Sudden stops in international capital flows pose significant challenges for policymakers, especially in emerging markets. These abrupt halts in cross-border flows disrupt firms’ access to external financing, leading to liquidity shortages that can severely undermine economic activity and growth. This column examines how credit support policies in the form of credit guarantees and central bank credit lines can help firms substitute the evaporating external credit for domestic borrowing, using the case of Chile during the COVID-19 pandemic. The analysis provides strong evidence that the interventions were effective in mitigating the impact of the shock.
Sudden stops in international capital flows – episodes where foreign financing rapidly withdraws – have long been a challenge for policymakers, especially in emerging markets. These events often trigger financial crises, deepening the economic downturn and amplifying volatility. Since Guillermo Calvo’s seminal 1998 work on this topic, which examined sudden stops in emerging markets during the 1990s, much research has focused on understanding how these phenomena disrupt access to external credit, leading to financial crises. Increased availability of microdata has enabled scholars to delve deeper into how these shocks unfold at the firm level (Ates and Saffie 2021, Dassatti et al. 2024). Yet it remains an open question whether government interventions can effectively mitigate the economic fallout of sudden stops and, if so, how these interventions should be designed. In this column, we discuss on going recent work, which examines these questions in the context of Chile’s experience during the COVID-19 pandemic. Using a rich dataset on Chilean firms and the credit support policies that were deployed during the pandemic, our research identifies how government actions helped alleviate the impact of the sudden stop of capital flows to firms and the mechanisms behind these effects.
The sudden stop amid COVID in Chile and the policy response
In March 2020, as the global economy grappled with the start of the pandemic, there was a dramatic contraction in capital flows to Chile, as shown in Figure 1. This contraction was not unique to Chile but reflected a broader global pattern of capital flow reversals in emerging markets. Chile’s experience mirrors what occurred in many emerging economies: a sudden, sharp withdrawal of foreign capital, which amounted to a 4-standard deviation shock for the Chilean case.
Figure 1 The sudden stop-COVID shock in Chile: EPFR-Bonds and CEMBI spread
Note: The figure depicts the fund flows’ EPFR measure and the CEMBI spread for Chile (right axis). The vertical line denotes February 2020, the month before the first COVID case in Chile in March 7, 2020. The data sources are, respectively, Informa PLC and Bloomberg.
To understand how this external shock affected firms within Chile, Figure 2 presents a striking increase in the firm-level uncovered interest parity (UIP) premia. These premia are a measure of the additional cost that firms face when borrowing in local currency relative to borrowing in foreign currencies. During the early months of the pandemic, we observe a near doubling of the UIP premia – indicating that firms’ cost of borrowing in pesos soared. This jump in UIP premia was a key transmission mechanism of the shock, as firms saw their borrowing costs increase sharply in local markets.
Figure 2 The sudden stop-COVID shock in Chile: Mean firm-level UIP deviation
Note: Details of how the UIP premia are calculated can be seen in Acosta-Henao et al. (2024)
In response to this rapid capital flow reversal, the Chilean government introduced two key policies aimed at easing financing constraints for firms: a new central bank credit line facility for commercial banks and government-backed guarantees on bank loans to firms. The noticeable reduction in the UIP premia in May 2020 (second vertical line in Figure 2) coincides with the month when the policies were deployed, after which the UIP premia began to decrease, suggesting that the policy interventions were effective in reducing borrowing costs for firms.
Our research delves deeper into the effectiveness of these policies. Specifically, we investigate how the government’s credit line facility and sovereign guarantees helped firms weather the shock by allowing them to shift their borrowing from costly external sources to more affordable domestic credit.
Firms’ foreign for domestic debt substitution
The central question of our research is whether government-backed credit guarantees and central bank credit lines can substitute for missing external financing during a sudden stop. Our analysis of the Chilean case during the pandemic shock provides strong evidence that these interventions were effective in mitigating the impact of the shock.
An important feature of the Chilean interventions was their size-dependent nature. The central bank’s credit lines were available to commercial banks only if they increased lending to firms below a certain size threshold. Similarly, the government-backed loan guarantees were only available to firms that met specific size requirements, based on their historical sales. This targeting of policies based on firm size allowed us to study the effects of these interventions on different types of firms to better understand their impact.
Figure 3 presents more descriptive evidence by documenting firms’ debt composition before and after the introduction of these policies according to their size. The left panel of the figure shows the share of domestic and external debt in firms’ total debt stocks in April 2020, just before the policies were enacted. The data revealed that relatively smaller firms were more reliant on domestic debt, with 75% of small firms’ total debt consisting of domestic borrowing. In contrast, mega firms, defined as those with annual sales above $35 million (given the prevailing exchange rate at the time), had a much smaller share of domestic debt – only 40%. This pattern of debt composition is consistent with previous studies that have found smaller firms tend to rely more on domestic sources of financing while larger ones tap more international capital markets (Gopinath et al. 2017).
The right panel of Figure 3 shows the flow of new debt between April and July 2020, when credit support policies were deployed. As can be seen, firms shifted their new debt issuance heavily toward domestic debt. Importantly, this shift was concentrated among small/medium and large firms, which were eligible for the government guarantees. These firms increased their reliance on domestic debt issuance, which accounted for 99% and 95%, respectively, of the new debt issued in this period. In contrast, the flow of debt from domestic sources among mega firms – those ineligibles for government guarantees – remained unchanged at 40% of the new debt issued. This stark contrast provides preliminary evidence that the government guarantees helped relatively smaller firms substitute external debt with more affordable domestic debt.
Figure 3 Stock and change in firms’ finance mix, April to July 2020
Notes: The left panel depicts the domestic (blue) and external (red) debt share over total debt for three groups of firms in April 2020: 1) Small and medium (yearly sales of less than 100,000 UF); 2) Large (yearly sales greater than 100,000 UF and less than 1,000,000 UF); 3) Mega (yearly sales greater or equal to 1,000,000 UF). The right panel shows the change of each type of debt, domestic and foreign, as a share of the total change in the debt stock between May and July 2020. All calculations convert all debt to dollars using the spot exchange rate.
To formally assess the causal impact of these policies, we use regression discontinuity design (RDD) methods, which leverage the firm-size threshold for eligibility to government guarantees. The threshold created a quasi-natural experiment, where firms just below the eligibility cutoff were treated with the policy, while those just above the cutoff were not. Figure 4 presents the results of this RDD analysis, showing a 9.4 percentage point increase in the share of domestic debt for eligible firms compared to ineligible firms. This provides evidence that government guarantees caused firms to substitute external debt with domestic debt, helping alleviate some of the negative effects of the capital flow shock.
Figure 4 Increase in domestic debt share for eligible firms
Notes: The red dots depict local polynomial approximations around the cutoff (vertical line). The specification shown in the figure is a degree-0 polynomial with a Triangular Kernel.
The role of credit risk pricing
A second key finding of our research is that the reduction in the UIP premium for eligible firms was primarily driven by a decline in the domestic interest rate on local currency debt. Our loan-level regression analysis reveals that, before the pandemic, firms in Chile faced a domestic UIP premium of about 4%, broadly in line with that found in other emerging markets (Kalemli-Ozan and Varela 2021, di Giovanni et al. (2022), and Gutierrez et al. 2023). As documented in Figure 2, during the early months of the pandemic, the average UIP premium doubled. Our results indicate that it disappeared for firms eligible for government guarantees. Crucially, this reduction in the UIP premium was not observed for ineligible firms, who continued to face higher borrowing costs abroad.
We also find that the reduction in the UIP premium for eligible firms was driven by a reduction in domestic interest rates on loans in local currency, rather than changes in foreign interest rates or the exchange rate. This suggests that the government guarantees played a key role in lowering borrowing costs for eligible firms by reducing perceived credit risk.
Complementarity of policies
Our third key finding is that government guarantees and central bank credit lines complemented each other to boost the supply of domestic credit while simultaneously reducing borrowing costs. We use a small open economy model with heterogeneous firms to explore how these policies interacted. In the model, firms can borrow both domestically and abroad and face market-specific collateral constraints that limit their ability to borrow. The supply of domestic credit comes from financial intermediaries, who lend based on their risk preferences and access to central bank funding.
The model allows us to simulate counterfactual scenarios to assess the effectiveness of each policy in isolation. We find that while government guarantees alone would have helped firms access more domestic credit, they would have counterfactually raised domestic interest rates due to increased credit demand. Similarly, the central bank credit line facility alone would not have fully offset the shock, as banks would have remained reluctant to lend in the more uncertain environment. However, when both policies are deployed jointly the domestic credit market recovers fully, with increased lending at lower interest rates, consistent with the Chilean experience. This underscores how the two policies complemented each other.
Policy implications
The Chilean experience offers valuable insights for other emerging markets facing sudden stops in capital flows. Under conditions of substantial financial stress, policymakers may want to consider government-backed guarantees and central bank interventions as part of their toolkit for mitigating the economic impacts of external financial shocks. However, these interventions must be carefully designed to target the firms that are most vulnerable to credit disruptions as well as limit moral hazard, which has been shown to increase during financial crises (Acharya et al. 2012). Additionally, while such interventions can provide short-term relief, longer-term strategies should focus on strengthening domestic financial markets and enhancing their ability to provide instruments to better manage risks from external debt issuance.
Our research also underscores the importance of building fiscal buffers to ensure the credibility of sovereign guarantees during times of crisis. The success of Chile’s policies was partly due to its strong fiscal position, which made the government guarantees credible in the eyes of markets. For other emerging markets, having strong fiscal and financial institutions that foster fiscal resilience and a strong regulatory framework is essential to ensure that similar interventions can be successfully deployed when needed.
Source : VOXeu
