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 Vulnerability to crises Of the different types of private capital flows, short-term loans are the most likely to be withdrawn during difficult times.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.
Quarterly data suggest an even more dramatic swing.
High levels of short-term liabilities involving the financial system also involve risks of bank runs and systemic crisis. Therefore, the risk of financial crisis is greater when the ratio of short-term debt to reserves is excessive and the banking system is heavily involved in intermediating debt flows. Since residents may opt to liquidate their short-term assets in the banking system and move them abroad in the event that risks rise, the ratio of broad money to reserves is an additional indicator of vulnerability. The growth of short-term borrowing in the 1990s naturally accompanied higher incomes, faster growth, and greater openness to trade in developing countries. But the rapid rise in such borrowing also reflected speculative asset booms in some countries.