FDI Flows and Sudden Stops in Small Open Economies

Balance of payment crises, characterized by Sudden Stops, are not a phenomenon exclusive to emerging economies. This paper identifies 16 and 50 crises in advanced and emerging economies, respectively. Further, decomposing the Financial Account uncovers important differences between both groups of economies in the Foreign Direct Investment (FDI) flows: the average net FDI in advanced economies is close to zero and in emerging economies is negative, and during Sudden Stop episodes, net FDI in emerging economies shows large contractions while advanced economies flows do not move at all. To quantify the FDI’s channel effect on the dynamics of a crisis episode we develop a model with incomplete markets and an endogenous collateral constraint that generates endogenous Sudden Stops. The results from the model suggest that an emerging economy that increases the outflow FDI and eliminates the expropriation risk would reduce the long-run probability of a Sudden Stop from 2.9 to 1.3 percent.