Current Account Deficits, Sudden Stops, and International Reserves Accumulation

Abstract

This dissertation addresses the causes of and policy responses to the 1990s current account crises. The first chapter explores the relative importance of external shocks as key determinants of the significant increase of foreign reserves accumulated in many emerging market economies, and provides a comprehensive framework to assess the adequacy of reserve holdings. Using the case of Mexico, I find that more than two thirds of the increase in international reserves can be replicated by a linear combination of external shocks, without an abrupt regime shift after the Tequila crisis. I also find that Mexico has historically adopted an appropriate reserves policy, with 1994 being an exception. However, under the current reserves policy, there is a positive probability of a current account crisis in the near future. In chapter Two, I investigate the optimal reserves policy. The analysis predicts an optimal level of reserves in Mexico that is considerably higher than the actual level. When I account for the possibility of a bailout by the outside world in case of a crisis, Mexico's current reserves policy is in the range of my model's predictions.

The final chapter proposes a new explanation for the existence and nature of sudden stops. In my model, a sudden stop forms a necessary solution to the moral hazard problem in investment and can be rationalized as part of an optimal lending strategy in the face of asymmetric information.