The Eurozone sovereign debt crisis has been one of the most difficult tests to the cohesion of the European Union and to the euro. Over indebtedness and financing constraints on both governments and banking sectors spelled disaster – leading to massive unemployment rates and permanent output reductions in the periphery countries: Greece, Portugal, Ireland, Spain and Cyprus. This paper briefly explores the dynamics of the balance of payments and focuses on the loss of access to international financing experienced by these countries, i.e. the sudden stop, and its impact. Furthermore, it analyses how foreign currency reserves could be used to maintain current account deficits after a sudden stop in a country that issues its own currency and how that is typically unfeasible; why the euro monetary union reinforces this unfeasibility for its members and how, at the same time, it created a mechanism to deal with the reversal in the direction of capital flows within the Eurozone: TARGET2.
The current account measures the net lending position of an economy, that is, the difference between domestic savings and investment. Together with the capital account they make up the two components of the balance of payments. The balance of payments is, by definition, equal to 0 – therefore, a current account deficit must be compensated by an equal capital account surplus. In other words, if the economy chooses to run a current account deficit then it necessarily needs to be financed by foreign capital inflows. In practice however, these do not always match. When the capital inflows are larger than the current account deficit the excess capital builds up as currency reserves. But what happens when the capital stops flowing?
To get to the key concept of this paper and following the tradition in literature I will quote the banker’s adage that coined the term: “It is not speed that kills, it is the sudden stop.” A sudden stop is an abrupt decrease in net capital inflows to an economy and typically happens when, after a series of current account deficits that create over indebtedness, there is a blow to confidence. It can be triggered by foreign investors who halt their capital inflows to the economy, or by domestic investors who pull their money out of it. The heart of the problem is that when investors lose confidence and the nation loses access to international financing it becomes unable to roll-over its debt and, consequently, is forced to close the current account deficit. That is the same as saying that the economy cannot keep the same levels of consumption and investment, it must reduce both, which decreases aggregate demand and throws it into a recession. In the context of the two-period investment economy, international financing allowed agents to first take the investment decision that maximizes their lifetime wealth and then lend or borrow in order to smooth consumption patterns. In other words, agents were able to separate their consumption and investment decisions. When the economy loses access to international financing it loses this separation property – the investment and consumption decisions become a single decision. If agents wish to invest today in order to consume more tomorrow, they must consume less today. This creates permanent reductions in lifetime wealth and standards of living because agents are financially constrained and unable to set the investment level that maximizes it, given that they have present consumption needs.
If a sudden stop occurs, the currency reserves could be used to finance the current account deficits. The central bank of a country that issues its own currency could make foreign currency available to the economy, thus allowing agents to borrow, pay for imports and in the future pay back. One can think of it as artificial international financing. This preserves the separation of consumption and investment decisions and maximizes wealth. However, in practice, the currency reserves are not enough for this purpose because most of them are used by the central bank to protect the domestic currency. It is essential that the central bank do so because sudden stops are usually accompanied by capital flight. That is, not only do investors stop pouring capital into a distressed economy, they also withdraw their capital. Which inexorably leads to currency devaluation and could escalate into a currency crisis. In this scenario firms of the affected nation are in trouble because their revenues are typically denominated in the domestic currency, but their debt is in foreign currency. They may easily become insolvent and tip the economy into a recession. Therefore, foreign currency reserves are typically unable to keep an economy afloat during a sudden stop episode because they are quickly depleted by central banks’ efforts to maintain the value of the domestic currency.
The Eurozone, by creating the single currency, has made it even harder for a member economy to finance a current account deficit with central bank foreign assets. Note that the main trading partners of Eurozone members are precisely other Eurozone members, thus their current account imbalances are, for the most part, vis-à-vis one another. Further they share the same currency, which means the “foreign” currency with which they run their deficits is not foreign at all – it is domestic – and it is not an asset of the national central banks, it is a liability – and as such cannot be extended to the economy. Therefore, the current account deficits observed in the periphery economies could not possibly be financed by currency reserves.
The European periphery countries experienced massive inflows of private capital during the period of 2002 to 2007-09. Followed by a sudden stop episode alongside capital flight. One would expect current account deficits to be reversed but the fact is that there was only a slight adjustment. What happened then? Private capital outflows were compensated for by an equally sizeable rise in public capital inflows. The bailout programmes were an important channel of these inflows but there was yet another channel that was crucial in its own right: the Eurosystem and its payments system, which by financing current account deficits through the creation of Intra-Eurosystem liabilities for the national central banks of periphery countries succeeded in mitigating the negative impact of the sudden stop. To see why let us look at what happens to banks’ balance sheets during capital flight.
European commercial banks are legally required to keep reserve accounts with their national central banks. TARGET2 settles international payments within the Eurozone by applying debits and credits to these accounts. In the event of capital flight, agents withdraw their deposits from the banks in the distressed countries – in this example, Portugal. This necessarily leads to an equal reduction in the reserve account at the commercial and central banks. Naturally, the opposite happens on the country receiving the capital. Now, if this was the whole story, then we can see that net capital positions at both national central banks would change; which would impact net profits. To solve this problem the system provides national central banks with credits and debits in the form of a bilateral position vis-à-vis the ECB, recorded in the balance sheets as “Intra-Eurosystem Assets” (IEA) and “Intra-Eurosystem Liabilities” (IEL). These liabilities are essentially liquidity extended by the ECB to the banking systems of the distressed countries, and, I reiterate, are what compensated for the private capital outflows thus allowing these economies to maintain, to a large extent, their current account imbalances. Other sources of public capital like the bailout programmes also helped of course. However, had this mechanism not been in place, the recessions experienced by the periphery could have been much more severe and led to even greater losses of output and wealth.
Nuno André Nóbrega, 3714
Merler, Silvia; Pisani-Ferry, Jean (2012): Sudden stops in the Euro area, Bruegel Policy Contribution, No. 2012/06
Whelan, Karl (2012): TARGET2 and central bank balance sheets
Mody and Bornhorst (2012): TARGET imbalances: financing the capital-account reversal in Europe
 Here defining: BOP = current account + capital account.
 Merler, Silvia; Pisani-Ferry, Jean (2012) identifies three sudden stop episodes but for the purpose of this article it is enough to group them in one episode.