Working Paper: NBER ID: w10519
Authors: Ricardo Caballero; Kevin Cowan; Jonathan Kearns
Abstract: Latin American economies are exposed to substantial external vulnerability. Domestic imbalances and terms of trade shocks are often exacerbated by sudden stops of capital inflow. In this paper we explore ways of overcoming external vulnerability, drawing lessons from a detailed comparison of the response of Chile and Australia to recent external shocks and from Australia's historical experience. We argue that in order to understand sudden stops and the mechanisms to smooth them, it is useful to identify and then distinguish between two inter-related dimensions of investors' confidence: country-trust and currency-trust. Lack of country-trust is a more fundamental and serious problem behind sudden stops. But lack of currency-trust may both be a source of country-trust problems and weaken a country's ability to deal with sudden stops. We discuss steps to improve along these two dimensions of investors' confidence in the medium run, and policies to reduce the impact of country-trust and currency-trust weaknesses in the short run.
Keywords: sudden stops; capital flows; countrytrust; currencytrust; external vulnerability; Australia; Chile
JEL Codes: E44; E52; F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| absence of countrytrust (F34) | economic downturn severity (in Chile) (N16) |
| lack of currencytrust (E42) | capital flight (in Chile) (F32) |
| currency derivatives market development (G13) | investor confidence (in Australia) (G31) |
| investor confidence (G24) | economic stability (in Australia) (E63) |
| monetary policy response (contractionary in Chile) (E69) | economic downturn severity (in Chile) (N16) |
| monetary policy response (flexible in Australia) (E63) | economic performance (in Australia) (P17) |
| enhancement of countrytrust (O57) | resilience against sudden stops (F32) |
| enhancement of currencytrust (F31) | resilience against sudden stops (F32) |