Capital Flow Reversals, the Exchange Rate Debate, and Dollarization

• Author: Guillermo A. Calvo and Carmen M. Reinhart
• Position: Professor of Economics at the University of Maryland/Associate Professor, School of Public Affairs and Department of Economics at the University of Maryland, and Research Associate at the National Bureau of Economic Research

More frequent and increasingly severe crises are encouraging emerging market economies to seek means to make themselves less vulnerable to sudden stops in capital flows. Capital controls have been widely discussed, but dollarization may offer a longer-term and more market-friendly solution.

Many symptoms of impending capital market crises are common to both developed and emerging market economies, but the similarities end there. Developed countries have emerged relatively unscathed from recent currency crises, such as the exchange rate mechanism (ERM) crises of 1992-93. But emerging market economies have been buffeted by deep and protracted crises that have been characterized by sharp capital flow reversals and output collapses, and exacerbated by serious banking problems.

Given the increased severity and the frequency of these crises, it is worthwhile to ask what kinds of policies and exchange rate arrangements might make emerging markets less vulnerable to sudden stops in capital flows. The magnitude of capital flow reversals, the substantial evidence that financial sector problems have deepened and lengthened these crises, and the limited effectiveness of capital controls provide the basis for reassessing the relative merits of fixed and flexible exchange rate policies. Dollarization may offer emerging market economies a viable and more market-friendly alternative to capital controls.

Sudden stops

Unlike their developed country counterparts, emerging market economies routinely lose access to international capital markets during crises. Their reliance on short-term debt financing also means that their public and private sectors are asked to repay existing debts on short notice. The problem is compounded by the fact that their debts are usually denominated in a foreign currency. Abrupt reversals, or sudden stops, of capital inflows can push a country into insolvency or drastically lower the productivity of existing capital stock, resulting in large unexpected swings in relative prices and costly bankruptcy battles.

Once a crisis has erupted and access to international capital markets has been lost, the policy options available to emerging market economies are severely restricted. Expansionary policies, which could offset some of the devastating effects of capital flow reversals, are possible only under capital controls-an unappealing option for many countries hesitant to reverse the process of financial liberalization or accept the inflationary consequences often associated with such policies.

Surges in capital inflows are often followed by sudden stops. With few exceptions, these sudden stops are involuntary and associated with a currency crisis and most often with a banking crisis as well. A comparison of recent crises suggests that their severity has intensified in the present decade. Until the recent Asian crisis, Latin America was the region most prone to large-scale capital inflow reversals. But 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 more than 8 percent in 1997), superseded the 20 percent reversal in Argentina in the early 1980s. In terms of reserve losses and...