Financial Diversification and Sudden Stops

Recent literature on sudden stops analyses the sharp and varied capital account reversals experienced by many emerging market economies. This paper claims that more information can be extracted from the behavior of gross capital flows than from their net results. It emphasizes the fact that, while one economy’s sudden stop can reveal exclusion from the international financial markets, another can be making adjustments to its investment portfolio causing a sudden start, and both produce the same net effect on the capital account. We present a simple model that rationalizes this empirical fact and its relationship with the economy’s financial diversification.