Sudden Stop (economics) - Economic Impact

Economic Impact

The balance of payments 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 runs. 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.