Sudden Stops and Currency Drops: A Historical Look
Catão, Luis; 2006
"...As with the post–Bretton Woods era, international capital flows in the pre–World War I world were anything but smooth. This paper has shown that all net capital - importing countries—for which the relevant annual data exist—experienced sporadic but often large and abrupt reversals in foreign capital inflows during 1870–1913. These “sudden stops” hit countries with widely disparate per capita GDPs, levels of financial development, and exchange rate regimes, as well as countries with low and high gold reserve coverages of their domestic currencies. This suggests that none of these factors can prevent a capital importer from being hit by a large capital account reversal—even though deeper financial markets, exchange rate flexibility, and high levels of precautionary reserves should help mitigate the associated side-effects on economic activity, as the recent literature on SSs indicates (Calvo, Izquierdo and Mejía, 2004; Edwards, 2004)...."
"...Two other salient policy implications also should be briefly mentioned. Time bunching in SSs implies that country insurance type of contracts are likely to be more effective, if not only feasible, when drawn between net capital exporters and net capital importing countries, since the latter tend to be badly hit about the same time thus limiting the scope for risk sharing among them. Last but not least, to the extent that SSs take place in the wake of monetary tightening in core advanced countries, this suggests that a high international reserve coverage of domestic monetary liabilities when world interest rates start creeping up is an important ingredient for minimizing the risk of abrupt and often contractionary currency drops. This underscores the importance of precautionary reserve accumulation at the earlier upswing stage of the international investment cycle."