Leverage Cycles and the Anxious Economy
Abstract (Via Yale)
We provide a pricing theory for emerging asset classes, like emerging markets, that are not yet mature enough to be attractive to the general public. We show how leverage cycles can cause contagion, flight to collateral, and issuance rationing in a frequently recurring phase we call the anxious economy. Our model provides an explanation for the volatile access of emerging economies to international financial markets, and for three stylized facts we identify in emerging markets and high yield data since the late 1990s. Our analytical framework is a general equilibrium model with heterogeneous agents, incomplete markets, and endogenous collateral, plus an extension encompassing adverse selection.
Introduction (Via Yale)
Since the 1990s, emerging markets have become increasingly integrated into global financial markets, becoming an asset class. Contrary to what was widely predicted by policymakers and economic theorists, however, these changes have not translated into better consumption smoothing opportunities for emerging economies. Their access to international markets has turned out to be very volatile, with frequent periods of market closures. Even worse, as we will show, emerging economies with sound fundamentals are the ones that issue less debt during these closures. The goal of this paper is to present a theory of asset pricing that will shed light on the problems of emerging assets (like emerging markets) that are not yet mature enough to be attractive to the general public. Their marginal buyers are liquidity constrained investors with small wealth relative to the whole economy, who are also marginal buyers of other risky assets. We will use our theory to argue that the periodic problems faced by emerging asset classes are sometimes symptoms of what we call a global anxious economy rather than of their own fundamental weaknesses.
We distinguish three different conditions of financial markets: the normal economy, when the liquidity wedge is small and leverage is high; the anxious economy, when the liquidity wedge is big and leverage is curtailed, and the general public is anxiously selling risky assets to more confident natural buyers; and, finally, the crisis or panicked economy, when many formerly leveraged natural buyers are forced to liquidate or sell off their positions to a reluctant public, often going bankrupt in the process. A recent but growing literature on leverage and financial markets has concentrated on crises or panicked economies. We concentrate on the anxious economy (a much more frequent phenomenon) and provide an explanation with testable implications for (1) contagion, (2) flight to collateral, and (3) issuance rationing.