Sudden stops and financial frictions : evidence from industry level data

The nature of the microeconomic frictions that transform sudden stops in output collapses is not only of academic interest, but also crucial for the correct design of policy responses to prevent and address these episodes and the lack of evidence on this regard is an important shortcoming. This paper uses industry-level data in a sample of 45 developed and emerging countries and a differences-in-differences methodology to provide evidence of the role of financial frictions for the consequences of sudden stops. The results show that, consistently with financial frictions being important, industries that are more dependent on external finance decline significantly more during a sudden stop, especially in less financially developed countries. The results are robust to controlling for other possible mechanisms, including labor market frictions. The paper also provides results on the role of comparative advantage during sudden stops and on the usefulness of various policy responses to attenuate the consequences of these shocks.Debt Markets,Emerging Markets,Access to Finance,Currencies and Exchange Rates,Economic Theory&Research

Financial Integration Without the Volatility

Integration to international capital markets is one of the key pillars of development. However, capital flows also bring volatility to emerging markets. Are there mechanisms to reap the benefits of capital flows without being hurt by their volatility? Are current practices, such as large reserves accumulation, public deleveraging, and export promotion strategies, efficient external insurance mechanisms? In this pa- per we start by documenting the external volatility faced by emerging markets as well as current self-insurance practices, especially among prudent economies. We then provide a simple model that illustrates the inefficient nature of these practices. We argue that with the help of the IFIs in developing the right contingent markets, similar protection could be obtained at lower cost by using financial hedging strategies. We also argue that, at least for now, local governments have an important role to play in the implementation of these external insurance mechanisms.

Maturity Mismatch and Financial Crises: Evidence from Emerging Market Corporations

Substantial attention has been paid in recent years to the risk of maturity mismatch in emerging markets. Although this risk is microeconomic in nature, the evidence advanced thus far has taken the form of macro correlations. This paper empirically evaluates this mechanism at the micro level by using a database of over 3,000 publicly traded firms from fifteen emerging markets. The paper measures the risk of short-term exposure by estimating, at the firm level, the effect on investment of the interaction of short-term exposure and aggregate capital flows. This effect is (statistically) zero, contrary to the prediction of the maturity-mismatch hypothesis. This conclusion is robust to using a variety of different estimators, alternative measures of capital flows, and controls for devaluation effects and access to international capital. The paper finds evidence that short-term-exposed firms pay higher financing costs and liquidate assets at fire sale prices, but the paper does not find that this reduction in net worth translates into a drop in investment.

Corporate Dollar Debt and Depreciations: Much Ado About Nothing?

Much has been written recently about the problems for emerging markets that might result from a mismatch between foreign-currency denominated liabilities and assets (or income flows) denominated in local currency. In particular, several models, developed in the aftermath of financial crises of the late 1990s, suggest that the expansion in the "peso" value of "dollar" liabilities resulting from a devaluation could, via a net worth effect, offset the expansionary competitiveness effect. Assessing which effect dominates is ultimately an empirical matter. In this vein, this paper constructs a new database with accounting information (including the currency composition of liabilities) for over 450 non-financial firms in five Latin American countries. The authors estimate, at the firm level, the reduced-form effect on investment of holding foreign-currency-denominated debt during an exchange-rate realignment. It is consistently found that, contrary to the predicted sign of the net-worth effect, firms holding more dollar debt do not invest less than their counterparts in the aftermath of a depreciation. The paper shows that this result is due to firms matching the currency denomination of their liabilities with the exchange-rate sensitivity of their profits. Because of this matching, the negative balance-sheet effects of a depreciation on firms holding dollar debt are offset by the larger competitiveness gains of these firms.

International Borrowing, Capital Controls and the Exchange Rate: Lessons from Chile

This paper analyzes the Chilean experience with capital flows. We discuss the role played by capital controls, financial regulations and the exchange rate regime. The focus is on the period after 1990, the period when Chile returned to international capital markets. We also discuss the early 80s, where a currency collapse triggered a financial crisis in Chile, despite stricter capital controls on inflows than the 90s and tighter currency matching requirements on the banking sector. We conclude that financial regulation and the exchange rate regime are at the center of capital inflows experiences and financial vulnerabilities. Rigid exchange rates induce vulnerabilities, which may lead to sharp capital account reversals. We also discuss three important characteristics of the Chilean experience since the 90s. The first is the fact that most international borrowing is done directly by corporations and it is not intermediated by the banking system. The second is the implication of the free trade agreement of Chilean and the US regarding capital controls. Finally, we examine the Chilean experience following the Asian-Russia crisis, showing that Chile did not suffer a sudden-stop, but a current account reversal due to policy reactions and a sudden-start in capital outflows.

Financial dollarization and central bank credibility

Why do firms and banks hold foreign currency denominated liabilities? The authors argue that foreign currency debt, by altering the effect of a devaluation on output, has a disciplining effect when the Central Bank's objectives differ from the social optimum. However, under imperfect information, bad priors about the Central Bank induce excess dollarization of liabilities, which in turn limits the ability of the Central Bank to conduct an optimal monetary policy. In addition the economy may become stuck in a"dollarization trap"in which dollarized liabilities limit the ability of agents to learn the true type of the monetary authority. The model has clear-cut policy implications regarding the taxation of foreign currency liabilities as a way to encourage perfect information and avoid dollarization traps. Moreover, it reinforces the existing argument for Central Bank independence. Finally, the authors believe this model to be consistent with a growing empirical literature on the determinants of foreign currency liabilities and their relationships to Central Bank credibility.Financial Intermediation,Environmental Economics&Policies,Payment Systems&Infrastructure,Economic Theory&Research,Fiscal&Monetary Policy,Economic Theory&Research,Economic Stabilization,Environmental Economics&Policies,Macroeconomic Management,Financial Intermediation

Fear of Sudden Stops: Lessons from Australia and Chile

Latin American economies are exposed to substantial external vulnerability. Domestic imbalances and terms of trade shocks are often exacerbated by sudden stops of capital inflow. In this paper we explore ways of overcoming external vulnerability, drawing lessons from a detailed comparison of the response of Chile and Australia to recent external shocks and from Australia's historical experience. We argue that in order to understand sudden stops and the mechanisms to smooth them, it is useful to identify and then distinguish between two inter-related dimensions of investors' confidence: country-trust and currency-trust. Lack of country-trust is a more fundamental and serious problem behind sudden stops. But lack of currency-trust may both be a source of country-trust problems and weaken a country's ability to deal with sudden stops. We discuss steps to improve along these two dimensions of investors' confidence in the medium run, and policies to reduce the impact of country-trust and currency-trust weaknesses in the short run.

High Frequency Dynamics of the Exchange Rate in Chile

We estimate a reduced form model for the daily dynamics of the nominal spot exchange rate in Chile. The model does reasonably well in explaining the long and short run dynamics for the peso-dollar exchange rate for the period 2001-2006. In addition, we extend the model to evaluate the effects of the foreign investment of pension funds, foreign exchange rate interventions by the Central Bank and other events whose effects on the exchange rate have policy implications. We find –in line with previous work conducted at the Central Bank - that the impact of Central Bank actions on the FX market seemed to be better channeled through public announcements. Moreover, we find that changes in the pension funds limits on foreign assets had significant, but small and transitory effects on the spot peso-dollar exchange rate.

Current Account and External Financing: An Introduction

Creation-DaThis brief review takes stock of the recent literature on current account and external financing and presents new analytical results and empirical research on the subject. Four key areas of related research are presented, namely global imbalances and macroeconomic adjustment; external adjustment in emerging economies, crises and current-account reversals; current account and exchange rate dynamics; and some policy issues concerning external financing. The review suggests a significant number of open questions, which were addressed in the thirteen groundbreaking papers presented at the Central Bank of Chile’s Annual Conference of 2006, which are summarized here.te:2007-12