This paper explores a how the financial uncertainty generated by volatile international
capital flows interacts with maturity mismatch on the balance sheets of nonfinancial
firms to increase the volatility of output, investment, and total factor productivity
(TFP) in emerging market economies. I build a model of a small open economy in which
financial frictions force firms to fund long-term projects with short-term debt. In
response to changes in the level of uncertainty regarding the availability of foreign
borrowing, firms adjust their long-term investment, contributing to the volatility
of investment and output as well as generating endogenous fluctuations in aggregate
productivity. Using data from a panel of major emerging markets, I show that the volatility
of portfolio debt flows negatively affects output by dampening investment, while the
volatility of equity flows, which do not generate maturity mismatch, has no effect.
Consistent with the mechanism in the model, the negative impact of capital flow volatility
is larger at low levels of financial development and in industries with longer time-to-build
lags. My estimates imply that shocks to capital flow volatility account for one fifth
of the excess output volatility of the emerging markets in my sample relative to a
set of small open advanced economies. (C) 2017 Elsevier Ltd. All rights reserved.