Sudden Stops
What happens when foreign investors pull their money from emerging economies?
By: Dan Rasmussen with Nick Sertl and Jeremiah Kim
Emerging economies not only rely on developed economies to purchase their exports but also to provide debt and equity capital. But foreign investors can be fickle, and changes in global financial conditions—or domestic politics in the emerging economy—can cause foreign investors to pull their money and stop investing. Academics call this a “sudden stop.”
The classic example of a sudden stop is Mexico’s “Tequila Crisis.” Foreign investment fueled an economic boom in Mexico in the early 1990s, with strong GDP growth funded by a 7% current account deficit and strong credit growth. But a violent uprising in Chiapas and the assassination of a presidential candidate in 1995 scared US investors. The sudden withdrawal of funds caused a 37% drop in the currency, a GDP decline of 10%, and an unemployment increase of 3%. Equities would take 10 years to recover in USD terms.
Berkeley professor Barry Eichengreen is the leading scholar on these types of balance-of-payments crises. In a 2016 paper, he performed a comprehensive study of 44 crises across 30 different countries, defining a crisis as an episode when capital inflows from nonresidents decline more than two standard deviations below the average.
Eichengreen finds that there are four major factors that predict the likelihood of a sudden stop: an elevated reading on the CBOE Volatility Index (VIX), high US interest rates, high capital inflows relative to GDP, and high domestic credit relative to GDP as shown in the regression below.
Figure 1: Correlates of Sudden Stops (Probit Model, Marginal Effects, 1991–2014)
Source: Eichengreen
Eichengreen finds that global macro conditions are strongly predictive of sudden stops. In regression two, an increase of one standard deviation in the VIX (log transformed) results in a 1.21% increase in the probability of a sudden stop. Today, we see the Fed raising interest rates in the US, as well as an elevated reading on the VIX. Using Eichengreen’s model, we estimate that this increases the probability of an emerging economy experiencing a sudden stop in the next quarter from 1.2% to 2.35%.
Figure 2: Probability of a Sudden Stop
Source: Eichengreen model, Verdad Estimates
Country-specific characteristics such as large capital inflows and expansion of domestic credit both increase the probability of a sudden stop. An increase in capital inflows/GDP by one standard deviation results in an increased probability of crisis of 52bps. For domestic credit, the corresponding figure is 29bps. Below, we show the 10 emerging markets that are most vulnerable to a sudden stop. South Korea screens as the most vulnerable country, due primarily to high levels of domestic credit (165% of GDP) as well as capital inflows measuring 5.7% of GDP. We estimate the probability of South Korea experiencing a crisis in the next quarter as 3.55%.
Figure 3: Countries at Risk of a Sudden Stop
Source: World Bank, IMF, Verdad
Eichengreen also studied how policymakers have responded to balance-of-payments crises. He found that the typical response is to tighten fiscal policy while loosening monetary policy. Governments tend to reduce spending because they no longer have access to foreign capital to finance budget deficits. At the same time, central banks tend to cut rates in order to support economic activity since the typical decline in GDP during a crisis is 4%.
Central banks are also likely to intervene in currency markets. The German economist, and former head of International Policy Analysis at the European Central Bank, Marcel Fratzscher published a comprehensive study in 2019 of intervention data from 33 central banks spanning 16 years. Fratzscher looked at two different types of currency intervention: intervention to maintain an exchange band and intervention following an adverse event or change in monetary policy. He found that countries that want to maintain their exchange rate within a “narrow band” are successful around 80% of the time at both smoothing and stabilizing their currency. But following an adverse event or change in monetary policy, moving the exchange rate in the opposite direction is significantly harder than smoothing volatility for a free-floating regime, resulting in a baseline success rate of only 60%.
We seem to have entered a regime of higher exchange rate volatility, and we will continue to study the ways in which we can understand and predict these markets.
Acknowledgments: This piece was co-authored by Nick Sertl. Nick previously worked on the investment team at Harvard Management Company for four years. While currently consulting for Verdad, Nick is pursuing a full-time position in public equities investing. Jeremiah Kim also contributed to this email. Jeremiah is a a senior at Harvard studying math and government. He will be working at Greenhill during summer 2023 and intends to work in banking after college. He is interested in philosophy, politics, and economics, and is considering eventually pursuing an MBA or Ph.D.