕlx ) ≡ 0.

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(22)

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Some bank borrowers do not export

There will be non-traded goods if the following condition holds: ϕlx = ϕl

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fl + fx fl



pdσ−ε P ε Y τ −σ Y ∗

1 ( σ−1 )

Financial Choice in a Non-Ricardian Model of Trade

> 1.

(23)

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Bond Borrower

Condition for marginal bond borrower πbT (ϕbx ) ≡ πlT (ϕbx ).

(24)

Bank borrowers export as long as: "  # (1−α)(1−σ) pdσ−ε P ε Y rl fb − fl ϕbx = · · 1 + (−σ) ∗ > 1. ϕlx fl + fx r (1−α)(1−σ) − r (1−α)(1−σ) τ Y b

Russ, Valderrama (UC-Davis, FRBSF)

(25)

l

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Outline 1

Introduction Motivation Our approach Related literature

2

Financial choice in a small open economy model of trade Domestic households Financial intermediaries Final goods production Intermediate goods production

3

Numerical results Reduction of financial frictions Reduction of trade costs

4

Conclusions

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Experiments Reduction in financial frictions Reduction in bond issuance costs (fb ) Reduction in bank monitoring costs (µ) Both types of policies develop each market, increase output, consumption, the real wage rate and welfare. However, they have opposite effects on the extensive margin of trade and the real exchange rate. Reduction in trade costs (τ ) Increase output, consumption, the real wage rate and welfare. Increase the extensive margin of trade The bank market grows while the bond market shrinks relative to output

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Reduction of financial frictions

Reduce bond issuance costs fb from 5: bond issuance costs 10 times as large as bank credit costs (approximating Pakistan) to 1: bond issuance costs twice as large as bank credit costs (approximating United States) Reduce bank monitoring costs µ from 0.3: approximating level “loss given default” in Latin America to 0.1: approximating level “loss given default” in United States/Portugal

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Figure: Reallocation of output towards medium-productivity firms levels as bond fixed costs fall Russ, Valderrama (UC-Davis, FRBSF)

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Figure: Reallocation of output towards lower-productivity firms levels as bank monitoring costs fall Russ, Valderrama (UC-Davis, FRBSF)

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Figure: Relative welfare gains from a reduction in bond issuance costs or bank monitoring costs depend on the fixed export cost Russ, Valderrama (UC-Davis, FRBSF)

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Figure: Reducing bond issuance costs increases welfare more when the banking sector is inefficient Russ, Valderrama (UC-Davis, FRBSF)

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Figure: Extensive margin of trade falls as bond issuance costs fall, rises as bank monitoring costs fall Russ, Valderrama (UC-Davis, FRBSF)

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Figure: The real exchange rate depreciates as bond issuance costs fall, but appreciates as bank monitoring costs fall Russ, Valderrama (UC-Davis, FRBSF)

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Reduction of trade costs

Reduce τ from 1.25: approximating tariffs and trade costs for Latin America to 1.05: approximating tariffs and trade costs for the United States

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Figure: Output reallocated to switchers firms when trade costs fall Russ, Valderrama (UC-Davis, FRBSF)

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Figure: Trade liberalization causes different measures of financial market development to diverge Russ, Valderrama (UC-Davis, FRBSF)

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Outline 1

Introduction Motivation Our approach Related literature

2

Financial choice in a small open economy model of trade Domestic households Financial intermediaries Final goods production Intermediate goods production

3

Numerical results Reduction of financial frictions Reduction of trade costs

4

Conclusions

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Conclusions Introduce concept of financial choice into modern model of production and trade Policies that benefit bank sector cause reallocation towards firms with higher marginal costs, increase the extensive margin of trade, and cause a RER appreciation Policies that benefit bond sector cause reallocation towards firms with lower marginal costs, lower the extensive margin of trade, and cause a RER depreciation Financial choice and trade openness interact and influence welfare: Increasing bank efficiency relatively more beneficial when fixed export costs are low Trade policy causes greater development of the bank sector versus the bond sector when imports are domestic intermediates are complements

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Open Questions Bank monitoring costs and the default rate vary over the business cycle, so financial choice may affect current account adjustment. Study business cycle properties of the model (composition of bank vs bond issuance). We have not considered international financial flows (foreign banks, investors, etc.). Introducing imperfect competition in the banking sector, a la Salop (Hotelling) Merging with a model of labor search (using Helpman, Itshoski, and Redding) to investigate the relationship between financial frictions and inequality

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Stylized facts There is significant differences in the development of local corporate bond markets across countries

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