ON THE EMPIRICSOF SUDDEN STOPS

Guillermo Calvo,Guillermo Calvo,

Alejandro IzquierdoAlejandro Izquierdo

and Luisand Luis--FFernandoernando Mejía Mejía

April 10, 2003April 10, 2003

OUTLINE

I. I. Financial Crises: Sudden Stops vs. Competing Financial Crises: Sudden Stops vs. Competing ViewsViews

IV.IV. Policy Lessons Policy Lessons

II. II. Sudden Stops: Definition, Characterization Sudden Stops: Definition, Characterization and Links to Key Macro Variablesand Links to Key Macro Variables

III. III. Determinants of Sudden StopsDeterminants of Sudden Stops

Sudden Stops in EMsSudden Stops in EMs

•The sequence of financial crises following the Tequila crisis The sequence of financial crises following the Tequila crisis suggests EMs are seriously vulnerable to shocks in the capital suggests EMs are seriously vulnerable to shocks in the capital account.account.

•Sudden Stops (SS) in capital flows can trigger major Sudden Stops (SS) in capital flows can trigger major adjustments, particularly through their effects on the RER, adjustments, particularly through their effects on the RER, resulting in major disruption in trade and finance.resulting in major disruption in trade and finance.

•EMs are particularly vulnerable to RER fluctuations given their EMs are particularly vulnerable to RER fluctuations given their high degree of liability dollarization. high degree of liability dollarization.

•By raising doubts about sustainability of the initial equilibrium, a By raising doubts about sustainability of the initial equilibrium, a SS could plunge the economy into a “bad equilibrium” with low SS could plunge the economy into a “bad equilibrium” with low investment and growth.investment and growth.

What Stops Lending? Competing ViewsWhat Stops Lending? Competing Views

•Is it lack of fiscal discipline?Is it lack of fiscal discipline? Could be, but this explanation finds Could be, but this explanation finds little support for East Asian crises (Korea’s public debt hovered little support for East Asian crises (Korea’s public debt hovered around 10% of GDP) around 10% of GDP)

•Is iIs itt soft pegs? soft pegs? Could be, but how does it account for the ensuing Could be, but how does it account for the ensuing real meltdown? real meltdown?

•Is it self-fulfilling Sudden Stops?Is it self-fulfilling Sudden Stops? Loss of access may not be the Loss of access may not be the result of over-indebtedness in the context of a “good” equilibrium, but result of over-indebtedness in the context of a “good” equilibrium, but rather the result of the economy having fallen in a bad equilibrium rather the result of the economy having fallen in a bad equilibrium triggered by a SS.triggered by a SS.

•““Inverse” fiscal view finds support in that SS tend to occur around Inverse” fiscal view finds support in that SS tend to occur around the same time, and for countries with very different fiscal conditions. the same time, and for countries with very different fiscal conditions. This view does not neglect the relevance of domestic factors, which This view does not neglect the relevance of domestic factors, which are key in explaining vulnerability to SS.are key in explaining vulnerability to SS.

Making Sudden Stops OperationalMaking Sudden Stops Operational

Sudden Stops meet the following characteristics:Sudden Stops meet the following characteristics:

• Fall in net capital inflows exceeds two standard deviations Fall in net capital inflows exceeds two standard deviations below the sample mean at the time of the fall (“unexpected” below the sample mean at the time of the fall (“unexpected” requirementrequirement))..

• SS are persistent events: they are over after 6 months of SS are persistent events: they are over after 6 months of consecutive positive changes in capital flows (yoy).consecutive positive changes in capital flows (yoy).

• The fall in capital flows exceeds 10% of private sector creditThe fall in capital flows exceeds 10% of private sector credit

• This phase overlaps with a 24-month window centered This phase overlaps with a 24-month window centered around RER depreciation exceeding 15%.around RER depreciation exceeding 15%.

RER RER DDepreciation and Reversals in EMsepreciation and Reversals in EMs

RER RER DDepreciation and Reversals in epreciation and Reversals in DEDEss

Key Characteristics of Sudden StopsKey Characteristics of Sudden Stops

•The capital account remains closed for EMs during currency The capital account remains closed for EMs during currency crises, but not for developed countries: 81% of depreciation crises, but not for developed countries: 81% of depreciation episodes are associated with large capital flow reversals, i.e. episodes are associated with large capital flow reversals, i.e. sudden stops take place. This figure is only 25% for developed sudden stops take place. This figure is only 25% for developed countries.countries.

•What comes first, RER depreciation or capital flow reversal? What comes first, RER depreciation or capital flow reversal? Not a clear-cut answer, though 65% of the time reversals come Not a clear-cut answer, though 65% of the time reversals come first.first.

•There is Sudden Stop bunching, particularly around the There is Sudden Stop bunching, particularly around the Russian crisis.Russian crisis.

Sudden Stop BunchingSudden Stop Bunching

Links to Key Macro VariablesLinks to Key Macro Variables

•Sudden Stops are associated with substantial increases in real Sudden Stops are associated with substantial increases in real interest rates. They represent shifts in the supply of international interest rates. They represent shifts in the supply of international credit.credit.

•Sudden Stops are associated with big output contractions, Sudden Stops are associated with big output contractions, implying real costs of loosing access to credit.implying real costs of loosing access to credit.

•Sudden Stops coincide with substantial reserve losses, implying Sudden Stops coincide with substantial reserve losses, implying central bank attempts to prevent abrupt CAD gap closures and central bank attempts to prevent abrupt CAD gap closures and exchange rate depreciation, a strategy that is not successful to the exchange rate depreciation, a strategy that is not successful to the extent that SS are persistent.extent that SS are persistent.

Sudden Stop and Interes Rates in EMsSudden Stop and Interes Rates in EMs

Sudden Stop and Reserves in EMsSudden Stop and Reserves in EMs

Sudden Stop and Growth in EMsSudden Stop and Growth in EMs

In Search of DeterminantsIn Search of Determinants

Based on Calvo, Izquierdo and Talvi (2002) we zero in on Based on Calvo, Izquierdo and Talvi (2002) we zero in on determinants of the likelihood of having a SS :determinants of the likelihood of having a SS :

= (Y - S)/Z = 1-CAD/Z = (Y - S)/Z = 1-CAD/Z as an indicator of potential as an indicator of potential RER changes, where ZRER changes, where Z = tradables absorption; Y = tradables = tradables absorption; Y = tradables output; S = non-factor paymentsoutput; S = non-factor payments

•Financial dollarizationFinancial dollarization

•Public dollarizationPublic dollarization

•Debt levelsDebt levels

•Reserves/CADReserves/CAD

•Exchange rate regimeExchange rate regime

Probit Results (All countries)Probit Results (All countries) (1) (2) (3) (4) (5) (6) (7) ss_15 ss_15 ss_15 ss_15 ss_15 ss_15 ss_15 Lag w -3.288 -4.136 -4.111 -3.284 -3.349 -3.392 -3.363 (2.37)** (2.44)** (2.42)** (1.95)* (1.99)** (2.07)** (2.05)** Lag fin. dol. 7.870 7.285 7.231 5.304 5.420 5.499 5.400 (4.22)*** (3.54)*** (3.49)*** (2.37)** (2.40)** (2.44)** (2.41)** Lag pub dol 0.806 0.812 0.593 0.301 0.161 0.235 (0.93) (0.93) (0.73) (0.25) (0.13) (0.20) Lag res/CAD -0.001 -0.000 -0.000 -0.001 -0.001 (0.19) (0.02) (0.02) (0.09) (0.08) Dummy EM 0.673 0.657 0.706 0.695 (1.53) (1.49) (1.59) (1.57) Lag scaled debt

13.750 17.252 15.551

(0.33) (0.41) (0.37) llys3 0.150 (0.92) llys5 0.079 (0.75) Constant 1.309 2.003 1.983 0.933 1.013 0.765 0.763 (0.98) (1.27) (1.26) (0.58) (0.62) (0.48) (0.47) Observations 252 228 228 228 228 228 228 Time dummies

Yes Yes Yes Yes Yes Yes Yes

Absolute value of z statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1%

Probit Results (EMs)Probit Results (EMs)

(1) (2) (3) (4) (5) (6) ss_15 ss_15 ss_15 ss_15 ss_15 ss_15 Lag w -3.891 -4.046 -4.397 -4.524 -4.640 -4.567 (2.00)** (2.01)** (2.14)** (2.19)** (2.22)** (2.21)** Lag fin. dol. 5.457 5.213 5.724 5.872 5.982 5.883 (2.39)** (2.27)** (2.32)** (2.37)** (2.37)** (2.36)** Lag pub dol 0.569 0.476 0.072 0.029 0.081 (0.66) (0.55) (0.05) (0.02) (0.06) Lag res/CAD 0.029 0.030 0.028 0.029 (1.19) (1.20) (1.14) (1.15) Lag scaled debt

18.687 19.697 18.468

(0.40) (0.41) (0.39) llys3 0.127 (0.60) llys5 0.051 (0.38) Constant 2.226 2.243 2.533 2.669 2.557 2.347 (1.17) (1.15) (1.27) (1.33) (1.26) (1.24) Observations 116 116 116 116 116 116 Time dummies

Yes Yes Yes Yes Yes Yes

Absolute value of z statistics in parentheses

* significant at 10%; ** significant at 5%; *** significant at 1%

The interaction between Tradable Absorption The interaction between Tradable Absorption Leverage and Financial DollarizationLeverage and Financial Dollarization

Probability of a Sudden Stop0

.2.4

.6.8

.6 .8 1 1.2 1.4 1.6lw

w_min_mean2 w_mean_mean2

w_max_mean2

Policy Lessons:Policy Lessons:

Two ways to go:Two ways to go:

• Contingent debt contracts: non-tradable price indexed, CPI Contingent debt contracts: non-tradable price indexed, CPI indexed, GDP indexed, commodity price indexed (when indexed, GDP indexed, commodity price indexed (when associated with SS).associated with SS).

• Work on structural deficiencies by putting in place domestic Work on structural deficiencies by putting in place domestic policies that:policies that:

• Increase openness (decrease leverage of absorption of Increase openness (decrease leverage of absorption of tradables),tradables),

• Decrease liability dollarization, andDecrease liability dollarization, and

• Bring down debt levels.Bring down debt levels.

Policy Lessons (cont.)Policy Lessons (cont.)

Increasing openness is particularly useful:Increasing openness is particularly useful:

a) It reduces the size of RER swings after Sudden a) It reduces the size of RER swings after Sudden StopStop

b) A higher share of tradable sectors in output b) A higher share of tradable sectors in output reduces risk of mismatches in private sector balance reduces risk of mismatches in private sector balance sheets and banking sector vulnerability.sheets and banking sector vulnerability.

Other findings:Other findings:

• Closed, dollarized Closed, dollarized economies may be vulnerable economies may be vulnerable independently of the exchange rate regime that is adopted.independently of the exchange rate regime that is adopted.