The liberalization of the capital account of the balance of payments was one of the main reasons of the increasing amount of capital flows that came in into many emerging economies. In the last decades the restrictions on these capital movements have been eliminated and the world has witnessed the creation of a liberalized environment. Whether it was driven by “push” or “pull” factors (originated in the lending and borrowing countries respectively), the inflowing of capitals brought many positive welfare implications for the borrowing countries and for their economies. However, there are some potential problems too and this article is going to focus on one of them: the sudden stops, and mostly about the ones that occurred in the Euro Area.
Sudden stops are an abrupt slowdown of private capital inflows into an economy, due to new information about the capability of a country to honor its financial obligations. It is usually very disruptive to an economy, since it forces an almost immediate reversal in the current account from an external deficit to a surplus one (unless the country benefits from significant balance of payments assistance). Therefore, policy challenges arise.
When it comes to the Euro Area case in particular, there have been countries like Portugal, Spain, Ireland, Greece and Italy that, right after the creation of the Economic and Monetary Union, started to see a large amount of capital to flow to their economies. They offered attractive investment opportunities and there was no longer the risk associated with the exchange rate. Everything was being seen as part of a well-functioning monetary union which was designed to make a balance of payment crisis (inability of country to pay for essential imports and/or service its debt repayment) impossible to happen. So, the current account imbalances that arose through time were disregarded. Nevertheless, macroeconomic imbalances occurred in the form of large and persistent current account deficits which had increase the accumulation of external debt and deteriorated the competitiveness of these countries when compared to the other euro zone ones.
Not much later, there were three main episodes of sudden stops: one by the time of the outbreak of the global financial crisis, another one by the time of the launch of the Greek programme, and the last in the second half of 2011. They suggest that has been contagion across countries and from what it has been discussed in class, is easy to point out that one of the biggest problems here is that a sudden stop requires a real exchange rate appreciation, which is difficult to achieve in this case.
1.Sudden stop episodes in southern euro-area countries, 2009-11
A special feature of the Euro area crisis is that even though the capital outflows have been impressive, the current account of deficit countries’ have only adjusted partially given the important role of Eurosystem financing. When compared to other countries outside the monetary union (The Baltics for example), data shows the adjustment when facing a sudden stop is much faster and sharper in the last ones. Even though different choices of fiscal policy and different patterns of bank ownership did also contribute to a delayed fiscal and external adjustment, the Eusosystem played a much crucial role. Its injection of liquidity has helped accommodate persistent current-account adjustments and also protect countries by minimizing the immediate effects of a sudden stop in private capital flows (it’s important to remember that they can no longer rely on adjusting their exchange rates).
2.Current account turnaround BELL= Baltic States (Estonia, Latvia and Lithuania) GIIPS= Greece, Ireland, Italy, Portugal and Spain
So basically, we can conclude that the effects of a sudden stop have been soften by a smooth functioning of the payment system and if it was not the case, the Euro currency could become unsustainable. It is important to act keeping in mind that the level of integration of the euro-area financial markets requires policies that should preserve it from the risk of further attacks.
However, welfare analysis suggests that a short and sharp adjustment path, like the one followed by the EU Member States outside the euro area actually had two advantages: less debt was accumulated and the macroeconomic performance was better if measured over time.
Catarina Coelho #640
Notes from the Professor