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Margin Calls, Trading Costs, and Asset Prices in Emerging Markets: The Finanical Mechanics of the 'Sudden Stop' Phenomenon

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  • Enrique G. Mendoza
  • Katherine A. Smith

Abstract

A central feature of emerging markets crises is the Sudden Stop' phenomenon characterized by large reversals of capital inflows and current accounts, deep recessions, and collapses in asset prices. This paper proposes an open-economy asset-pricing model with financial frictions that yields predictions in line with these observations. Margin requirements and information costs distort asset trading between a small open economy and foreign securities firms. If the economy's debt-equity ratio is low, standard productivity shocks cause normal recessions with smooth current-account adjustments. If the ratio is high, the same productivity shocks trigger margin calls forcing domestic agents to firesell equity to foreign traders who are slow to adjust their portfolios. This sets off a Fisherian asset-price deflation and subsequent rounds of margin calls. A current account reversal and a collapse in consumption occur if the fire-sale of assets cannot prevent a sharp increase in net foreign asset holdings.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9286.

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Date of creation: Oct 2002
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Handle: RePEc:nbr:nberwo:9286

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  1. Luis Felipe Cespedes & Roberto Chang & Andres Velasco, 2000. "Balance Sheets and Exchange Rate Policy," NBER Working Papers 7840, National Bureau of Economic Research, Inc.
  2. Coen-Pirani, Daniele, 2005. "Margin requirements and equilibrium asset prices," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(2), pages 449-475, March.
  3. Ben Bernanke & Mark Gertler & Simon Gilchrist, 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," NBER Working Papers 6455, National Bureau of Economic Research, Inc.
  4. Lawrence J. Christiano & Christopher Gust & Jorge Roldos, 2000. "Monetary Policy in an International Financial Crisis," Econometric Society World Congress 2000 Contributed Papers, Econometric Society 1814, Econometric Society.
  5. Paasche, Bernhard, 2001. "Credit constraints and international financial crises," Journal of Monetary Economics, Elsevier, Elsevier, vol. 48(3), pages 623-650, December.
  6. Arvind Krishnamurthy & Ricardo J. Caballero, 1999. "Emerging Markets Crisis," IMF Working Papers 99/129, International Monetary Fund.
  7. Obstfeld, Maurice, 1982. "Aggregate Spending and the Terms of Trade: Is There a Laursen-Metzler Effect?," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 97(2), pages 251-70, May.
  8. Backus, David K. & Gregory, Allan W. & Zin, Stanley E., 1989. "Risk premiums in the term structure : Evidence from artificial economies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 24(3), pages 371-399, November.
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