Uncertainty shocks and financial conditions in Latin-American countries

Abstract

We study the connection between financial conditions and economic uncertainty across five major Latin American countries: Brazil, Chile, Colombia, Mexico, and Peru. Using a Bayesian Threshold Vector Autoregression (BVAR) model with stochastic volatility, our findings reveal that sudden jumps in uncertainty tighten financial conditions, increasing the likelihood of financial distress when the country credit spread exceeds a threshold value. Additionally, we find that uncertainty shocks are recessionary, leading to lower domestic short-term interest rates and a depreciation of domestic currencies against the US dollar. Notably, these effects are more pronounced and persistent during periods of financial distress. Another important finding is the heterogeneity in countries' responses to uncertainty, which reflects significant cross-country differences in economic fundamentals and policy frameworks. Finally, our results suggest that, while uncertainty contributes modestly to overall business cycle volatility, it has a substantial impact on financial variables—a dynamic that becomes significantly amplified during episodes of financial distress.