Abstract
Currency crises in emerging and developing countries have often been characterized by “sudden stops” of capital flows. A variety of mechanisms have been adduced to explain the emergence of this phenomenon. This paper integrates these mechanisms into a simple and transparent analytical model in which currency mismatches, large current account deficits, and large stocks of short-term debt interact with low reserve stocks to generate dual equilibria. In this context, the “panic” equilibrium is characterized by a currency crisis, a sudden stop, and an output collapse. The potential for various policies to avoid this outcome is explored, as are the implications of the analysis for reserve accumulation.
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Notes
Note that capital-flow reversals need not be associated with current account reversals if central banks are willing and able to finance current account deficits by selling reserves. Only if they are not so willing would the exchange rate have to move, thus potentially resulting in a currency crisis. Reserve depletion thus potentially breaks the link between capital flow reversals and currency crises by breaking the link between capital-flow and current account reversals. This mechanism figures prominently in the model developed in this paper. For the empirical relationship between capital-flow reversals and current-account reversals, see Edwards (2004).
External triggers have also been explored, of course (Mody and Taylor 2002, for example, consider advanced-country interest rates, growth and high-yield spreads, while others have examined the effects of contagion from crises elsewhere), but these are less relevant for present purposes.
As shown below, however, the association of sudden stops with panics does not imply that the sudden stop is arbitrary or irrational.
We can refer to this by the traditional term of capital flight. It is the component of the country panic that is analogous to the withdrawal of deposits during a bank panic. Rothenberg and Warnock (2006) emphasize the need to take the behavior of current residents into account in the analysis of sudden stops.
Alternatively, suppose there is a lower bound to domestic residents’ end-of-period demand for money given, say by M D. This could be the result, say, of a convex transactions cost function. Then we could define a panic as a situation in which F = 0 and M D is driven down to M D. The workings of the model would be similar in this case to that in the text, except that capital outflows by domestic residents would be larger.
Notice what this means: if a rational panic is possible, then the resulting equilibrium will share an important feature with “first generation” currency crisis models – i.e., the central bank will experience a “speculative attack” in the form of a sudden stop of capital inflows (and possibly of capital outflows by domestic agents) – that will deplete its stock of foreign exchange reserves and thus force it to abandon the officially-determined exchange rate. As we will see below, however, the outcome differs from that in first-generation currency crisis models in that the attack is neither inevitable nor can its timing be foreseen.
Calvo et al. (2004), as well as Edwards (2004) provide empirical evidence that openness tends to mitigate the adverse output effects of “sudden stops.” In the model of this paper, the explanation for this result is that openness tends to mitigate the real exchange rate adjustment associated with a sudden stop, and thus reduce the macroeconomic dislocations associated with real depreciation in the presence of currency mismatches.
In the context of the “soft” pegs maintained by the Asian crisis countries before the crisis, this would refer to the width of their exchange rate bands.
These include measures such as the Chilean encaje, as well as specific prudential regulations on external borrowing by domestic agents.
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Montiel, P.J. The Simple Analytics of Sudden Stops. Open Econ Rev 24, 267–281 (2013). https://doi.org/10.1007/s11079-012-9241-9
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DOI: https://doi.org/10.1007/s11079-012-9241-9