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Overreaction in capital flows to emerging markets: Booms and sudden stops

  • Manuel Agosin
  • Franklin Huaita

This paper applies the overreaction hypothesis of De Bondt and Thaler (1985), developed for stock price behaviour, to capital flows to emerging markets. We find that a surge in capital flows, or what we call a capital boom, can predict future sharp contractions in capital flows, or sudden stops. We use a large list of possible economic fundamentals as control variables, and the results show that the best predictor of a sudden stop is a preceding capital boom. Moreover, the probability of a country undergoing a sudden stop increases considerably with the length of the boom: this probability more than doubles when the boom is three years old, and rises by three to four times when the boom lasts for four years. These results are interesting for two reasons. In the first place, they contradict previous studies that emphasize worsening fundamentals as the ultimate cause of a sudden stop. Second, they are of policy interest because of the enormous negative impacts that sudden stops have on the real economy

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File URL: http://www.econ.uchile.cl/uploads/publicacion/078efa65-0c68-47d6-8ac5-ae97a801958e.pdf
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Paper provided by University of Chile, Department of Economics in its series Working Papers with number wp295.

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Date of creation: Apr 2009
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Handle: RePEc:udc:wpaper:wp295
Contact details of provider: Web page: http://www.econ.uchile.cl/

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  12. Jillian Faucette & Alexander Rothenberg & Francis Warnock, 2005. "Outflows-induced sudden stops," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 8(2), pages 119-129.
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  16. Guillermo Calvo & Alejandro Izquierdo & Luis-Fernando Mejía, 2004. "On the empirics of Sudden Stops: the relevance of balance-sheet effects," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  17. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  18. Robert J. Shiller, 2002. "From Efficient Market Theory to Behavioral Finance," Cowles Foundation Discussion Papers 1385, Cowles Foundation for Research in Economics, Yale University.
  19. Alexander D. Rothenberg & Francis E. Warnock, 2006. "Sudden Flight and True Sudden Stops," NBER Working Papers 12726, National Bureau of Economic Research, Inc.
  20. Levy-Yeyati, Eduardo & Sturzenegger, Federico, 2005. "Classifying exchange rate regimes: Deeds vs. words," European Economic Review, Elsevier, vol. 49(6), pages 1603-1635, August.
  21. Pablo E. Guidotti & Federico Sturzenegger & Agustín Villar, 2004. "On the Consequences of Sudden Stops," ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION, ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.
  22. Fiess, Norbert, 2003. "Capital flows, country risk, and contagion," Policy Research Working Paper Series 2943, The World Bank.
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