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Sudden Stops and the Mexican Wave: Currency Crises, Capital Flow Reversals and Output Loss in Emerging Markets

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Author Info
Michael Hutchison (University of California Santa Cruz Economics Department)
Ilan Noy (University of Hawaii, Manoa. Department of Economics)

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Abstract

Sudden Stops are the simultaneous occurrence of a currency/balance of payments crisis with a reversal in capital flows (Calvo, 1998). We investigate the output effects of financial crises in emerging markets, focusing on whether sudden-stop crises are a unique phenomenon and whether they entail an especially large and abrupt pattern of output collapse (a "Mexican wave"). Despite an emerging theoretical literature on Sudden Stops, empirical work to date has not precisely identified their occurrences nor measured their subsequent output effects in broad samples. Analysis of Sudden Stops may provide the key to understanding why some currency/balance of payments crises entail very large output losses, while others are frequently followed by expansions. Using a panel data set over the 1975-97 period and covering 24 emerging-market economies, we distinguish between the output effects of currency crises, capital inflow reversals, and sudden-stop crises. We find that sudden-stop crises have a large negative, but short-lived, impact on output growth over and above that found with currency crises. A currency crisis typically reduces output by about 2-3 percent, while a Sudden Stop reduces output by an additional 6-8 percent in the year of the crisis. The cumulative output loss of a Sudden Stop is even larger, around 13-15 percent over a three-year period. Our model estimates correspond closely to the output dynamics of the 'Mexican wave' (such as seen in Mexico in 1995, Turkey in 1994 and elsewhere), and out-of-sample predictions of the model explain well the sudden (and seemingly unexpected) collapse in output associated with the 1997-98 Asian Crisis. The empirical results are robust to alternative model specifications, lag structures and using estimation procedures (IV and GMM) that correct for bias associated with estimation of dynamic panel models with country-specific effects. Our study supports the hypothesis that sudden stops have a much larger adverse effect on output than other forms of currency attack, and explains the wide divergence in economies' performances following international financial crises. Establishing this empirical regularity for emerging market economies is the first step in empirically identifying the transmission mechanism through which sudden stops have such large output effects.

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Paper provided by Department of Economics, UC Santa Cruz in its series Santa Cruz Department of Economics, Working Paper Series with number 1009.

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Date of creation: 04 Apr 2004
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Rodrik, Dani, 2006. "The Social Cost of Foreign Exchange Reserves," CEPR Discussion Papers 5483, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  2. Sula, Ozan & Willett, Thomas D., 2006. "Reversibility of Different Types of Capital Flows to Emerging Markets," MPRA Paper 384, University Library of Munich, Germany. [Downloadable!]
  3. David Fernando López Angarita, 2006. "Nivel de reservas internacionales y riesgo cambiario en Colombia," Revista de Economía Institucional, Universidad Externado de Colombia - Facultad de Economía, vol. 8(15), pages 117-159, July-Dece. [Downloadable!]
  4. Sula, Ozan, 2006. "Surges and Sudden Stops of Capital Flows to Emerging Markets," MPRA Paper 383, University Library of Munich, Germany. [Downloadable!]
  5. Michael M. Hutchison & Ilan Noy & Lidan Wang, 2007. "Fiscal and Monetary Policies and the Cost of Sudden Stops," Working Papers 200724, University of Hawaii at Manoa, Department of Economics. [Downloadable!]
  6. Flores Prieto, Pedro & Fullerton, Thomas M., Jr. & Andrade Olivas, Cesar, 2007. "Evidencia empirica sobre deuda externa, inversion, y crecimiento en Mexico, 1980-2003
    [Empirical evidence on foreign debt, investment, and growth in Mexico, 1980-2003]    ," MPRA Paper 9497, University Library of Munich, Germany, revised Apr 2007. [Downloadable!]
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  8. David Hofman & Ruben Atoyan & Dimitri Tzanninis & Mauro Mecagni, 2007. "The Duration of Capital Account Crises--An Empirical Analysis," IMF Working Papers 07/258, International Monetary Fund. [Downloadable!]
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