Uncertainty Shocks and Financial Regimes in Emerging Markets

We study the link between financial conditions and economic uncertainty in five emerging markets (Brazil, Chile, Colombia, Mexico, and Peru). In the empirical model, uncertainty is measured as the volatility of the economy's structural shocks and its macroeconomic effect is contingent on the state of financial markets (normal or distress). We find that sudden jumps in uncertainty tighten financial conditions, increasing the likelihood of financial distress. We also find that uncertainty shocks are recessionary at all periods, induce lower interest rates and weaken domestic currencies against the US dollar. Importantly, these responses are larger and more persistent during periods of financial distress.