An Informational-frictions Approach to the Sudden Stops Phenomena in Emerging Economies
International finance literature has devoted much work to analyze the causes of the recently documented episodes of sudden stops phenomena, defined as episodes of major cutback of capital inflows accompanied with significant decline in the capital account. These are typically treated as exogenous events with sharp falls in output and employment. Problems of moral hazard, adverse selection, lack of market discipline, time inconsistency, and information asymmetry have been thoroughly considered to explain these phenomena, both empirically and theoretically. The focus was on identifying causes and designing policies to prevent such events, minimizing costs, and measuring their frequencies. And a wide range of policy alternatives for minimizing the impact of these problems in developing, emerging, and transition economies have been constructed. This literature, however, has given little attention to rationalizing sudden stops and had typically treated them as exogenous shocks. In this paper, I will provide a framework for understanding why it is possible to rationalize sudden stops as part of an optimal lending strategy in the face of asymmetric information and what causes them to be endogenous. This way of approaching sudden stops has received little study thus far, and this paper is one step toward developing systematic framework. One key policy goal to deal with informational frictions, like those discussed in this paper, is to improve information channels. Recent efforts by the IMF and developing countries to improve data dissemination are in the spirit of the goal.
Keywords: Endogenous, Moral Hazard, Sudden Stops, Optimal Contract, Emerging Economies
PhD Candidate, Department of Economics, Queen's University