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Reserve Uncertainty and the Supply of International Credit

  • Joshua Aizenman
  • Nancy Marion

This paper examines how increased uncertainty about an emerging market's international reserves affects the willingness of foreign investors to supply international credits. We illustrate the relevance of this concern for South Korea during the recent financial crisis. Using available information about Korea's reserves at the onset of the crisis, we show that 'usable' reserves turned out to be much lower than what a reasonable forecast would have predicted. We then develop a model of an emerging-market economy where there is sovereign risk and moral hazard is a problem because agents expect the emerging market to bail out creditors with its reserves. We show that reserve uncertainty has a non-linear effect on the supply of credit. When the expected reserve position of an emerging market is large relative to the potential bailout in bad states of nature, reserve volatility does not matter. However, the same amount of reserve volatility can cause a large reduction in the supply of international credit if the emerging market's foreign debt is large enough or if the collapse of output forces the private sector to downgrade its priors about repayment possibilities. In addition, reserve volatility can reduce international credit if investors become more pessimistic about the emerging market's reserve position.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7202.

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Date of creation: Jul 1999
Date of revision:
Publication status: published as Journal of Money, Credit and Banking, Vol. 34, no. 3, part 1 (August 2002): 631-649
Handle: RePEc:nbr:nberwo:7202
Note: IFM
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  1. Roberto Chang & Andres Velasco, 1998. "Financial crises in emerging markets: a canonical model," FRB Atlanta Working Paper 98-10, Federal Reserve Bank of Atlanta.
  2. Aizenman, Joshua, 1989. "Country Risk, Incomplete Information and Taxes on International Borrowing," Economic Journal, Royal Economic Society, vol. 99(394), pages 147-61, March.
  3. Giancarlo Corsetti & Paolo Pesenti & Nouriel Roubini, 1998. "Paper tigers? A model of the Asian crisis," Research Paper 9822, Federal Reserve Bank of New York.
  4. Alba, Pedro & Bhattacharya, Amar & Claessens, Stijn & Ghosh, Swati & Hernandez, Leonardo, 1998. "Volatility and contagion in a financially integrated world : lessons from East Asia's recent experience," Policy Research Working Paper Series 2008, The World Bank.
  5. Robert M. Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  6. Steven Radelet & Jeffrey D. Sachs, 1998. "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1), pages 1-90.
  7. Joshua Aizenman & Stephen Turnovsky, 1999. "Reserve Requirements on Sovereign Debt in the Presence of Moral Hazard -- on Debtors or Creditors?," Discussion Papers in Economics at the University of Washington 0044, Department of Economics at the University of Washington.
  8. Aizenman, Joshua & Marion, Nancy, 1999. "Volatility and Investment: Interpreting Evidence from Developing Countries," Economica, London School of Economics and Political Science, vol. 66(262), pages 157-79, May.
  9. Roberto Chang & Andres Velasco, 1998. "Financial Crises in Emerging Markets," NBER Working Papers 6606, National Bureau of Economic Research, Inc.
  10. Boyd, John H & Smith, Bruce D, 1994. "How Good Are Standard Debt Contracts? Stochastic versus Nonstochastic Monitoring in a Costly State Verification Environment," The Journal of Business, University of Chicago Press, vol. 67(4), pages 539-61, October.
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