Finally, there is evidence of a nonlinear relationship between the risk perceptions of creditors and economic shocks in developing countries. This relationship lies at the heart of the greater procyclical response of short-term debt to adverse shocks. Perceived risk may increase more during a large adverse shock than it declines during a small adverse or a positive shock. Two reasons may explain the procyclical behavior of short-term capital flows. First, economic shocks tend to be larger and more frequent in developing countries, reflecting these countries' narrower economic bases and greater dependence on primary commodity exports.
Adverse shocks cause a country's creditworthiness to be downgraded.
Changes in risk perception and rating downgrades can lead to rationing of credit to marginally creditworthy borrowers, and such changes can worsen rather than smooth their adjustment. Second, these negative effects are exacerbated by the asymmetry of information available to borrowers and lenders, which may trigger herd behavior as panicked investors rush to withdraw their capital in response to an adverse shock. Vulnerability to crises Of the different types of private capital flows, short-term loans are the most likely to be withdrawn during difficult times. The cost of pulling out is minimal for lenders of short-term debt, whereas liquidating foreign direct investment may involve selling plant and machinery, and selling stocks or bonds during a crisis usually involves a loss for the sellers. Many countries suffered large reversals in short-term capital flows during the recent financial crises, precipitating severe external liquidity crises.