Quid pro Quo: National Institutions and Sudden Stops in International Capital Movements

Eduardo Cavallo and Andrés Velasco

No 4490, Research Department Publications from Inter-American Development Bank, Research Department

Abstract: The paper explores the incidence of sudden stops in capital flows on the incentives for building national institutions that secure property rights in a world where sovereign defaults are possible equilibrium outcomes. Also thepaper builds upon the benchmark model of sovereign default and direct creditor sanctions by Obstfeld and Rogoff (1996). In their model it is in the debtor country’s interest to “tie its hands” and secure the property rights of lenders as much as possible because this enhances the credibility of the country’s romise to repay and prevents default altogether. It incorporate two key features of today’s international financial markets that are absent from the benchmark model: the possibility that lenders can trigger sudden stops in capital movements, and debt contracts in which lenders transfer resources to the country at the start of the period, which have to be repaid later. The papershows that under these conditions the advice “build institutions to secure repayment at all costs” may be very bad advice indeed.

Date: 2006-11
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Working Paper: Quid pro Quo: National Institutions and Sudden Stops in International Capital Movements (2006)
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