Literature on private capital flows in crisis episodes

Another body of research on the private sector’s role in crises focuses on capital flows.3 Capital movements, that is, the composition, size, and direction of private investment flows, are key factors for the success or failure of crisis resolution. If creditors “rush to the exit” in situations of financial distress, they are likely to make things worse. In contrast, fresh money inflows, such as the spontaneous lending during the Mexican crisis, can help to avoid serious adverse consequences of a crisis.

One crucial determinant of creditor actions during crises is the behavior of the IMF. The literature on catalytic finance has focused on this, examining if and how private capital flows toward distressed countries are influenced by official lending announcements (See Morris and Shin 2004 and Corsetti et al. 2006 for analytic models). Dfaz-Cassou et al. (2006) provide a comprehensive review of the empirical literature and summarize the following main determinants of such catalytic flows: (1) the macroeconomic and political conditions in the crisis countries; (2) the kind of the IMF program (long versus short term, conditional versus unconditional); and (3) the program’s total volume. Overall, the evidence suggests that the catalytic effect is large only in countries that have “intermediate” fundamentals and those that have not been hit excessively by the crisis (Eichengreen and Mody 2001; Mody and Saravia 2003). Bad performers appear to receive less catalytic flows (Bordo et al. 2004). Additionally, Eichengreen et al. (2006) and Dfaz-Cassou et al. (2006) provide some evidence that programs for crisis prevention have a particularly positive effect on private flows.4

The second strand of literature that should be considered is articles on contagion, analyzing herd behavior of private creditors in withdrawing capital from crisis countries. A number of theoretical studies illustrated how rumors or unexpected changes in fundamentals can lead to such contagious behavior and the occurrence and spread of financial crises (see the overview in Pericoli and Sbracia 2003). Others, such as Goldstein et al. (2000) and Kaminsky et al. (2004), provide empirical evidence for contagion, showing that private creditors, such as international banks and mutual funds, play a crucial role in transmitting of crises. Regarding banks, both Heid et al. (2005) and Van Rijckeghem and Weder (2003) show clear evidence for contagion during the Russian crisis. Similarly, Gande and Parsley (2005) show for the bond market that a change in the sovereign credit rating of one crisis country can have a contagious effect on the credit spreads of other emerging markets (see also Eichengreen et al. 2001). As a general tendency, an interesting article by Mauro et al. (2002) finds that in recent times, investors appear to pay less attention to an individual country’s characteristics than in earlier decades. Instead, today’s investors appear to invest and divest in groups of countries simultaneously. Given the rich and convincing evidence on the topic, it seems quite obvious that contagion and herd behavior may have a considerable impact on the likelihood of private-public cooperation in debt crises.

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