Policymakers in emerging economies have long suffered sudden stops, those paralyzing episodes in which foreign credit dries up. Such episodes can cause painful domestic adjustments that exact significant losses in GDP.
But not all sudden stops are equal, and they do not all inflict the same amount of pain. Take the case of Latin America. During the Tequila Crisis, when foreign lending to the region decreased by around $30 billion, and the Russian and Asian crises, when it was cut by about $40 billion, the effects were severe. They ranged from recession and bank failures to widespread unemployment and debt defaults that gripped significant parts of the region. By contrast, when the 2008 crisis at Lehman Brothers unleashed a global financial crisis, some $110 billion in foreign lending fled Latin America. But the ensuing adjustments were less drastic. Why was this so?
As a recent study we conducted indicates, capital repatriation by Latin American investors helped offset the flight by foreign investors during the more recent global crisis. It shows that under the right conditions, local investors won’t be afraid to bring their money back from abroad to scoop up opportunities left behind by fleeing foreigners.
The concept of a sudden stop, as studied in depth by Guillermo Calvo and colleagues, refers to an abrupt reversal in net capital flows to countries that are borrowing from the rest of the world to finance an excess of domestic consumption compared to production (i.e., to finance a current account deficit). Countries that suffer a sudden stop have to adjust in order to eliminate any outstanding current account deficit promptly. This is usually a very tortuous thing to do for any country in a short period of time, especially when there are other factors in the mix, like high levels of dollar-denominated debts in the public and/or private sectors.
Although much of the initial research argued that sudden stops started with a trigger from abroad that was amplified by domestic conditions, there was no specific data on the behavior of foreigners. The only available data was on net capital flows, including transactions from both foreigners and locals.
More recently, as data became available, the concept of sudden stops has been refined to distinguish between the roles of foreign and local investors in determining what happens to net capital flows. Net capital flows are the difference between gross inflows (which is the net lending provided by foreigners) and gross outflows (which is local investors purchasing net foreign assets). When gross inflows exceed gross outflows, net capital flows are positive. That means that adding all transactions up, the country is borrowing on net from the rest of the word (i.e., it is running a current account deficit). By contrast, when gross outflows exceed gross inflows, the country is on net lending resources to the rest of the world (i.e., it is running a current account surplus). This distinction matters, because different behavior by foreign and local investors can affect outcomes leading to different types of sudden stops.
Think of foreign investors as those driving gross inflows, while local investors control gross outflows. There may be situations, for example, when foreign investors stop lending (i.e., a sudden stop in gross inflows) but local investors simultaneously decide to repatriate foreign assets, thus offsetting the effects of the sudden stop in gross inflows. In other situations, the actions of foreign and local investors may reinforce each other.
In the case of Latin America, the Tequila and Asian/Russian financial crises were examples of the latter: everybody was basically leaving at the same time, leading to substantial sudden stops in net capital flows and painful adjustments. During the global financial crisis of 2008, however, a substantial amount of capital repatriation by local investors mitigated the pullback from foreign investors, preventing to a large extent a more significant and painful adjustment in the region.
What determines the different outcomes? What are the antidotes to sudden stops that make locals step in and prevent a crisis initiated by foreigners? Identifying those elements is key. It makes up a significant part of our recent study, in which we look at the features that can turn a potentially devastating sudden stop initiated by foreigners into a more manageable situation (prevented sudden stop) in which net capital flows are not too adversely affected because of the offsetting actions of local investors.
A key departure point is the understanding that sudden stops in gross inflows often have little to do with decisions by local policymakers. A move by the U.S. Federal Reserve to raise interest rates, for example, can cause foreign investors to pull up stakes from emerging economies for better opportunities in the United States. Or fragilities in certain developing economies, like those of Russia and Asia in the late 1990s, can make investors wary of developing economies where they perceive, rightly or wrongly, similar problems. All these things are beyond the control of local authorities. What local authorities can do is prepare the terrain for a softer landing.
We find that in periods of global distress in capital markets, the ability of a country to build resilience against sudden stops in net capital flows relies heavily on the soundness of domestic conditions. We show that net sudden stops are more likely to be prevented in countries with a strong institutional background, and a credible inflation targeting regime that is accompanied consistently by a flexible exchange rate regime. In contrast, prevented sudden stops are less likely in countries with high levels of foreign-currency liabilities and with higher inflation.
Of course, other factors are important too. As explained in a recent blog, locals can more easily repatriate their assets when those assets are more liquid. Foreign Direct Investment, in which an investor purchases a company, for example, is more difficult to liquidate than bank loans. Portfolio investments (stocks and bonds) are more liquid still. When it comes to foreign assets, the ease with which they can be repatriated is key for their insurance value.
But one way or the other the ability and desire of locals to bring their money home and prevent a full-fledged sudden stop in net capital flows can make all the difference. It can prevent painful adjustments that can ripple through the economy and inflict deep pain. The crux of the matter is confidence. Locals may well be tempted to bring their money back when opportunities present themselves, but only if they have faith in local macroeconomic conditions.