Smoothing Sudden Stops

Emerging economies are exposed to severe and sudden shortages of international financial resources. Yet domestic agents seem not to undertake enough precautions against these sudden stops. Following our previous work, we highlight in this paper the central role played by limited domestic development in ex-ante (insurance) and ex-post (spot) financial markets in generating this collective undervaluation of external resources and insurance. Within this structure, this paper studies several canonical policies to counteract the external underinsurance. We do this by first solving for the optimal mechanism given the constraints imposed by limited domestic financial development, and then considering the main - in terms of the model and practical relevance - implementations of this mechanism.

Optimal reserve management and sovereign debt

Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.Debt ; Default (Finance)

Are Indexed Bonds a Remedy for Sudden Stops?

Recent policy proposals call for setting up a benchmark indexed bond market to prevent "Sudden Stops". This paper analyzes the macroeconomic implications of these bonds using a general equilibrium model of a small open economy with financial frictions. In the absence of indexed bonds, negative shocks to productivity or to the terms of trade trigger Sudden Stops through a debt-deflation mechanism. This paper establishes that whether indexed bonds can help to prevent Sudden Stops depends on the "degree of indexation", or the percentage of the shock reflected in the return. Quantitative analysis calibrated to a typical emerging economy suggests that indexation can improve macroeconomic conditions only if the level of indexation is less than a critical value due to the imperfect nature of the hedge provided by these bonds. When indexation is higher than this critical value (as with full-indexation), "natural debt limits" become tighter, leading to higher precautionary savings. The increase in the volatility of the trade balance that accompanies the introduction of indexed bonds outweighs the improvement in the covariance of the trade balance with income, increasing consumption volatility. Additionally, we find that at high levels of indexation, the borrowing constraint can become suddenly binding following a positive shock, triggering a debt-deflation.Indexed Bonds, Degree of Indexation

Quid pro Quo: National Institutions and Sudden Stops in International Capital Movements

The paper explores the incidence of sudden stops in capital flows on the incentives for building national institutions that secure property rights in a world where sovereign defaults are possible equilibrium outcomes. Also thepaper builds upon the benchmark model of sovereign default and direct creditor sanctions by Obstfeld and Rogoff (1996). In their model it is in the debtor country’s interest to “tie its hands” and secure the property rights of lenders as much as possible because this enhances the credibility of the country’s romise to repay and prevents default altogether. It incorporate two key features of today’s international financial markets that are absent from the benchmark model: the possibility that lenders can trigger sudden stops in capital movements, and debt contracts in which lenders transfer resources to the country at the start of the period, which have to be repaid later. The papershows that under these conditions the advice “build institutions to secure repayment at all costs” may be very bad advice indeed.

A Quantitative Model of Sudden Stops and External Liquidity Management

Emerging market economies, which have much of their growth ahead of them, run persistent current account deficits in order to smooth consumption intertemporally. The counterpart of these deficits is their dependence on capital inflows, which can suddenly stop. In this paper we develop and estimate a quantifiable model of sudden stops and use it to study practical mechanisms to insure emerging markets against them. We first assess the standard practice of protecting the current account through the accumulation of international reserves and conclude that, even when optimally managed, this mechanism is expensive and incomplete. External insurance, on the other hand, is hard to obtain because sudden stops often come together with distress in emerging market investors themselves (the most natural insurers). Thus, one needs to find global (non-emerging-market-specific) assets that are correlated to sudden stops. We show an example of such an asset based on the S&P 500's implied volatility index. If added to these countries portfolios, it would significantly enhance their sudden stop risk-management strategies. In our simulations, the median gain in terms of reserves available at the time of sudden stop is around 30 percent. Moreover, in instances where the level of non-contingent reserves is low, the median gain is close to 300 percent. We also find that as countries manage to reduce the size of the sudden stops that afflict them, they should reduce their stock of reserves and significantly increase their share of contingent reserves. The main insights of the paper extend to external liquidity and liability management more generally.

Inflation Targeting, Sudden Stops and the Cost of Fear of Floating

Sudden stops seem to create the perfect environment for disinflation, especially when central banks defend the exchange rate by increasing interest rates. We propose a variation of the output gap model that incorporates the sudden stop shock. The use of the model in policy analysis shows that fear of floating is pro-cyclical and inflation targeting, counter-cyclical. The model is run for Brazil, Colombia, Korea and Thailand, the inflation targeting countries that have recently had sudden stops. The three policy implications direct attention to the medium and long run. First,the central banks that are targeting inflation should focus on inflation, not during but after the sudden stop. Second, they could complement this medium term view by monitoring a measure of inflation of non traded goods. Third, the monetary authorities could eventually introduce an escape clause to the CPI inflation target under a sharp depreciation.

Emerging Market Business Cycles: The Cycle is the Trend

Business Cycles in emerging markets are characterized by strongly counter-cyclical current accounts, consumption volatility that exceeds income volatility and dramatic sudden stops' in capital inflows. These features contrast with developed small open economies and highlight the uniqueness of emerging markets. Nevertheless, we show that both qualitatively and quantitatively a standard dynamic stochastic small open economy model can account for the behavior of both types of markets. Motivated by the observed frequent policy regime switches in emerging markets, our underlying premise is that these economies are subject to substantial volatility in the trend growth rate relative to developed markets. Consequently, shocks to trend growth are the primary source of fluctuations in these markets rather than transitory fluctuations around a stable trend. When the parameters of the income process are structurally estimated using GMM for each type of economy, we find that the observed predominance of permanent shocks relative to transitory shocks for emerging markets and the reverse for developed markets explains differences in key features of their business cycles. Lastly, employing a VAR methodology to identify permanent shocks we find further support for the notion that the cycle is the trend' for emerging economies.

Large Hoarding of International Reserves and the Emerging Global Economic Architecture

This paper analyzes competing interpretations for the large increases in the hoarding of international reserves by developing countries. While the first phase of the rapid hoarding of reserves in the aftermath of the East Asian crisis has been dominated by self insurance against exposure to foreign shocks, the self insurance motive falls short of explaining the hoarding in Asia in the 2000s. These developments may be a symptom of an emerging new global financial architecture, which is manifested in the proliferation of decentralized and less cooperative arrangements. The emerging financial configuration of developing countries in the aftermath of the 1990s crises has been growing managed exchange rate flexibility, greater monetary independence, and deeper financial integration. Hoarding international reserves is a key ingredient enhancing the stability of this emerging configuration. While not a panacea, international reserves help by providing self insurance against sudden stops; mitigating REER effects of TOT shocks; smoothing overtime the adjustment to shocks by allowing more persistent current account patterns; and possibly even export promotion, though this mercantilist use of reserves remains debatable due to possible coordination issues. Countries following an export oriented growth strategy may end up with competitive hoarding, akin to competitive devaluations. The sheer size of China, and its lower sterilization costs suggests that China may be the winner of a hoarding game. Hoarding international reserves may also be motivated by a desire to deal with vulnerability to internal and external instability, which is magnified by exposure of the banking system to non performing loans. Testing the self insurance and precautionary motives in the context of China may be challenged by a version of the "peso problem." Hoarding international reserves and sterilization have been complementing each other during the last ten years, as developing countries have increased the intensity of both margins.

Are Asset Price Guarantees Useful for Preventing Sudden Stops?: A Quantitative Investigation of the Globalization Hazard-Moral Hazard Tradeoff

The globalization hazard hypothesis maintains that the current account reversals and asset price collapses observed during 'Sudden Stops' are caused by global capital market frictions. A policy implication of this view is that Sudden Stops can be prevented by offering global investors price guarantees on emerging markets assets. These guarantees, however, introduce a moral hazard incentive for global investors, thus creating a tradeoff by which price guarantees weaken globalization hazard but strengthen international moral hazard. This paper studies the quantitative implications of this tradeoff using a dynamic stochastic equilibrium asset-pricing model. Without guarantees, distortions induced by margin calls and trading costs cause Sudden Stops driven by Fisher's debt-deflation mechanism. Price guarantees prevent this deflation by introducing a distortion that props up foreign demand for assets. Non-state-contingent guarantees contain Sudden Stops but they are executed often and induce persistent asset overvaluation. Guarantees offered only in high-debt states are executed rarely and prevent Sudden Stops without persistent asset overvaluation. If the elasticity of foreign asset demand is low, price guarantees can still contain Sudden Stops but domestic agents obtain smaller welfare gains at Sudden Stop states and suffer welfare losses on average in the stochastic steady state.