IntroductionThe modelGeneral frameworkOptimization behaviorsWithin-period equilibriumLong-run dynamicsEquilibrium pathsThe safe stationary stateThe safe transitory dynamicsFinancial fragility in the long runGeneral resultsThe example of ArgentinaEffect of exogenous shocksConclusionAppendixA microfoundation for the borrowing constraintThe saving problem of householdsProof of proposition 1Autarky interest rateProof of lemma ??CalibrationFinancial fragility in emerging markets:firm balance sheets and the sectoral structureYannick Kalantzis∗(ENPC, UC Berkeley)This version: January 2007First draft: January 2005AbstractThis paper builds an overlapping generation model of a two-sector small open economy inorder to study the evolution of the sectoral structure and its impact on financial fragility. Firmsin the economy are subject to a borrowing constraint. It is also assumed that there is a cur-rency mismatch in the balance sheets of the non-tradable sector. Under these two assumptions,multiple within-period equilibria associated with different real exchange rates and investmentlevels may arise, making self-fulfilling balance-of-payments crises possible. The within-periodcrisis equilibrium exists when the non-tradable sector is large enough compared to the tradablesector and sufficiently leveraged.The paper studies the dynamics of the relative size and leverage of the non-tradable sector.It shows that their evolution leads to a financially fragile state in economies sufficiently openedto external finance and in times of high international liquidity.Keywords: two-sector models, balance-of-payments crises, sunspots, foreign currency debt, bor-rowing constraint.JEL Classification Numbers: E44, F32, F34, F43, O411 IntroductionThe opening of developing economies to international finance in the last three decades has led ina number of cases to severe balance-of-payments crises with large real costs. The Southern Conecrises at the beginning of the nineteen-eighties, the Mexican crisis of 1994, the Asian crises of 1997,and the Argentine crisis of 2001, to mention but a few of them, all took place after the capitalaccount had been liberalized. The literature dedicated to the empirical analysis of these events(Kaminsky & Reinhart 1999, Tornell & Westermann 2002, Calvo, Izquierdo & Mej´ıa 2004, among∗University of California, Berkeley, 549 Evans Hall, #3880, Berkeley CA 94720-3880, USA.E-mail: kalantzis.at.berkeley.edu.I would like to thank Robert Boyer, Andr´e Cartapanis, Pierre Jacquet, Ricardo Hausmann, Philippe Martin,Jean-Paul Pollin, and Aaron Tornell for their useful comments and advice, as well as participants of the 10thLACEAmeeting, the LIVthCongr`es de l’AFSE and a seminar in PSE. Of course, all the remaining errors are my own.1others) has identified a consistent set of stylized facts: the balance-of-payments crises go togetherwith a real depreciation, a sharp drop of investment and a current-account reversal. Financialfactors play a crucial role, and a lot of these currency crises were coupled with banking crises.Some authors have also pointed to the role played by sectoral factors in these crisis episodes.Tornell & Westermann (2002) show that the relative size of the non-tradable sector usually increasesbefore twin crises in middle-income countries. Calvo et al. (2004) find that the probability of asudden stop is higher in economies where the absorption of tradable goods is small compared tothe pre-crisis current-account deficit, a proxy for the size of a possible sudden stop. The rationalebehind these findings is that any shock resulting in a lower demand for non-tradable goods hasto be accommodated by a real depreciation in the short run. When the demand for non-tradablegoods stemming from the tradable sector is large compared to the size of the non-tradable sector,it acts as a stabilizing buffer, so that the real exchange rate needed to close the gap is not verydepreciated.But the sectoral structure of an economy is endogenous and the size of both the tradable andnon-tradable sectors evolves over time. Therefore, in order to fully understand these crisis episodes,one has to explain the sectoral dynamics of emerging economies. A first account of the link betweenfinancial crises and sectoral dynamics is provided by Schneider & Tornell (2004). Using a finite-time model, they study the growth of the non-tradable sector during a transitory lending boomand show that it can lead to a self-fulfilling crisis.This paper extends Schneider & Tornell’s (2004) framework and builds a model to study howthe allocation of resources between the tradable and non-tradable sectors evolves over an infinitetime horizon and how it affects the possibility of self-fulfilling balance-of-payments crises. It showsthat the sectoral dynamics depends, among other factors, on external financing conditions, namelythe financial openness and the international interest rate. In particular, a permanent increase inthe supply of international liquidity can lead to a reallocation of resources towards the non-tradablesector. The paper studies whether this sectoral change is sufficient to make balance-of-paymentscrises possible.The paper models a two-sector small open economy with an overlapping generation structure.It embeds a static mechanism of self-fulfilling crisis which can produce multiple equilibria withina single time period, including a crisis equilibrium with a depreciated real exchange rate anddefaults in the non-tradable sector. The within-period crisis equilibrium exists when (a) the debtrepayments of firms producing non-tradable goods are high enough relative to their cash-flow and(b) the non-tradable sector is large enough relative to the tradable sector. Financial fragility thusdepends on both a financial factor, the firm-level financial structure within the non-tradable sector,and a real factor, the sectoral structure of the whole economy. Both factors evolve along dynamicequilibrium paths. Starting from a closed economy, a country slightly opened to external financereallocates resources towards the tradable sector in the long run in order to pay its external debt.2In more opened economies however, this is compensated by capital inflows which finance a higherdemand for non-tradable goods, thus increasing the weight of the non-tradable sector in the longrun.1I show that for a sufficient degree of financial openness or equivalently a low enough worldinterest rate, this sectoral evolution leads to