Living as a debtor in a world of sudden stops: The roles of exposure to trade and commitment

Financial stability is an important public policy objective. Promoting stability requires preventing "sudden stops" in capital flows, which are triggered by the unexpected disappearance of foreign financing. This dissertation presents three essays on the causes and the consequences of sudden stops.; The first essay provides new evidence on the causal connection between lack of exposure to commercial trade and proclivity to sudden stops. On the theoretical front, it is shown how commercial trade reduces the probability of crises in financially constrained economies. This proposition is tested using "gravity estimates," which are based on countries' geographic characteristics, as appropriate instruments for trade. The results indicate that a 10 percentage point decrease in the trade to GDP ratio increases the probability of a sudden stop between 30% and 40%.; Sudden stops, when they happen, are typically accompanied of sharp output contractions and subsequent recoveries. Therefore, these crises are associated with an increase in output volatility. If exposure to trade reduces the probability of sudden stops, it should also mitigate output volatility through this route. This counteracts the destabilizing effects of exposure to trade associated with terms-of-trade shocks. The second essay tests what is the net effect of exposure to trade on output volatility. It presents new empirical evidence suggesting that it is stabilizing. Additional evidence is presented showing that this effect comes (at least in part) through the financial stability channel.; The third essay explores the effect of sudden stops on countries' incentives to secure the property rights of lenders, in the setting of a simple general equilibrium model of sovereign default and direct creditor sanctions. In the benchmark model debt default is prevented through the design of suitable incentive-compatible contracts and, therefore, the sanctions for default are never exercised. Thus, it is in the debtor countries interest for sanctions to be as dire as possible, as their only effect is to increase the commitment to repay and raise creditworthiness. The benchmark model is modified allowing sovereign defaults to happen in equilibrium, as they do in practice. In that context, it is shown that debt default might be the optimal response to a sudden stop. Therefore, sanctions can be exercised and the debtor weighs this in when choosing its level of commitment through either auto-imposed sanctions or via the level of debt. The welfare analysis shows that it is in the debtor countries interest not to overcommit in order to increase its creditworthiness, and that excessive borrowing might be a response to the risk of sudden stops.