Reforming the International Monetary and Financial System

5 When Capital Inflows Suddenly Stop: Consequences and Policy Options

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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The Mexican crisis of 1994–95 was associated with a rescue package of unprecedented size. Yet, bailout package notwithstanding, Mexico suffered its largest one-year output decline in 1995, as GDP shrank by more than 6 percent. Since Mexico’s crisis, international organizations have brokered several more rescue plans involving vast sums of funds. Yet, as in Mexico, all the recipients of this financing have had to undertake drastic adjustment as private capital flows dried up. Furthermore, these countries have had to cope with severe recessions. Hence, if we are to assess whether the balance has tilted in recent years toward adjustment, despite the larger bailout packages from the international community, we must begin by comparing the severity of recent crises with their earlier counterparts. In what follows, we aim to assess the burden of adjustment by considering alternative ways of measuring the severity of crises.

Currency and banking crises are not unique to emerging markets. For instance, many European countries found themselves engulfed by the currency turmoil that spread through the region in 1992-93 during what is known as the exchange rate mechanism crises. Like Mexico, Korea, and Thailand, several of these countries, most notably the Scandinavian group, were also experiencing systemic banking sector problems. Confronted with the incompatible goals of defending the exchange rate peg (which would entail maintaining high interest rates) and acting as a lender of last resort to the banks, several countries succumbed to the speculative pressures and either allowed their currencies to float freely or adopted an arrangement that permitted their currencies to oscillate within a wide band.

Thus far, their predicament sounds very similar to that faced by many emerging market economies during the 1990s. Indeed, developed countries and emerging markets share many of the symptoms that are typical antecedents of currency and banking crises.1 Figuring prominently among these common symptoms are large capital inflows, asset price and credit booms, currency overvaluation, and large current account deficits.2 Where industrial and emerging markets economies part company is in the developments that usually follow the onset of crises. Bailout packages were not needed to cope with the currency and banking crises in Europe. Furthermore, output did not collapse following the exchange rate mechanism crisis, and none of these countries lost their access to international capital markets. This benign outcome could not be further removed from the experience of emerging markets. Argentina’s GDP fell more than 4 percentage points in 1995, following the unsuccessful speculative attacks associated with the devaluation of the Mexican peso, and Hong Kong, another nondevaluer, is mired in deep recession at the time of this writing. Yet their bleak performance pales by comparison with the output collapses in emerging markets that have accompanied many of the devaluations both recent and past. In 1998, output fell by 13.7 percent in Indonesia; Mexico’s 6.2 percent output decline in 1995 marked the country’s deepest recession.3

Unlike their more developed counterparts, emerging markets routinely lose their access to international capital markets. Furthermore, given the common reliance on short-term debt financing, the public and private sectors in these countries are often asked to repay their existing debts on short notice. Even with the recent large-scale rescue packages, official financing makes up for only part of this shortfall. Hence, the need for abrupt adjustment arises. Calvo (1998a) has argued that these large negative swings in capital inflows, or sudden stops, are harmful (this is further elaborated in the following section). The corollary is, of course, that large current account deficits are to be feared, irrespective of how they are financed, but particularly so if they are financed by short-term debt. The capital inflow slowdown or reversal could push the country into insolvency or drastically lower the productivity of its existing capital stock. This could be the result of large unexpected swings in relative prices and costly bankruptcy battles.

By the time the crisis erupts and a country has lost its access to international capital markets, the range of policy options available to the country to manage the situation has been severely restricted. Expansionary policies intended to offset some of the devastating effects of the capital flow reversal on economic activity and the financial system become possible only under the umbrella of capital controls, an option that has little appeal for countries not wishing to reverse the process of financial liberalization or that have a distaste for the inflationary consequences often associated with such policies.

In this paper, we ask whether crises in emerging markets have become more severe and what kinds of policies and exchange rate arrangements can make an emerging market less vulnerable to the sudden-stop problem in the first place. While avoiding crises altogether may be a goal well beyond the reach of policymakers, limiting the severity and duration of the crises clearly lies within the realm of the feasible.

In the next two sections, we provide evidence on the magnitude of the rescue packages, and of the sudden-stop problem and its consequences on output and other key economic indicators. We examine the nature of the recovery process in an effort to assess to what extent the financial sector plays a role in determining the depth of the recession and the speed of recovery of the economy. In the section on improving the sudden-stop problem, we turn to the issue of capital controls. Specifically, we present the recent experience with controls that are meant to reduce the amplitude of the capital flow cycle by altering the maturity profile of the capital inflows. We also discuss some alternatives to these measures. In the section on fixed versus flexible exchange rates, we examine the relative merits of fixed versus flexible exchange rates, including the case of complete dollarization. The last section offers some concluding thoughts.

Sudden Stops: Evidence on Painful Adjustment

In this section we briefly sketch the simple analytics of the sudden stop. We then move on to provide some stylized evidence on the orders of magnitude of these capital account reversals and on the severity of the ensuing crises.


By national income accounting and abstracting from errors and omissions, capital inflows equal the current account deficit plus the accumulation of international reserves. Therefore, sudden stops have to be met by reserve losses or lower current account deficits. In practice, both take place. While a loss of international reserves increases a country’s financial vulnerability, contractions in the current account deficit usually have serious effects on production and employment.

To see this, note that, again by national income accounting, the current account deficit equals aggregate demand minus GNP. Thus, a sudden contraction in the current account deficit is likely to lead to a sharp decline in aggregate demand (the only exception being the unlikely case in which there is an offsetting increase in GNP). The decline in demand, in turn, lowers the demand for tradables and nontradables. The excess supply of tradables thus created can be shipped abroad, but the nontradables are, by definition, bottled up at home and, thus, their relative price will have to fall (resulting in a real depreciation of the currency). A prominent example is the real estate sector, where relative prices have exhibited sharp falls in all recent crises.

How does one go from here to infer a loss of output and employment? We can identify two channels: Keynesian, and Fisherian (for Irving Fisher). The Keynesian channel is straightforward and familiar. It is predicated on the assumption that prices/wages are inflexible downward. Under these conditions, a fall in aggregate demand brings about a fall in output and employment.

The Fisherian channel is less familiar but, in our view, potentially more damaging. Financial contracts are, as a general rule, contingent on very few “states of nature,” i.e., objective variables like the terms of trade, profits, demand, etc. A bank loan, for example, is typically serviced by a series of fixed installments unless the borrower goes bankrupt. To illustrate the Fisherian channel, we will assume that all loans are made at a fixed, predetermined interest rate, taking into account expected future variables, but not conditioned on their future realizations. Consider a situation in which the exchange rate is fixed and the international price of tradables is exogenous and constant over time. A decline in aggregate demand that accompanies a sudden stop calls for a lower relative price of nontradables with respect to tradables. Since the price of tradables is stable, to achieve a lower relative price of nontradables with respect to tradables the nominal price of nontradables must fall. Thus, since the interest rates are invariant with respect to the sudden stop, there is a surge in the ex post real interest rate faced by nontradables producers, increasing the share of nonperforming loans. This problem may be less acute if the currency is devalued because, under those circumstances, the price of nontradables need not fall. However, there are at least two relevant complications that may offset the positive effects of devaluation. First, many emerging markets are heavily dollarized and, hence, devaluation is less effective (this is obvious if the country is fully dollarized). Moreover, in countries where asset dollarization is not significant (Chile and Indonesia), there still exists sizable liability dollarization (i.e., foreign-exchange-denominated debts). Liability dollarization is, in fact, quite general in emerging markets because external debt in all of these countries is, as a general rule, denominated in foreign currency. It is well known, for example, that Indonesia’s private sector had a sizable external short-term debt when the crisis hit and that this type of debt played a key role in that country’s ensuing financial difficulties. Second, even if there is no dollarization to speak of, bank loans, for instance, are of shorter maturity than the underlying productive projects. Since real interest rates are likely to be revised upward after the sudden stop (as a result of, for instance, the ensuing higher country risk), this also increases the incidence of nonperforming loans.

The Fisherian channel enhances the severity of crises because it hits the financial sector. As a result, banks become more cautious and cut their loans—especially to small and medium-sized firms—and interenterprise and trade credits dry up, all of which could contribute to a major and long-lasting recession (for further discussion, see Calvo, 1998a).

Capital Inflow Reversals

How big are these capital account reversals? To answer this question it is useful to get a handle on the size of the capital inflows in the most recent inflow episode.4Table 1 presents selected evidence on all the major capital importers of the 1990s, with the exception of China. The second column presents the dates of the heavy inflow episode; the third column provides information on the magnitude of the cumulative inflow; and the last column lists the inflow during the peak year as a percent of GDP. The higher these numbers, the higher the vulnerability to the sudden-stop problem.

Table 1.Recent Surges in Capital Inflows(Net private capital flows as a percent of GDP)
CountryInflow Episode1Cumulative Inflows/GDP at End of EpisodeMaximum Annual Inflow
South Korea1991–949.33.5
Sri Lanka1991–9422.68.2
Venezuela, República Bolivariana de1992–935.43.3
Sources: World Bank, World Debt Tables, various issues; and International Monetary Fund, International Financial Statistics, various issues.

Period during which the country experienced a surge in net private capital inflows.

Sources: World Bank, World Debt Tables, various issues; and International Monetary Fund, International Financial Statistics, various issues.

Period during which the country experienced a surge in net private capital inflows.

Both cumulative inflows and peak inflows are sizable, particularly for some of the affected Asian economies, most notably Thailand and Malaysia. In the case of the latter, inflows hit a peak of 23.2 percent of GDP in 1993. Because a high share of those inflows were short term and perceived by the authorities to be “hot money,” capital controls on short-term flows were introduced in Malaysia in January 1994.5 It is also noteworthy that two countries that were hard hit by the sudden-stop problem—Argentina during the Mexican tequilazo effect and Indonesia after the Thai baht was devalued—had relatively low capital inflows. In both cases, however, domestic capital flight severely compounded the sudden stop.

As Table 2 shows, many of those countries listed in Table 1 as having experienced a surge in capital inflows in the earlier part of this decade also suffered an abrupt capital account reversal and the accompanying need for a severe adjustment in the current account. Up until the recent Asian crises, Latin America was the region most prone to these large-scale capital inflow reversals. Until the Thai crisis, which resulted in a 26 percentage point swing in private capital flows (from inflows of about 18 percent of GDP in 1996 to outflows of over 8 percent in 1997), Argentina’s crisis in the early 1980s had recorded one of the largest capital account reversals (20 percent). The large historic discrepancy in capital account volatility and in the severity of financial crises between Asia and Latin America appears to have eroded in the 1990s. This narrowing in regional differences is also evident in various measures of the severity of the crises, the issue we turn to next.

Table 2.Selected Large Reversals in Net Private Capital Flows(As a percent of GDP)
Argentina, 1982–8320
Argentina, 1994–954
Chile, 1981–837
Chile,1 1990–918
Ecuador, 1995–9619
Hungary, 1995–967
Indonesia, 1996–975
Malaysia,1 1993–9415
Mexico, 1981–8312
Mexico, 1993–956
Philippines, 1996–977
South Korea, 1996–9711
Thailand, 1996–9726
Turkey, 1993–9410
Venezuela, República Bolivariana de, 1992–949
Sources: World Bank, World Debt Tables, various issues; and International Monetary Fund, International Financial Statistics, various issues.

Reversal owing to the introduction of controls on capital inflows.

Sources: World Bank, World Debt Tables, various issues; and International Monetary Fund, International Financial Statistics, various issues.

Reversal owing to the introduction of controls on capital inflows.

The Severity of Crises

The preceding discussion has suggested that surges in capital inflows are often followed by sudden stops. With the exception of two episodes—Chile in 1990–91 and Malaysia in 1993–94, in which the reversal was deliberately engineered by the introduction of restrictions on short-term capital inflows—the negative capital account swing was involuntary (from the vantage point of the capital-importing country) and was associated with a currency crisis and most often with a banking crisis as well.6

If we wish to assess whether the balance has tilted in recent years toward adjustment despite larger bailout packages from the international community, we must begin by comparing the severity of recent crises with their earlier counterparts. We consider alternative ways of measuring the severity of the crisis. We should also review the extent of financing provided by the rescue packages not only in their dollar value, as is commonly done, but relative to the size of the recipient economy. Table 3 documents some recent episodes.

Table 3.Recent Rescue Packages
Rescue Package
CountryYear(In billions of U.S. dollars)(As a percent of GDP)

As discussed in Calvo (1998a), one of the reasons why the sudden stop may lead to a contraction in output has to do with large and unexpected swings in relative prices. Consider the case where loans were extended to the nontraded sector, such as real estate, under the expectation that the price of nontraded goods relative to traded goods (the real exchange rate) would remain stable over the duration of the contract. Under these circumstances, a large, unexpected real depreciation could render many of these loans nonperforming. Hence, one measure of the severity of a crisis could include the magnitude of the real depreciation of the currency. Also, the greater the extent to which the central bank has already depleted its stock of foreign exchange reserves by the time the crisis erupts, the greater the burden of adjustment that is required to close the current account deficit on short notice.

To analyze this issue formally, we measure the severity of currency and banking crises as in Kaminsky and Reinhart (1999 and 1998). For currency crises, we construct an index that gives equal weight to reserve losses and the real exchange rate depreciation. This index is centered on the month of the currency crisis, and it combines the percentage decline in foreign exchange reserves in the six months prior to the crisis—since reserve losses typically occur before the central bank capitulates—and the real depreciation of the currency in the six months following the abandonment of the existing exchange rate arrangement, be it a peg or a band. While this is not akin to the unexpected portion of the relative price swing, it does provide a rough sense of the magnitude of the realignment. As to the severity of banking crises, we use the cost of the bailout as a share of GDP as our proxy.

Table 4 presents these measures of severity for the 76 currency crises and 26 banking crises in the Kaminsky-Reinhart sample.7 For the 1970-94 sample, currency and banking crises were far more severe in Latin America than elsewhere. The crises in East Asia, by contrast, were relatively mild and not that different by these metrics from the crises in the European countries that dominate the “others” group. The picture that emerges during 1995-97 is distinctly different. The Latin American crises include those of Mexico and Argentina in late 1994 and early 1995, respectively. While Argentina did not devalue, it sustained major reserve losses associated with a series of bank runs that left the level of bank deposits by mid-March 1995 about 18–19 percent below their level prior to the devaluation of the Mexican peso.

Table 4.The Severity of Crises: Then and Now
Currency CrisesBanking Crises
PeriodLatin AmericaEast AsiaOthersLatin AmericaEast AsiaOthers
Source: Kaminsky and Reinhart (1998).

The difference from the historic mean is statistically significant at standard confidence levels.

Source: Kaminsky and Reinhart (1998).

The difference from the historic mean is statistically significant at standard confidence levels.

Both in terms of this measure of the severity of the currency crisis, as well as the estimated costs of bailing out the banking sector, the severity of the Asian crises even surpasses that of their Latin American counterparts in the 1990s, and it is a significant departure from the historic regional norm.8 On the basis of these measures of severity—specifically the huge burden of bailing out the banks, as well as the order of magnitude of the capital account reversals (Table 2)—it does appear that during the course of the 1990s the balance between financing and adjustment has shifted toward adjustment, despite the larger packages put together by the IMF during the recent crises in emerging markets.

Collapsing Output and Protracted Banking Crises

Sudden stops can lead to collapses in output and do severe damage to the financial system. Indeed, nearly all the banking crises in our sample are associated with a reversal from capital inflows to outflows.9 While in most cases the banking sector problems begin before the sudden stop, the abrupt capital flow reversal deepens the financial sector problems. Moreover, the Latin American crises and the Asian crises of the late 1990s are markedly more severe than the crises in Europe or in Asia’s own past. In what follows, we examine the economic landscape in the aftermath of sudden stops and currency and banking crises. The emphasis is on assessing the magnitude of the output losses and the economy’s speed and capacity to return to normal. We also compare some of the recent experiences with the historical patterns. Before turning to the performance of real GDP in the postcrisis period, however, we assess how various indicators often stressed in the literature on capital markets crises behave following the sudden stop and, in particular, how many months elapse before their behavior returns to normal.

To do so, we must define what is normal. In what follows, we define periods of tranquility to exclude the 24 months before and after currency crises. In the case of banking crises, the 24 months before the banking crisis begins and the 36 months following it are excluded from tranquil periods. For each indicator, we tabulate its average behavior during tranquil periods. We then compare the postcrisis behavior of the indicator to its average in periods of tranquility.

Table 5 summarizes the results for that exercise for currency and banking crises separately, as we have stressed that banking crises have tended to be more protracted affairs and more closely linked with sudden stops. The number reported is the average number of months that it takes that variable to reach its norm during tranquil periods. In parentheses, we note whether the level or growth rate of the variable remains above or below its norm in the postcrisis period.

Table 5.The Aftermath of Financial Crises

(Average number of months it takes a variable to return to normal behavior after the crisis)1

IndicatorBanking CrisisCurrency Crisis
Bank deposits30 (below)12 (above)
Domestic credit/GDP215 (above)9 (above)
Exports20 (below)8 (below)
imports29 (below)18 (below)
M2/reserves15 (above)7 (above)
Output18 (below)10 (below)
Real interest rate315 (above)7 (below)
Stock prices30 (below)13 (below)
Source: Goldstein, Kaminsky, and Reinhart (2000).

We note in parentheses whether the variable remained below or above the norm during periods of tranquility.

Domestic credit/GDP remains above normal levels largely as a result of the marked decline in GDP following the crisis; it is a debt overhang.

The disparity between the postcrisis behavior of real interest rates lies in the fact that a large share of the currency crises occurred in the 1970s, when interest rates were controlled, and is not very informative about market conditions.

Source: Goldstein, Kaminsky, and Reinhart (2000).

We note in parentheses whether the variable remained below or above the norm during periods of tranquility.

Domestic credit/GDP remains above normal levels largely as a result of the marked decline in GDP following the crisis; it is a debt overhang.

The disparity between the postcrisis behavior of real interest rates lies in the fact that a large share of the currency crises occurred in the 1970s, when interest rates were controlled, and is not very informative about market conditions.

Several features of Table 5 are worth noting. First, the data bear out that banking crises have more lingering deleterious effects on economic activity than currency crises. This may be due to the kinds of Fisherian channels stressed in Calvo (1998a) or to a credit channel mechanism. Whatever the explanation, this difference is evident in several of the indicators. While the 12-month change in output remains below its norm in periods of tranquility for 10 months on average following a currency crash, it takes nearly twice that amount of time to recover following a banking crisis. This more sluggish recovery pattern is also evident in imports, which take about two and a half years to return to their norm. Bank deposits also remain depressed. The weakness in asset prices, captured here by equity returns, persists for 30 months on average for banking crises, more than twice the time it takes to recover from a currency crash. It is worth recalling that assets, be they equity or real estate, are a common form of collateral against loans. Hence, a collapse in asset prices may trigger margin calls and increase the incidence of nonperforming loans, worsening the problems in the banking sector.10 Interest rates remain high after banking crises, whereas this is not the case for currency crises. This result is largely due to the fact that banking crises in our sample are clustered in the financial postliberalization period when interest rates are market determined. By contrast, the number of currency crises are about evenly split into pre- and postliberalization subsamples. In the case of the former, interest rate ceilings were prevalent among emerging markets, removing most of the information content of interest rates.

Second, Table 5 highlights that there are likely to be important sectoral differences in the pace of recovery, depending also on the type of crisis. For instance, following the devaluations that characterize the bulk of the currency crises, exports recover relatively quickly and ahead of the rest of the economy. However, following banking crises, exports continue to sink for nearly two years following the onset of the crisis. This may be due to a persistent overvaluation (recall that in this sample banking crises typically begin before currency crises); high real interest rates (the Fisherian channel); or a credit crunch story.

Table 6 highlights the protracted nature of banking crises by showing the average number of months elapsed from the beginning of the crisis to its zenith for the 26 banking crises studied in the sample. On average, it takes a little over a year and a half for a banking crisis to ripen; in some instances, it has taken over four years. This protracted profile is, in part, due to the fact that often the financial sector problems do not begin with the major banks, but rather with more risky finance companies. As the extent of leveraging rises, households and firms become more vulnerable to any adverse economic or political shock that leads to higher interest rates and lower asset values. Defaults increase, and the problems spread to the larger institutions. If there are bank runs, such as in Republica Bolivariana de Venezuela in 1994, the spread to the larger institutions may take less time.

Table 6.The Protracted Nature of Banking Crises: Time Elapsed from Beginning of Crisis to Its Peak
Descriptive StatisticsNumber of Months
Standard deviation17

However, the information presented in Table 6 does not fully disclose the length of time that the economy may be weighed down by banking sector problems, and it does not provide information on the time elapsed between the crisis peak and its ultimate resolution. Rojas-Suarez and Weisbrod (1995), which examines the resolution of several banking crises in Latin America, highlights the sluggishness of the resolution process in many episodes. The ongoing Japanese banking crisis, which has spanned most of the 1990s, is a recent example of this sluggish recognition/admission/resolution process.

We next focus on the evolution of GDP in the aftermath of crises. Tables 7 and 8 present the time profile of post-banking and currency crises deviations in GDP growth from the mean rate of growth during tranquil periods. We distinguish between the moderate-inflation and high-inflation countries; the latter encompass mostly Latin American countries. We report averages for some of the recent crises separately and examine to what extent they depart from the historical averages.

Table 7.Real GDP Growth in the Aftermath of Banking Crises: Deviations from Tranquil Periods (1970-94 Sample)
All countries-3.2-2.1-0.8-1.1
Moderate-inflation countries1-1.6-2.3-1.6-1.4
High-inflation countries-4.5-1.70.0-0.5
Recent experiences-13.32

Moderate-inflation countries are those with inflation rates below 100 percent in all years surrounding the crisis; high-inflation countries are those in which inflation exceeded 100 percent in at least one year.

Includes Argentina, Hong Kong, Indonesia, Korea, Mexico, and Thailand. Argentina is classified as a banking crisis (albeit a very mild one) owing to the widespread bank runs (see Kaminsky and Reinhart (1999) for a detailed discussion of dating banking crises).

Moderate-inflation countries are those with inflation rates below 100 percent in all years surrounding the crisis; high-inflation countries are those in which inflation exceeded 100 percent in at least one year.

Includes Argentina, Hong Kong, Indonesia, Korea, Mexico, and Thailand. Argentina is classified as a banking crisis (albeit a very mild one) owing to the widespread bank runs (see Kaminsky and Reinhart (1999) for a detailed discussion of dating banking crises).

Table 8.Real GDP Growth in the Aftermath of Currency Crises: Deviations from Tranquil Periods (1970-94 Sample)
All countries-2.7-1.9-0.6-0.8
Moderate-inflation countries1-1.9-1.6-0.70.0
High-inflation countries-3.8-2.2-0.1-1.5
Recent experiences-12.32

Moderate-inflation countries are those with inflation rates below 100 percent in all years surrounding the crisis; high-inflation countries are those in which inflation exceeded 100 percent in at least one year.

Includes two successful defenses: Argentina and Hong Kong; and four successful attacks: Indonesia, Korea, Mexico, and Thailand. The successful defenses do not register as crises, but as turbulence, owing to the substantial reserve losses.

Moderate-inflation countries are those with inflation rates below 100 percent in all years surrounding the crisis; high-inflation countries are those in which inflation exceeded 100 percent in at least one year.

Includes two successful defenses: Argentina and Hong Kong; and four successful attacks: Indonesia, Korea, Mexico, and Thailand. The successful defenses do not register as crises, but as turbulence, owing to the substantial reserve losses.

channel story may lead to a severe contraction in investment. The credit crunch explanation is, indeed, plausible in light of banks’ need to recapitalize and to provision. The recessions following the recent crises are far more severe than the historic norm, even if Indonesia is excluded from the sample.

Devaluations are perceived to be expansionary in industrial countries. This view is reflected in the assumed policy trade-off in many second-generation models of currency crises that stress the policymakers’ conflict between the credibility losses incurred if the peg is abandoned and the economic gains from devaluation. While this proposition may be an adequate representation for industrial countries, the evidence presented here bears out the results of the earlier studies by Edwards (1986 and 1989) and others. As Table 8 highlights, currency crises do not appear to have a salutary effect on the economy because growth remains below that observed during tranquil periods in the three years following the crisis. Some of the most recent sudden- stop episodes, which have included both successful and unsuccessful speculative attacks, highlight the staggering output losses associated with the sudden-stop problem. The last row of the table reports the averages for six recent episodes. It includes two successful defenses, Argentina and Hong Kong, and four successful attacks, Indonesia, Korea, Mexico, and Thailand. As shown, the output collapse in the year following the sudden stop is dramatically higher than the comparable historic norm. For all the devaluers in that recent sample, these currency crises were also accompanied by deep and costly banking crises. As with banking crises, the recent output losses are a significant departure from the historic pattern.

The results for the full sample reveal that the recessions are somewhat milder than those following a banking crisis. Reinforcing the results shown in Table 7, the moderate-inflation economies appear to recover more quickly from a currency crisis than from a banking crisis, unless the currency collapse is accompanied by a banking crisis as well.11

Improving the Sudden-Stop Problem: Is There a Role for Capital Controls?

In principle, we would expect the volume and composition of capital inflows to respond to the policy stance that the recipient countries adopt. In some instances, domestic policies were explicitly designed precisely to shape the volume and/or composition of inflows (capital controls). In others, the effects of the policies were largely unintended (sterilized intervention). In this section, we briefly review the evidence on the effects of these policies. The discussion draws heavily on Montiel and Reinhart (1999); hence, its scope is limited to assessing the effectiveness of controls of various types on capital inflows. Controls on capital outflows, which are often introduced during or after crises, as Malaysia did after the 1997 Asian crisis, are not considered here. We also discuss the relative merits of some variants to the types of policies adopted by Brazil, Chile, Colombia, the Czech Republic, and Malaysia, which primarily targeted either short-term or portfolio inflows.

Empirical Evidence on Controls

It remains controversial whether the intent to influence the volume or composition of flows has been successful during these experiences in the 1990s. Here we provide a brief summary of the key findings of Montiel and Reinhart (1999) on the basis of panel data containing annual observations on the volume and composition of capital inflows for 15 emerging markets over the 1990-96 period. The countries in our sample are listed at the bottom of Table 9. The analysis disaggregates among three types of capital flows: portfolio flows, short-term flows, and foreign direct investment (FDI). The results for the capital account balance are also reported. Further details on the data, the measures that proxy for capital controls and sterilization, and the methodology employed are available from the original paper.

The key findings that can be gleaned from Table 9 can be summarized as follows:

Table 9.Fixed Effects Estimates, Instrumental Variables: 1990–96, 15-Country Panel
Dependent VariableSterilization IndexCapital Control ProxyJapanese Interest RateU.S. Interest RateNumber of Listed Stocks
Capital account1.762-0.716-0.224-0.4250.006
As a percent of GDP(2.927)(-1.092)(-1.931)(-2.311)(2.653)
Portfolio flows0.374-0.238-0.313-0.1610.017
As a percent of GDP(1.064)(-0.976)(-3.046)(-1.025)(2.826)
Short-term flows0.902-0.451-0.048-0.1360.001
As a percent of GDP(2.335)(-1.081)(-0.518)(0.883)(0.612)
Portfolio plus short-term flows0.870-0.642-0.210-0.0700.009
As a percent of GDP(2.344)(-1.302)(-1.116)(-0.822)(2.184)
FDI flows0.9131.785-0.149-0.122-0.001
As a percent of GDP(1.145)(0.792)(-1.032)(-1.116)(-0.024)
Portfolio plus short-term flows34.709-32.856-30.91313.051
As a percent of total flows(1.986)(-2.233)(-1.321)(1.225)
FDI flows-18.90043.75332.776-9.976
As a share of total flows(-1.936)(1.894)(1.672)(-1.018)
Notes: The countries in the sample are Argentina, Brazil, Chile, Colombia, Costa Rica, Czech Republic, Egypt, Indonesia, Kenya, Malaysia, Mexico, Philippines, Sri Lanka, Thailand, and Uganda. t-statistics are reported in parentheses. Standard errors have been corrected for general forms of heteroskedasticity.Ellipsis points denote not applicable.
Notes: The countries in the sample are Argentina, Brazil, Chile, Colombia, Costa Rica, Czech Republic, Egypt, Indonesia, Kenya, Malaysia, Mexico, Philippines, Sri Lanka, Thailand, and Uganda. t-statistics are reported in parentheses. Standard errors have been corrected for general forms of heteroskedasticity.Ellipsis points denote not applicable.

Sterilized intervention increases the volume of total capital flows through short-term capital. Portfolio flows and foreign direct investment do not appear to be responsive to the intensity of sterilization. By widening and preserving domestic-foreign interest rate differentials, sterilized intervention significantly alters the composition of capital flows, increasing the share of short-term and portfolio flows. This may be taken as an argument against a soft peg, as the capacity for sterilized intervention is limited or nonexistent in a currency board arrangement—an issue we will take up later.

Although the signs of the estimates are negative, capital controls appear to have no statistically significant effect on reducing the overall volume of flows. Capital controls, however, do appear to alter the composition of capital flows in the direction usually intended by these measures, reducing the share of short-term and portfolio flows while increasing that of foreign direct investment.

As in most of the earlier literature on this subject, foreign interest rates appear to have a significant effect on both the volume and composition of flows. Specifically, total capital flows, and especially portfolio flows, respond systematically to changes in U.S. and Japanese interest rates in the direction suggested by theory, even after controlling for some of the domestic policy fundamentals and some of the characteristics of the capital market.

Some Thoughts on Alternative Measures

Some caveats about the previous results, however, are in order. While they clearly show that taxes or reserve requirements that target short-term inflows had a significant effect on the maturity profile of the flows, we do not know whether this is, to some extent, an artifact of reclassification. We also do not know to what degree these measures simply encouraged a substitution of foreign short-term debt for domestic short-term debt.12 To the extent that domestic short-term debt is also an implicit claim on the reserves of the central bank, then such a substitution would not ameliorate the liquidity problems during a sudden stop. An exception would be the case where through moral suasion the government and the central bank have greater leverage in persuading the local residents to roll over those debts. This has been, to some degree, the case of Brazil, where the debt is largely from the public sector. Such leverage would be less likely if the domestic debt that needs to be rolled over is private.

If part of the general problem of the sudden stop is short-term debt (irrespective of whether it is domestic or external) then, obviously, emerging market governments should adopt more conservative debt-management strategies and lengthen the maturity of their debt. However, while a prudent public debt-management strategy is necessary to ameliorate the sudden-stop problem, it is doubtful that it is sufficient. In Korea, it was the banks that were borrowing short. It is worth noting that the balance sheet problems of the banks in all these recent crises involved both currency and maturity mismatches. Furthermore, the problem is not limited to the banks—in Indonesia it was the corporate sector. In this regard, a tax on all short-term borrowing may be a preferable strategy to just taxing foreign short-term borrowing. In the case of banks, this could be through high reserve requirements for shorter maturity deposits, irrespective of the currency of denomination of the deposit. Thus, governments that pursue capital controls will likely be driven to cast a wide net that covers all financial intermediaries, and even nonfinancial corporations, since the latter participate in the sizable interenterprise credit market (see Ramey, 1992). This is an enormous task. Moreover, countries that succeed in this task may find themselves deeply immersed in central planning. Therefore, capital controls can be at best a short-term response to capital inflows or outflows.

Sterilized intervention policies during the capital inflow period should be discouraged, since typically these open market operations place more shortterm debt in the hands of the private sector. In several episodes (see Reinhart and Reinhart, 1998), the sterilization objective led central banks to complement the stock of public sector debt with debt of their own, adding an important quasi-fiscal dimension to the short-term debt problem. This would be no major problem if central banks held in stock sterilized reserves as a backup for the associated central bank short-term obligations. In practice, however, there is strong temptation to utilize those reserves for other purposes (prominently bailing out the financial sector, as in Mexico and Thailand).

Revisiting an Old Debate

Previous sections have established the extreme severity of recent emerging market crises. In addition, we have argued that the sudden-stop episodes are associated with a previous surge of capital inflows and that the severity of sudden stops is enhanced by the presence of short-term debt (both domestic and external). Unfortunately, what may appear as a natural line of defense—namely, imposing controls on international capital mobility—is fraught with serious implementation problems and, if maintained over the medium term, may imply a gradual reversion to central planning.

Fixed Versus Flexible Exchange Rates

In this section we will discuss the role of the foreign exchange system. All crisis episodes took place against a background of soft-pegged exchange rates. This has led many analysts to conclude that “the peg did it.” At some level, the statement is right because, if the exchange rate were allowed to float freely, some of the international reserve loss would have been prevented. Even at this level of abstraction, however, the analysis is seriously incomplete. It misses a key point: namely, that in many crisis episodes either the government or the private sector, or both, had relatively large foreignexchange- denominated short-term debt obligations that exceeded by far the stock of international reserves. Therefore, the balance of payments crises most likely would have taken place under more flexible exchange rate arrangements as well. In effect, Korea, Malaysia, and the Philippines were classified as managed floats, while both Mexico and Indonesia had exchange rate bands.

However, at a deeper level it could be argued that liability dollarization is partly a result of pegging, magnified by the overconfidence and moral hazard problems that pegging may bring about. As the argument usually goes, if the exchange rate were free to float, domestic investors—especially those in the nontradable sector—would shy away from foreign-exchange-denominated loans. This is so because they would now face a larger currency risk than under a fixed rate. This sounds convincing, but it misses two important points: most emerging market economies start from a situation of partial dollarization (at the very least, liability dollarization), and it is really very hard to find instances in which an emerging market country completely ignores exchange rate volatility. These points reinforce each other. Partial dollarization increases the cost of exchange rate volatility (through the Fisherian channel, for example), which, in turn, induces the central bank to intervene in the foreign exchange markets to prevent fluctuations in the nominal exchange rate. In fact, as the cases of El Salvador, the Philippines, and Venezuela attest, this fear of floating may be so severe that the exchange rate spends long stretches of time at a fixed level, making it observationally equivalent to a soft peg.13 On the other hand, fear of floating induces more liability dollarization, creating a vicious circle from which it is very hard to exit. In addition, fear of floating arises whenever domestic firms utilize foreign raw materials. In this case, floating is less destructive than in the previous example, but it can still cause financial difficulties in the medium term. Fear of floating and lack of the discipline that underlies fixed exchange rates may drive authorities to adopt additional control measures, such as dual exchange rates and controls on capital mobility. Even when fear of floating does not lead to capital controls and countries adopt market-friendly ways of stabilizing the exchange rate through open market operations, such policies have significant costs both in terms of the interest rate volatility associated with them as well as their procyclical nature.14 Thus, contrary to the view that floating provides authorities with an extra degree of freedom to guarantee a market-friendly environment, the opposite may happen.

Traditional theory teaches that the choice of a foreign exchange regime ought to be a function of the nature of shocks. The basic lesson is if the shocks are mostly real, float; otherwise, fix. For a simple presentation of this theory that incorporates some key aspects of the current policy debate, see Calvo (1999b). Recent crisis episodes, though, show that shocks come predominantly through the capital account and, as a result, they contain both real and nominal components. So the choice of the exchange rate system on that basis becomes more difficult. In addition, a major deficiency of received theory is that it takes shocks as fully exogenous, when all available evidence points to the fact that credibility and reputation are critical in determining how hard an emerging market country is hit by financial turmoil (i.e., how big the shocks are). In fact, Argentina’s dollarization proposal is an attempt to make policymaking more credible and, thus, lower country risk differentials (see Calvo, 1999a, for further discussion).

Moreover, traditional theory can be criticized even on its own grounds. Traditional theory ranks foreign exchange regimes by their associated output volatility. Financial and Fisherian considerations, however, lead one to worry also about relative price volatility and, in particular, volatility of the real exchange rate. As shown in Calvo (1999b), focusing on real exchange rate volatility drastically changes the traditional ranking. With sticky prices, for example, fixed rates would obviously dominate floating exchange rates.

Another weakness of traditional theory is oversimplification. Defenders of floating exchange rates on these grounds point to the fact that flexible exchange rates make the adjustment of relative prices less costly because equilibrium changes can be accommodated by a higher or a lower exchange rate with little effect on output and employment. This point is well taken in the context of a Mickey Mouse textbook model with homogeneous tradables and nontradables. In a realistic economy, however, there are several distinct goods, each with a distinct labor market: gauchos cannot be quickly retrained as nuclear physicists, and vice versa. Thus, given wages, a 20 percent fall in the international price of meat, for instance, may call for an equiproportional currency devaluation to ensure the gauchos’ full employment. But a 20 percent devaluation might generate excess demand and inflation in physics. More generally, the problem is that the exchange is only one instrument, and price/wage stickiness is a multidimensional issue. Devaluation is not a silver bullet. Devaluation in practice is an exercise in political compromise. Gauchos want 20 percent, physicists less than that (assuming that they dislike inflation). As a result, devaluation makes no group totally happy. Finally, devaluation can be substituted by fiscal policy. If the real exchange rate is overappreciated, for example, labor subsidies can be put in place to replicate in a more controlled way the desired real depreciation.

Let us now turn to dollarization. Dollarization has been criticized on the following grounds: it leaves the country without a lender of last resort, and use of a foreign currency may entail loss of seigniorage.15 Both of these criticisms have easy answers. Starting with the latter, the two countries involved (i.e., the dollarized emerging market and the country whose currency is utilized by the emerging market) could share the seigniorage (as proposed by Argentina, see Calvo, 1999a). As for the first criticism, it would hold true to the extent that the lender of last resort has no genuine resources of its own and has to rely on money issuance. As shown in Calvo (1999a), however, under dollarization and a seigniorage-sharing arrangement, a large portion of international reserves could be used to provide lender-of-last-resort services. This would, of course, require the holding of a large enough stock of reserves or the creation of a stabilization fund by foreign donors.

In summary, much of the glitter of flexible exchange rates disappears upon closer examination. The extra degrees of freedom provided by exchange rate flexibility are fallacious or can be substituted by fiscal policy. Finally, strong pegs like dollarization can help to reduce the incidence of external shocks, especially those that filter through the capital account. Granted, not every emerging market needs to go that far, and not every emerging market could go that far, but dollarization is not the silly idea that conventional thinkers would have us believe.

Dollarization from the U.S. Perspective

We have presented arguments to suggest that dollarization may be an attractive option for emerging markets to deal with the problems of recurring and all-too-frequent sudden stops. While full dollarization will not eliminate banking sector problems, it may alleviate them if it reduces the problems that stem from currency and maturity mismatches, and it will do away with speculative attacks on the currency. After all, speculators cannot attack the peso if it does not exist. We next address the benefits or costs that full dollarization carries for the United States.

The issue that monetary policy for fully dollarized emerging markets will be set by the Federal Open Market Committee in the United States is not novel. As shown in Calvo, Leiderman, and Reinhart (1993) and other studies, U.S. interest rates have long influenced capital flows to emerging markets, particularly in Latin America. From the U.S. vantage point, the only difference is that under full dollarization the exportation of U.S. policies is made more transparent. Nor is the seigniorage issue new. As noted earlier, many emerging market countries are already heavily dollarized. Incremental seigniorage is likely to be a marginal consideration. One concern, frequently voiced by those who suggest that the United States should not encourage dollarization, is that the United States would be heavily involved in large bailout packages for emerging market countries. Yet, this issue is also not new. Direct and indirect involvement (via influencing IMF lending) by the United States has already skyrocketed in the 1990s, as witnessed by the unprecedented size of the bailouts. As to the potential effects of full dollarization by emerging markets on the U.S. real economy, we consider three possible effects below.

First, the constituency opposing trade agreements between the United States and emerging market countries, on the grounds that a reduction in trade barriers places U.S. labor at a disadvantage, should welcome dollarization. After all, if a country is fully dollarized it cannot gain a trade advantage by frequently devaluing its currency and making its goods and labor relatively cheap. Thus, the massive realignment between Mexican and U.S. wages in dollar terms that occurred in late 1994-95 could not have taken place. Other things equal, this inability to devalue bodes well for narrowing the persistent U.S. current account deficit. We can refer to this channel as a relative price effect.

Second, if full dollarization improves the sudden-stop problem for the reasons discussed earlier, the United States stands to gain from the more stable and sustained income gains of its trading partners. We have seen U.S. exports adversely affected by the output collapses in Asia and by Mexico’s 1995 recession. In that regard, if U.S. exports are to benefit from greater income stability and growth in any region of the world, it would be from Latin America. Table 10 reports the share of United States imports in the total imports of selected trading partners in the Americas, Europe, and Asia. It is fairly evident that the Latin American countries have the highest propensity to import from the United States. Seventy-five percent of Mexico’s imports come from the U.S., more than nine times the share of the United States in European imports. Hence, if emerging market countries in Latin America were to dollarize, the U.S. current account deficit would benefit from this income effect.

Table 10.Imports from the U.S. as a Percent of Total Imports for Selected Countries(In percent)
The Americas
Source: IMF, Direction of Trade Statistics, Yearbook 1998, and various issues, 1997 and 1998.
Source: IMF, Direction of Trade Statistics, Yearbook 1998, and various issues, 1997 and 1998.

Lastly, and related to the previous points, U.S. financial institutions that operate overseas are likely to benefit from dollarization in emerging markets. U.S. financial institutions would enjoy a comparative edge stemming from the fact that they have expertise in intermediating dollar funds. As opposed to local financial institutions, U.S. institutions benefit more from scale economies. Moreover, they would have ready access to a lender of last resort of U.S. dollars, whereas the financial institutions in emerging market economies would have a more limited security blanket.


In this paper we have presented evidence that sudden-stop problems have become more severe for emerging market countries, particularly for Asian economies that historically had a comparatively more placid economic cycle than their Latin American counterparts. Because policy options are relatively limited in the midst of a capital market crisis and because so many emerging markets have had crises recently, we have focused on some policies that could reduce the incidence of crises in the first place, or at least make the sudden-stop problem less severe. In this regard, we considered the relative merits of capital controls and dollarization. Floating is, of course, another option, but for the reasons discussed earlier we are doubtful that many emerging market countries will be ready to embrace floating along the lines practiced in only a handful of industrial countries. We conclude that, while the evidence suggests that capital controls appear to influence the composition of flows by skewing them away from short maturities, such policies are not likely to be a long-run solution to the recurring problem of sudden capital flow reversals. Yet, because of fear of floating, many emerging market economies are likely to turn to increased reliance on controls. Dollarization would appear to have the edge as a more market-oriented option to ameliorate, if not eliminate, the sudden-stop problem.

Appendix. Crisis Definitions

Currency Crisis

Most often, currency crises are resolved through a devaluation of the domestic currency or the floatation of the exchange rate. But central banks often resort to an interest rate defense and foreign exchange market intervention to fight the speculative attack. In these latter cases, currency market turbulence will be reflected in steep increases in domestic interest rates and massive losses of foreign exchange reserves. Hence, an index of currency crises should capture these different manifestations of speculative attacks. The index of currency market turbulence below is a weighted average of exchange rate changes and reserve changes. Interest rates were excluded as many emerging markets in our sample had interest rate controls through much of the sample.

The index I is a weighted average of the rate of change of the exchange rate,Δe/e, and of reserves, ΔR/R, with weights such that the two components of the index have equal sample volatilities I=(Δe/e)(σe/σR)(ΔR/R),

where σe is the standard deviation of the rate of change of the exchange rate and σR is the standard deviation of the rate of change of reserves. Since changes in the exchange rate enter with a positive weight and changes in reserves have a negative weight attached, readings of this index that were three standard deviations or more above the mean were cataloged as crises. For countries in the sample that had hyperinflation, the construction of the index was modified. While a 100 percent devaluation may be traumatic for a country with low-to-moderate inflation, a devaluation of that magnitude is commonplace during hyperinflation. A single index for the countries that had hyperinflation episodes would miss sizable devaluations and reserve losses in the moderate inflation periods, since the historic mean is distorted by the high-inflation episode. To avoid this, we divided the sample according to whether inflation in the previous six months was higher than 150 and then constructed an index for each subsample. Our cataloging of crises for the countries coincides fairly well with our chronology of currency market disruptions.

Banking Crisis

With regard to banking crises, our analysis stresses events. The main reason for following this approach has to do with the lack of high frequency data that capture when a financial crisis is under way. If the beginning of a banking crisis is marked by bank runs and withdrawals, then changes in bank deposits could be used to date the crises. Often, the banking problems do not arise from the liability side, but from a protracted deterioration in asset quality, be it from a collapse in real estate prices or increased bankruptcies in the nonfinancial sector. In this case, changes in asset prices or a large increase in bankruptcies or nonperforming loans could be used to mark the onset of the crisis. For some of the earlier crises in emerging markets, however, stock market data are not available. Indicators of business failures and nonperforming loans are usually available only at low frequencies, if at all; the latter are also made less informative by the banks’ desire to hide their problems for as long as possible.

Table A.1Crises Dates
CountryCurrency CrisisBeginning of Banking Crisis
ArgentinaJune 1975
February 19811March 1980
July 1982
September 19861May 1985
April 1989
February 1990December 1994
BoliviaNovember 1982
November 1983
September 1985October 1987
BrazilFebruary 1983
November 19861November 1985
July 1989
November 1990
October 1991December 1994
ChileDecember 1971
August 1972
October 1973
December 1974
January 1976
August 19821September 1981
September 1984
ColombiaMarch 19831July 1982
February 19851
DenmarkMay 1971
June 1973
November 1979March 1987
August 1993
FinlandJune 1973
October 1982
November 19911September 1991
September 19921
IndonesiaNovember 1978
April 1983
September 1986November 1992
August 1997
IsraelNovember 1974
November 1977
October 1983October 1983
July 1984
MalaysiaJuly 1975July 1985
August 19971September 1997
MexicoSeptember 1976
February 19821September 1982
December 19821
December 19941October 1992
NorwayJune 1973
February 1978
May 19861November 1988
December 1992
PeruJune 1976March 1983
October 1987
PhilippinesFebruary 1970
October 19831January 1981
June 1984
July 19971July 1997
SpainFebruary 1976
July 19771November 1978
December 1982
February 1986
September 1992
May 1993
SwedenAugust 1977
September 1981
October 1982
November 19921November 1991
ThailandNovember 19781March 1979
July 1981
November 1984
July 19971May 1996
TurkeyAugust 1970
January 1980
March 19941January 1991
UruguayDecember 19711March 1971
October 19821March 1981
Venezuela, República Bolivariana de
February 1984
December 1986
March 1989October 1993
May 19941
December 1995

Twin-crises episode.

Twin-crises episode.


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*The authors wish to thank Peter Kenen for detailed and careful comments. Thanks are also due to Vincent Reinhart for useful comments and suggestions. However, we retain full responsibility for all errors and opinions.
1When currency and banking crises occur in close proximity, we will refer to these episodes as the “twin crises.” Further details on the timing and classification of crises episodes are provided in the following section.
2See Kaminsky and Reinhart (1998) for a comparison.
3The evidence that devaluations are contractionary in developing countries is more than anecdotal (see Edwards (1986 and 1989) and Morley (1992), for empirical analyses of this issue).
4Large capital inflows usually precede these crises, but a large negative swing in the capital account can also be due to a surge in capital flight.
5Most of those controls were lifted in August of that year.
6In the case of Chile, reserve requirements on short-term offshore borrowing were introduced in mid-1990; in Malaysia, strict prohibitions on domestic residents’ sales of short-term domestic assets to nonresidents were introduced in January 1994.
7Details on sample coverage, definitions, and the dating of the crises are provided in Appendix Tables 1 and 2.
8Both banking and currency crises measures are statistically significant at standard confidence levels for the Asian sample. For Latin America, there is weak evidence of a reduction in the severity of the crises, but, owing to the large variance in the regional sample, we cannot conclude that this difference is statistically significant.
9The link between currency crises and sudden stops is less clear in our sample, as many of the currency crises took place in the 1970s in an environment of capital controls and highly regulated domestic financial markets. By contrast, nearly all the banking crises are in the postliberalization period, hence, their closer link to the sudden stop.
11Kaminsky and Reinhart (1999) present evidence that the twin crises are more severe and the recovery more sluggish than episodes when currency crises are not associated with banking sector problems.
12In fact, the insignificant effect of controls on the volume of capital inflows, even though there is a noticeable lengthening of the maturity structure of those flows, strongly suggests that the system as a whole must have ways to effectively bypass and neutralize those controls.
13This was also the case for Mexico prior to the Colosio assassination, despite an announced ever-widening band.
14There are plenty of examples of interest rate hikes during bad states of nature (terms-of-trade declines, recessions, etc.).
15In addition, it has been criticized for making relative price changes costly. But this issue has been discussed above.

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