FDI flows and sudden stops in small open economies

Abstract

Why are balance of payments crises, characterized by Sudden Stops of capital inflows, more frequent in emerging economies than advanced economies? This paper argues that differences in the composition of the financial account flows explain 30 percent of the gap in the probability of a crisis. I document that although advanced economies have, on average, zero net foreign direct investment (FDI), they have sufficient FDI outflows to act as buffer savings during financial distress. To quantify the effect of this FDI channel on the probability of a crisis, I propose a small open economy model with a loan-to-value collateral constraint and FDI vulnerable to government confiscation risk. The calibrated model suggests that if an emerging economy increases its capital-to-GDP ratio and eliminates government confiscation risk, it would reduce the probability of a Sudden Stop from 2.9 to 2.7 percent, while simultaneously increasing its debt-to-GDP ratio from 47 to 65 percent.