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A Quantitative Model of Sudden Stops and External Liquidity Management

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  • Ricardo Caballero
  • Stavros Panageas

Abstract

Emerging market economies, which have much of their growth ahead of them, run persistent current account deficits in order to smooth consumption intertemporally. The counterpart of these deficits is their dependence on capital inflows, which can suddenly stop. In this paper we develop and estimate a quantifiable model of sudden stops and use it to study practical mechanisms to insure emerging markets against them. We first assess the standard practice of protecting the current account through the accumulation of international reserves and conclude that, even when optimally managed, this mechanism is expensive and incomplete. External insurance, on the other hand, is hard to obtain because sudden stops often come together with distress in emerging market investors themselves (the most natural insurers). Thus, one needs to find global (non-emerging-market-specific) assets that are correlated to sudden stops. We show an example of such an asset based on the S&P 500's implied volatility index. If added to these countries portfolios, it would significantly enhance their sudden stop risk-management strategies. In our simulations, the median gain in terms of reserves available at the time of sudden stop is around 30 percent. Moreover, in instances where the level of non-contingent reserves is low, the median gain is close to 300 percent. We also find that as countries manage to reduce the size of the sudden stops that afflict them, they should reduce their stock of reserves and significantly increase their share of contingent reserves. The main insights of the paper extend to external liquidity and liability management more generally.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11293.

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Date of creation: May 2005
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Handle: RePEc:nbr:nberwo:11293

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Citations

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Cited by:
  1. Marcello Spanò, 2013. "Foreign Reserves as Hedging Instruments in Emerging Countries," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 60(2), pages 203-230, April.
  2. Kimakova, Alena, 2008. "The political economy of exchange rate regime determination: Theory and evidence," Economic Systems, Elsevier, Elsevier, vol. 32(4), pages 354-371, December.
  3. Ricardo J. Caballero, 2006. "On the Macroeconomics of Asset Shortages," NBER Working Papers 12753, National Bureau of Economic Research, Inc.
  4. Ran Bi & Prakash Kannan & Suman Sambha Basu, 2010. "Regional Reserve Pooling Arrangements," 2010 Meeting Papers, Society for Economic Dynamics 675, Society for Economic Dynamics.
  5. Alexander D. Rothenberg & Francis E. Warnock, 2007. "Sudden Flight and True Sudden Stops," The Institute for International Integration Studies Discussion Paper Series, IIIS iiisdp187, IIIS.
  6. Marcello Spanò, 2012. "The Effect Of Openness On Foreign Reserves And Growth In The Emerging Economies," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 1, pages 7-23, March.
  7. Alexander D. Rothenberg & Francis E. Warnock, 2006. "Sudden Flight and True Sudden Stops," NBER Working Papers 12726, National Bureau of Economic Research, Inc.
  8. Ricardo J. Caballero & Stavros Panageas, 2003. "Hedging Sudden Stops and Precautionary Contractions," NBER Working Papers 9778, National Bureau of Economic Research, Inc.
  9. Ronald U. Mendoza, 2007. "A Compendium of Policy Instruments to Enhance Financial Stability and Debt Management in Emerging Market Economies," Working Papers, United Nations, Department of Economics and Social Affairs 48, United Nations, Department of Economics and Social Affairs.
  10. Flavia Corneli & Emanuele Tarantino, 2011. "Reserve management and sovereign debt cost in a world with liquidity crises," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 797, Bank of Italy, Economic Research and International Relations Area.
  11. Barry Eichengreen, 2007. "Insurance Underwriter or Financial Development Fund: What Role for Reserve Pooling in Latin America?," Open Economies Review, Springer, Springer, vol. 18(1), pages 27-52, February.
  12. Enrique G. Mendoza, 2006. "Lessons From the Debt-Deflation Theory of Sudden Stops," NBER Working Papers 11966, National Bureau of Economic Research, Inc.
  13. Panageas, Stavros, 2010. "Bailouts, the incentive to manage risk, and financial crises," Journal of Financial Economics, Elsevier, Elsevier, vol. 95(3), pages 296-311, March.
  14. Ricardo J. Caballero & Pierre Yared, 2008. "Inflating the Beast: Political Incentives Under Uncertainty," NBER Working Papers 13779, National Bureau of Economic Research, Inc.
  15. Olivier Jeanne, 2007. "International Reserves in Emerging Market Countries: Too Much of a Good Thing?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 38(1), pages 1-80.
  16. Stavros Panageas, 2009. "Bailouts, the Incentive to Manage Risk, and Financial Crises," NBER Working Papers 15058, National Bureau of Economic Research, Inc.
  17. Kevin Cowan L. & José De Gregorio R. & Alejandro Micco A. & Christopher Neilson M., 2007. "Financial Diversification and Sudden Stops," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 10(3), pages 45-65, December.

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