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Argentina’s vulnerability to Sudden Stops in capital flows provides an alternative explanation for the fall of Argentina’s Convertibility Program. Sudden Stops are typically accompanied by a substantial depreciation of the real exchange rate that wreaks havoc in countries that are heavily dollarized in their liabilities, making otherwise sustainable fiscal and corporate sector positions unsustainable. In particular, we stress that the required change in relative prices is larger the more closed the economy is in terms of its supply of tradable goods. We also provide an explanation for the political maelstrom that ensued after the Sudden Stop triggered by the Russian crisis of 1998.

The Argentine crisis has been variously blamed on fiscal imbalances, real overvaluation, and self-fulfilling investor pessimism triggering a capital flow reversal. This chapter provides a full assessment of the role of these and other ingredients in the collapse. It shows that in the final years of its Convertibility program, Argentina was not hit harder than other emerging markets in Latin America by global terms-of-trade shocks and financial disturbances. Hence the crisis reflects primarily the high vulnerability to disturbances built into Argentina’s policy framework. These fragilities reinforced each other in such a way that taken jointly they led to a much larger vulnerability to adverse external shocks than in any other country in the region.

The author deals with the management of capital flows and financial vulnerability in Asia by focusing on the crisis and developing countries. There is a growing consensus that vulnerability of emerging markets to financial contagion and shocks depends in large part on how capital inflows are managed, since options are limited during sudden stops and reversals. Vulnerabilities associated with surges in capital flows lie in four areas: (i) currency and maturity mismatches in private balance sheets, especially of financial institutions; (ii) credit, asset and investment bubbles; (iii) unsustainable currency appreciations and external deficits; and (iv) reliance on help and policy advice from the International Monetary Fund (IMF) rather than self‐insurance against sudden stops and reversals of capital flows. Crisis prevention should thus aim at preventing fragility in private balance sheets and external payments, checking financial and investment bubbles, and building adequate self‐insurance against reversal of capital inflows.

An immature international creditor generates large saving surpluses, but its own currency is not used in lending to foreigners. Domestic financial markets are not sufficiently developed, possibly still with interest rate restrictions and capital controls, for foreigners to voluntarily borrow in that currency. In China's case, foreigners typically don’t solicit RMB-denominated loans from Chinese banks or seek to issue RMB-denominated bonds in Shanghai. The risk to foreign borrowers would seem even greater if China bashing inculcated the fear that the RMB might appreciate in the near future. Given dollar dominance, the only alternative for Chinese private (nonstate) financial institutions—such as banks, pension funds, and insurance companies—is to build up liquid assets denominated in dollars for financing China's trade (saving) surplus. But since their principal liabilities to domestic depositors, pensioners, and annuity holders are in RMB, any buildup of dollars assets would lead to a currency mismatch. A dollar depreciation could wipe out their net worth. The upshot is that they would be unwilling to accumulate the dollar claims from the trade surplus. Thus a pure float, where the People's Bank of China withdrew from the foreign exchange market, would result in an indefinite upward spiral in the RMB.

This chapter evaluates several proposals for the reform of the international financial architecture using the lending policies and practices of the International Monetary Fund (IMF) as an organizing device for discussing selected issues in the reform debate. These include proposals to increase the interest rate or reduce the maturity of IMF loans, to restrict the size of IMF rescue packages and to replace ex post macroeconomic policy conditionality of the IMF. The analysis reveals that proposals for addressing currency mismatching problems appear to be either too costly or too drastic. This chapter suggests a combination of managed floating and active development of hedging mechanisms.