On the Empirics of Sudden Stops: The Relevance of Balance Sheet Effects. The case of 12 Emerging Central and Eastern Eur

1. On the Empirics of Sudden Stops: The Relevance of Balance Sheet Effects. The case of 12 Emerging Central and Eastern European Economies. Student:Valeria Birău Coordinator: Professor Moisă Altăr, PhD Bucharest -July 2009-

2. Summary • Introduction • Alternative explanations to the phenomenon • Literature review • Adopted view • The model • Results and interpretation of results • Conclusions and directions for further research

3. Abstract Inspired by the study of Guillermo A. Calvo, Alejandro Izquierdo and Luis-Fernando Mejia (2004), this study aims to look into the empirical characteristics of SuddenStops in capital flows and the relevance of BalanceSheet effects in the occurrence of SuddenStop episodes for 12 developing economies from Central and Eastern Europe. I look into the fact if the variables of “openness” (understood as a the level of financing from abroad of the absorption of tradables) and DLD (Domestic Liability Dollarization, meaning foreign exchange denominated domestic liability) appear as key determinants of the probability of a Sudden Stop for the Central and Eastern European developing economies. The result obtained here is similar to the one in Calvo (2004), the variables of openness and DLD having a significant role in determining the probability of a Sudden Stop .

4. Introduction The last 19 years have been full of turmoil from the economic and financial point of view. Considering the number of financial crises that have taken place and the unfolding of the current financial crisis that began in 2007, I considered the phenomenon of Sudden Stop an important issue, especially in emergent and developing economies. Looking into recent developments in Romania: falling output and exports, reduction in capital inflows , Current Account adjustment, depreciating Leu against the Euro (which due to high portion of domestic credit denomination in foreign currency makes it more expensive for consumers and companies to service their loans) , which materialized in the fact that Romania’s government had to turn to the IMF for a 24-month Stand-By Arrangement of EUR 12.95 billion. The unfolding of the above phenomena are related to a sharp decrease in access to foreign capital. I’ve noticed the above mentioned elements in Calvo’s description of phenomena that accompany a Sudden Stop in Capital Flows and have turned to his work to understand factors that might affect the probability of such an episode occurring.

5. The study of Guillermo A. Calvo, Alejandro Izquierdo and Luis-Fernando Mejia (2004)defines Sudden Stops as a sharp fall in capital inflow relative to their past trajectory. Although the initial shock is considered exogenous, the dimension of materialization of a Sudden Stop depends on domestic financial vulnerabilities. Episodes of Sudden Stops (large decreases in external capital inflows) are accompanied by the following phenomena: • Large Real Exchange Rate fluctuations of the local currency, large depreciations being a common event, especially in developing and emergent economies (due to adjustments in the absorption of tradable goods ) • “bunching”- the contagion phenomenon from one economy to the others derived from financial market imperfections • Output contractions • Current Account adjustments • Decrease in International Reserves Calvo (1999) argues that many of the recent crises were originated by credit shocks in international markets and as a result, he comes upon the conclusion that measures of crises ought to be more closely connected to large and unexpected capital account movements rather than to measures that focus on large nominal currency fluctuations or current account reversals.

6. Alternative explanations: In an attempt to explain the causes of financial crises in Emergent Countries, the following views have been pursued: • “Lack of fiscal discipline”- high fiscal deficits lead to an unsustainable level of public debt, leading to a certain moment when due to the high level of debt the lenders refuse to grant more funds • This theory may prove sufficient in the case of 1980s Latin American Debt Crisis it does not find support in Asia, especially under the conditions of the 1997 Asian crisis, where most countries run a fiscal deficit considerably lower compared to the ones from Latin American countries in 1994 or developed countries (Japan). • Fiscal View cannot explain the “bunching” phenomenon

7. Alternative explanations: • Soft pegs view - affirms that countries that use soft pegs, when hit by a currency crisis, were reluctant to abandon unsustainable exchange rates in a timely manner and only did so only after they were hit by a balance-of-payments crisis. • At some level, the statement is right because if the exchange rate was allowed to float freely, some of the international reserve loss would have been prevented. However, even at this level of abstraction, 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 foreign-exchange denominated short-term debt obligations, which exceeded by far the stock of international reserves. 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. • The Soft peg view doesn’t hold up under the criticism of the phenomenon of “bunching” and does not offer an explanation for real meltdown (collapse in output) for example.

8. Alternative explanations: • Transitory or non-credible policy models • As shown in Calvo (1998) some models would be able to rationalize a large cut in capital inflows due to unexpected changes in policies. • The phenomenon of bunching displayed by Sudden Stop crises shows that it is quite improbable for several countries to suffer sudden policy reversals at the same time due to the fact that the policies would become unsustainable at the same time.

9. Adopted View: • Following the view spelled out in Calvo, Izquierdo and Mejia (2004) I look into the importance of shocks to the Current Account that materialize in large changes in the Real Exchange Rate (the relative price of tradables with respect to non-tradables). • By national accounting, and abstracting from errors and omissions, capital inflows equal current account deficit plus accumulation of international reserves. Therefore, SS has to be met by reserve losses or lower current account deficits. In practice, both take place. A sudden contraction in the current account deficit is likely to lead to a sharp decline in aggregate demand. 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, its relative price will have to fall (resulting in a real depreciation of the currency). • The importance of RER fluctuations that take place in an EM derive from the amount of Domestic Liability Dollarization. • A real currency depreciation materialized in a significant rise in RER makes it more difficult to repay loans for firms producing non-tradable goods.

10. The dimension of the effect depends on the size of the RER fluctuation, the stock of foreign exchange denominated loans and the ability of firms to switch in the short run the production of non-tradables into tradables along their possibilities frontier. • May trigger substantial uncertainty about the solvency of the banking system as loans become non-performing, sometimes leading to bank runs and expectations of bank bankruptcies.

11. Literature Review: • Calvo (1999) argues that many of the recent crises were originated by credit shocks in international markets and as a result of that, he comes upon the conclusion that measures of crises ought to be more closely connected to large and unexpected capital account movements rather than to measures that focus on large nominal currency fluctuations or current account reversals. • Edwards (2003) looks into the consequences of dollarization and Sudden Stops on relevant variables such as economic growth and determines that, although Sudden Stops and Current Account reversals are connected, it is the latter that causes the drop in output. • Chari, Kehoe and McGrattan (2005) in a small open economy business model (standard equilibrium model) in which foreign borrowing is subject to a collateral constraint sudden stops do not translate into drops in output. Other factors that overpower the effect of the Sudden Stop need to be considered. • Edwards (2001) finds that under some definitions of currency crisis, currency account deficits are a significant determinant of the probability of experiencing currency crises.

12. Model: • The strategy taken here focuses on the valuation effects of domestic dollarized liabilities (liabilities in terms of tradable goods), so the interest lies in the real exchange rate fluctuations. Regarding the Current Account, the focus does not fall on the current account itself, but rather on the percentage fall of the absorption of tradable goods, which, as will arise from the model we define later, represents a summary statistic for the rise in RER following a Sudden Stop. • I will endogenize RER using a separable intertemporal utility function, which is also iso-elastic in its arguments in order to show how the modification in capital flows will affect the real exchange rate. • Intuitively: a Sudden Stop, being a sizable cut in credit, will cause a fall in aggregate demand and, consequently, a possibly large increase in the RER.

13. Assume that the demand function for nontradables is: • where h = log H – logarithm of demand for nontradable goods, • z = log Z – logarithm of demand for tradable goods, • rer = log RER and α, β and δ are parameters. • The Current Account Deficit (CAD) , in terms financing of absorption of tradables is: • Y is the output of tradables and S are factor payments, remittances, Z being as previously defined the demand for tradable goods.

14. A Sudden Stop will now be considered. The typical situation, is that prior to a Sudden Stop a country’s Current Account deficit is positive, starting to decline as the Sudden Stop episode starts to unfold, approaching zero value or at times even run into positive territory, as documented for EMs by Calvo (2003). • given Y and Z: • By taking first differences in equation (1) and approximating the relative change in Z by the first difference in logs,

15. and assuming that the supply of non-tradables is constant, • becomes From relationships (5) and (8): • The relative change in the Real Exchange Rate is proportional to the prevailing Current Account Deficit prior to the Sudden Stop episode taking place, relative to the absorption of tradable goods. This equation models the part of the change in RER that is likely to be very difficult to prevent once a Sudden Stop occurs and is not intended to model the actual change in the actual Real Exchange Rate.

16. Sudden Stop: the contagion effect • In a situation in which shocks spread from one country to other regions due to rules in the capital market transactions (margin calls) these may not be related at all to the countries’ fundamentals. Let’s assume an investor with a diversified portfolio in certain assets from multiple countries. In Calvo (1999) it is justified how a liquidity shock to informed investors (say due to a margin call as a result of the fall of price of assets in a particular country) can result in the sale of assets from a different country in order to restore liquidity. Encountered with the phenomenon, a set of uninformed investors faced with a signal-extraction problem interpret the sale as motivated by anticipated lower returns and decide to short their assets as well, even though the initial sale of the informed investors had nothing to do with lower returns but were caused by margin calls. When this occurs, a country that has few ties to the country at the epicenter of the crisis is exposed to a large and unexpected liquidity shock. • Thus, a Sudden Stop episode can be defined as an exogenous initial shock.

17. In order to determine Sudden Stop episodes is necessary a measure that reflects large and unexpected falls in capital inflows that have costly consequences in terms of disruptions in economic activity, through the important impact on repayment capacity that leads to such types of tumults. Sudden Stops will be defined here as: • A period that contains at least one observation where the year-on-year fall in capital flows lies at least 2 standard deviations below its sample mean (this is what is referred to as the “unexpected” requirement of the Sudden Stop); • The Sudden Stop episode ends once the annual change in capital flows exceeds one standard deviation below its sample mean. • The beginning of a Sudden Stop episode is determined by the first time the annual change in capital flows falls one standard deviation below the sample mean. • Output contraction during the above mentioned phenomena

18. Bulgaria Estonia

19. Lithuania

20. The next question to be addressed is whether large RER depreciations precede Sudden Stops or do Sudden Stops precede large RER depreciations, in the cases in which large RER depreciations lie in the neighborhood of a Sudden Stop (one year window preceding the Sudden Stop episode and one year after). Analyzing the data available for the sample studied here does not offer a clear-cut answer, 50% of the RER depreciations following the decrease of capital inflows, although it is important to mention that some of the RER depreciations start before the occurrence of the Sudden Stop episode and carry out through-out the period. The same happened in the case of Calvo, Izquierdo and Mejia (2004), where the authors were unable to make a clear decision on whether Sudden Stops precede large RER fluctuations, in their case though, 61% of the depreciations episodes followed the decrease in capital flows.

21. The dynamic of International Reserves in the neighborhood of a Sudden Stop is significant due to the fact that some countries use the Reserves to smooth out the effect of a Sudden Stop on the Current Account Deficit. This might prove to be a losing strategy in the case of highly persistent Sudden Stop episodes; these might lead to the depletion of the Reserves. Calvo, Izquierdo and Mejia (2004) show that many countries have engaged in reserve loss strategies in order to avoid an abrupt Current Account adjustment that might lead to the depreciation of the local currency, perhaps in the hope that the Sudden Stop would be reversed. As discussed in Calvo (2003), in the occurrence of a Sudden Stop episode, a Central Bank may have incentives to use its reserves in crediting non-tradable corporate sectors via credit expansion (a strategy that requires keeping a quasi-fixed exchange rate). As shown in Appendix Table 2 there is significant loss in International Reserves prior to a Sudden Stop phase. The countries in the sample saw an average loss of 16.32% in International Reserves in the period prior to the Sudden Stop. • Looking at the Current Account Balance Behavior, also illustrated in Appendix Table 2, it can be noticed that Sudden Stops bring along Current Account adjustments. The countries in the sample studied here incurred an average adjustment in Current Account of 1.59% of GDP in the period preceding the Sudden Stop episode. In 40% of the cases the countries suffered a Current Account reversal. • In a world of heterogenous agents, though, full-fledged Sudden Stops could take place even under Current Account surplus, because there could be key sectors that exhibit a Current Account deficit while the rest of the economy exhibits an even larger surplus. In Calvo, Izquierdo and Mejia (2008), 5% of the sample of countries included in the study go through a Sudden Stop episode under a Current Account surplus the period prior to the crisis.

23. Returning to the model: the increase in RER depends on the percentage fall in the absorption of tradable goods needed to close the Current Account gap. • It can be further inferred that the less leveraged the absorption of tradable goods, the smaller will be the effect on the RER. In order to do this CAD/Z can be written as follows: • Higher values of 1-ω show that a country’s economy relies more on financing from abroad for its tradables, making it more vulnerable to RER depreciations that might result from the abrupt decrease of the Current Account Deficit, the value of 1-ω being defined as openness.

24. A Panel Probit model is used as a benchmark due to the authors’ belief, which was later confirmed by results, that large and unexpected capital flows have non-linear effects.The Panel Probit model estimates the probability of falling into a Sudden Stop episode as function of lagged values of 1-ω and DLD and also controlling for time effects by introducing yearly dummy variables. • The DLD variable has been constructed by adding up bank foreign deposits and bank foreign borrowing as a share of GDP, as defined by the authors in the 2004 study. • The variables used in the regression have been lagged in order to avoid endogeneity issues.

26. The estimation output shows that both the lagged openness variable and the lagged DLD prove to be significant at the 5% level, highlighting the importance of openness as an indicator of potential Sudden Stops, taken as a signal of the potential change in relative prices that could materialize at the time of the Sudden Stop. Collectively, all the coefficients are statistically significant, since the value of the LR statistic is 28.16740 with a p-value of 0.000443. Although the results obtained by Calvo, Izquierdo and Mejia (2004) are statistically significant at the 1% level, taking into consideration the fact that the sample size used here is significantly smaller and more diverse than the one used by the above mentioned authors, the results are still important. We notice the McFadden R-squared with the 0.276567 value, showing that openness and Domestic Liability Dollarization have a significant role in explaining the probability of occurrence of a Sudden Stop episode. • Looking back on the results obtained by other authors and mentioned in the Literature Review section of the study, we introduce some macroeconomic variables and watch for the reaction of the model to them. The results obtained confirm the importance of openness and DLD (statistical significance at the 5 percent and 10 percent respectively levels), the other variables not returning statistically significant coefficients.

27. The following regression output shows the inclusion of the Terms of Trade dummy (which takes the value 1 in the case of a terms-of-trade increase and zero in the case of a decrease) variable in the Panel Probit model. The terms-of-trade variable is included contemporaneously, due to the fact that an improvement in a nation's terms of trade (the increase of the ratio) is good for that country in the sense that it has to pay less for the products it imports and it would influence the RER in the same period. • It can be noticed that the p-value for TOT comes back as 0.7557, showing that terms of trade evolution does not prove significant in determining the probability of the occurrence of a Sudden Stop episode, although the sign of the estimated coefficient shows the direction of the relationship, indicating that falls in terms-of-trade growth increase the likelihood of a Sudden Stop episode. Openness (1-ω) and DLD remain statistically significant at the 10% level, though. Taking a look at the McFadden R-squared 0.265751 we notice that the latter case has less explaining power than the previous one, and if we take a look at the Akaike Information Criterion (0.686794 compared to 0.611195 in the first regression) this model does not offer a better alternative than the previous one. in the case of Calvo, Izquierdo and Mejia (2004), which use a sample of 32 countries, the TOT does not prove statistically significant either.

29. When the share of Foreign Direct Investment to GDP is included in the Panel Probit model (Table 5 summary of the Appendix Table 5), we can state that openness (1-ω) and DLD remain statistically significant at the 10% level while the fluctuation of the Terms of Trade and Foreign Direct Investment share to GDP do not prove to have statistical significance in predicting the probability of a Sudden Stop episode occurring. We notice that the McFadden R-squared 0.269057 has decreased compared to the compared to the regression output that includes only openness and Domestic Liability Dollarization, thus the model does not have better explaining power that the first one. • The Foreign Direct Investment share to GDP doesn’t prove statistically significant either, with a p-value of 0.5775. The same conclusion appeared in Calvo, Izquierdo and Mejia (2004), the authors determining that the FDI share to GDP does not influence the probability of the economy going through a Sudden Stop episode. Of interest is the sign of the coefficient for FDI share to GDP, which intuitively should be negative. A similar problem appeared in Calvo, Izquierdo and Mejia (2008) where they are able to prove by including a financial integration variable that depending on the level of financial integration, the coefficient for FDI may be different for developing and developed countries.

31. Calvo, Izquierdo and Mejia (2004), looking on the interaction between openness and Domestic Liability Dollarization, find that the relationship between the two is highly non-linear. They find that the effects of openness on the probability of occurring a Sudden Stop crucially depend on the degree of Domestic Liability Dollarization. Low values of ω, which imply a high value of the Current Account Deficit imply a higher probability of Sudden Stop, but this is particularly so for dollarized economies. • The high non-linearity described in the study shows that a low level of ω (high leverage of financing from abroad for the absorption of tradable goods) and a high Dollarization level can be a very dangerous combination, thus potential balance sheet effects are highly relevant in determining the probability of a Sudden Stop.

32. Addressing endogeneity:

33. Conclusions: • Large RER fluctuations are a phenomenon that accompanies Sudden Stop episodes in Emergent and Developing economies. • Sudden Stops appear in bunches and group countries that are different from several points of view. • Sudden Stops are accompanied by large current account adjustments, swings in RER and reserve losses, suggesting that these phenomena are associated with shifts in the supply of the capital flows. • Openness, understood as a large supply of tradable goods relative to the absorption of tradable goods together with Domestic Liability Dollarization has a significant effect on the probability of a Sudden Stop. Issues that need to be addressed: • It might prove important to look into different exchange rate regimes, taking into account the diversified nature of the sample of countries used here. • The definition of Sudden Stop based on output contraction is probably not the best choice, since there might be domestic factors that could lead to output decrease. Further research of Calvo regarding Sudden Stop has focused on sudden stops that take place in conjunction with a sharp rise in aggregate interest-rate spreads. • It might be important to take a look and include in the sample certain restrictions regarding transactions denominated in foreign exchange prior to Capital Account Liberalization. • Monetary policies and sound institutions that might decrease a developing country’s vulnerability from external capital flow shocks.

34. Michael D. Bordo: “What emerging countries really need to do to protect themselves from Sudden Stops and crises is to grow up and become an advanced country”. Thank you for your attention!

35. References: • Arellano, Cristina and Enrique Mendoza (2002), “Credit Frictions and Sudden Stops in Small Open Economies : An Equilibrium Business Cycle Framework for Emergent Market Crises”, Working Paper 8880, National Bureau of Economic Research. • Arteta, Carlos O. (2003) “ Are Financially Dollarized Countries More Prone to Costly Crises?” International Finance Discussion Papers, Number 763, Board of Governors of the Federal Reserve System. • Bordo, Michael D. (2006) “Sudden Stops , Financial Crises and Original Sin in Emerging Countries: Déjà vu?”, Working Paper 12393, National Bureau of Economic Research. • Calvo, Guillermo A. (1999), “Contagion in Emerging Markets: When Wall Street Is a Carrier”, Draft, University of Maryland. • Calvo, Guillermo A. and Carmen Reinhart (1999), “When Capital Inflows come to a Sudden Stop : Consequences and Policy Options”, Draft from June 29,1999, University of Maryland • Calvo, Guillermo A., Alejandro Izquierdo and Luis – Fernando Mejia, (2004) “On The Empirics of Sudden Stops : The Relevance of Balance – Sheet Effects”, Working Paper 10520, National Bureau of Economic Research. • Calvo, Guillermo A., Alejandro Izquierdo and Rudy Loo-Kung (2005), “Relative Price Volatility under Sudden Stops: The Relevance of Balance Sheet Effects”, Working Paper 11492, National Bureau of Economic Research. • Calvo, Guillermo A., (2006)“Monetary Policy Challenges in Emerging Markets: Sudden Stop, Liability Dollarization, and Lender of Last Resort”, Working Paper 12788, National Bureau of Economic Research. • Calvo, Guillermo A., Alejandro Izquierdo and Ernesto Talvi (2006), “Sudden Stops and Phoenix Miracles in Emerging Markets”, American Economic Review, Vol 96 No.2, May 2006 • Caballero, Ricardo J. and ArvindKrishnamurti (2003), “Inflation Targeting and Sudden Stops”, Working Paper 9599, National Bureau of Economic Research. • Chari V.V., Patrick J. Kehoe and Ellen R .McGrattan,(2005) “Sudden Stops and Output Drops”, Working Paper 11133, National Bureau of Economic Research. • Edwards, Sebastian (2001), “Does Current Account Matter ?”, Working Paper 8275, National Bureau of Economic Research. • Edwards, Sebastian (2004), “Financial Openness, Sudden Stops and Current Account Reversals”, Working Paper 10277, National Bureau of Economic Research. • Gujarati, Damodar (2004) “Basic Econometrics”, Fourth Edition, The McGraw-Hill Companies. • Mendoza, Enrique G. (2006) “Lessons from the Debt-Deflation Theory of Sudden Stops”, American Economic Review, Vol 96 No.2, May 2006 • Wooldridge, J. (2002), “Econometric Analysis of Cross-Sectional and Panel Data”, MIT press