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Precautionary demand for foreign assets in sudden stop economies: an assessment of the new mercantilism

  • Ceyhun Bora Durdu
  • Enrique G. Mendoza
  • Marco E. Terrones

Financial globalization had a rocky start in emerging economies hit by Sudden Stops. Foreign reserves have grown very rapidly since then, as if those countries were practicing a New Mercantilism that views foreign reserves as a war-chest for defense against Sudden Stops. This paper conducts a quantitative assessment of this argument using a stochastic intertemporal equilibrium framework in which precautionary foreign asset demand is driven by output variability, financial globalization, and Sudden Stop risk. In this framework, credit constraints produce endogenous Sudden Stops. We find that financial globalization and Sudden Stop risk can explain the surge in reserves but output variability cannot. These results hold using the intertemporal preferences of the Bewley-Aiyagari-Hugget precautionary savings model or the Uzawa-Epstein setup with endogenous impatience.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 911.

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Date of creation: 2007
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Handle: RePEc:fip:fedgif:911
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  1. Woon Gyu Choi & Sunil Sharma & Maria Str�mqvist, 2009. "Net Capital Flows, Financial Integration, and International Reserve Holdings: The Recent Experience of Emerging Markets and Advanced Economies," IMF Staff Papers, Palgrave Macmillan, vol. 56(3), pages 516-540, August.
  2. Enrique G. Mendoza, 2006. "Endogenous Sudden Stops in a Business Cycle Model with Collateral Constraints:A Fisherian Deflation of Tobin's Q," NBER Working Papers 12564, National Bureau of Economic Research, Inc.
  3. Durdu, Ceyhun Bora & Mendoza, Enrique G. & Terrones, Marco E., 2009. "Precautionary demand for foreign assets in Sudden Stop economies: An assessment of the New Mercantilism," Journal of Development Economics, Elsevier, vol. 89(2), pages 194-209, July.
  4. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries; Formulas and Applications," IMF Working Papers 06/229, International Monetary Fund.
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  6. Sunil Sharma & Woon Gyu Choi & Maria Strömqvist, 2007. "Capital Flows, Financial Integration, and International Reserve Holdings; The Recent Experience of Emerging Markets and Advanced Economies," IMF Working Papers 07/151, International Monetary Fund.
  7. Jonathan D. Ostry & Carmen M. Reinhart, 1992. "Private Saving and Terms of Trade Shocks: Evidence from Developing Countries," IMF Staff Papers, Palgrave Macmillan, vol. 39(3), pages 495-517, September.
  8. Aizenman, Joshua & LEE, JAEWOO, 2005. "International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence," Santa Cruz Department of Economics, Working Paper Series qt44g3n2j8, Department of Economics, UC Santa Cruz.
  9. Guillermo A. Calvo, 1998. "Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 35-54, November.
  10. Sebastian Edwards, 2005. "Capital Controls, Sudden Stops and Current Account Reversals," NBER Working Papers 11170, National Bureau of Economic Research, Inc.
  11. Laura Alfaro & Fabio Kanczuk, 2007. "Optimal reserve management and sovereign debt," Working Paper Series 2007-29, Federal Reserve Bank of San Francisco.
  12. Enrique G. Mendoza, 2005. "Real Exchange Rate Volatility and the Price of Nontradables in Sudden-Stop-Prone Economies," NBER Working Papers 11691, National Bureau of Economic Research, Inc.
  13. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
  14. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  15. Epstein, Larry G., 1983. "Stationary cardinal utility and optimal growth under uncertainty," Journal of Economic Theory, Elsevier, vol. 31(1), pages 133-152, October.
  16. Guillermo A. Calvo & Alejandro Izquierdo & Luis-Fernando Mejia, 2004. "On the Empirics of Sudden Stops: The Relevance of Balance-Sheet Effects," NBER Working Papers 10520, National Bureau of Economic Research, Inc.
  17. Ceyhun Bora Durdu, 2007. "Quantitative implications of indexed bonds in small open economies," International Finance Discussion Papers 909, Board of Governors of the Federal Reserve System (U.S.).
  18. Marco Terrones & Eswar Prasad & M. Ayhan Kose, 2003. "Financial Integration and Macroeconomic Volatility," IMF Working Papers 03/50, International Monetary Fund.
  19. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
  20. Enrique G. Mendoza & Vincenzo Quadrini & Jose-Victor Rios-Rull, 2007. "Financial Integration, Financial Deepness and Global Imbalances," NBER Working Papers 12909, National Bureau of Economic Research, Inc.
  21. Ricardo J. Caballero & Stavros Panageas, 2003. "Hedging Sudden Stops and Precautionary Contractions," NBER Working Papers 9778, National Bureau of Economic Research, Inc.
  22. Michael Dooley & David Folkerts-Landau & Peter Garber, 2005. "An essay on the revived Bretton Woods system," Proceedings, Federal Reserve Bank of San Francisco, issue Feb.
  23. Enrique G. Mendoza, 2006. "Lessons From the Debt-Deflation Theory of Sudden Stops," NBER Working Papers 11966, National Bureau of Economic Research, Inc.
  24. Enrique G. Mendoza, 2002. "Credit, Prices, and Crashes: Business Cycles with a Sudden Stop," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 335-392 National Bureau of Economic Research, Inc.
  25. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  26. C. Bora Durdu & Enrique G. Mendoza & Marco Terrones, 2007. "Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Mercantilism: Working Paper 2007-10," Working Papers 18952, Congressional Budget Office.
  27. Martín Uribe, 2006. "Individual Versus Aggregate Collateral Constraints and the Overborrowing Syndrome," NBER Working Papers 12260, National Bureau of Economic Research, Inc.
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