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.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
10790.
Length: Date of creation: Sep 2004 Date of revision: Handle: RePEc:nbr:nberwo:10790
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Find related papers by JEL classification: F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
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Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003.
"Debt Intolerance,"
NBER Working Papers
9908, National Bureau of Economic Research, Inc.
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Other versions:
Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003.
"Debt intolerance,"
MPRA Paper
13932, University Library of Munich, Germany.
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Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003.
"Debt Intolerance,"
Brookings Papers on Economic Activity,
Economic Studies Program, The Brookings Institution, vol. 34(2003-1), pages 1-74.
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