Credit Frictions and Sudden Stops in Small Open Ec

NBERWORKINGPAPERSERIESCREDITFRICTIONSAND‘SUDDENSTOPS’INSMALLOPENECONOMIES:ANEQUILIBRIUMBUSINESSCYCLEFRAMEWORKFOREMERGINGMARKETSCRISESCristinaArellanoEnriqueG.MendozaWorkingPaper8880©2002byCristinaArellanoandEnriqueG.Mendoza.Allrightsreserved.Shortsectionsoftext,nottoexceedtwoparagraphs,maybequotedwithoutexplicitpermissionprovidedthatfullcredit,including©notice,isgiventothesource.CreditFrictionsand‘SuddenStops’inSmallOpenEconomies:AnEquilibriumBusinessCycleFrameworkforEmergingMarketsCrisesCristinaArellanoandEnriqueG.MendozaNBERWorkingPaperNo.8880April2002JELNo.F41,F32,E44,D52ABSTRACTFinancialfrictionsareacentralelementofmostofthemodelsthattheliteratureonemergingmarketscriseshasproposedforexplainingthe‘SuddenStop’phenomenon.Todate,fewstudieshaveaimedtoexaminethequantitativeimplicationsofthesemodelsandtointegratethemwithanequilibriumbusinesscycleframeworkforemergingeconomies.Thispapersurveysthesestudiesviewingthemasability-to-payandwillingness-to-payvariationsofaframeworkthataddsoccasionallybindingborrowingconstraintstothesmallopeneconomyreal-business-cyclemodel.AcommonfeatureofthedifferentmodelsisthatagentsfactorintheriskoffutureSuddenStopsintheiroptimalplans,sothatequilibriumallocationsandpricesaredistortedevenwhencreditconstraintsdonotbind.SuddenStopsareapropertyoftheunique,flexible-pricecompetitiveequilibriumofthesemodelsthatoccursinaparticularregionofthestatespaceinwhichnegativeshocksmakeborrowingconstraintsbind.Theresultingnonlineareffectsimplythatsolvingthemodelsrequiresnon-linearnumericalmethods,whicharedescribedinthesurvey.TheresultsshowthatthemodelscanyieldrelativelyinfrequentSuddenStopswithlargecurrentaccountreversalsanddeeprecessionsnestedwithinsmootherbusinesscycles.Still,researchinthisareaisatanearlystageandthissurveyaimstostimulatefurtherwork.CristinaArellanoEnriqueG.MendozaDepartmentofEconomicsDepartmentofEconomicsSocialSciencesBuildingUniversityofMarylandDukeUniversityCollegePark,MD20742Durham,[e-mail]fthefinancialandeconomiccrisisthathitMexicoafterthedevaluationofthepesoinDecemberof1994,andtheunprecedented“TequilaEffect”bywhichMexico’sfinancialwoes“infected”emergingmarketsworldwidewereaharbingerofaperiodofintenseturbulenceininternationalcapitalmarkets.Sevenyearslater,inDecember2001amajorcrisisbrokeoutinArgentinawithanexplosivecombinationofsovereigndefault,massivecurrencydevaluationandcollapseofproductionandaggregatedemand.Inthesevenyearsseparatingthesetwocrises,similarcrisesengulfednearlyalloftheso-called“emergingmarkets,”includingHongKong,Korea,Indonesia,Malaysia,Thailand,Russia,Colombia,Ecuador,Brazil,andTurkey.Interestingly,devaluationitselfprovednottobeaprerequisiteforthesecrises,asillustratedbytheexperiencesofArgentinain1995,HongKongin1997orChilein1999.ContagioneffectssimilartotheTequilaEffectwerealsoarecurrentphenomenon,ascrisesspreadquicklytothecapitalmarketsofcountrieswithnoapparenteconomiclinkagestocountriesincrisis.AfavoriteexampleisthecorrectioninU.S.equitypricesintheFallof1998thatresultedfromthewaveofmargincallsonglobalinvestorstriggeredbytheRussiandefault.ThesystemicnatureofthiscorrectionforcedtheU.S.FederalReservetolowerinterestratesandcoordinatetheorderlycollapseofhedgefundLongTermCapitalManagement.Emerging-marketscrisesarecharacterizedbyasetofstrikingempiricalregularitiesthatCalvo(1998)labeledthe“SuddenStop”phenomenon.Theseempiricalregularitiesinclude:(a)asuddenlossofaccesstointernationalcapitalmarkets,(b)alargereversalofthecurrentaccountdeficit,(c)acollapseofdomesticproductionandaggregatedemand,and(d)sharpcorrectionsinassetpricesandinthepricesofnon-tradedgoodsrelativetotradedgoods.Figures1-3illustrate2someofthesestylizedfactsforArgentina,Korea,Mexico,RussiaandTurkey.1Figure1showsrecenttimeseriesdataforeachcountry’scurrentaccountasashareofGDP.SuddenStopsaredisplayedintheseplotsassudden,largeswingsofthecurrentaccountthatinmostcasesexceededfivepercentagepointsofGDP.Figure2showsdataonconsumptiongrowthasanindicatorofrealeconomicactivity.TheseplotsshowthatSuddenStopsareassociatedwithacollapseintherealsectoroftheeconomy.Figure3providesinformationontwokeyfinancialindicatorsforeachcountry,thepriceofdomesticequity(valuedinU.S.dollars)andthespreadoftheyieldinJPMorgan’sEmergingMarketsBondIndexPlus(EMBI+)foreachcountryrelativetoU.S.Treasurybills.Largedeclinesinequitypricesandsudden,sharpincreasesinEMBI+spreadsarefeaturesofSuddenStops,withequitypricesoftenleadingthesurgeoftheEMBI+spreadatthemonthlyfrequency.TheSuddenStopsph