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International Liquidity Illusion: On the Risks of Sterilization

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  • Ricardo J. Caballero
  • Arvind Krishnamurthy

Abstract

During the booms that precede crises in emerging economies, policymakers often struggle to limit capital flows and their expansionary consequences. The main policy tool for this task is a sterilization of capital inflows - essentially a swap of international reserves for public bonds. Despite its widespread use, sterilization is often criticized for its ineffectiveness and, in extreme cases, its potential backfiring. We argue that these concerns are justified when countries experience occasional external crises and domestic financial markets are illiquid. In this context, while standard Mundell-Fleming considerations may determine the impact of the sterilization on short term peso interest rates, a potentially more powerful and offsetting mechanism is triggered by the anticipated reversal of this policy in the event of an external crisis. If the instruments used in the sterilization are illiquid or result in fiscal deficits that reduce the liquidity of the private sector, then the effective dollar cost of capital, which considers the whole path of expected future rates, may be lowered rather than raised by this policy. Most importantly, this dollar cost of capital reduction does not reflect a true increase in the country's international liquidity during the external crisis and reversal, as would be the case with a successful sterilization, but just a decline in domestic private liquidity. The impact of the latter on relative asset prices creates a sort of 'international liquidity illusion' which fosters rather than depress aggregate demand, and exacerbates short term capital inflows.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8141.

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Date of creation: Feb 2001
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Handle: RePEc:nbr:nberwo:8141

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  1. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, vol. 84(4), pages 933-55, September.
  2. Ricardo Caballero & Arvind Krishnamurthy, 2000. "International and Domestic Collateral Constraints in a Model of Emerging Market Crises," NBER Working Papers 7971, National Bureau of Economic Research, Inc.
  3. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
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  8. Douglas W. Diamond & Raghuram G. Rajan, 2002. "Liquidity Shortages and Banking Crises," NBER Working Papers 8937, National Bureau of Economic Research, Inc.
  9. Ricardo J. Caballero & Arvind Krishnamurthy, 2000. "International Liquidity Management: Sterilization Policy in Illiquid Financial Markets," Econometric Society World Congress 2000 Contributed Papers 1700, Econometric Society.
  10. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Fall.
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  13. Corbo, Vittorio & Hernandez, Leonardo, 1996. "Macroeconomic Adjustment to Capital Inflows: Lessons from Recent Latin American and East Asian Experience," World Bank Research Observer, World Bank Group, World Bank Group, vol. 11(1), pages 61-85, February.
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Cited by:
  1. Fernando Broner & Guido Lorenzoni & Sergio L. Schmukler, 2003. "Why do emerging economies borrow short term?," Economics Working Papers 838, Department of Economics and Business, Universitat Pompeu Fabra, revised Dec 2011.
  2. Herrala, Risto, 2003. "The rigidity bias," Research Discussion Papers 31/2003, Bank of Finland.
  3. Antonio E. Bernardo & Ivo Welch, 2002. "Financial Market Runs," NBER Working Papers 9251, National Bureau of Economic Research, Inc.
  4. Michael P. Dooley & David Folkerts-Landau & Peter M. Garber, 2004. "The US Current Account Deficit and Economic Development: Collateral for a Total Return Swap," NBER Working Papers 10727, National Bureau of Economic Research, Inc.
  5. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2004. "Smoothing sudden stops," Journal of Economic Theory, Elsevier, vol. 119(1), pages 104-127, November.
  6. Layal Mansour, 2012. "Hoarding of International Reserves and Sterilization in Dollarized and Indebted Countries : an effective monetary policy?," Working Papers 1208, Groupe d'Analyse et de Théorie Economique (GATE), Centre national de la recherche scientifique (CNRS), Université Lyon 2, Ecole Normale Supérieure.

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