Margin Calls, Trading Costs, and Asset Prices in Emerging Markets: The Finanical Mechanics of the 'Sudden Stop' Phenomenon

Mendoza, Enrique G.; Smith, Katherine A.

doi:10.3386/w9286

Cited by 64 publications

(59 citation statements)

References 25 publications

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“…In a broad historical examination, Bordo et al (2001) argue that the sudden stop problem has become more severe since the abandonment of the gold standard in the early 1970s. Mendoza and Smith (2002) define three key features of Sudden Stops: "sharp reversals in capital inflows and current account deficits, large downward adjustments in domestic production and absorption, and collapses in asset prices and in the relative prices of nontradable goods relative to tradables." (p. 1) An examination of the data reveals that most currency/balance of payments crises are not characterized by Sudden Stops (Table 1).…”

Section: Introductionmentioning

confidence: 99%

Sudden Stops and the Mexican Wave: Currency Crises, Capital Flow Reversals and Output Loss in Emerging Markets

Hutchison

2002

SSRN Journal

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Sudden Stops are the simultaneous occurrence of a currency/balance of payments crisis with a reversal in capital flows (Calvo, 1998). We investigate the output effects of financial crises in emerging markets, focusing on whether sudden-stop crises are a unique phenomenon and whether they entail an especially large and abrupt pattern of output collapse (a "Mexican wave"). Despite an emerging theoretical literature on Sudden Stops, empirical work to date has not precisely identified their occurrences nor measured their subsequent output effects in broad samples. Analysis of Sudden Stops may provide the key to understanding why some currency/balance of payments crises entail very large output losses, while others are frequently followed by expansions. Using a panel data set over the 1975-97 period and covering 24 emerging-market economies, we distinguish between the output effects of currency crises, capital inflow reversals, and sudden-stop crises. We find that sudden-stop crises have a large negative, but short-lived, impact on output growth over and above that found with currency crises. A currency crisis typically reduces output by about 2-3 percent, while a Sudden Stop reduces output by an additional 6-8 percent in the year of the crisis. The cumulative output loss of a Sudden Stop is even larger, around 13-15 percent over a three-year period. Our model estimates correspond closely to the output dynamics of the 'Mexican wave' (such as seen in Mexico in 1995, Turkey in 1994 and elsewhere), and out-of-sample predictions of the model explain well the sudden (and seemingly unexpected) collapse in output associated with the 1997-98 Asian Crisis. The empirical results are robust to alternative model specifications, lag structures and using estimation procedures (IV and GMM) that correct for bias associated with estimation of dynamic panel models with country-specific effects. Our study supports the hypothesis that sudden stops have a much larger adverse effect on output than other forms of currency attack, and explains the wide divergence in economies' performances following international financial crises. Establishing this empirical regularity for emerging market economies is the first step in empirically identifying the transmission mechanism through which sudden stops have such large output effects. JEL: F32, F43, O162

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Section: Introductionmentioning

confidence: 99%

Sudden Stops and the Mexican Wave: Currency Crises, Capital Flow Reversals and Output Loss in Emerging Markets

Hutchison

2002

SSRN Journal

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“…In the augmented model this price is 1 + η e t which depends on the distribution costs parameter η. From (30) and (31) it is clear that through this price, distribution costs affect in equilibrium the optimal intratemporal decisions between labor and consumption of the traded good as well as the optimal intertemporal choices 25 In the simple model F T h T t = wt for consumption of the traded good. On the other hand distribution services generate an extra demand of non-traded goods as is captured by the last term, ηc T t , of the right hand side of (28).…”

Section: The New Equilibrium Conditionsmentioning

confidence: 99%

“…30 Since there are no robust estimates of a New-Keynesian Phillips curve for emerging economies we choose values for γ and µ that are consistent with the values used in the closed economy literature about nominal price rigidities. 31 Table 2 summarizes the parametrization.…”

Section: The Determinacy Of Equilibrium Analysismentioning

confidence: 99%

Fighting Against Currency Depreciation, Macroeconomic Instability, and Sudden Stops

Zanna

2006

SSRN Journal

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In this paper we show that in the aftermath of a crisis, a government that changes the nominal interest rate in response to currency depreciation can induce aggregate instability in the economy by generating self-fulfilling endogenous cycles. In particular if a government raises the interest rate proportionally more than an increase in currency depreciation then it induces self-fulfilling cyclical equilibria that are able to replicate some of the empirical regularities of emerging market crises. We construct an equilibrium characterized by the self-validation of people's expectations about currency depreciation and by the following stylized facts of the "Sudden Stop" phenomenon: a decline in domestic production and aggregate demand, a significantly larger currency depreciation, a collapse in asset prices, a sharp correction in the price of traded goods relative to non-traded goods and an improvement in the current account deficit.

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“…Two of their main findings are that (i) sudden stops are preceded by periods of below-normal interest rates, which rise when a sudden stop occurs and revert to their normal levels in the following years; and that (ii) sudden stops follow periods of low interest rate volatility that increases sharply at the beginning of the sudden stop and remains persistently high for multiple periods. 21 We adopt the approach taken in 19 This amplification mechanism was initially introduced to the positive study of sudden stops by Mendoza (2002), Mendoza and Smith (2002), Mendoza and Smith (2006) and Mendoza (2010). 20 The literature has focused on two different aspects of optimal policy, either its "prudential" features, in the sense that policy is undertaken ex ante in order to reduce the probability of a crisis, as we do in this paper, or its ex post characteristics, after the crisis has occurred.…”

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confidence: 99%

“…This framework has relied on models traditionally exploited to study the positive side of large and abrupt capital outflows in EMEs-also known as sudden stops-to analyze normative aspects of policy. Mendoza and Smith (2002) and Mendoza (2010) explore the positive aspects of this framework.…”

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confidence: 99%

Managing Capital Flows in the Presence of External Risks

Reyes-Heroles

Tenorio²

2017

internationalfinance

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We introduce external risks, in the form of shocks to the level and volatility of world interest rates, into a small open economy model subject to the risk of sudden stops-large recessions together with abrupt reversals in capital inflowsand characterize optimal macroprudential policy in response to these shocks. In the model, collateral constraints create a pecuniary externality that leads to "overborrowing" and sudden stops that arise when the constraints bind. The typical sudden stop generated by the model replicates existing empirical evidence for emerging market economies: Low and stable external interest rates reinforce "overborrowing" and lead to greater exposure to crises typically accompanied by abrupt increases in interest rates and a persistent rise in their volatility. We solve for the optimal policy and argue that the size of a tax on international borrowing that implements the policy depends on two factors, the incidence and the severity of potential future crises. We show quantitatively that these taxes respond to both the level and volatility of interest rates even though optimal decisions in the competitive equilibrium do not respond substantially to changes in volatility, and that the size of the optimal tax is non-monotonic with respect to external shocks.JEL classification: E3, E6, F3, F4, F6, G1, G2

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Margin Calls, Trading Costs, and Asset Prices in Emerging Markets: The Finanical Mechanics of the 'Sudden Stop' Phenomenon

Abstract: for helpful comments and suggestions. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

Cited by 64 publications

References 25 publications

Sudden Stops and the Mexican Wave: Currency Crises, Capital Flow Reversals and Output Loss in Emerging Markets

Sudden Stops and the Mexican Wave: Currency Crises, Capital Flow Reversals and Output Loss in Emerging Markets

Fighting Against Currency Depreciation, Macroeconomic Instability, and Sudden Stops

Managing Capital Flows in the Presence of External Risks

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