Putting the Brakes on Sudden Stops: The Financial Frictions-Moral Hazard Tradeoff of Asset Price Guarantees

51 Pages Posted: 6 Oct 2004 Last revised: 27 Jun 2010

See all articles by Enrique G. Mendoza

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Ceyhun Bora Durdu

Board of Governors of the Federal Reserve System

Date Written: September 2004

Abstract

The hypothesis that Sudden Stops to capital inflows in emerging economies may be caused by global capital market frictions, such as collateral constraints and trading costs, suggests that Sudden Stops could be prevented by offering price guarantees on the emerging-markets asset class. Providing these guarantees is a risky endeavor, however, because they introduce a moral-hazard-like incentive similar to those that are also viewed as a cause of emerging markets crises. This paper studies this financial frictions-moral hazard tradeoff using an equilibrium asset-pricing model in which margin constraints, trading costs, and ex-ante price guarantees interact in the determination of asset prices and macroeconomic dynamics. In the absence of guarantees, margin calls and trading costs create distortions that produce Sudden Stops driven by occasionally binding credit constraints and Irving Fisher's debt-deflation mechanism. Price guarantees contain the asset deflation by creating another distortion that props up the foreign investors' demand for emerging markets assets. Quantitative simulation analysis shows the strong interaction of these two distortions in driving the dynamics of asset prices, consumption and the current account. Price guarantees are found to be effective for containing Sudden Stops but at the cost of introducing potentially large distortions that could lead to 'overvaluation' of emerging markets assets.

Suggested Citation

Mendoza, Enrique G. and Durdu, Ceyhun Bora, Putting the Brakes on Sudden Stops: The Financial Frictions-Moral Hazard Tradeoff of Asset Price Guarantees (September 2004). NBER Working Paper No. w10790, Available at SSRN: https://ssrn.com/abstract=595189

Enrique G. Mendoza (Contact Author)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

Ceyhun Bora Durdu

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
2024523775 (Phone)

HOME PAGE: http://www.ceyhunbora.com

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