Currency Crises and Sudden Stops

Extensive integration in international capital markets exposes countries to sudden stops, even in the absence of domestic vulnerabilities.

Currency crises have plagued the last decade of the twentieth century, transcending national borders and regions. The Thai crisis, for example, engulfed Malaysia, Indonesia, and the Philippines within days, while the Russian crisis spread quickly to countries as far apart as Brazil and Pakistan. These events triggered an intense debate about the seemingly contagious nature of crises and fueled a large and increasing body of empirical research on financial contagion.

Past work on contagion has focused on the ability of countries to access international capital markets in times of stress. In Latin America, for example, there is evidence that when there are capital outflows from the large nations, the smaller countries in the region are also affected. Some researchers have examined the role of common creditors: foreign banks can exacerbate the original crisis by calling loans and restricting credit for the crisis country, but they can also propagate crises by calling loans to other nations as they rebalance the overall risk of their portfolio after the initial losses. In the aftermath of the 1982 Latin American debt crisis and the 1997 Asian crisis, for example, the countries most affected by capital flow reversals were the ones that borrowed from the same group of international banks as the immediate crisis nations.

In Crises and Sudden Stops: Evidence from International Bond and Syndicated-Loan Markets (NBER Working Paper No. 14249), author Graciela Kaminsky uses the gross primary issuance of international bonds and syndicated loans, rather than net capital inflows, as an indicator of emerging markets' access to the international capital market. While the absence of net capital inflows may reflect a lack of access to international capital markets, it also may reflect full access to these markets and offsetting inflows and outflows. In contrast, gross issuance captures the ability of a country to both access new credit and roll over maturing debt.

Using new data on 24 emerging-market countries, Kaminsky examines the aftermath of the Mexican, Thai, and Russian crises and asks what type of economic, political, and financial conditions trigger the largest reversals in international gross issuance. She finds that extensive integration in international capital markets exposes countries to sudden stops, even in the absence of domestic vulnerabilities. She also finds that larger reversals in gross issuance tend to occur in countries with banking and current account problems.

Because reversals typically are accompanied by large real depreciations and deep recessions, policymakers seek to avoid sharp downturns in capital flows. Therefore, some countries have introduced capital controls in the midst of crises. While capital controls may be effective short- term responses to sudden stops, they may have unintended long-term effects. In particular, capital controls protect inefficient domestic financial institutions and thus may trigger even further financial vulnerabilities. Capital controls also may delay improvements in corporate governance of non-financial firms. As countries liberalize their capital accounts, domestic corporations start participating in international capital markets, mainly through cross-listing in major world stock exchanges with higher disclosure standards and under the jurisdiction of a superior legal system. This promotes transparency in firm management and can trigger improvements in corporate governance. Thus, imposing capital controls may heighten long-run financial vulnerabilities and lower long-term economic growth.

-- Lester Picker