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Quid pro Quo: National Institutions and Sudden Stops in International Capital Movements
Inter-American Development Bank
Banco Interamericano de Desarrollo (BID)
Research Department
Departamento de Investigación
Working Paper #587







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




by

Eduardo A. Cavallo*
Andrés Velasco**





* Inter-American Development Bank
** Harvard University



November 2006






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Cataloging-in-Publication data provided by the
Inter-American Development Bank
Felipe Herrera Library


Cavallo, Eduardo A.

Quid pro quo : national institutions and sudden stops in international capital movements /
by Eduardo A. Cavallo, Andrés Velasco.

p. cm.
(Research Department Working paper series ; 587)
Includes bibliographical references.

1. Debts, Public. 2. Capital movements. I. Velasco, Andrés. II. Inter-American
Development Bank. Research Dept. III. Title. IV. Series.


HJ8011 .C28 2006
336.34 C28---dc22









©2006
Inter-American Development Bank
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Washington, DC 20577

The views and interpretations in this document are those of the authors and should not be
attributed to the Inter-American Development Bank, or to any individual acting on its behalf.

This paper may be freely reproduced provided credit is given to the Research Department, Inter-
American Development Bank.

The Research Department (RES) produces a quarterly newsletter, IDEA (Ideas for Development
in the Americas), as well as working papers and books on diverse economic issues. To obtain a
complete list of RES publications, and read or download them please visit our web site at:
http://www.iadb.org/res.
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Abstract

We explore 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. This paper 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 countrys interest to tie its
hands and secure the property rights of lenders as much as possible because this
enhances the credibility of the countrys promise to repay and prevents default
altogether. We incorporate two key features of todays 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. We show that under these conditions the advice build institutions to secure
repayment at all costs may be very bad advice indeed.

JEL Classification: F34; F36; F51
Keywords: Sudden Stops; National Institutions; Debt Accumulation; Default;
Sanctions.
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1. Introduction

Countries wanting to develop are told time and again to fix your institutions and protect
property rights. The two are related, for one main task of good institutions is to keep property
rights from being violated. If countries follow this advice, then presumably traders and investors
carry out profitable trades and projects and the country prospers.
International borrowing and lending provides a concrete application of this general
advice. Countries can guarantee repayment by entering into binding international agreements,
designing rules or institutions that make non-payment costly or making themselves vulnerable to
international sanctions. If they do, then capital inflows occur, profitable projects are financed and
opportunities for international risk-sharing do not go to waste.
We call this the tie your hands and prosper strategy, or THAP. The Washington
Consensus included THAP among its commandments,
1
and Washington International Financial
Institutions have been enthusiastically prescribing THAP to their member countries.
2

In this paper we argue that when applied to international borrowing and lending, the
THAP strategy may well be incorrect. Or, more precisely, that it is correct only under very
narrow and specific circumstances. Under other conditions, which are more prevalent in todays
financial markets, the advice build institutions to secure repayment at all costs may be very
bad advice indeed.
Take the standard risk-sharing model of Obstfeld and Rogoff (1996), for example. The
model focuses on the insurance aspects of international capital markets (i.e., there is no expected
gain or loss from borrowing abroad, but borrowing helps shield countries from unexpected
shocks) and makes the assumption that foreign insurers can credibly make commitments to a
future state-contingent payment stream, whereas the borrower cannot. Foreign claimholders thus
have no legal rights to apply sanctions unless the borrower does not comply with the payments.
They show that unless debt default is ruled out by sufficiently strong sanctions, the borrower can
never take full advantage of open capital markets to diversify all the risk away and smooth
consumption. The source of the problem is simple: the borrower can not credibly pre-commit to
a future state-contingent payment stream. Thus, the prescription is also simple: increase as much
as possible the share of output that lenders can seize in the event of non-payment. If that share is

1
Williamson (1990).
2
See, for example, Williamson (2000).
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one, then the contract offered by lenders will entail full insurance. The countrys consumption
will be fully stabilized no matter how large the shocks to its income, and the countrys utility will
be as large as can be.
In this paper we consider two variations on the simple Obstfeld-Rogoff framework. First,
lenders are not always well behaved: in any period when lenders have to make a net transfer to
the country, there is an exogenous probability that transfer will not occur. We can think of this as
an example of the sudden stops to capital movements phenomenon discussed in the by now
very voluminous literature started by Calvo (1998).
3
,
4

Second, consider not only an insurance
contract but also a debt contract, in which lenders transfer resources to the country at the start of
the period, which have to be repaid later.
These apparently minor changes have a strong impact on the policy implications arising
from the standard international risk-sharing model a la Obstfeld-Rogoff (1996). The first and key
change is that THAP is no longer optimal. Tying your hands as much as possible, or making
yourself extremely vulnerable to sanctions, may well decrease rather than increase expected
country welfare. The reason is that sanctions can be applied because debt repudiation is a
possible equilibrium outcome in a world with sudden stops. Therefore, by making itself
vulnerable to sanctions in the aftermath of default, the country is giving away to lenders a greater
share of output in the event of a crisis.
The extended model also yields a theory of the optimal size of international debt. In the
standard model the size of debt is irrelevant. Here that is not the case. The size of debt matters:
with larger debt, the country gets more relief from non-payment. And that relief may be
necessary if in equilibrium lenders do not make the net transfers they were supposed to make
under the contract. We find that the optimal debt stock depends, among other things, on the
perceived risk of sudden stops. If borrowers expect that lenders will not make the promised

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A key feature of that literature is that the sudden stops in capital inflows occur for reasons that are exogenous to
the country. The same is true in our model. Alternatively, in a more complicated setting one could think of this
sudden stop as the outcome of a coordination problem among lenders, in the spirit of Sachs (1982) and, more
recently, Morris and Shin (1998). Then, the probability q of a sudden stop can be thought of as the probability
associated with a sunspot in a model with multiple equilibria. See also Rodrik and Velasco (2000).
4
On the causes of sudden stops, see for example, Calvo Izquierdo and Mejía (2003), Edwards (2004), Cavallo and
Frankel (2004) and Cavallo (2005). On the consequences of sudden stops see for example, Calvo, Izquierdo and
Talvi (2003) and Guidotti, Sturzenegger and Villar (2004).