Are Asset Price Guarantees Useful for Preventing Sudden Stops?A Quantitative Investigation of the Globalization Hazard-Moral Hazard Tradeoff
IMF Working Papers, March 1, 2006
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Bibliographic details
- Authors: Enrique G. Mendoza, Ceyhun Bora Durdu
- Published: March 1, 2006
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451863338.001
Summary
- Authors: Enrique G. Mendoza, Ceyhun Bora Durdu
- Date: March 1, 2006
- Main question: Can offering foreign investors price guarantees on emerging market assets prevent sudden stops, and what tradeoff does this create between reducing the "globalization hazard" and inducing international moral hazard?
- Method: Equilibrium asset-pricing model used to study the globalization hazard–moral hazard tradeoff.
- Core finding: Price guarantees can prevent deflationary Sudden Stops by propping up foreign asset demand, but their effectiveness and welfare implications depend critically on the price elasticity of foreign demand and on making the guarantees contingent on debt levels.
Model, Mechanism, and Drivers of Sudden Stops
- Without guarantees:
- Margin calls and trading costs cause Sudden Stops driven by Fisher's debt-deflation process.
- With price guarantees:
- Guarantees prevent this deflation by propping up foreign asset demand.
- Critical dependencies:
- Price elasticity of foreign demand.
- Contingency of guarantees on debt levels.
Findings and Interpretations
- Price guarantees reduce the likelihood and severity of Sudden Stops by supporting asset prices.
- Guarantees weaken the globalization hazard mechanism but create international moral hazard.
- Welfare implications are ambiguous and hinge on:
- How responsive foreign demand is to price changes (price elasticity).
- Policy design choices, especially whether guarantees are made contingent on debt levels.
Policy Recommendations and Design Considerations
- Make price guarantees contingent on debt levels to mitigate moral hazard.
- Evaluate the price elasticity of foreign demand before implementing guarantees, since effectiveness depends critically on this parameter.
- Balance the tradeoff between preventing Fisher-style debt-deflation dynamics and avoiding encouragement of risky borrowing through moral hazard.