Domestic barriers to entry and external vulnerability in emerging economies

Abstract

Emerging economies (EMEs) exhibit high regulatory costs of firm creation. At the same time, lower firm-creation costs are associated with greater financial development and use of formal credit, which can expose EME firms to external financial shocks that propagate to EMEs via the banking system such as those that EMEs experienced during the Global Financial Crisis. We present evidence showing that in response to an adverse shock to the US banking system, EMEs with low firm-creation costs exhibit smaller contractions and earlier recoveries in cross-border bank flows, domestic bank credit, and GDP compared to EMEs with high firm-creation costs. A two-country model with banking frictions, cross-border bank flows, and endogenous firm entry can successfully capture this evidence. Our findings suggest that greater domestic credit-market deepening via lower barriers to firm entry in EMEs need not be associated with greater macro and domestic credit-market volatility.