Emerging markets have slowed alongside a rise in longer term US rates. The fear of ‘sudden stops’ in capital flows has risen. The academic literature on capital flows, perhaps as in other areas, has tended to focus on contemporaneous concerns:
- During the 1980s capital flight took centre stage – or, in other words, the gross outflows of residents took centre stage (see Cuddington 1986, Dooley 1986).1
- During the 1990s and early 2000s the focus turned to Sudden Stops in net flows – that required current account adjustments.
With the global financial crisis, the analysis of gross flows has again become fashionable, but widened to include both advanced and developing countries:
- One strand of this recent work has suggested that sudden reversals in gross capital flows, but even when net capital flows remaining stable, can be very painful (see, e.g., Bruno and Shin 2012a, 2012b; and Shin 2012).
In a recent paper we propose a new taxonomy of Sudden Stops that is founded on the behaviour of gross and net capital flows (Cavallo et al. 2013). We argue that not all Sudden Stops are the same, with some much more disruptive than others. Our results raise further questions, suggesting avenues for new research and policy analysis.
A Sudden Stop can be defined on the basis of net flows (e.g. a fall in net flows relative to a trend, as in Calvo et. al. 2004) or on the basis of gross flows (e.g. a fall in gross inflows or a surge in outflows relative to trend, as in Forbes and Warnock 2012).
Figure 1. A taxonomy of Sudden Stops
Considering the Venn diagram in Figure 1, there are seven potential types of Sudden Stops:
- Arguably an ‘SSIN’ is the classic 1990s Sudden Stop, being both a fall in net flows and a fall in gross inflows.
- An ‘SSON’ is a Sudden Surge in gross outflows that is also a Sudden Stop in net flows, perhaps the main concern given the capital flight of the 1980s.
- At the very centre, an ‘SSION’ is separately a Sudden Stop in gross inflows, a Sudden Surge in gross outflows and a Sudden Stop in net inflows (that is, the perfect storm).
- An ‘SSN’ is a milder reduction in gross inflows and increase in gross outflows, such that neither qualifies as a Sudden Stop by itself, and yet the fall in net flows qualifies as a Sudden Stop (note that the classic Calvo et al. definition of Sudden Stops actually included all of these first four categories).
- An ‘SSI’ is a Sudden Stop in gross inflows that does not imply a Sudden Stop in net flows -- which means it is ‘financed’ by a reduction in gross outflows (i.e., capital repatriation by residents).
- An ‘SSO’ is a Surge in gross outflows (i.e., capital flight by residents) that is not a Sudden Stop in net flows and hence is ‘financed’ by an increase in gross inflows.
- An ‘SSIO’ is a Sudden Stop in gross inflows and a Sudden Surge in gross outflows that is not Sudden Stop in net flows. However, while this may be a logical possibility, in practice it is unlikely to occur and we find no such episodes in the data.
Which Sudden Stops have occurred, where and when?
A taxonomy is only useful to the extent it yields interesting results when actually used. Figure 2 illustrates the incidence Sudden Stop types in developing and in advanced economies2 over time.
Figure 2. Incidence of Sudden Stops in advanced and developing countries.
For developing countries, pre-2000, the majority of Sudden Stops in gross inflows were also net flow Sudden Stops -- the two circles representing Sudden Stops in gross inflows and Sudden Stops in net flows largely overlap. Sudden Stops in gross inflows were then almost synonymous with Sudden Stops in net flows. On the other hand there were many Sudden Surges of gross outflows that were not Sudden Stops in net flows. Post-2000 there is less overlap between Sudden Stops in net flows and Sudden Stops in gross inflows. Net flow Sudden Stops came with sudden surges in gross outflows as well as Sudden Stops in gross inflows.
In the case of advanced economies, pre-2000 there is much less overlap between the three circles. While advanced economies were exposed to Sudden Stops in gross inflows and Sudden Surges in gross outflows, the incidence of Sudden Stops in net flows was much lower. Sudden Stops in gross flows were then largely financed within the capital account; they did not require adjustments in the current account. However, post-2000, this changed and the overlap across the three circles increased. Advanced economies have suffered from more net flow type Sudden Stops in the later period.
Sudden Stops in developing countries and advanced economies looked quite different pre-2000. In the former, Sudden Stops were largely in gross inflows and in net flows but post-2000, developing countries suffered more from other types of Sudden Stops. In advanced economies, pre-2000, there were very few Sudden Stops in net flows but this changed post-2000. Both groups of countries now look more alike, with Sudden Stops in (only) gross flows and Sudden Stops in net flows now occurring in both.
Are all Sudden Stop types equally painful? The answer is a clear ‘no’! We do not go through the technical details here, but the results of a detailed empirical analysis suggest that the ordering of episodes from the least to the most disruptive in terms of declines in GDP is:
The ‘SSION’ episodes are found to be the most disruptive. Perhaps this is intuitive as they represent a perfect storm combining a Sudden Surge in gross outflows and Sudden Stop in gross inflows and in net flows. Interestingly, this is then followed by ‘SSIN’ and ‘SSI’ in terms of the greatest declines in GDP.
A follow up question is, then, ‘are Sudden Stops in gross flows that are not simultaneously sudden stops in net flows painful’? The answer is ‘yes’, but not always. In particular, Sudden Stops in gross inflows that are not Sudden Stops in net flows are associated with significant declines in GDP. But this is not true of Sudden Surges in gross capital outflows. The differences suggest that there is something associated with fluctuations in gross capital inflows which make inflow-related episodes more disruptive than surges in outflows.
Are sudden stops disruptive in developing countries only? The answer is ‘no’. Although the literature before the global financial crisis emphasised the typical economic vulnerabilities of an emerging economy (such as liability dollarisation and lack of openness), we find that Sudden Stops are disruptive in advanced economies as well.
Does capital flow composition matter? Yes. Stops in some types of capital flows (e.g., bank flows) are more disruptive than others. Sudden Stops that combine falls in net flows and that are driven by an abrupt reduction in bank inflows appear to be one of the most disruptive combinations.
Puzzles and policies
The results raise several puzzles and suggest new avenues for research and future policy analysis. For example, what can countries do to reduce the vulnerability to Sudden Stops? If a Sudden Stop is financed within the capital account, why might it be disruptive? But a deeper puzzle is why Sudden Stops in (only) gross inflows are more disruptive than Sudden Surges in (only) gross outflows?
Perhaps countries have found more effective ways to backstop abrupt changes in the stock of foreign asset held by residents than for an abrupt reduction in gross capital inflows? Arguably the results underscore the importance of international liquidity assistance via an international lender of last resort particularly during Sudden Stops in inflows.3 Given continued financial globalisation, how developing and advanced economies can protect themselves against such episodes at minimum cost remains a critical topic for research and policy analysis.
Editor’s note: The opinions expressed in this publication are those of the authors and do not necessarily reflect the views of the Inter-American Development Bank, its Board of Directors, or the countries they represent.
Arozamena, L, and A Powell (2003), “Liquidity Protection versus Moral Hazard: The Role of the IMF”, Journal of International Money and Finance 22(7), 1041-1063.
Bruno, V, and H Shin (2012a), “Capital Flows, Cross-Border Banking and Global Liquidity”, NBER Working Paper 19038, Cambridge, United States, National Bureau of Economic Research.
Bruno, V, and H Shin (2012b), “Capital Flows and the Risk-Taking Channel of Monetary Policy.” Basel, Switzerland: Bank for International Settlements, Monetary and Economic Department.
Calvo, G (2005), Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy?, Cambridge, United States, MIT Press.
Calvo, G, A Izquierdo and L F Mejía (2004), “On the Empirics of Sudden Stops: The Relevance of Balance-Sheet Effects”, NBER Working Paper 10520, Cambridge, United States, National Bureau of Economic Research.
Cavallo, EA, Pedemonte, M, Powell, A and Tavella, Pilar (2013), “A New Taxonomy of Sudden Stops: Which Sudden Stops Should Countries Be Most Concerned About?”, Inter-American Development Bank, working paper, August.
Committee on International Economic Policy and Reform (2012), “Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses”.
Cuddington, J (1986), Capital Flight: Estimates, Issues, and Explanations, Princeton Studies in International Finance, Princeton, United States, Princeton University, Department of Economics, International Finance Section.
Dooley, M (1986), “Country-Specific Risk Premiums, Capital Flight, and Net Investment Income Payments in Selected Developing Countries”, Washington, DC, United States, International Monetary Fund. unpublished manuscript.
Forbes, K, and F Warnock (2012), “Capital Flow Wages: Surges, Stops, Flight and Retrenchment”, Journal of International Economics 88(2), 235-251.
Fischer, S (1999), “On the Need for an International Lender of Last Resort”, Journal of Economic Perspectives 13(4), 85-104.
Shin, HS (2012), “Global Banking Glut and Loan Risk Premium”, IMF Economic Review 60(2), 155-192.
1 In the 1980s a set of papers considered the phenomenon of capital flight –understood as the gross outflows of residents abroad—as a response to the debt crisis in LAC and other problems in developing countries. See, for example Cuddington (1986) and Dooley (1986).
2 We use the World Bank’s standard classification to group countries into advanced and developing.
3 On the need for an international lender of last resort see Fischer (1999), Arozamena and Powell (2003) and Calvo (2005).