Free PDF Ebooks Files @AcrobatPlanet.Com

The sequence of financial crises that started with the so-called Tequila crisis in Mexico in 1994-95 strongly suggests that these phenomena cannot simply be rationalized in terms of advanced-country business cycle models. More is at stake here. In particular, these episodes are associated with a sharp contraction of international capital flows, or Sudden Stop, which may by itself have triggered the ensuing disruption. Sudden Stops are associated with large depreciations and major financial disruptions, leading to significantly lower rates of return, investment and growth. This is the point of view that will be elaborated on and subjected to empirical analysis in the present paper.

For starters, we would like to say a few words on alternative explanations of deep financial crises in Emerging Market economies (EMs) and give an intuitive presentation of the approach pursued in this paper. A popular explanation for these crises used to be and, in some quarters still is, “lack of fiscal discipline.” As the argument goes, crisis-prone EMs have a tendency to run high fiscal deficits, which eventually result in an unsustainable level of public debt. Thus, there comes a time when lenders stop lending, forcing a major domestic adjustment. This explanation is very appealing for the 1980s Debt Crisis in Latin America, but finds little support in Asia. For example, at the inception of its 1997 crisis, Korea’s public debt hovered around only 10 percent of GDP. Moreover, debt levels in EMs are comparable to if not significantly lower than in advanced countries (e.g., Japan).

Ardent believers in the fiscal view may not be entirely convinced by these observations, because during a financial crisis, the country as a whole, and the government in particular, lose access to international capital markets. Thus, lenders behave as if they have smelled “something rotten in the State of Denmark.” However, loss of access need not be the result of over indebtedness in the context of a good equilibrium, but rather the result of a bad equilibrium triggered by a Sudden Stop. This Inverse Fiscal View finds support in the fact that Sudden Stop episodes tend to occur around the same time, and for countries exhibiting a variety of fiscal situations (indeed, the “bunching” of Sudden Stops is an important characteristic that we identify in the empirical section). The most outstanding such episode was associated with the Russian August 1998 crisis, in which practically all EMs suffered serious Sudden Stops and an increase in country risk premiums.

The fiscal view started to be questioned during the 1997 Asian crises because these countries’ fiscal stances were much stronger than those in Latin America. Even the IMF (1999) recognized that it made a mistake in calling for strong fiscal adjustment in that part of the world. As a result, attention shifted to other variables. It did not take long for professional opinion to identify soft pegs as the likely culprit. The Soft Peg view is that crisis countries engaged in unsustainable exchange rate pegs, which they were reluctant to abandon in a timely fashion, and only did so when hit by a balance-of-payments crisis. This is an eminently sensible argument, but it falls short of providing an explanation for the ensuing real meltdown (collapse in output and employment, for instance). Thus, our criticism follows the same lines that we have just utilized to question the relevance of the fiscal view, and it need not be repeated.

The view that will be spelled out in this paper is that EMs suffer from structural weaknesses that make them vulnerable—much more than advanced economies—to shocks. In particular, we will zero in on shocks that are reflected in large changes in the real exchange rate (RER), i.e., the relative price of tradables with respect to nontradables. The RER is a fundamental relative price that cuts across the fabric of the whole economy and involves a large variety of non-tradable goods. Large variety, in turn, militates against the existence of effective state-contingent markets (e.g., futures markets) like those found in commodities markets. There is, of course, nothing special about EMs in this respect. However, what could make the variability of the RER deadly in EMs is the fact that many of them suffer from Domestic Liability Dollarization (DLD), i.e., a high incidence of foreign-exchange denominated obligations with the domestic banking system. Hence, a rise in the RER (i.e., real currency depreciation) makes it more difficult to repay loans for firms producing nontradables. This effect is particularly relevant because it may trigger substantial uncertainty about the solvency of the banking system as loans become non-performing, sometimes leading to bank runs in expectation of bank bankruptcies, which, in turn, almost inevitably affect the payments system and cause disruption in transactions and output.

Whether or not this effect is large depends, of course, on the size of the RER change, the stock of foreign-exchange denominated loans, and the ability of firms to switch production into tradables along their production possibilities frontier (which is likely to be difficult, particularly in the short run). Thus, one could conjecture that real devaluations are particularly dangerous after a period in which there have been significant capital inflows (like the period from 1990 to 1996 in EMs). The next section will present a simple model that helps to endogenize the RER. It should be intuitive, however, that a Sudden Stop, being a sizable cut in credit, will bring about a fall in aggregate demand and, consequently, a possibly large increase in the RER. Thus, a Sudden Stop may sow the seeds of a self-fulfilling crisis. This is the main line that will be pursued in the paper. However, it will be argued that equilibrium-multiplicity is not required in order to rationalize the existence of Sudden Stops. Thus, for example, Sudden Stops might be displayed in models in which the equilibrium set does not vary continuously with respect to fundamentals (Calvo, 2003).

Our empirical findings support the view that potential RER fluctuations coupled with DLD are key determinants of the probability of experiencing Sudden Stops, thus highlighting the relevance of potential balance-sheet effects in explaining the likelihood of a crisis. As will be discussed later, we argue that potential changes in the RER are linked to the size of the current account deficit prevailing before the materialization of a Sudden Stop. Thus, our approach focuses on the impact of dollarization on the likelihood of a Sudden Stop, rather than on the consequences of dollarization and Sudden Stops on relevant variables such as economic growth, as in Edwards (2003), for example.

Recent empirical literature has focused on alternative measures of crisis, whether currency crises (Frankel and Rose, 1996; Kaminsky and Reinhart, 1999; Edwards, 2001; Arteta, 2003; Razin and Rubinstein, 20049) or current account reversals (Milesi-Ferretti and Razin, 2000; Edwards, 2003). However, we believe that to the extent that many of the recent crises originated in credit shocks in international markets, as argued in Calvo (1999), measures of crisis should be more closely linked to large and unexpected capital account movements rather than to measures that focus on large nominal currency fluctuations or current account reversals. Besides, current account and exchange rate behavior may be more affected by policy choices than Sudden Stops. Moreover, Sudden Stops may imply quite different timings for the onset of a crisis compared to exchange rate crises or current account reversals.

Our strategy concentrates on the valuation effects of domestic dollarized liabilities (or, more specifically, on liabilities in terms of tradable goods), so our interest lies in real rather than nominal exchange rate fluctuations. Furthermore, we do not focus on the current account itself, but rather on the percentage fall in the absorption of tradable goods, which, as will be argued later, may represent a summary statistic for the rise in the RER following a Sudden Stop. Moreover, we highlight DLD, a phenomenon not considered in previous empirical studies of crises, with the exception of Arteta (2003), who explores the significance of Liability Dollarization in explaining the probability of a currency crisis. Interestingly, he finds no significant role for Liability Dollarization. This result is not incompatible with our findings, given that we do not focus on currency crises, and, as stated earlier, the timing of currency crises may be quite different from that of Sudden Stops. Additionally, our measure of dollarization is different in that it includes not only deposits but also foreign borrowing, something that is particularly relevant for EMs when trying to proxy for credit awarded in foreign currency.

The paper is organized as follows: Section 2 describes a model that identifies the variables that determine the change in the RER, which is at the heart of our crisis framework. Section 3 develops an empirical definition and characterization of Sudden Stops. Section 4 focuses on an empirical analysis of the determinants of Sudden Stops, following a panel Probit approach. Section 5 concludes with a description of our main findings and future lines of research.

Download
PDF Ebook On the Empirics of Sudden Stops: The Relevance of Balance-Sheet Effects