Essays on Preventing Sudden Stops

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Durdu, Ceyhun Bora
Mendoza, Enrique G
Capital markets have witnessed a rash of `Sudden Stops' during the last decade. Policy proposals to prevent these crises include creating indexed bond markets and providing price guarantees for emerging market assets. Chapter 1 explores the macroeconomic implications of indexed bonds with a return indexed to the key variables driving emerging market economies such as terms of trade or productivity. We employ a quantitative model of a small open economy in which Sudden Stops are driven by the financial frictions inherent to world capital markets. While indexed bonds provide a hedge to income fluctuations and can undo the effects of financial frictions, they lead to interest rate fluctuations. Due to this tradeoff, there exists a non-monotonic relation between the "degree of indexation" (i.e., the percentage of the shock reflected in the return) and the overall effects of these bonds on macroe- conomic fluctuations. Therefore, indexation can improve macroeconomic conditions only if the degree of indexation is less than a critical value. When the degree of indexation is higher than this threshold, it strengthens the precautionary savings motive, increases consumption volatility and impact effect of Sudden Stops. The threshold degree of indexation depends on the volatility and persistence of income shocks as well as the relative openness of the economy. Chapter 2 explores the implications of asset price guarantees provided by an international financial organization on the emerging market assets. This policy is motivated by the globalization hazard hypothesis, which suggest that Sudden Stops caused by global financial frictions could be prevented by offering foreign investors price guarantees on emerging markets assets. These guarantees create a trade- off, however, because they weaken globalization hazard while creating international moral hazard. We study this tradeoff using a quantitative, equilibrium asset-pricing model. Without guarantees, margin calls and trading costs cause Sudden Stops driven by a Fisherian deflation. Price guarantees prevent this deflation by propping up foreign demand for assets. The effectiveness of price guarantees, their distor- tions on asset markets, and their welfare implications depend critically on whether the guarantees are contingent on debt levels and on the price elasticity of foreign demand for domestic assets.