Sudden stops are when capital inflows dry up abruptly (see e.g. Kalemi-Ozcan 2014). In a new paper, we analyse these episodes in emerging markets over the past quarter century, contrasting their incidence severity and policy response before and after 2002 (Eichengreen and Gupta 2016).
We classify an episode as a sudden stop when portfolio and other inflows by non-residents decline below the average in the previous 20 quarters by at least one standard deviation, when the decline lasts for more than one quarter, and when flows are two standard deviations below their prior average in at least in one quarter. Episodes then end when capital flows recover.
These episodes last on average for four quarters. Capital outflows during sudden stops average about 1.5% of GDP per quarter (cumulatively 6% of GDP for the duration of the sudden stop) compared to inflows of about 1.7% of GDP a quarter over the preceding year. This implies a swing in capital flows of some 3% of GDP in a quarter, which is a large amount.
Table 1. Sudden stops, 1990-2002 vs. 2003-2015
Note: Country sample is all emerging markets with their own currencies for which capital flow data are available for at least 24 consecutive quarters between 1991 and 2015. Capital flows are non-FDI flows by non-residents, consisting of portfolio and other flows. Data is from the International Monetary Fund’s International Finance Statistics. Table 1 is an update of Eichengreen and Gupta (2016) since it includes the data for 2015.
The frequency of sudden stops is not significantly different now than in the past (contrast the two entries in the second row of Table 1). Interruptions to capital flows during the Fed’s talk of tapering of security purchases in 2013 do not qualify as sudden stops. They were shorter and entailed smaller reversals of capital flows. We might call them “sudden pauses” rather than “sudden stops.” A few countries in our sample (Chile and South Korea) did experience sudden stops during the slowdown in capital flows to emerging markets in 2015, but, perhaps surprisingly, the slowdown in inflows to other countries was not sufficiently large or long-lasting to qualify as a sudden stop on our criteria – at least yet.
Sudden stops have both financial and real effects. The financial effects show up first: the currency depreciates, reserves decline, and equity prices fall; GDP growth then decelerates, investment slows, and the current account strengthens. The growth of GDP falls by roughly 4% year on year in the first four quarters. Because the fall in investment is proportionally larger than the fall in GDP and, by implication, than the fall in saving, the current account strengthens. While the impact on financial variables peaks in the first two quarters, the impact on the current account, GDP growth and investment peaks later.
The big difference between the two sub-periods is in the magnitude of the capital flow turnaround, defined as average capital flows during the sudden stops minus average capital flows in the four preceding quarters (all scaled by GDP). The turnaround so measured is significantly larger in the second sub-period (2003-2014). The decline in GDP is somewhat larger in the second sub-period too, reflecting a larger global shock (larger increase in the VIX) and a larger capital flow turnaround, something whose effects were offset only partially by stronger macroeconomic positions.
Figure 1. Financial and real impacts of the sudden stops
We analyse the probability of a country experiencing a sudden stop by estimating a probit model. We include the log of the VIX as a proxy for global risk aversion; G4 money supplies as a proxy for global liquidity; world GDP growth to account for the strength of the global economy, and the Federal Reserve’s policy interest rate (to account for the special role of the dollar as a source of liquidity to the global financial system) as the relevant variables in the model. We include the number of sudden stops starting elsewhere in the region or in the world in the same quarter. As domestic factors we consider GDP growth, budget deficit, and the increase in capital flows in previous period. We include variables intended to capture increased leverage during episodes of large capital inflows, such as the current account balance, bank credit, and real exchange rate appreciation. We also include reserves as a measure of the ability to withstand the impact of sudden stop and thus lowering the probability of sudden stop itself.
In our results, global factors, particularly the VIX, have become more important relative to country-specific characteristics in explaining the incidence of sudden stops. Sudden stops now tend to affect different parts of the world simultaneously rather than bunching regionally, indicating the growing importance of global factors. Domestic vulnerabilities have played a less consistent role in recent years, when sudden stops have occurred even in the presence of relatively strong economic growth, large reserve cover, low foreign currency exposure and flexible exchange rates.
Figure 2. Sudden stops in recent years have occurred amidst strong domestic conditions
Note: Variables are averages of eight previous quarters (or two previous years). Foreign currency position is an index; a higher value means less negative foreign currency position. All variables have been normalized around zero mean and standard deviation equal to one.
If there is a conventional wisdom regarding the policy response, it is that countries tighten monetary and fiscal policies to counter the drop in the exchange rate and to restore confidence. In extreme cases, they tighten controls on capital outflows and appeal to the IMF for assistance. But in fact, in only eight of the 43 cases considered here did countries tighten both monetary and fiscal policies. Monetary policy was eased in response to sudden stops more often than it was tightened. Instead governments respond to sudden stops with a variety of other measures targeted at buttressing the stability of their domestic financial system and signalling to investors their commitment to sound and stable policies.
Figure 3. Policy tradeoffs in sudden stop episodes
Note: We assign either a zero, one, or negative one to a country in each episode, with a one when a country tightened monetary policy, tightened fiscal policy, made its exchange rate regime more flexible, or committed to structural reforms. Zero when there is no change, and minus one when a country eased monetary policy or fiscal policy. Countries with all minus one are at the centre of the figure, whereas countries with all ones are at the four vertexes (they trace out the diamond).
Countries responded in the 1990s by stepping down the exchange rate, sometimes floating the currency, and then supporting that new exchange rate or float with a tighter monetary policy. In the worst-hit cases there was also resort to an IMF programme, extension of which typically entailed trade reforms, fiscal tightening, and privatization of public enterprises. In the second sub-period, there was less of a tendency to tighten both monetary and fiscal policies. Indeed, some countries were actually able to reduce policy interest rates so as to support economic activity and financial markets.
These choices are consistent with the changing nature of sudden stops and the position of countries experiencing them. In the 1990s, sudden stops were heavily associated with weak macroeconomic fundamentals, whereas episodes in the subsequent decade were associated more with external factors and occurred despite stronger domestic economic and financial fundamentals. In the second sub-period, countries experiencing sudden stops had smaller budget deficits and public debts (as shares of GDP) and significantly lower rates of inflation. Their international reserves as a share of GDP were more than twice as high as in the first sub-period. These stronger fundamentals made IMF support less imperative and gave them some additional leeway to adjust in ways that provided more support to domestic economic activity and the financial system, in some cases loosening monetary policy and limiting the extent of fiscal consolidation.
Finally, and contrary to popular assertion, there has not been much of a tendency to change capital account restrictions (to loosen, tighten or re-impose capital controls) in response to sudden stops. There is however increasing recourse to other macroprudential measures.
Table 2. Capital account and macroprudential measures during sudden stops
While stronger macroeconomic and financial frameworks have allowed policymakers to respond more flexibly, these stronger positions and more flexible responses have not guaranteed insulation from sudden stops or mitigated their impact. Any benefit from stronger country fundamentals has been offset by larger external shocks emanating from the rest of the world.
Nor has progress on the policy front reduced the negative output effects. It would appear with the continued growth of international financial markets and transactions, countries are now exposed to larger capital flow reversals, and those larger reversals have more disruptive output effects. It is troubling that neither national officials, with increased policy space, nor the international financial institutions, with their proliferation of new financing facilities, have succeeded in cushioning emerging markets from these effects. Our findings suggest that the challenge of understanding and coping with capital-flow volatility is far from fully met.
Eichengreen, B, and P Gupta (2016), “Managing Sudden Stops”, Policy Research Paper 7639, World Bank.
Kalemi-Ozcan, S (2014), “The Next Sudden Stop”, VoxEU.org (7 January).