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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. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
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  4. Ricardo J. Caballero & Arvind Krishnamurthy, 2000. "International Liquidity Management: Sterilization Policy in Illiquid Financial Markets," NBER Working Papers 7740, National Bureau of Economic Research, Inc.
  5. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
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  8. 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, vol. 11(1), pages 61-85, February.
  9. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
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  11. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
  12. 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.
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Cited by:
  1. Risto Herrala, 2004. "The rigidity bias," Finance 0404019, EconWPA.
  2. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2004. "Smoothing sudden stops," Journal of Economic Theory, Elsevier, vol. 119(1), pages 104-127, November.
  3. 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.
  4. Fernando Broner & Guido Lorenzoni & Sergio L. Schmukler, 2011. "Why Do Emerging Economies Borrow Short Term?," Working Papers 308, Barcelona Graduate School of Economics.
  5. Antonio E. Bernardo & Ivo Welch, 2002. "Financial Market Runs," NBER Working Papers 9251, National Bureau of Economic Research, Inc.
  6. 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.

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