Working Paper: NBER ID: w9286
Authors: Enrique G. Mendoza; Katherine A. Smith
Abstract: A central feature of emerging markets crises is the Sudden Stop' phenomenon characterized by large reversals of capital inflows and current accounts, deep recessions, and collapses in asset prices. This paper proposes an open-economy asset-pricing model with financial frictions that yields predictions in line with these observations. Margin requirements and information costs distort asset trading between a small open economy and foreign securities firms. If the economy's debt-equity ratio is low, standard productivity shocks cause normal recessions with smooth current-account adjustments. If the ratio is high, the same productivity shocks trigger margin calls forcing domestic agents to firesell equity to foreign traders who are slow to adjust their portfolios. This sets off a Fisherian asset-price deflation and subsequent rounds of margin calls. A current account reversal and a collapse in consumption occur if the fire-sale of assets cannot prevent a sharp increase in net foreign asset holdings.
Keywords: emerging markets; sudden stop; asset pricing; financial frictions
JEL Codes: F41; F32; E44; D52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high debt-equity ratio + adverse productivity shocks (E44) | margin calls (E44) |
| margin calls (E44) | fire sale of assets (G33) |
| fire sale of assets (G33) | decline in equilibrium asset prices (D53) |
| decline in equilibrium asset prices (G19) | further margin calls (G33) |
| further margin calls (G33) | decline in consumption (D12) |
| fire sale of assets (G33) | sudden stop (F32) |
| sudden stop (F32) | reversal of capital inflows (F32) |
| sudden stop (F32) | collapse in consumption (E21) |
| sudden stop (F32) | significant downturn in economic activity (F44) |