Modeling financial fragility in transition economies

Capital inflows have an enormous importance in the financing of investment in emerging and transition economies. However short-term inflows, intermediated by the banking sector of the emerging economy, may be subject to early withdrawals. We model a situation where such withdrawals are motivated by a change in either the domestic or the foreign fundamentals. We show that, for a given change in fundamentals, a reversal in the capital flows (and hence a currency crisis) is more likely the more risk averse are the foreign investors into the emerging economy. We also show that a policy to tax early withdrawals may discourage capital inflows which are more likely to give rise to fundamental runs, by helping to select relatively less risk averse investors. However, such a policy would have to be fine tuned in order not to discourage all capital inflows.