Putting the brakes on Sudden Stops: the financial frictions - moral hazard tradeoff of asset price guarantees

The hypothesis that Sudden Stops to capital inflows in emerging economies may originate in frictions inherent to global capital markets, such as collateral constraints and trading costs, suggests that Sudden Stops could be prevented by an international organization that offers exante price guarantees on the emerging-markets asset class. Providing these guarantees is a risky endeavor, however, because they introduce a moral-hazard-like incentive similar to those that are viewed as another culprit behind emerging markets crises. This paper studies this financial frictions-moral hazard tradeoff using an equilibrium asset-pricing model in which margin constraints, trading costs, and ex-ante price guarantees interact in the determination of asset prices and macroeconomic dynamics. In the absence of price guarantees, margin calls and trading costs create distortions in asset markets that produce Sudden Stops driven by occasionally binding credit constraints and Irving Fisher?s debt-deflation mechanism, as in the model proposed by Mendoza and Smith (2003). Price guarantees contain the asset deflation by creating another distortion that props up the foreign investors? demand for emerging markets assets. Quantitative simulation analysis shows the strong interaction of these two distortions in determining asset prices and the dynamics of consumption and the current account. Price guarantees are shown to be effective at containing Sudden Stops but at the cost of introducing potentially large distortions leading to ?overvaluation? of emerging markets assets.