Interest Rate Volatility and Sudden Stops: An Empirical Investigation

Abstract

Using a multi-country regime-switching vector autoregressive (VAR) model we document the existence of two regimes in the volatility of interest rates at which emerging economies borrow from international financial markets, and study the statistical relationship of such regimes with episodes of sudden stops. Periods of high volatility tend to be persistent and are associated with high interest rates, the occurrence of sudden stops in external financing, and large declines in economic activity. Most strikingly, we show that regime switches drive the countercyclicality of interest rates in emerging markets documented in previous literature (Neumeyer and Perri, 2005) and that high-volatility regimes forecast sudden stops 6 and 12 months ahead.