ON THE EMPIRICS OF SUDDEN STOPS Guillermo Calvo, Alejandro Izquierdo and Luis-Fernando Mejía and Luis-Fernando Mejía April 10, 2003

OUTLINE I. Financial Crises: Sudden Stops vs. Competing Views I. Financial Crises: Sudden Stops vs. Competing Views IV. Policy Lessons II. Sudden Stops: Definition, Characterization and Links to Key Macro Variables III. Determinants of Sudden Stops

Sudden Stops in EMs The sequence of financial crises following the Tequila crisis suggests EMs are seriously vulnerable to shocks in the capital account. The sequence of financial crises following the Tequila crisis suggests EMs are seriously vulnerable to shocks in the capital account. Sudden Stops (SS) in capital flows can trigger major adjustments, particularly through their effects on the RER, resulting in major disruption in trade and finance. Sudden Stops (SS) in capital flows can trigger major adjustments, particularly through their effects on the RER, resulting in major disruption in trade and finance. EMs are particularly vulnerable to RER fluctuations given their high degree of liability dollarization. EMs are particularly vulnerable to RER fluctuations given their high degree of liability dollarization. By raising doubts about sustainability of the initial equilibrium, a SS could plunge the economy into a “bad equilibrium” with low investment and growth. By raising doubts about sustainability of the initial equilibrium, a SS could plunge the economy into a “bad equilibrium” with low investment and growth.

What Stops Lending? Competing Views Is it lack of fiscal discipline? Could be, but this explanation finds little support for East Asian crises (Korea’s public debt hovered around 10% of GDP) Is it lack of fiscal discipline? Could be, but this explanation finds little support for East Asian crises (Korea’s public debt hovered around 10% of GDP) Is it soft pegs? Could be, but how does it account for the ensuing real meltdown? Is it soft pegs? Could be, but how does it account for the ensuing real meltdown? Is it self-fulfilling Sudden Stops? Loss of access may not be the result of over-indebtedness in the context of a “good” equilibrium, but rather the result of the economy having fallen in a bad equilibrium triggered by a SS. Is it self-fulfilling Sudden Stops? Loss of access may not be the result of over-indebtedness in the context of a “good” equilibrium, but rather the result of the economy having fallen in a bad equilibrium triggered by a SS. “Inverse” fiscal view finds support in that SS tend to occur around the same time, and for countries with very different fiscal conditions. This view does not neglect the relevance of domestic factors, which are key in explaining vulnerability to SS. “Inverse” fiscal view finds support in that SS tend to occur around the same time, and for countries with very different fiscal conditions. This view does not neglect the relevance of domestic factors, which are key in explaining vulnerability to SS.

Making Sudden Stops Operational Sudden Stops meet the following characteristics: Fall in net capital inflows exceeds two standard deviations below the sample mean at the time of the fall (“unexpected” requirement). Fall in net capital inflows exceeds two standard deviations below the sample mean at the time of the fall (“unexpected” requirement). SS are persistent events: they are over after 6 months of consecutive positive changes in capital flows (yoy). SS are persistent events: they are over after 6 months of consecutive positive changes in capital flows (yoy). The fall in capital flows exceeds 10% of private sector credit The fall in capital flows exceeds 10% of private sector credit This phase overlaps with a 24-month window centered around RER depreciation exceeding 15%. This phase overlaps with a 24-month window centered around RER depreciation exceeding 15%.

RER Depreciation and Reversals in EMs

RER Depreciation and Reversals in DEs

Key Characteristics of Sudden Stops The capital account remains closed for EMs during currency crises, but not for developed countries: 81% of depreciation episodes are associated with large capital flow reversals, i.e. sudden stops take place. This figure is only 25% for developed countries. The capital account remains closed for EMs during currency crises, but not for developed countries: 81% of depreciation episodes are associated with large capital flow reversals, i.e. sudden stops take place. This figure is only 25% for developed countries. What comes first, RER depreciation or capital flow reversal? Not a clear-cut answer, though 65% of the time reversals come first. What comes first, RER depreciation or capital flow reversal? Not a clear-cut answer, though 65% of the time reversals come first. There is Sudden Stop bunching, particularly around the Russian crisis. There is Sudden Stop bunching, particularly around the Russian crisis.

Sudden Stop Bunching

Links to Key Macro Variables Sudden Stops are associated with substantial increases in real interest rates. They represent shifts in the supply of international credit. Sudden Stops are associated with substantial increases in real interest rates. They represent shifts in the supply of international credit. Sudden Stops are associated with big output contractions, implying real costs of loosing access to credit. Sudden Stops are associated with big output contractions, implying real costs of loosing access to credit. Sudden Stops coincide with substantial reserve losses, implying central bank attempts to prevent abrupt CAD gap closures and exchange rate depreciation, a strategy that is not successful to the extent that SS are persistent. Sudden Stops coincide with substantial reserve losses, implying central bank attempts to prevent abrupt CAD gap closures and exchange rate depreciation, a strategy that is not successful to the extent that SS are persistent.

Sudden Stop and Interes Rates in EMs

Sudden Stop and Reserves in EMs

Sudden Stop and Growth in EMs

In Search of Determinants Based on Calvo, Izquierdo and Talvi (2002) we zero in on determinants of the likelihood of having a SS :  = (Y - S)/Z = 1-CAD/Z as an indicator of potential RER changes, where Z = tradables absorption; Y = tradables output; S = non-factor payments  = (Y - S)/Z = 1-CAD/Z as an indicator of potential RER changes, where Z = tradables absorption; Y = tradables output; S = non-factor payments Financial dollarization Financial dollarization Public dollarization Public dollarization Debt levels Debt levels Reserves/CAD Reserves/CAD Exchange rate regime Exchange rate regime

Probit Results (All countries) (1) (2) (3) (4) (5) (6) (7) ss_15 Lagw (2.37)** (2.44)** (2.42)** (1.95)* (1.99)** (2.07)** (2.05)** Lag fin.dol (4.22)*** (3.54)*** (3.49)*** (2.37)** (2.40)** (2.44)** (2.41)** Lagpub dol (0.93) (0.93) (0.73) (0.25) (0.13) (0.20) Lagres/CAD (0.19) (0.02) (0.09) (0.08) DummyEM (1.53) (1.49) (1.59) (1.57) Lagscaled debt (0.33) (0.41) (0.37) llys (0.92) llys (0.75) Constant (0.98) (1.27) (1.26) (0.58) (0.62) (0.48) (0.47) Observations Time dummies Yes Absolute value of z statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1%

Probit Results (EMs) (1) (2) (3) (4) (5) (6) ss_15 Lagw (2.00)** (2.01)** (2.14)** (2.19)** (2.22)** (2.21)** Lag fin.dol (2.39)** (2.27)** (2.32)** (2.37)** (2.36)** Lagpub dol (0.66) (0.55) (0.05) (0.02) (0.06) Lagres/CAD (1.19) (1.20) (1.14) (1.15) Lag scaled debt (0.40) (0.41) (0.39) llys (0.60) llys (0.38) Constant (1.17) (1.15) (1.27) (1.33) (1.26) (1.24) Observations 116 Time dummies Yes Absolute value of z statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1%

The interaction between Tradable Absorption Leverage and Financial Dollarization Probability of a Sudden Stop lw w_min_mean2w_mean_mean2 w_max_mean2

Policy Lessons: Two ways to go: 1) Contingent debt contracts: non-tradable price indexed, CPI indexed, GDP indexed, commodity price indexed (when associated with SS). 2) Work on structural deficiencies by putting in place domestic policies that: Increase openness (decrease leverage of absorption of tradables), Increase openness (decrease leverage of absorption of tradables), Decrease liability dollarization, and Decrease liability dollarization, and Bring down debt levels. Bring down debt levels.

Policy Lessons (cont.) Increasing openness is particularly useful: a) It reduces the size of RER swings after Sudden Stop b) A higher share of tradable sectors in output reduces risk of mismatches in private sector balance sheets and banking sector vulnerability. Other findings: Closed, dollarized economies may be vulnerable independently of the exchange rate regime that is adopted. Closed, dollarized economies may be vulnerable independently of the exchange rate regime that is adopted.