Hedging Sudden Stops and Precautionary Contractions

NBER Working Paper No. 9778
Issued in April 2006
NBER Program(s): EFG IFM AP

---- Abstract -----

Even well managed emerging market economies are exposed to significant external risk, the

bulk of which is financial. At a moment's notice, these economies may be required to reverse

the capital inflows that have supported the preceding boom. While capital flows crises are

sudden nonlinear events (sudden stops), their likelihood fluctuates over time. The question

we address in the paper is how should a country react to these fluctuations. Depending on the

hedging possibilities the country faces, the options range from pure self-insurance to hedging the

sudden stop jump itself. In between, there is the more likely possibility to hedge the smoother

fluctuations in the likelihood of sudden stops. The main contribution of the paper is to provide

an analytically and empirically tractable model that allows us to characterize and quantify

optimal contingent liability management in a variety of scenarios. We show, with a concrete

example, that the gains from contingent liability management can easily exceed the equivalent

of cutting a country's external liabilities by 10 percent of GDP.

*This is a revision of the June 2003 version.

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This paper was revised on July 18, 2006

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