What Is Sudden Stop?
A sudden stop is an abrupt reduction in net capital flows into an economy, especially an emerging economy.
- A sudden stop is the abrupt reduction of capital flows into a nation's economy, which are often accompanied by economic recessions and market corrections.
- Sudden stops may also be followed by a currency crisis, as foreigners lose faith in a nation's economy.
- Sudden stops affect small economies disproportionately as foreign capital inflows cease even as domestic capital outflows rise.
Understanding Sudden Stop
A sudden stop is characterized by swift reversals of international capital flows, declines in production and consumption, and corrections in asset prices. It may also be accompanied by a currency crisis, a banking crisis, or both.
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, a phenomenon also known as capital flight, 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.
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 the country's 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.
The genesis of the term sudden stop in the economic context is generally attributed to economist Rudiger Dornbusch, who, along with his colleagues co-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."
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.
Sudden Stop Examples
Sudden stops in recent decades tend to be clustered around global financial and economic crises. Recent examples include the Asian contagion of the 1990s, the Euro area following the 2008-09 Great Recession, and the economic fallout of the 2020 Covid-19 pandemic.
- In the early to mid-1990s, Indonesia, Malaysia, the Philippines, Singapore, and Thailand ran large current account deficits. Rapid economic growth driven by investment encouraged foreign creditors to maintain capital flows into the region. At the same time, rapid expansion of the local supplies of money credit combined with exchange rates pegged to the dollar and heavy borrowing in U.S. denominated assets by governments and central banks, contributed to significant financial imbalances. As investors eventually lost confidence in the sustainability of the regional economy, a series of currency crises emerged in these countries leading to an abrupt reversal of capital flows, or sudden stop.
- From 2010-2012, following the global financial crisis, investors and creditors who had for years financed large balance-of-payment deficits in the periphery of the Euro area—Portugal, Ireland, Italy, Greece, and Spain (PIIGS)—lost confidence in the fiscal and financial stability of these countries in the face of local government debt crises. Capital flows form core EU countries, such as Germany and France, ceased and then reversed, inducing a sudden stop.
- In 2020, governments around the world responded to the outbreak of Covid-19 by shuttering commerce, industry, and travel. Many emerging nations experienced rapid outflows of capital as investors sought to move into safe-haven assets in developed nations. Financial and economic contraction in many emerging economies actually preceded any direct local impact of the new disease due to the sudden stop in capital flows that they experienced during this period.