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Sudden Stop: With the money comes a crisis

Over the past decade cumulative capital flows into emerging markets have been substantially large. In principle, this brings benefits to both capital-importing and capital-exporting countries. Nonetheless these benefits come at the risk of a sudden stop for the recipient. A sudden stop is a sudden reversal or stoppage of capital flows associated with sharp currency depreciation in the capital-importing country. This can have some significant negative effects on the receiving country.

The Asian Crisis in 1997 is a good example for how a sudden stop can be caused. In this case a combination of risky financial and economic conditions, like fixed or semi-fixed exchange rates, large current account deficits and high domestic interest rates, where involved. The high domestic interest rates caused investments and borrowing from abroad. This made the economies vulnerable for an appreciation of the U.S. dollar, what eventually happened. Currencies became overvalued, causing devaluations and a capital flight or sudden stop.

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Figure 1: Net private capital flows to EMEs

Source: Ahmed and Zlate (2013)

           Figure 1 shows net capital flows into several emerging markets. As for the rest of the emerging world there is a clear increase in net capital flows. During the Global Financial Crisis, capital flows into emerging markets collapsed, though they recovered even stronger afterwards. The problem of this enormous capital flow into emerging markets is that this flow can be reversed very abruptly.

Before the global financial crises most capital flows into the emerging markets were ‘pulled’ in because of low savings and strong economic growth. However, since 2008 emerging market economies have not reached the old growth level, but received similar or more capital from abroad. The global saving glut caused by quantitative easing since the global financial crises can be seen as an important reason for this.

Quantitative easing is an unconventional monetary policy used frequently by central banks in developed countries to stimulate the economy by depreciating the value of their currency. Current events have shown that the issued money is merely used by banks and multinationals to invest in emerging markets (Lynch, 2010). These inflows are hard to handle for the recipients and can cause bubbles. Moreover unconventional monetary policies are fully reversible, therefore the pushed capital has to return. When big central banks, like the FED, normalize their policy, currencies in developed countries will appreciate causing a weaker position of currencies in emerging market economies, which will lead to a flight of capital out of the emerging markets. This situation has some interesting similarities with the Asian crisis example. Not the large deficits, but mainly behavior from capital-exporting countries can lead to a sudden stop.

            Different behavior of central banks in developed countries is hard to enforce. Therefore a question is what emerging markets can do to prevent themselves from this danger. According to Reinhart and Calvo (2000) dollarization in emerging markets would be a legitimate option. This means that a strong currency from a developed economy would (partially) substitute the local currency. The fear for devaluation would be taken away completely, eliminating the sudden stop problem. Another less extreme option would be capital controls. This would influence the composition of flows, avoiding short maturities. Nevertheless this is as Reinhart and Calvo say not likely to be a long-run solution. Finally there is a solution proposed by the IMF. The writer of the paper “The Yin and Yang of Capital Flow Management: Balancing Capital Flows with Capital Outflows” refer to Confucius: “The green reed which bends in the wind is stronger than the mighty oak which breaks in the storm.” This simply means that there is no hard response to capital flows, instead emerging markets should bend and thereby encouraging capital outflows instead of stopping capital inflows.

           Current international financial markets have shown not to be problem resistant. Money comes and goes leaving an alarming situation behind. Here it is at the expense of emerging markets. What to do about it is a difficult question, since many countries are involved and just a few can cause major problems. In the end it is the financial system that needs to be repaired to avoid more sudden stop problems.

Nuno Antunes (649) and Stefanus Leeffers (642)
Blog entry, Macroeconomic analysis, 2013

References

Ahmed, S. and Zlate, A. (2013), Capital Flows to Emerging Market Economies: A Brave New World? International Finance Discussion Papers, No. 1081.

http://www.federalreserve.gov/pubs/ifdp/2013/1081/ifdp1081.pdf

Reinhart, C. and Calvo, G. (2000), When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options, in Peter Kenen and Alexandre Swoboda, eds. Reforming the International Monetary and Financial System, (Washington DC: International Monetary Fund, 2000), 175-201.

http://mpra.ub.uni-muenchen.de/6982/

IMF (2013), The Yin and Yang of Capital Flow Management: Balancing Capital Flows with Capital Outflows.

http://www.imf.org/external/pubs/ft/weo/2013/02/pdf/c4.pdf

Lynch, D.J. (2010), Bernanke’s `Cheap Money’ Stimulus Spurs Corporate Investment Outside U.S., Bloomberg.

http://www.bloomberg.com/news/2010-11-17/bernanke-s-cheap-money-stimulus-spurs-corporate-investment-outside-u-s-.html

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Author: studentnovasbe

Master student in Nova Sbe

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