Sudden stop (economics)
Encyclopedia
A sudden stop in capital flows is defined as a sudden slowdown in private capital inflows into emerging market economies, and a corresponding sharp reversal from large current account deficits into smaller deficits or small surpluses. Sudden stops are usually followed by a sharp decrease in output
, private spending
and credit to the private sector, and real exchange rate appreciation. The term “sudden stop” was inspired by a banker’s comment on a paper by Rüdiger Dornbusch and Alejandro Werner about Mexico, that “it is not speed that kills, it is the sudden stop”.
Sudden stops are commonly described as periods that contain at least one observation where the year-on-year fall in capital flows lies at least two standard deviation
s below its sample mean
. The start of the sudden stop period is determined by the first time the annual change in capital flows falls one standard deviation below the mean and the end of the sudden stop period is determined once the annual change in capital flows exceeds one standard deviation below its sample mean.
identity establishes that the current account is equal to the capital account plus the accumulation of international reserves
. Therefore, a large slowdown in capital inflows is met either by a loss of international reserves and/or a lower current account deficit, both of which have negative economic effects.
A reduction in the current account deficit is achieved through a decrease in domestic aggregate demand for tradable goods. Since tradable and non-tradable goods are complements, this also reduces demand for non-tradable goods. The demand for tradable goods reflects in a reduction in imports; however, the lower demand for non-tradable goods translates into lower output and real depreciation of the currency (lower relative price of non tradable to tradable goods). Firms producing non-tradable goods face an increase in the real cost of financing, as the cost of loans in terms of the price of non-tradable goods rises. These firms get lower revenues, which reduce their ability to repay their loans. As a result, banks face a higher rate of non-performing loans from this sector. In this situation, banks become more cautious and decrease loans, which worsens the economic recession.
A collapse in asset prices also contributes to a sharp slowdown in economic activity. The value of loan collaterals are severely reduced which further impacts the situation of the financial system and reduces credit, reflecting in lower consumption and investment. Furthermore, lower asset prices have negative wealth effects for consumers, which further reduce consumption spending. The features of sudden stops are similar to those of balance of payment crises in terms of devaluations of the domestic currency followed by periods of output loss. However, sudden stops are characterized by sharper recessions and a larger fall in the price of non-tradable to tradable goods.
A similar argument relates large changes in relative prices of tradable and non-tradable goods with the effects of a sudden stop. The mechanism is explained by a credit based approach to currency crises, where countries with less developed financial markets experience a sharper output fall during a sudden stop episode, regardless of whether the country has a fixed
or floating exchange rate
regime, as the source of the crisis is through the deterioration of private firms’ balance sheets. Therefore, a higher proportion of foreign currency debt increases the vulnerability to currency devaluations. Different to first generation crisis models, in their model crises may occur even under low unemployment and sound fiscal policies.
An additional effect of sudden stops and third generation crises in emerging markets are related to financial institutions and sudden stops in short term capital inflows, in comparison to previous crises where the main features were related to fiscal imbalances or weakness in real activity. In this type of model, international financial markets play a key role, where small open economies face a problem of international illiquidity during the crisis episodes, associated with the collapse of the financial system.
Due to the inherent structure of the banking system, banks transform maturity from liquid deposits to illiquid assets, which creates vulnerability to bank run
s. Even in situations where banks might be solvent
, in the short run bank runs create an illiquidity problem, where banks would need to borrow funds to meet the temporary deposit withdrawals. However, under this situation, it might be harder to obtain foreign funds, as foreign creditors may also panic depending on the degree of commitment to repay international debts. Moreover, the higher the level of short term debt the higher the exposure to illiquidity problems. This models is particularly related to the situation in emerging markets, because of the larger role of banks compared to other financial institutions in these economies and because it is more difficult for them to get emergency funds from world markets during crisis periods.
An alternative explanation of sudden stops focuses on the interaction of temporary and permanent technology shocks, where highly volatile trend shocks in emerging market economies are closely related to sudden stop episodes. Emerging markets are characterized by frequent regime switches related to changes in fiscal, monetary and trade policies, which reflect in more volatile shocks to the trend. The sharp effects of sudden stop episodes are not only related to the large magnitude of the shock, but also to the fact that there is a negative productivity shock with a change in trend.
In order to study sudden stop episodes, using data from the 1994 economic crisis in Mexico
, this model decomposes it to obtain a representation of transitory and permanent technology shocks. The results show that including permanent technology shocks is able to produce the behavior observed during a sudden stop episode. The model predicts a large contraction in output, consumption and investment, as well as a sharp current account reversal.
Emerging markets
Some empirical studies focus on the interaction between sudden stops and financial crises in emerging market economies. Using a sample of emerging market countries with large capital inflows from Latin America, Asia and Europe, they compare the severity of the sudden stop episodes associated with currency crises and banking crises. The severity of sudden stop episodes in emerging market economies are compared using indicators such as the real depreciation of the currency and indicators of currency and banking crises. Results suggest that currency and banking crises in Asia in 1995-1997 were more severe than the sharpest crises in Latin America, in terms of banking bailout costs and the size of capital account reversal.
Another topic of study is the impact of sudden stops on output. Sudden stops can be accompanied by a currency crisis and/or a banking crisis. Empirical studies show that the effects of a banking crisis are more pernicious than the effects of a currency crisis, due to the additional effect of the credit channel
on output. Lower asset prices are a persistent fact after a banking crisis, which indicate a low value of collaterals to loans, and therefore, negatively impact the banking sector and the supply of loans.
Regarding exports, currency crises show a faster recovery in the export sector, while exports remain low for an average of two years after banking crises. Banking crises also present a sharper recession, consistent with the disruption of the financial sector. There is a distinguishable boom–bust cycle, as unsustainable massive capital inflows that precede a sudden stop episode sharply increase economic activity.
Emerging markets and advanced economies
Other studies focus on the relationship between current account reversals and sudden stops in both emerging markets and advanced economies. Using cross-country data for a sample of 157 countries during the 1970-2001 period, the results indicate that 46.1% of countries that suffered a sudden stop also faced a current account reversal, while 22.9% of countries that faced current account reversals also faced a sudden stop episode. The less-than-one relationship could be related to an effective use of international reserves to offset capital outflows during sudden stops, while during current account reversals, there are some countries that were not receiving large capital inflows, so their deficits were financed through a loss of international reserves.
A comparison of the stylized facts observed during sudden stop episodes in emerging market economies and developed countries on the financial crises of the 1990s relate sudden stops in emerging market and advanced economies with the presence of contagion effects. Most sudden stop episodes for emerging markets occur around the Tequila (1994), East Asian (1997) and Russian (1998) crises. In the case of developed economies, sudden stop episodes occur around the European Exchange Rate Mechanism
(ERM) (1992–1993) crisis.
Output (economics)
Output in economics is the "quantity of goods or services produced in a given time period, by a firm, industry, or country," whether consumed or used for further production.The concept of national output is absolutely essential in the field of macroeconomics...
, private spending
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
and credit to the private sector, and real exchange rate appreciation. The term “sudden stop” was inspired by a banker’s comment on a paper by Rüdiger Dornbusch and Alejandro Werner about Mexico, that “it is not speed that kills, it is the sudden stop”.
Sudden stops are commonly described as periods that contain at least one observation where the year-on-year fall in capital flows lies at least two standard deviation
Standard deviation
Standard deviation is a widely used measure of variability or diversity used in statistics and probability theory. It shows how much variation or "dispersion" there is from the average...
s below its sample mean
Mean
In statistics, mean has two related meanings:* the arithmetic mean .* the expected value of a random variable, which is also called the population mean....
. The start of the sudden stop period is determined by the first time the annual change in capital flows falls one standard deviation below the mean and the end of the sudden stop period is determined once the annual change in capital flows exceeds one standard deviation below its sample mean.
Economic impact
The balance of paymentsBalance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
identity establishes that the current account is equal to the capital account plus the accumulation of international reserves
Foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...
. Therefore, a large slowdown in capital inflows is met either by a loss of international reserves and/or a lower current account deficit, both of which have negative economic effects.
A reduction in the current account deficit is achieved through a decrease in domestic aggregate demand for tradable goods. Since tradable and non-tradable goods are complements, this also reduces demand for non-tradable goods. The demand for tradable goods reflects in a reduction in imports; however, the lower demand for non-tradable goods translates into lower output and real depreciation of the currency (lower relative price of non tradable to tradable goods). Firms producing non-tradable goods face an increase in the real cost of financing, as the cost of loans in terms of the price of non-tradable goods rises. These firms get lower revenues, which reduce their ability to repay their loans. As a result, banks face a higher rate of non-performing loans from this sector. In this situation, banks become more cautious and decrease loans, which worsens the economic recession.
A collapse in asset prices also contributes to a sharp slowdown in economic activity. The value of loan collaterals are severely reduced which further impacts the situation of the financial system and reduces credit, reflecting in lower consumption and investment. Furthermore, lower asset prices have negative wealth effects for consumers, which further reduce consumption spending. The features of sudden stops are similar to those of balance of payment crises in terms of devaluations of the domestic currency followed by periods of output loss. However, sudden stops are characterized by sharper recessions and a larger fall in the price of non-tradable to tradable goods.
A similar argument relates large changes in relative prices of tradable and non-tradable goods with the effects of a sudden stop. The mechanism is explained by a credit based approach to currency crises, where countries with less developed financial markets experience a sharper output fall during a sudden stop episode, regardless of whether the country has a fixed
Fixed exchange rate
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.A fixed exchange rate is usually used to...
or floating exchange rate
Floating exchange rate
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....
regime, as the source of the crisis is through the deterioration of private firms’ balance sheets. Therefore, a higher proportion of foreign currency debt increases the vulnerability to currency devaluations. Different to first generation crisis models, in their model crises may occur even under low unemployment and sound fiscal policies.
An additional effect of sudden stops and third generation crises in emerging markets are related to financial institutions and sudden stops in short term capital inflows, in comparison to previous crises where the main features were related to fiscal imbalances or weakness in real activity. In this type of model, international financial markets play a key role, where small open economies face a problem of international illiquidity during the crisis episodes, associated with the collapse of the financial system.
Due to the inherent structure of the banking system, banks transform maturity from liquid deposits to illiquid assets, which creates vulnerability to bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
s. Even in situations where banks might be solvent
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...
, in the short run bank runs create an illiquidity problem, where banks would need to borrow funds to meet the temporary deposit withdrawals. However, under this situation, it might be harder to obtain foreign funds, as foreign creditors may also panic depending on the degree of commitment to repay international debts. Moreover, the higher the level of short term debt the higher the exposure to illiquidity problems. This models is particularly related to the situation in emerging markets, because of the larger role of banks compared to other financial institutions in these economies and because it is more difficult for them to get emergency funds from world markets during crisis periods.
An alternative explanation of sudden stops focuses on the interaction of temporary and permanent technology shocks, where highly volatile trend shocks in emerging market economies are closely related to sudden stop episodes. Emerging markets are characterized by frequent regime switches related to changes in fiscal, monetary and trade policies, which reflect in more volatile shocks to the trend. The sharp effects of sudden stop episodes are not only related to the large magnitude of the shock, but also to the fact that there is a negative productivity shock with a change in trend.
In order to study sudden stop episodes, using data from the 1994 economic crisis in Mexico
1994 economic crisis in Mexico
The 1994 Economic Crisis in Mexico, widely known as the Mexican peso crisis, was caused by the sudden devaluation of the Mexican peso in December 1994....
, this model decomposes it to obtain a representation of transitory and permanent technology shocks. The results show that including permanent technology shocks is able to produce the behavior observed during a sudden stop episode. The model predicts a large contraction in output, consumption and investment, as well as a sharp current account reversal.
Empirical issues
Empirical studies mention a group of indicators that may be related to sudden stops. The composition of capital inflows, with a higher proportion of short term financing may be more risky as they generate larger slowdowns in capital inflows. The time profile of maturity debt is important in assessing the potential for sudden reversals in capital flows. The shorter the maturity of a country’s debt, the more prone it is for a sudden stop crises.Emerging markets
Some empirical studies focus on the interaction between sudden stops and financial crises in emerging market economies. Using a sample of emerging market countries with large capital inflows from Latin America, Asia and Europe, they compare the severity of the sudden stop episodes associated with currency crises and banking crises. The severity of sudden stop episodes in emerging market economies are compared using indicators such as the real depreciation of the currency and indicators of currency and banking crises. Results suggest that currency and banking crises in Asia in 1995-1997 were more severe than the sharpest crises in Latin America, in terms of banking bailout costs and the size of capital account reversal.
Another topic of study is the impact of sudden stops on output. Sudden stops can be accompanied by a currency crisis and/or a banking crisis. Empirical studies show that the effects of a banking crisis are more pernicious than the effects of a currency crisis, due to the additional effect of the credit channel
Credit channel
The credit channel mechanism of monetary policy describes the theory that a central bank's policy changes affect the amount of credit that banks issue to firms and consumers for purchases, which in turn affects the real economy....
on output. Lower asset prices are a persistent fact after a banking crisis, which indicate a low value of collaterals to loans, and therefore, negatively impact the banking sector and the supply of loans.
Regarding exports, currency crises show a faster recovery in the export sector, while exports remain low for an average of two years after banking crises. Banking crises also present a sharper recession, consistent with the disruption of the financial sector. There is a distinguishable boom–bust cycle, as unsustainable massive capital inflows that precede a sudden stop episode sharply increase economic activity.
Emerging markets and advanced economies
Other studies focus on the relationship between current account reversals and sudden stops in both emerging markets and advanced economies. Using cross-country data for a sample of 157 countries during the 1970-2001 period, the results indicate that 46.1% of countries that suffered a sudden stop also faced a current account reversal, while 22.9% of countries that faced current account reversals also faced a sudden stop episode. The less-than-one relationship could be related to an effective use of international reserves to offset capital outflows during sudden stops, while during current account reversals, there are some countries that were not receiving large capital inflows, so their deficits were financed through a loss of international reserves.
A comparison of the stylized facts observed during sudden stop episodes in emerging market economies and developed countries on the financial crises of the 1990s relate sudden stops in emerging market and advanced economies with the presence of contagion effects. Most sudden stop episodes for emerging markets occur around the Tequila (1994), East Asian (1997) and Russian (1998) crises. In the case of developed economies, sudden stop episodes occur around the European Exchange Rate Mechanism
European Exchange Rate Mechanism
The European Exchange Rate Mechanism, ERM, was a system introduced by the European Community in March 1979, as part of the European Monetary System , to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of...
(ERM) (1992–1993) crisis.
Policy measures
Regarding policy measures adopted during sudden stop episodes, the massive slowdown in capital inflows, usually presented as large capital outflows, can be counteracted by exchange rate devaluation, loss of international reserves and/or increases in real interest rates. The nominal exchange rate behavior during most sudden stop episodes show that sudden stops in emerging markets are followed by a devaluation of the domestic currency, while most depreciation episodes in developed countries are not related to sudden stop phases. Real interest rates sharply increase during sudden stop episodes, especially in the case of emerging market economies. A sharp loss of international reserves is also observed during sudden stop episodes, both in developed countries and emerging markets. The current account balance shows a sharp reduction in current account deficits, with a significantly higher increase in the current account balance in emerging markets.See also
- Balance of paymentsBalance of paymentsBalance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...
- Sovereign defaultSovereign defaultA sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full. It may be accompanied by a formal declaration of a government not to pay or only partially pay its debts , or the de facto cessation of due payments...
- Currency crisisCurrency crisisA currency crisis, which is also called a balance-of-payments crisis, is a sudden devaluation of a currency caused by chronic balance-of-payments deficits which usually ends in a speculative attack in the foreign exchange market. It occurs when the value of a currency changes quickly, undermining...
- Financial crisisFinancial crisisThe term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
- Bank runBank runA bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
- Domestic Liability DollarizationDomestic liability dollarizationDomestic liability dollarization refers to the denomination of banking system deposits and lending in a currency other than that of the country in which they are held...