Putting the Brakes on Sudden Stops: The Financial Frictions-Moral Hazard Tradeoff of Asset Price Guarantees

The hypothesis that Sudden Stops to capital inflows in emerging economies may be caused by global capital market frictions, such as collateral constraints and trading costs, suggests that Sudden Stops could be prevented by offering price guarantees on the emerging-markets asset class. Providing these guarantees is a risky endeavor, however, because they introduce a moral-hazard-like incentive similar to those that are also viewed as a cause of emerging markets crises. This paper studies this financial frictions-moral hazard tradeoff using an equilibrium asset-pricing model in which margin constraints, trading costs, and ex-ante price guarantees interact in the determination of asset prices and macroeconomic dynamics. In the absence of guarantees, margin calls and trading costs create distortions that produce Sudden Stops driven by occasionally binding credit constraints and Irving Fisher's debt-deflation mechanism. Price guarantees contain the asset deflation by creating another distortion that props up the foreign investors' demand for emerging markets assets. Quantitative simulation analysis shows the strong interaction of these two distortions in driving the dynamics of asset prices, consumption and the current account. Price guarantees are found to be effective for containing Sudden Stops but at the cost of introducing potentially large distortions that could lead to 'overvaluation' of emerging markets assets.

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.

Essays on Preventing Sudden Stops

Capital markets have witnessed a rash of `Sudden Stops' during the last decade. Policy proposals to prevent these crises include creating indexed bond markets and providing price guarantees for emerging market assets. Chapter 1 explores the macroeconomic implications of indexed bonds with a return indexed to the key variables driving emerging market economies such as terms of trade or productivity. We employ a quantitative model of a small open economy in which Sudden Stops are driven by the financial frictions inherent to world capital markets. While indexed bonds provide a hedge to income fluctuations and can undo the effects of financial frictions, they lead to interest rate fluctuations. Due to this tradeoff, there exists a non-monotonic relation between the "degree of indexation" (i.e., the percentage of the shock reflected in the return) and the overall effects of these bonds on macroe- conomic fluctuations. Therefore, indexation can improve macroeconomic conditions only if the degree of indexation is less than a critical value. When the degree of indexation is higher than this threshold, it strengthens the precautionary savings motive, increases consumption volatility and impact effect of Sudden Stops. The threshold degree of indexation depends on the volatility and persistence of income shocks as well as the relative openness of the economy. Chapter 2 explores the implications of asset price guarantees provided by an international financial organization on the emerging market assets. This policy is motivated by the globalization hazard hypothesis, which suggest that Sudden Stops caused by global financial frictions could be prevented by offering foreign investors price guarantees on emerging markets assets. These guarantees create a trade- off, however, because they weaken globalization hazard while creating international moral hazard. We study this tradeoff using a quantitative, equilibrium asset-pricing model. Without guarantees, margin calls and trading costs cause Sudden Stops driven by a Fisherian deflation. Price guarantees prevent this deflation by propping up foreign demand for assets. The effectiveness of price guarantees, their distor- tions on asset markets, and their welfare implications depend critically on whether the guarantees are contingent on debt levels and on the price elasticity of foreign demand for domestic assets

Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Merchantilism

Financial globalization was off to a rocky start in emerging economies hit by Sudden Stops since the mid 1990s. Foreign reserves grew very rapidly during this period, and hence it is often argued that we live in the era of a New Merchantilism in which large stocks of reserves are a war-chest for defense against Sudden Stops. We conduct a quantitative assessment of this argument using a stochastic intertemporal equilibrium framework with incomplete asset markets in which precautionary saving affects foreign assets via three mechanisms: business cycle volatility, financial globalization, and Sudden Stop risk. In this framework, Sudden Stops are an equilibrium outcome produced by an endogenous credit constraint that triggers Irving Fisher's debt-deflation mechanism. Our results show that financial globalization and Sudden Stop risk are plausible explanations of the observed surge in reserves but business cycle volatility is not. In fact, business cycle volatility has declined in the post-globalization period. These results hold whether we use the formulation of intertemporal preferences of the Bewley-Aiyagari-Hugget class of precautionary savings models or the Uzawa-Epstein setup with endogenous time preference.

Quantitative implications of indexed bonds in small open economies

This paper analyzes the macroeconomic implications of real-indexed bonds, indexed to the terms of trade or GDP, using a general equilibrium model of a small open economy with financial frictions. Although indexed bonds provide a hedge to income fluctuations and can thereby mitigate the effects of financial frictions, they introduce interest rate fluctuations. Because of this tradeoff, there exists a nonmonotonic relation between the "degree of indexation" (i.e., the percentage of the shock reflected in the return) and the benefits that these bonds introduce. When the nonindexed bond market is shut down and only indexed bonds are available, indexation strengthens the precautionary savings motive, increases consumption volatility and deepens the impact of Sudden Stops for degrees of indexation higher than a certain threshold. When the nonindexed bond market is retained, nonmonotonic relationship between the degree of indexation and the benefits of indexed bonds still remain. Degrees of indexation higher than a certain threshold lead to more volatile consumption than lower degrees of indexation. The threshold degree of indexation depends on the volatility and persistence of income shocks as well as on the relative openness of the economy.Inflation-indexed bonds ; Bond market

Emerging Market Business Cycles with Remittance Fluctuations

This paper analyzes the implications of remittance fluctuations for various macroeconomic variables and sudden stops. The paper employs a quantitative two-sector model of a small open economy with financial frictions calibrated to Mexican and Turkish economies, two major recipients, whose remittance receipts feature opposite cyclical characteristics. We find that remittances dampen business cycles in Mexico, whereas they amplify the cycles in Turkey. Their quantitative effects in the long run, approximated by the stochastic steady state, are mild. In the short run, however, remittances have quantitatively large impacts on the economy, when the economy is borrowing-constrained. This is because agents in the economy cannot adjust their precautionary wealth to sudden tightening in credit, and hence, fluctuations in remittances get magnified through an endogenous debt-deflation mechanism. The findings suggest that procyclical (or countercyclical) remittances can play a significant deepening (or mitigating) role for sudden stops.