A Quantitative Model of Sudden Stops and External Liquidity Management

51 Pages Posted: 12 Apr 2005

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Stavros Panageas

University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

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Date Written: April 4, 2005

Abstract

Emerging market economies, which have much of their growth ahead of them, 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. In this paper we develop and estimate a quantifiable model of sudden stops and use it to study practical mechanisms to insure emerging markets against them. We first assess the standard practice of protecting the current account through the accumulation of international reserves and conclude that, even when optimally managed, this mechanism is expensive and incomplete. External insurance, on the other hand, is hard to obtain because sudden stops often come together with distress in emerging market investors themselves (the most natural insurers). Thus, one needs to find global (non-emerging-market-specific) assets that are correlated to sudden stops. We show an example of such an asset based on the S&P 500's implied volatility index. If added to these countries portfolios, it would significantly enhance their sudden stop risk-management strategies. In our simulations, the median gain in terms of reserves available at the time of sudden stop is around 30 percent. Moreover, in instances where the level of non-contingent reserves is low, the median gain is close to 300 percent. We also find that as countries manage to reduce the size of the sudden stops that afflict them, they should reduce their stock of reserves and significantly increase their share of contingent reserves. The main insights of the paper extend to external liquidity and liability management more generally.

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

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

Suggested Citation

Caballero, Ricardo J. and Panageas, Stavros, A Quantitative Model of Sudden Stops and External Liquidity Management (April 4, 2005). Available at SSRN: https://ssrn.com/abstract=703241 or http://dx.doi.org/10.2139/ssrn.703241

Ricardo J. Caballero (Contact Author)

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Stavros Panageas

University of California, Los Angeles (UCLA) - Finance Area ( email )

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