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

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  • Enrique G. Mendoza
  • Ceyhun Bora Durdu

Abstract

The hypothesis that Sudden Stops to capital inflows in emerging economies may be caused by global capital market frictions, such as collateral constraints and trading costs, suggests that Sudden Stops could be prevented by offering 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 also viewed as a cause of 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 guarantees, margin calls and trading costs create distortions that produce Sudden Stops driven by occasionally binding credit constraints and Irving Fisher’s debt-deflation mechanism. 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 driving the dynamics of asset prices, consumption and the current account. Price guarantees are found to be effective for containing Sudden Stops but at the cost of introducing potentially large distortions that could lead to ‘overvaluation’ of emerging markets assets.

Suggested Citation

  • Enrique G. Mendoza & Ceyhun Bora Durdu, 2004. "Putting the brakes on Sudden Stops: the financial frictions-moral hazard tradeoff of asset price guarantees," Working Paper Series 2004-33, Federal Reserve Bank of San Francisco.
  • Handle: RePEc:fip:fedfwp:2004-33
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    References listed on IDEAS

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    Cited by:

    1. Mendoza, Enrique G. & Smith, Katherine A., 2006. "Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices," Journal of International Economics, Elsevier, vol. 70(1), pages 82-114, September.
    2. Ashot Tsharakyan & Martin Janíčko, 2010. "The Binding Credit Constraints and the Welfare Effects of Housing Price Appreciation," Prague Economic Papers, University of Economics, Prague, vol. 2010(4), pages 359-382.

    More about this item

    Keywords

    Prices ; Economic development ; Investments;

    JEL classification:

    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

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