This paper analyzes the drivers of international waves in capital flows. We build on the literature on “sudden stops” and “bonanzas” to develop a new methodology for identifying episodes of extreme capital flow movements using quarterly data on gross inflows and gross outflows, differentiating activity by foreigners and domestics. We identify episodes of “surge”, “stop”, “flight”, and “retrenchment” and show how our approach yields fundamentally different results than the previous literature that used measures of net flows. Global factors, especially global risk, are the most important determinants of these episodes. Contagion, especially through trade and the bilateral exposure of banking systems, is important in determining stop and retrenchment episodes. Domestic macroeconomic characteristics are generally less important, although changes in domestic economic growth influence episodes caused by foreigners. We find little role for capital controls in reducing capital flow waves. The results help provide insights for different theoretical approaches explaining crises and capital flow volatility.

Capital Flow Waves: Surges, Stops, Flights and Retranchment

Recent sovereign defaults in emerging countries are accompanied by interest rate spikes and deep recessions. This paper develops a small open economy model to study default risk and its interaction with output, consumption, and foreign debt. Default probabilities and interest rates depend on incentives for repayment. Default occurs in equilibrium because asset markets are incomplete. The model predicts that default incentives and interest rates are higher in recessions, as observed in the data. The reason is that in a recession, a risk averse borrower finds it more costly to repay non-contingent debt and is more likely to default. In a quantitative exercise the model matches various features of the business cycle in Argentina such as: high volatility of interest rates, higher volatility of consumption relative to output, a negative correlation of interest rates and output and a negative correlation of the trade balance and output. The model can also predict the recent default episode in Argentina.

Default risk and income fluctuations in emerging economies

The origin and propagation of the European sovereign debt crisis can be attributed to the flawed original design of the euro. In particular, there was an incomplete understanding of the fragility of a monetary union under crisis conditions, especially in the absence of banking union and other European-level buffer mechanisms. Moreover, the inherent messiness involved in proposing and implementing incremental multicountry crisis management responses on the fly has been an important destabilizing factor throughout the crisis. After diagnosing the situation, we consider reforms that might improve the resilience of the euro area to future fiscal shocks.

https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.26.3.49

The European Sovereign Debt Crisis

The evidence from Sudden Stops in emerging economies shows that financial crashes are generally followed by major economic crises. This paper explains this phenomenon as an equilibrium outcome of a business cycle model with an endogenous collateral constraint that induces amplification and asymmetry in the responses of macro-aggregates to shocks. Cyclical dynamics produce economic expansions during which the ratio of debt to asset values raises enough to hit the constraint, triggering a Fisherian deflation that causes a spiraling decline in credit and in the price and quantity of collateral assets. Output and factor allocations also fall because the collateral constraint cuts access to working capital financing. In the long run, precautionary saving makes Sudden Stops low probability events nested within normal cycles, as observed in the data.

/pdf/sudden-stops-financial-crises-and-leverage-10odewfbhh.pdf

Sudden Stops, Financial Crises, and Leverage

https://www.nber.org/system/files/working_papers/w17351/w17351.pdf

Capital Flow Waves: Surges, Stops, Flight, and Retrenchment

This paper analyzes the joint behavior of international capital flows by foreign and domestic agents - gross capital flows - over the business cycle and during financial crises. We show that gross capital flows are very large and volatile, especially relative to net capital flows. When foreigners invest in a country, domestic agents tend to invest abroad, and vice versa. Gross capital flows are also pro-cyclical, with foreigners investing more in the country and domestic agents investing more abroad during expansions. During crises, especially during severe ones, there is retrenchment, that is, a reduction in both capital inflows by foreigners and capital outflows by domestic agents. This evidence sheds light on the nature of shocks driving capital flows and helps discriminate among existing theories. Our findings seem consistent with shocks that affect foreign and domestic agents asymmetrically, such as sovereign risk and asymmetric information.

/pdf/gross-capital-flows-dynamics-and-crises-4qhimsejcv.pdf

Gross Capital Flows: Dynamics and Crises

https://www.bde.es/f/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosTrabajo/10/Fic/dt1039e.pdf

Gross capital flows: Dynamics and crises

We argue that emerging economies borrow short term due to the high risk premium charged by bondholders on long-term debt. First, we present a model where the debt maturity structure is the outcome of a risk sharing problem between the government and bondholders. By issuing long-term debt, the government lowers the probability of a rollover crisis, transferring risk to bondholders. In equilibrium, this risk is reflected in a higher risk premium and borrowing cost. Therefore, the government faces a trade-off between safer long-term debt and cheaper short-term debt. Second, we construct a new database of sovereign bond prices and issuance. We show that emerging economies pay a positive term premium (a higher risk premium on long-term bonds than on short-term bonds). During crises, the term premium increases, with issuance shifting towards shorter maturities. The evidence suggests that international investors' time-varying risk aversion is crucial to understand the debt structure in emerging economies.

Why Do Emerging Economies Borrow Short Term

Conventional wisdom says that, in the absence of sufficient default penalties, sovereign risk constraints credit and lowers welfare We show that this conventional wisdom rests on one implicit assumption: that assets cannot be retraded in secondary markets Once this assumption is relaxed, there is always an equilibrium in which sovereign risk is stripped of its conventional effects In such an equilibrium, foreigners hold domestic debts and resell them to domestic residents before enforcement In the presence of (even arbitrarily small) default penalties, this equilibrium is shown to be unique As a result, sovereign risk neither constrains welfare nor lowers credit At most, it creates some additional trade in secondary markets The results presented here suggest a change in perspective regarding the origins of sovereign risk and its remedies To argue that sovereign risk constrains credit, one must show both the insufficiency of default penalties and the imperfect workings of secondary markets To relax credit constraints created by sovereign risk, one can either increase default penalties or improve the workings of secondary markets

https://papers.ssrn.com/sol3/Delivery.cfm/nber_w12783.pdf?abstractid=953206

Sovereign Risk and Secondary Markets

Conventional wisdom says that, in the absence of default penalties, sovereign risk destroys all foreign asset trade. We show that this conventional wisdom rests on one implicit assumption: that assets cannot be retraded in secondary markets. Without this assumption, foreign asset trade is possible even in the absence of default penalties. This result suggests a broader perspective regarding the origins of sovereign risk and its remedies. Sovereign risk affects foreign asset trade only if default penalties are insufficient and secondary markets work imperfectly. To reduce its effects, one can either increase default penalties or improve the working of secondary markets. (JEL F34, G12, G15)

/pdf/sovereign-risk-and-secondary-markets-4j43di4a7f.pdf

Fernando Broner

Papers

Gross Capital Flows: Dynamics and Crises

Gross capital flows: Dynamics and crises

Why Do Emerging Economies Borrow Short Term

Sovereign Risk and Secondary Markets

Sovereign Risk and Secondary Markets