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Investor Risk Aversion and Financial Fragility in Emerging Economies

  • J. H. Nilsen
  • R. Rovelli

Bank intermediated short-term capital inflows play a crucial role in the financial structure of many emerging economies. Yet since these funds are subject to the risk of early withdrawal, an excessive reliance on this financing is often associated with a financial or currency crisis. We model a situation where withdrawals are motivated by a change in either the domestic or foreign fundamentals. We show that, for a given change in fundamentals, a sudden reversal in the capital flows, and hence a financial crisis, is more likely the more risk averse are the foreign investors. We also show that a policy to tax early withdrawals may discourage the inflows more likely to cause fundamental runs, as it prevents the relatively more risk averse investors from investing. However, the policy must be fine-tuned to avoid discouraging all capital inflows.

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Paper provided by Dipartimento Scienze Economiche, Universita' di Bologna in its series Working Papers with number 380.

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Date of creation: 2000
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Handle: RePEc:bol:bodewp:380
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  1. Sebastian Edwards, 1999. "How Effective Are Capital Controls?," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 65-84, Fall.
  2. Jason Furman & Joseph E. Stiglitz, 1998. "Economic Crises: Evidence and Insights from East Asia," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 1-136.
  3. Chang, R. & Velasco, A., 1998. "Financial Fragility and the Exchange Rate Regime," Working Papers 98-05, C.V. Starr Center for Applied Economics, New York University.
  4. Eichengreen, Barry & Rose, Andrew K, 1998. "Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises," CEPR Discussion Papers 1828, C.E.P.R. Discussion Papers.
  5. Reinhart, Carmen & Montiel, Peter, 1999. "Do capital controls influence the volume and composition of capital flows? Evidence from the 1990s," MPRA Paper 13710, University Library of Munich, Germany.
  6. Chang, Roberto & Velasco, Andres, 2000. "Banks, debt maturity and financial crises," Journal of International Economics, Elsevier, vol. 51(1), pages 169-194, June.
  7. Alonso, Irasema, 1996. "On avoiding bank runs," Journal of Monetary Economics, Elsevier, vol. 37(1), pages 73-87, February.
  8. Dani Rodrik & Andres Velasco, 1999. "Short-Term Capital Flows," NBER Working Papers 7364, National Bureau of Economic Research, Inc.
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