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International Liquidity Illusion: On the Risks of Sterilization

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  • Ricardo J. Caballero
  • Arvind Krishnamurthy

Abstract

During the booms that precede crises in emerging economies, policymakers often struggle to limit capital flows and their expansionary consequences. The main policy tool for this task is a sterilization of capital inflows - essentially a swap of international reserves for public bonds. Despite its widespread use, sterilization is often criticized for its ineffectiveness and, in extreme cases, its potential backfiring. We argue that these concerns are justified when countries experience occasional external crises and domestic financial markets are illiquid. In this context, while standard Mundell-Fleming considerations may determine the impact of the sterilization on short term peso interest rates, a potentially more powerful and offsetting mechanism is triggered by the anticipated reversal of this policy in the event of an external crisis. If the instruments used in the sterilization are illiquid or result in fiscal deficits that reduce the liquidity of the private sector, then the effective dollar cost of capital, which considers the whole path of expected future rates, may be lowered rather than raised by this policy. Most importantly, this dollar cost of capital reduction does not reflect a true increase in the country's international liquidity during the external crisis and reversal, as would be the case with a successful sterilization, but just a decline in domestic private liquidity. The impact of the latter on relative asset prices creates a sort of 'international liquidity illusion' which fosters rather than depress aggregate demand, and exacerbates short term capital inflows.

Suggested Citation

  • Ricardo J. Caballero & Arvind Krishnamurthy, 2001. "International Liquidity Illusion: On the Risks of Sterilization," NBER Working Papers 8141, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:8141
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    References listed on IDEAS

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    1. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear of Floating," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 379-408.
    2. Ricardo J. Caballero & Arvind Krishnamurthy, 2000. "International Liquidity Management: Sterilization Policy in Illiquid Financial Markets," NBER Working Papers 7740, National Bureau of Economic Research, Inc.
    3. Jeffrey A. Frankel, 1997. "Sterilization of money inflows: Difficult (Calvo) or Easy (Reisen)?," Estudios de Economia, University of Chile, Department of Economics, vol. 24(2 Year 19), pages 263-285, December.
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    5. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
    6. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, April.
    7. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    8. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-388, May.
    9. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December.
    10. Corbo, Vittorio & Hernandez, Leonardo, 1996. "Macroeconomic Adjustment to Capital Inflows: Lessons from Recent Latin American and East Asian Experience," World Bank Research Observer, World Bank Group, vol. 11(1), pages 61-85, February.
    11. Douglas W. Diamond, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, Oxford University Press, vol. 106(3), pages 709-737.
    12. Carmen Reinhart & Guillermo Calvo & Leonardo Leiderman, 1992. "Capital Inflows to Latin America; The 1970's and the 1990's," IMF Working Papers 92/85, International Monetary Fund.
    13. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, vol. 84(4), pages 933-955, September.
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    15. Aizenman, Joshua, 1989. "Country Risk, Incomplete Information and Taxes on International Borrowing," Economic Journal, Royal Economic Society, vol. 99(394), pages 147-161, March.
    16. Ricardo J. Caballero & Arvind Krishnamurthy, 2000. "Dollarization of Liabilities: Underinsurance and Domestic Financial Underdevelopment," NBER Working Papers 7792, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Ricardo J. Caballero & Arvind Krishnamurthy, 2002. "A Dual Liquidity Model for Emerging Markets," American Economic Review, American Economic Association, vol. 92(2), pages 33-37, May.
    2. Fernando A. Broner & Guido Lorenzoni & Sergio L. Schmukler, 2013. "Why Do Emerging Economies Borrow Short Term?," Journal of the European Economic Association, European Economic Association, vol. 11, pages 67-100, January.
    3. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2004. "Smoothing sudden stops," Journal of Economic Theory, Elsevier, vol. 119(1), pages 104-127, November.
    4. Layal Mansour, 2012. "Hoarding of International Reserves and Sterilization in Dollarized and Indebted Countries : an effective monetary policy?," Working Papers halshs-00695611, HAL.
    5. Antonio E. Bernardo & Ivo Welch, 2002. "Financial Market Runs," NBER Working Papers 9251, National Bureau of Economic Research, Inc.
    6. Maurício Yoshinori Une & Marcelo Savino Portugal, 2005. "Fear of disruption: a model of Markov-switching regimes for the Brazilian country risk conditional volatility," Econometrics 0509005, University Library of Munich, Germany.
    7. repec:sbe:breart:v:29:y:2009:i:2:a:3440 is not listed on IDEAS
    8. Michael P. Dooley & David Folkerts-Landau & Peter M. Garber, 2004. "The US Current Account Deficit and Economic Development: Collateral for a Total Return Swap," NBER Working Papers 10727, National Bureau of Economic Research, Inc.
    9. Herrala, Risto, 2003. "The rigidity bias," Research Discussion Papers 31/2003, Bank of Finland.

    More about this item

    JEL classification:

    • E59 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Other
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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