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Financial crises, capital liquidation and the demand for international reserves

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  • Mourmouras, Alex
  • Russel, Steven H.

Abstract

We study a simple neoclassical model of investment in a developing country, modified to allow for long-term projects and short-term debt. Early signals indicating low productivity of investment may lead creditors to call loans in early. In such a crisis, firms protected by limited liability default and liquidate capital, even thought they do so at a loss (a 'fire sale'). We show that short-term debt financing is beneficial in good (normal) times: when there is no adverse signal, and thus no need to liquidate capital, investment, the capital-labor ratio, wages and ex post worker utility are all higher than they would be if liquidation were not possible or was prohibited. Capital liquidation exacerbates the effects of negative shocks by lowering the capital-labor ratio and lowering wages in bad times (crises). Capital liquidation raises the variability of wages and hurts workers who cannot insure against wage income (this seems plausible in emerging market economies). Accumulating a stock of international reserves to be used during or after a crisis can mitigate the adverse effects of capital liquidation on wage variability and worker welfare.

Suggested Citation

  • Mourmouras, Alex & Russel, Steven H., 2009. "Financial crises, capital liquidation and the demand for international reserves," University of Göttingen Working Papers in Economics 88, University of Goettingen, Department of Economics.
    • Handle: RePEc:zbw:cegedp:88
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    Cited by:

    1. Alexander Mihailov & Harun Nasir, 2022. "Sudden Stops, Productivity and the Optimal Level of International Reserves for Small Open Economies," Open Economies Review, Springer, vol. 33(5), pages 825-851, November.
    2. Qian, Xingwang & Steiner, Andreas, 2017. "International reserves and the maturity of external debt," Journal of International Money and Finance, Elsevier, vol. 73(PB), pages 399-418.

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