A Global Equilibrium Model of Sudden Stops and External Liquidity Management

Abstract

Emerging market economies, which have much of their growth ahead of them, either run or should run persistent current account deficits in order to smooth consumption intertemporally. The counterpart of these deficits is their dependence on capital inflows, which can suddenly stop. We make two contributions in this paper: First, we develop a quantitative global-equilibrium model of sudden stops. Second, we use this structure to discuss practical mechanisms to insure emerging markets against sudden stops, ranging from conventional non-contingent reserves accumulation to more sophisticated contingent instrument strategies. Depending on the source of sudden stops, their correlation with world events, and the quality of the hedging instrument available, the gains from these strategies can represent a substantial improvement over existing practices.

Keywords: Capital flows, sudden stops, reserves, international liquidity management, world, capital markets, swaps, insurance, hedging, options, hidden states, Bayesian methods

JEL Classification: E2, E3, F3, F4, G0, C1