Fear of Sudden Stops: Lessons from Australia and Chile

Latin American economies are exposed to substantial external vulnerability. Domestic imbalances and terms of trade shocks are often exacerbated by sudden financial distress. In this paper we explore ways of overcoming external vulnerability drawing lessons from a detailed comparison of the response of Chile and Australia to recent external shocks and from Australia’s historical experience. We argue that in order to understand sudden stops and the mechanisms to smooth them, it is useful to highlight and then draw a distinction between two dimensions of investors confidence: country-trust and currency-trust. While these two dimensions are interrelated, there are important distinctions. Lack of country-trust is a more fundamental and serious problem behind sudden stops. But lack of currency-trust may both be a source of country-trust problems as well as weaken a country’s ability to deal with sudden stops. We discuss steps to improve along these two dimensions of investors’ confidence in the medium run, and policies to reduce the impact of country-trust and currency-trust weaknesses in the short run. ∗Respectively: MIT and NBER; IADB; Reserve Bank of Australia. This paper is a revised version of the paper prepared for the Financial Dedollarization: Policy Options conference at the Inter-American Development Bank, 1–2 December 2003. The views expressed in this paper are those of the authors and should not be attributed to the IADB, the Reserve Bank or any other institution with which they are affiliated. We thank Guy Debelle, Luci Ellis, Darren Flood, Ilan Goldfajn, Simon Guttmann, Paulo Mauro, Tony Richards and Alejandro Werner for their comments. Erwin Hansen provided excellent research assistance.