What is Sudden Stop
A sudden stop is an abrupt reduction in net capital flows into an economy. A sudden stop is characterized by swift reversals of international capital flows, declines in production and consumption, and corrections in asset prices. Sudden stops can be triggered either by foreign investors, when they reduce or stop capital inflows into an economy, and/or by domestic residents when they pull their money out of the domestic economy, resulting in capital outflows. Since sudden stops are generally preceded by robust expansions that drive asset prices significantly higher, their occurrence can have a very adverse impact on the economy and tip it into a recession. A sudden stop may also be accompanied by a currency crisis or a banking crisis or both.
BREAKING DOWN Sudden Stop
The genesis of the term “sudden stop” in the economic context is generally attributed to economist Rudiger Dornbusch et al, who authored a 1995 research paper on the Mexican peso's collapse titled “Currency Crises and Collapses.” Dornbusch and his co-authors quoted a banker's adage in the paper – “It is not speed that kills, it is the sudden stop.”
According to the fundamental balance-of-payments equation, current account deficits must necessarily be financed by net capital inflows. If these capital inflows significantly exceed the amounts required to finance a nation’s current account deficits, the excess inflows would go to build up its currency reserves. If a sudden stop occurs, those currency reserves can be used to finance the current account deficit. In practice, however, those currency reserves rarely prove equal to the task, since most of the reserves may be used by the central bank to fend off speculative attacks on the domestic currency. As a result, the current account deficit generally shrinks rapidly after a sudden stop, since the current account deficit relies on net capital inflow to finance it. If a currency crisis accompanies a sudden stop, as is often the case, the domestic currency devaluation would further shrink the current account deficit as it would stimulate exports and make imports more expensive.
Research on Sudden Stops
In a 2011 research paper on sudden stops in 82 countries from 1970 to 2007, World Bank economists found the following results:
- Global investors are more likely to pull out or stop investing in countries with a volatile export base (such as those with abundant natural resources) and poor economic performance. Rigid exchange rates and high integration with financial markets make such countries more vulnerable to sudden stops.
- Local residents are more likely to invest abroad (triggering capital outflows) if there is high domestic inflation and/or large current account surpluses.
- Financial openness makes an economy more vulnerable to sudden stops caused either by foreign investors or local residents.