This graph is an extract from a term paper written by three co-authors and I for Professor Guillermo Calvo. We adapted Calvo’s own ‘Sudden Stop’ framework, and applied it to peripheral Europe.
Because the GIIPS are members of a monetary union, they experience some, but not all, of the effects typically associated with ‘Sudden Stops’. There is a large, if slower, adjustment in the Current Account as the capital needed to finance it dries up. Being members of monetary union, lacking monetary policy autonomy, inflation does not soar on the back of a currency devaluation, while the Real Exchange Rate adjustment – through ‘internal devaluation’ is consequently slower.
The flipside of monetary union is that official funding and fiscal stimulus mitigate the fall in capital inflows, slowing the Current Account adjustment. To isolate the fall in private sector inflows, we start with the following identity:
CA = Budget Balance + Private Sector Balance
We solved for the Private Sector Balance to identify the movement of private capital:
Private Sector Balance = CA – Budget Balance
Which can be expressed as:
(SP – IP) = CA – (SG – IG)
The bar graph represents the annual average private sector balance (in millions of euro), while the red and green lines represent two and one standard deviations in quarterly private sector balances.
A Sudden Stop episode is identified when inflows fall below the two standard deviation threshold (i.e. when the blue bar moves above the red line). Once identified, SS is deemed to have started in the quarter when inflows last crossed the one standard deviation threshold (i.e. the last time the blue bar moves above the green line before it falls below the red line). The end-date for the SS is marked when inflows re-cross the one standard deviation threshold (i.e. when the blue bar next falls below the green line).
Of the GIIPS, we found that Ireland was the first to experience a Sudden Stop – as early as Q1 2008 – after the financial crisis struck, and suffered the longest SS, 13 quarters until Q1 2011. We observe that, while private outflows temporarily abated in 2009 (although still experiencing a sudden stop), they regained force when the Greek program was agreed in the second quarter of 2010.
As Dornbusch & Werner (1994) pointed out: “It’s not the speed that kills you, it’s the Sudden Stop.” Capital flows do not necessarily have to reverse – i.e. turn negative – to precipitate a wrenching Current Account adjustment: a sharp slowdown can be enough. In Ireland’s case, however, there is evidence of significant flight of private capital from early 2008 onwards. Portugal was the only one of the GIIPS to escape negative private capital flows over the period under study. It experienced a Sudden Stop, and private capital inflows dried up completely, but they did not turn negative.
Dornbusch, Rüdiger and Werner, Alejandro; 1994; Brookings Papers on Economic Activity; “Mexico: Stabilization, Reform and No Growth”; http://www.jstor.org/stable/10.2307/2534633