External Financing Risks: How Important is the Composition of the International Investment Position?

Building on the vast literature, this paper focuses on the role of the structure of the international investment position (IIP) in affecting countries’ external vulnerabilities. Using a sample of 73 advanced and emerging economies and new database on the IIP’s currency composition, we find that the size and structure of external liabilities and assets, especially with regards to currency denomination, matter in understanding balance-of-payments pressures. Specifically, and beyond the standard macroeconomic factors highlighted in other studies, higher levels of gross external debt increase the likelihood of an external crisis, while higher levels of foreign-currency-denominated external debt increase the likelihood of sudden stops. Foreign reserve assets play a mitigating role, although with diminishing returns, and the combination of flow and stock imbalances amplifies external risks, especially during periods of heightened global risk aversion. The results are especially strong for emerging economies, where the impact of flow and stock imbalances and foreign currency mismatches are larger and more robust across specifications.

Abstract

Building on the vast literature, this paper focuses on the role of the structure of the international investment position (IIP) in affecting countries’ external vulnerabilities. Using a sample of 73 advanced and emerging economies and new database on the IIP’s currency composition, we find that the size and structure of external liabilities and assets, especially with regards to currency denomination, matter in understanding balance-of-payments pressures. Specifically, and beyond the standard macroeconomic factors highlighted in other studies, higher levels of gross external debt increase the likelihood of an external crisis, while higher levels of foreign-currency-denominated external debt increase the likelihood of sudden stops. Foreign reserve assets play a mitigating role, although with diminishing returns, and the combination of flow and stock imbalances amplifies external risks, especially during periods of heightened global risk aversion. The results are especially strong for emerging economies, where the impact of flow and stock imbalances and foreign currency mismatches are larger and more robust across specifications.

I. Introduction

Global financial integration, measured as the sum of gross external assets and liabilities, has more than tripled as a share of GDP since the early 1990s (Figure 1). If well managed, this integration can improve risk sharing, provide countries with the needed capital to fund domestic investment, and enhance their ability to absorb shocks. That said, it can also pose serious risks to macro-financial stability, especially in countries with weak policy frameworks and buffers, thin domestic financial markets and limited export capacity. (e.g. Borio et al. 2016, Bruno and Shin 2015, Kim 2012, and Coeurdacier et al. 2019). These risks have also been highlighted by other studies (e.g. Obstfeld et al. 2009, 2010, Rose and Spiegel 2009, 2011) on crisis early warning systems, which gathered momentum following the Global Financial Crisis (GFC).

Figure 1.
Figure 1.

Stock Imbalances, 1990–2018

Citation: IMF Working Papers 2021, 020; 10.5089/9781513568102.001.A001

Sources: External Wealth of Nations database (Lane and Milesi-Ferretti 2007); and IMF, World Economic Outlook database.Note: AE = advanced economies; EMDE = emerging market and developing economies.

Building on previous work on the determinants of external vulnerabilities, this paper examines the role of the size and structure of the international investment position (IIP) in affecting countries’ likelihood of experiencing either an external crisis, which is defined as involving a sovereign default or restructuring, or recourse to IMF financing, or a sudden stop with high adverse growth impact.2 In disentangling the role of the structure of the IIP, the paper emphasizes the differences between gross and net imbalances, equity and debt positions, the currency composition of external debt, as well as the role of official and non-official foreign assets in mitigating risks. While the focus is on disentangling how the different components of the IIP affect external vulnerabilities, the paper also examines the role of global factors as well as domestic macroeconomic fundamentals and policies already identified in the literature, such as the current account balance, the degree of exchange rate overvaluation, the fiscal position and the credit cycle. The paper, however, does not take a view on the determinants of currency composition, but rather studies how the structure of debt influences external financing risks.3

Using a sample of 73 advanced and emerging economies, and different statistical approaches (including event analysis and probit models), the paper finds that the high negative predictive power of a country’s net IIP in explaining the likelihood of an external crisis or sudden stop event is predominantly driven by its gross debt liability position, with equity counterparts and non-official debt assets neither being statistically significant nor robust across specifications. The likelihood of an external crisis or a sudden stop event increases with the size of foreign currency denominated debt, especially for emerging market and developing economies (EMDEs).4 Foreign official reserves act as a mitigating factor to external crisis, although its impact is non-linear and with diminishing returns.

Going beyond the IIP structure, and consistent with the existing literature, we find that higher current account deficits increase the likelihood of an external crisis, while an overvalued exchange rate, fiscal deficits, and excessive credit increase the likelihood of a sudden stop. Meanwhile, higher levels of global risk aversion, all else equal, increase the likelihood of both an external crisis or sudden stop event, confirming that global “push” factors also matter. Overall, the magnitude of the results is similar to what the existing literature deems as sizable and of economic significance (e.g. Gourinchas and Obstfeld, 2012).

Our estimations also reveal that a combination of vulnerabilities can amplify external risks. Specifically, the combination of a large stock of foreign currency denominated debt, a large current account deficit, and low foreign official reserves can significantly increase the likelihood of an external crisis or sudden stop event, and more so in periods of higher global risk aversion: The main findings of the paper survive a battery of robustness checks involving changes in the country sample, the definition of crisis episodes, and the inclusion of additional control variables.

The rest of the paper is organized as follows. Section II summarizes the literature. Section II provides a detailed description of external stress episodes, including data sources. Section IV discusses the results for external crises events, including event analysis, probit model estimates, and their macroeconomic impact. Section V presents a similar analysis for sudden stop episodes, focusing on the key similarities and differences with external crises events. Section VI concludes.

II. Related Literature

Our work is related to a large body of literature on crisis early warning systems (Frankel and Rose, 1996; Eichengreen et al., 1996; Kaminsky et al., 1998; Kaminsky and Reinhart, 1999), which show that the size of the current account deficit, extent of real exchange rate overvaluation and inadequacy of reserve coverage as leading indicators of external crises. However, evidence from more recent studies is mixed. Rose and Spiegel (2009, 2011), which use a stricter crisis definition—involving large declines in real GDP, equity prices, exchange rate, and sovereign debt indicators—are unable to identify any specific variables that consistently explain the severity and cross-country incidence of crises. Meanwhile, Frankel and Saravelos (2012), using a similar crisis definition but a longer sample and an additional variable to capture “resort to IMF financing”, find that official reserve coverage (both relative to GDP and external debt) and the degree of currency overvaluation to matter the most, with external debt, the current account deficit, and credit growth also having some predictive power. This result is consistent with Obstfeld et al. (2009, 2010), who find that the ratio of reserves to M2 to be a useful predictor of sharp currency depreciations, although the predicted power varies considerably across samples.

Our paper is most closely related to a study by Catão and Milesi-Ferretti (2014), who use a probit model to examine the determinants of external crises with a focus on the importance of external liabilities and their composition. The authors find net external liabilities to be an important crisis predictor, but find no additional effect of including gross positions. We build on Catão and Milesi-Ferretti’s work in three dimensions: (i) apart from external crises, this paper studies the determinants of episodes of sudden stops with high adverse growth impact, (ii) this paper looks at the role of currency composition of external liabilities, and zooms into other IIP components, to disentangle the role of gross assets and liabilities, (iii) it expands the set of control variables to identify other factors that impact the likelihood of external risk events.5 Importantly, our analysis goes beyond that of other studies by exploring the role of the aforementioned IIP components using a novel data set on the currency composition of external assets and liabilities compiled by Bénétrix and others (2019).

Our paper thus contributes to the literature by further enhancing our understanding of the role of IIP and its components in affecting external risks. Importantly, as far as we are aware, this is the first paper that uses a wide country and time coverage to assess in detail the relationship between the IIP currency composition and external financing risks, and estimates the output costs from external crises and their relationship to underlying pre-existing vulnerabilities.

III. Data and Definitions

The paper studies episodes of external stress (external crises and sudden stops) for a group of 73 advanced and emerging and developing economies (see Table A.1 in the appendix). Given data constraints, especially regarding the availability of data on the currency composition of external debt, the period considered is 1991–2018. The underlying data for the IIP (including foreign official reserves), current account, and nominal GDP are taken from the updated version of External Wealth of Nations database (EWN; Lane and Milesi-Ferretti, 2007), while the foreign currency shares of external liabilities are based on Bénétrix et al. (2019).6 Appendix Table A.2 includes the source of the variables used in the analysis.7

Two types of external stress episodes are considered: external crisis and sudden stops with high output declines:8

  • External crisis: An external crisis is an episode of either a sovereign debt default or restructuring, or an IMF-supported program (excluding precautionary and nondisbursing arrangements). Sovereign debt defaults and restructuring episodes are identified based on an updated version of the data sets in Das, Papaioannou, and Trebesch (2011) and Asonuma and Trebesch (2016); and recent Paris Club reports. (http://www.clubdeparis.org/en/traitements). As shown in Table A.3, 128 cases of external crisis are identified, most of which involving EMDEs. The distribution of crisis episodes is evenly spread over the time horizon (Figure 2).

  • Sudden stops with high adverse growth impact: As discussed in Basu et. al (forthcoming), based on the work of Dornbusch et. al (1995) and Mendoza (2002) among others, sudden stops with high growth impact represent episodes where a large decline in net private capital inflows tighten financial constraints, resulting in unusually large recessions or recourse to IMF financial support. In line with the literature (e.g. Catão, 2006; IMF, 2013), sudden stop episodes are defined as those where net private capital inflows are either: (i) 1½ standard deviation below their mean and the annual decline is ¾ standard deviations from a year earlier (defined in real U.S. dollars); or (ii) have declined by at least 3 percentage points of GDP relative to the previous year and 2 percentage points from two years earlier.9 Meanwhile, a large output decline episode is one where real GDP growth, relative to the average of the past 5-years, is in the bottom 5th percentile of the distribution (across time and across countries). As shown in Table A.4, 32 episodes involving a combination of sudden stops and large output declines were identified, many of them in large EMDEs. Interestingly, while sudden stop only episodes are evenly spread over the time horizon, those with large growth impact are far more concentrated (peaks during the GFC and the Asian Financial Crisis) and have been less visible in recent years (Figure 3).

Figure 2.
Figure 2.

External Crisis Episodes, 1990–2018

Citation: IMF Working Papers 2021, 020; 10.5089/9781513568102.001.A001

Sources: Das and others (2011); Asonuma and Trebesch (2016); Paris Club; and authors’ calculations.
Figure 3.
Figure 3.

Sudden Stop Episodes, 1991–2018

Citation: IMF Working Papers 2021, 020; 10.5089/9781513568102.001.A001

Sources: IMF, World Economic Outlook database and authors’ calculations.

IV. External Crisis

A. Event Analysis: Pre- and Post-crisis IIP Dynamics

We start our analysis by studying the evolution of the main IIP components around external crisis episodes. The sample comprises 73 advanced and emerging market economies during 1991–2018.10 This event-study analysis controls for country and time fixed effects to capture differences in countries’ average IIP levels as well as the influence of common shocks. In line with the analysis in Gourinchas and Obstfeld (2012) and Catão and Milesi-Ferretti (2014), the following specification is used to perform a standard unconditional event analysis:

yit=αi+βt+Σs=55βsDt+s+εit(1),

where αt and βt are country and time fixed effects, respectively; Dt+s are dummy variables to identify when the crisis event occurs; and yit is the IIP component under consideration. The coefficient βs thus captures the extent to which the IIP component affects the external stress event. 11

As shown in Figure 4, which presents estimates for the evolution of key IIP components (together with 90 percent confidence bands), the deterioration of the net IIP as a share of GDP ahead of an external crisis seems to be driven predominantly by a sharp increase in foreign currency-denominated external debt liabilities, (which in part reflects valuation effects from currency depreciation, and lower real GDP growth in the years preceding the crisis). Meanwhile, foreign-currency external debt assets also rise, reflecting a combination of private capital flight and valuation effects, while foreign exchange reserves decline sharply just ahead of the crisis. 12 Equities play a mitigating role (in particular the value of equity liabilities falls ahead of crisis) while the rise in domestic-currency external indebtedness is much less pronounced. Following the crisis, net IIP typically rises, driven primarily by a significant drop in foreign-currency-denominated external debt liabilities, which likely reflects the necessary deleveraging and restructuring as well as some positive valuation effects from currency appreciation in the years after the crisis. The decline in foreign official reserves precedes the crisis but continues in its aftermath. Other components exhibit smaller fluctuations or remain essentially flat.

Figure 4.
Figure 4.

Conditional Mean of Key IIP Components, the REER and Growth Around External Crisis Episodes

Citation: IMF Working Papers 2021, 020; 10.5089/9781513568102.001.A001

Source: Authors’ calculations.Note: The solid blue line corresponds to the mean of all external crisis episodes, while the blue shaded area corresponds to the 90 percent confidence interval. The red line corresponds to the mean of large crisis episodes. An increase (decrease) in the Real Effective Exchange Rate denotes appreciation (depreciation).

Similar, yet starker, dynamics of IIP components occur for a subsample of large external crises, which involve cases of IMF financial assistance exceeding 200 percent of quota. In these cases, the drop in net IIP is far more pronounced, driven even more important rise in foreign currency-denominated debt liabilities and decline in official reserve assets. That said, while IIP components also rebound more sharply following the crisis, they tend to end well below pre-crisis peaks.

B. Probit Estimation Results

A pooled probit model is used to study how the IIP and its components relate to the likelihood of external crisis events. The empirical approach is similar to Catão and Milesi-Ferretti (2014) and Turrini and Zeugner (2019), and is extended to include the currency denomination of external assets and liabilities. The dependent variable is the occurrence of an external crisis (a value of 1 indicates a crisis episode in a given country and year), and explanatory variables include various IIP components and standard macroeconomic variables, including the current account balance, the real effective exchange rate gap (measured as deviations of the real exchange rate from the average of the previous five years), relative income per capita, and a global risk indicator.13 The estimated specification includes additional controls, including (i) the credit gap (constructed analogously to the real exchange rate gap), to measure the role of financial excess; and (ii) the degree of financial development (an index measuring market depth, access, and efficiency, which is also interacted with relative income per capita). to account for differences in the ability to respond to external shocks (see Svirydzenka 2016). The country and time coverages and crisis definition are same as in the event study analysis. All variables, except global risk aversion, are lagged one year to address endogeneity issues.14 Regression results also report log pseudolikelihood and AUROC estimates to give a sense of goodness of fit and compare across specifications.15

In line with the literature, a negative net IIP position is associated with a higher likelihood of an external crisis, a result that is robust to the inclusion of additional controls (see Table 1, columns 1 and 5). When disaggregating net IIP into its main net components, we find that while net external debt and net foreign official reserves affect the probability of external crises, the net equity position does not (Table 1, columns 2 and 6). Moreover, when further disaggregating the net external debt components by currency, only the net foreign-currency-denominated debt component becomes significant (Table 1, columns 3 and 7). Finally, when focusing on the gross components of the IIP, foreign-currency denominated debt liabilities and foreign official reserves become the most robust and significant determinants (Table 1, columns 4 and 8).16 The log-likelihood and AUROC criteria suggest that the most disaggregated model with gross positions and additional controls is the one that fits the data best (Table 1).

Table 1.

Probit Estimates for External Crisis Events

article image
Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1All country-specific variables are lagged by one year.Net refers to assets minus liabilities. Net debt, net equity, net foreign debt, and net domestic debt are computed using the underlying gross numbers.

The main regressions use stata command “xtprobit”. Approximate AUROC estimates are calculated using stata command “probit” and then applying “lroc”.

Among standard macroeconomic variables, the current account balance (included in the regression as the lagged two year average) and global risk aversion (proxied by the VXO) are the most robust determinants of external crises and are always significant when included in the probit regressions (Table 1, columns 5 to 8). The financial development index is significant when the net IIP components are considered, as well as when the gross IIP components are considered, although it requires interacting financial development with relative income per capita. The real exchange rate and credit gaps appear with the correct sign in the regressions but are not significant in any of the specifications.

The main findings in Table 1, namely the importance of foreign-currency-denominated debt liabilities, foreign official reserves, current account balances and global risk aversion are robust to alternative specifications of the probit baseline regression. When limiting the sample to EMDEs (Table 2, column 2), the impact of foreign-currency denominated debt liabilities increases (consistent with the probability margin exercise in the next subsection), while other components like external debt in domestic currency and equity positions drop in significance. 17 Meanwhile, foreign official reserves serve a more important mitigating factor in crisis, yet crisis risks rise even more with higher current account deficits and levels of global risk aversion. Finally, the level of financial development and income per capita are not significant in the EMDE sample, likely reflecting the more homogeneous nature of this group. External assets held by the private sector play a limited mitigating role, suggesting these reflect resident capital flight that respond to weak policy frameworks and underlying vulnerabilities. 18

Table 2.

Robustness Checks for External Crisis Events

article image
Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1All country-specific variables are lagged by one year.

The main regressions use stata command “xtprobit”. Approximate AUROC estimates are calculated using stata command “probit” and then applying “lroc”.

The main results are also robust to a battery of alternative specifications. In particular, foreign currency-denominated debt liabilities are always statistically significant, and the magnitude is remarkably stable across alternative specifications.19The first set of robustness checks involves changes in country sample, to exclude oil exporters and financial centers, and consider Spain’s European Stability Mechanism (ESM) program (Table 2, columns 2, 3 and 4). The second set involves alternative definitions of the left-hand-side variable, such as: (i) focusing on large crises (IMF programs greater than 200 percent of quota); (ii) using a two-year window in defining a crisis, and (iii) excluding consecutive crisis years, both for the full sample and for the EMDE sample. The third set of alternative specifications involves having additional controls to consider the exchange rate regime, capital account openness, commodity price changes and the fiscal balance.,20, Only commodity prices are significant, and the inclusion of additional controls does not alter key results. Finally, windsorizing the data prior to estimation (1 percent for both tails), and estimating a logit regression delivers similar results. 21

C. Probit Margins

Predicted probabilities are computed by keeping all the variables in the estimated model fixed at their sample means, while changing the variable of interest in specified increments (for other applications of this approach, see, for example, Gourinchas and Obstfeld 2012). This estimation is useful in uncovering the nonlinear effects of certain variables on the likelihood of external crises. As shown in Figure 5. the estimated effects are economically more meaningful in the model estimated for EMDEs. Specifically:

  • In the EMDE sample, an increase in foreign-currency-denominated debt liabilities from 40 percent of GDP (near the EMDE median) to 60 percent of GDP is associated with a 5-percentage point increase in the predicted probability of an external crisis. Meanwhile, in the full sample, this rise in debt would result increases the crisis probability by only 0.2 percentage points.

  • A decline in the current account balance from a surplus of 5 percent of GDP to a deficit of 5 percent of GDP is associated with an increase in the predicted probability of an external crisis by 5.3 percentage points for EMDEs. For the full sample, the probability rises by only 1.1 percentage points.

  • The relationship between foreign official reserves and external crises is markedly nonlinear. The predicted external stress probability is near zero when reserves are above 30 percent of GDP. As reserves decline, the predicted external crisis probability increases. In EMDEs, a decline in foreign exchange reserves from 20 percent to 10 percent of GDP is associated with a 6.5 percentage points increase in the likelihood of an external crisis, while a further decline from 10 percent to 0 percent of GDP increases the predicted probability by an additional 12.6 percentage points. For the full sample, corresponding values for the entire sample are much lower (0.7 and 2.1 percentage points, respectively).

  • Global risk aversion also has a differentiated and nonlinear impact depending on the sample. In EMDEs, a doubling of global risk aversion from its historical mean increases crisis predicted probabilities by 6.5 percentage points, with a further doubling to levels witnessed in the early phase of the Global Financial Crisis and the Covid-19 pandemic increases predicted crisis probabilities by 23.5 percentage points. For the full sample, the probability rises by 0.7 and 4 percentage points, respectively.

Figure 5.
Figure 5.

External Crises: Model Predicted Probabilities (Margins)

Citation: IMF Working Papers 2021, 020; 10.5089/9781513568102.001.A001

Note: All panels display the predicted probabilities of an external crisis episode, keeping all covariates except foreign currency debt, foreign exchange reserves, the current account, and global risk aversion at their sample mean. The solid blue line corresponds to the mean estimate, the dotted lines correspond to the 90 percent confidence interval.

The finding that external vulnerabilities are more strongly related to risks of external stress for EMDEs reflects differences in the estimated coefficients and mean of control variables across the full and EMDE sample. For instance, the estimated coefficient on the effect of foreign-currency-denominated debt on the probability of an external crisis is about four times larger than for the full sample. In addition, the EMDE sample has a lower average financial development index, which likely constrains a country’s ability to weather external shocks.

The results also imply that a combination of two or more external vulnerabilities greatly increases the probability of external crisis in EMDEs (Figure 6). The same level for foreign-currency-denominated debt liabilities could signal very different risks of an external crisis episode, depending on other vulnerabilities. When foreign currency debt is 40 percent of GDP, the predicted probability ranges from 2–13 percent, depending on whether foreign official reserves and the current account balance are at high levels (75th percentile of the sample) or at low levels (25th percentile). Similarly, the vulnerabilities associated with large current account deficits depend on the levels of foreign official reserves and foreign-currency-denominated debt. Predicted crisis probabilities associated with a current account deficit of 5 percent range from 2.5 to 21 percent depending on whether the economy is less vulnerable (with official reserves above the 75th percentile and foreign-currency-denominated debt below the 25th percentile) or more vulnerable (with official reserves below the 25th percentile and foreign-currency-denominated debt above the 75th percentile). A similar logic applies to the risks associated with low foreign official reserves, which are higher when current account deficits and foreign-currency-denominated debt are at high levels as well.

Figure 6.
Figure 6.

Selected Predictors of External Crises in the Emerging Market and Developing Economies Sample

Citation: IMF Working Papers 2021, 020; 10.5089/9781513568102.001.A001

Sources: External Wealth of Nations database (Lane and Milesi-Ferretti 2007); Haver Analytics; IMF, World Economic Outlook database; and authors’ calculations.Note: All panels display the predicted probabilities of an external crisis episode, keeping all covariates except foreign currency debt, foreign exchange reserves, the current account, and global risk aversion at their sample mean. More vulnerable countries are defined as those with foreign currency debt at the 75th percentile and foreign exchange reserves and current account balance at the 25th percentile of the sample. Less vulnerable countries are defined as those with foreign currency debt at the 25th percentile and foreign exchange reserves and current account balance at the 75th percentile. Median countries are defined as those with foreign currency debt, foreign exchange reserves, and current account balance at the median.

Finally, the estimated model has important implications for the global risks currently facing EMDEs. When global risk aversion reaches the peak values as seen in the initial phase of the Covid-19 pandemic (about 80, a value also reached during the Global Financial Crisis), the external crisis probability for an EMDE with median levels of preexisting vulnerabilities rises to about 40 percent— more than double the estimated probability for less vulnerable EMDEs (as defined previously). Results reaffirm the importance of external buffers to deal with global risk shocks.

D. Output Costs and Macroeconomic Effects of Crises

In addition to affecting the likelihood of an external crisis, high levels of foreign currency-denominated debt liabilities, high current account deficits, and low foreign official reserves may affect post-crisis macroeconomic outcomes and the speed of the subsequent recovery. To investigate this hypothesis, the asymmetry in post-crisis outcomes related to these indicators is analyzed using the local projections method (Jordà, 2005), which helps trace out the dynamic response of output, exchange rates and the current account after a crisis materializes, for the EMDE sample. 22

For the purposes of the analysis, countries are again classified as having higher or lower vulnerabilities based on the preexisting level of foreign-currency-denominated debt liabilities, current account deficits, and foreign official reserves. In particular, the following specification is specified:

yi,t+kyi,t1=αi+γt+βH,kDi,tHCrisisi,t+βo,k(1Di,tH)Crisisi,t+ΓXi,t+εi,t

for horizons k=0,1,...5 years and where:

  • yi,t+k is the log of real GDP, the log of the REER, or the CA/GDP ratio of country i at time t+k,

  • αi and γt are country and time fixed effects,

  • DHi,t is a dummy variable = 1 for countries with high foreign currency denominated debt (above median of sample), high current account deficit (below median of current account balance), and low foreign official reserves (below median); and 0 for the rest of the sample,

  • Crisisi,t is a dummy variable (1 for crisis and 0 otherwise),

  • Xi,t contains additional regressors: 2-year lags of the first difference of the log of real GDP, the log of the REER, and the CA/GDP ratio. Γ is the associated vector of estimated coefficients.

  • ε is the regression residual.

The results suggest that EMDEs with a high vulnerabilities (a combination of high foreign-currency debt liabilities, high current account deficit, and low foreign official reserves) tend to experience higher and more proacted output losses following the crisis (Figure 7, top panels). Specifically, in vulnerable EMDEs the initial output loss is over 4 percent, and output remains below pre-crisis levels after five years. In the rest of the EMDE sample. initial losses are smaller (1 percent) and output rises to above pre-crisis level after four years. In addition (Figure 7, mid and bottom panels), more vulnerable EMDEs observe larger initial exchange rate depreciations (averaging 10 percent) and current account adjustment (averaging 2 percent of GDP). Overall, these results suggest that the post-crisis adjustment is larger when countries have multiple pre-existing external vulnerabilities, and the recovery is slower.

Figure 7.
Figure 7.

Dynamic Evolution of Output, Real Exchange Rates, and Current Account Balance Following External Crisis Episodes

Citation: IMF Working Papers 2021, 020; 10.5089/9781513568102.001.A001

Note: Shaded area corresponds to the 90 percent confidence interval. The horizontal axis denotes time in years, and 0 is the year of the external crisis episode. EMDEs = emerging market and developing economies; REER = real effective exchange rate.1/ Vulnerable EMDEs are defined as those with foreign currency debt above the EMDE median, and current account balance and foreign exchange reserves below the EMDE median.

V. Sudden Stops with High Growth Impact

This section applies similar tools to understand the behavior and role played by IIP components around sudden stop events. The main differences with respect to the analysis of external crisis events are highlighted.

A. Event Analysis

The qualitative results (Figure 8) are similar to the case of external crisis. Sudden stops are preceded by (i) net IIP declines, which are mostly driven by increases in external debt liabilities denominated in foreign currency as percent of GDP (with currency depreciation and negative real growth also playing a role); and (ii) foreign official reserves declines, which continue in its aftermath, suggesting reserve sales are often used to buffer the impact of sudden stops. Meanwhile, external debt liabilities denominated in domestic currency are flat around sudden stop episodes, with equities following a similar path as in crisis episodes.

Figure 8.
Figure 8.

Conditional Mean of Key IIP Components, the REER and Growth Around Sudden Stop Episodes

Citation: IMF Working Papers 2021, 020; 10.5089/9781513568102.001.A001

Note: The solid blue line corresponds to the mean of all sudden stop episodes, while the blue shaded area corresponds to the 90 percent confidence interval. IIP components are expressed as percent of GDP. An increase (decrease) in the Real Effective Exchange Rate denotes appreciation (depreciation).

In quantitative terms, the magnitudes involved are much larger, suggesting that the identified sudden stop events are more severe than the identified external crises (Section IV A). The net IIP declines by more than 40 percentage points around a sudden stop episode, while it declines by about 3 percentage points for all external crises and by about 14 percentage points for large external crises, which involve cases of IMF financial assistance exceeding 200 percent of quota. Foreign-currency-denominated external debt liabilities increase by almost 80 percentage points for sudden stops, compared with 12 percentage points in the case of external crises and 22 percentage points in the case of large external crises.

B. Probit Estimation Results and Probability Margins

As in the case of external crisis events, deterioration in the net IIP position increases the probability of sudden stops, with statistically significant effects (column 1), driven both by an increase in net debt and net equity positions (Table 3). However, once foreign and domestic currency components of net debt are considered, the net equity position loses statistical significance (columns 3, 4, 7, and 8), suggesting that sudden stops are driven by debt and its foreign-currency component. Higher net foreign-currency denominated assets reduce the likelihood of sudden stops, although the effect is mostly driven by lower gross foreign currency debt liabilities (columns 4 and 8). This finding is in line with the results of the event analysis, confirming that gross external debt liabilities are the main driver of IIP risks. Interestingly, domestic-currency denominated debt liabilities appear to mitigate such risks, likely reflecting (as discussed earlier) stronger policy frameworks and deeper capital markets, which in turn increase the ability to issue external debt in domestic currency.23

Table 3.

Probit Estimates for Sudden Stops

article image
Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1All country-specific variables are lagged by one year.Net refers to assets minus liabilities. Net debt, net equity, net foreign debt, and net domestic debt are computed using the underlying gross numbers.

The main regressions use stata command “xtprobit”. Approximate AUROC estimates are calculated using stata command “probit” and then applying “lroc”.

Going beyond the IIP structure, the results from other macroeconomic variables are somewhat different from the cases of external crisis events. Overvalued exchange rates and excessive credit increase the likelihood of sudden stops (neither variable was significant in external crisis), while levels of global risk aversion play an even larger role. On the other hand, the impact of current account deficits and foreign official reserves are no longer statistically significant. The results are robust to the same battery of tests (Table 4), and the role of gross external debt liabilities is stable across specifications, including for EMDEs, where the results are stronger. In addition, and unlike the case of external crises, the fiscal balance is now a significant variable, with higher fiscal deficits increasing the probability of sudden stops.24

Table 4.

Robustness Checks for Sudden Stops

article image
Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1All country-specific variables are lagged by one year.

The main regressions use stata command “xtprobit”. Approximate AUROC estimates are calculated using stata command “probit” and applying “lroc”.

Generally, the estimated probit margins for sudden stops are much lower than for the case of external crises, which suggests that they are rare events that are difficult to predict.25 For instance, an increase of foreign currency denominated debt liabilities from 40 to 60 percent is associated with only a marginal increase in the probability of a sudden stop, yet the impact is non linear (increases with the size of FX denominated debt) and increases when combined with other vulnerabilities, especially in the EMDE sample. Only for the case of the global risk aversion indicator, we obtain predicted probabilities that are quantitatively similar to the case of external crises.

VI. Conclusion

This paper provides new evidence on the role of the structure of IIP in affecting countries’ external financing risks. In particular, using an extended time and country coverage, and building on previous work on this area (Gourinchas and Obstfeld, 2012; Catão and Milesi-Ferretti (2014); Turrini and Zeugner, 2019), the paper focuses in quantifying the external risks associated with the structure of external liabilities., with emphasis on currency composition, The paper finds that the size and currency composition of the IIP matters, especially for EMDEs: higher external debt increases the likelihood of external crises, while higher foreign currency-denominated debt increases the likelihood of sudden stops. Official reserves act as a mitigating factor by reducing the probability of external crises, with diminishing returns. Our results also highlight the role of macroeconomic variables— higher current account deficit increases the probability of external crises, overvalued exchange rates and high credit and fiscal deficits increase the chances of a sudden stop with high growth impact. Higher global risk aversion increases the likelihood of both events. Finally, the combination of vulnerabilities in two or more variables amplify these risks non-linearly.

While the substantial financial integration in EMDEs over the last two decades has brought benefits due to factors such as improved risk sharing and access to much needed capital to boost potential growth, it also could make these economies susceptible to external stress if not properly managed. The results imply that monitoring vulnerabilities requires carefully assessing different aspects of flow and stock imbalances, including foreign currency denominated debt as well as mitigating factors like official reserve buffers. Nonlinearities in the combined effects of vulnerabilities suggest that guarding against the buildup of external debt, especially in foreign currency, should remain a priority, given its amplifying effects when external financing conditions and risk appetite sour. In addition, the macroeconomic consequences—in terms of lost real GDP and the sharpness of current account and real effective exchange rate adjustment— are likely to be significantly greater for economies with greater preexisting vulnerabilities when external crisis episodes occur. These vulnerabilities are also likely to be relevant for low-income countries (LICs) that have borrowed in foreign currency (by issuing Eurobonds, for instance) over the last decade. Data constraints prevented including more LICs in the analysis, but future research should aim at studying vulnerabilities for these countries as well.

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Appendix Tables

Table A.1.

Sample Economies

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Table A.2.

Data Sources

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Table A.3.

External Crisis Episodes

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