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On the Empirics of Sudden Stops: The Relevance of
Balance Sheet Effects. The case of 12 Emerging Central
and Eastern European Economies.
Student: Valeria Birău
Coordinator: Professor Moisă Altăr, PhD
Bucharest
-July 2009-
Summary
 Introduction
 Alternative explanations to the phenomenon
 Literature review
 Adopted view
 The model
 Results and interpretation of results
 Conclusions and directions for further research
Abstract
Inspired by the study of Guillermo A. Calvo, Alejandro Izquierdo
and Luis-Fernando Mejia (2004), this study aims to look into the
empirical characteristics of Sudden Stops in capital flows and
the relevance of Balance Sheet effects in the occurrence of
Sudden Stop episodes for 12 developing economies from Central
and Eastern Europe.
I look into the fact if the variables of “openness” (understood as a
the level of financing from abroad of the absorption of tradables)
and DLD (Domestic Liability Dollarization, meaning foreign
exchange denominated domestic liability) appear as key
determinants of the probability of a Sudden Stop for the Central
and Eastern European developing economies. The result
obtained here is similar to the one in Calvo (2004), the variables
of openness and DLD having a significant role in determining
the probability of a Sudden Stop .
Introduction
The last 19 years have been full of turmoil from the economic and
financial point of view. Considering the number of financial crises that
have taken place and the unfolding of the current financial crisis that
began in 2007, I considered the phenomenon of Sudden Stop an
important issue, especially in emergent and developing economies.
Looking into recent developments in Romania: falling output and
exports, reduction in capital inflows , Current Account adjustment,
depreciating Leu against the Euro (which due to high portion of
domestic credit denomination in foreign currency makes it more
expensive for consumers and companies to service their loans) , which
materialized in the fact that Romania’s government had to turn to the
IMF for a 24-month Stand-By Arrangement of EUR 12.95 billion. The
unfolding of the above phenomena are related to a sharp decrease in
access to foreign capital. I’ve noticed the above mentioned elements in
Calvo’s description of phenomena that accompany a Sudden Stop in
Capital Flows and have turned to his work to understand factors that
might affect the probability of such an episode occurring.
The study of Guillermo A. Calvo, Alejandro Izquierdo and Luis-Fernando Mejia
(2004) defines Sudden Stops as a sharp fall in capital inflow relative to their
past trajectory. Although the initial shock is considered exogenous, the
dimension of materialization of a Sudden Stop depends on domestic financial
vulnerabilities.
Episodes of Sudden Stops (large decreases in external capital inflows) are
accompanied by the following phenomena:
 Large Real Exchange Rate fluctuations of the local currency, large depreciations
being a common event, especially in developing and emergent economies (due
to adjustments in the absorption of tradable goods )
 “bunching”- the contagion phenomenon from one economy to the others
derived from financial market imperfections
 Output contractions
 Current Account adjustments
 Decrease in International Reserves
Calvo (1999) argues that many of the recent crises were originated by credit shocks
in international markets and as a result, he comes upon the conclusion that
measures of crises ought to be more closely connected to large and unexpected
capital account movements rather than to measures that focus on large
nominal currency fluctuations or current account reversals.
Alternative explanations:
In an attempt to explain the causes of financial crises in
Emergent Countries, the following views have been
pursued:
 “Lack of fiscal discipline”- high fiscal deficits lead to an
unsustainable level of public debt, leading to a certain
moment when due to the high level of debt the lenders
refuse to grant more funds
 This theory may prove sufficient in the case of 1980s Latin
American Debt Crisis it does not find support in Asia,
especially under the conditions of the 1997 Asian crisis, where
most countries run a fiscal deficit considerably lower
compared to the ones from Latin American countries in 1994
or developed countries (Japan).
 Fiscal View cannot explain the “bunching” phenomenon
Alternative explanations:
 Soft pegs view - affirms that countries that use soft pegs, when hit by a currency
crisis, were reluctant to abandon unsustainable exchange rates in a timely
manner and only did so only after they were hit by a balance-of-payments
crisis.
 At some level, the statement is right because if the exchange rate was allowed to
float freely, some of the international reserve loss would have been prevented.
However, even at this level of abstraction, the analysis is seriously incomplete. It
misses a key point, namely, that in many crisis episodes, either the government
or the private sector, or both, had relatively large foreign-exchange denominated
short-term debt obligations, which exceeded by far the stock of international
reserves. It could be argued that liability dollarization is partly a result of
pegging, magnified by the overconfidence and moral hazard problems that
pegging may bring about.
 The Soft peg view doesn’t hold up under the criticism of the phenomenon of
“bunching” and does not offer an explanation for real meltdown (collapse in
output) for example.
Alternative explanations:
 Transitory or non-credible policy models
 As shown in Calvo (1998) some models would be able to
rationalize a large cut in capital inflows due to
unexpected changes in policies.
 The phenomenon of bunching displayed by Sudden
Stop crises shows that it is quite improbable for several
countries to suffer sudden policy reversals at the same
time due to the fact that the policies would become
unsustainable at the same time.
Adopted View:
 Following the view spelled out in Calvo, Izquierdo and Mejia (2004) I look into the
importance of shocks to the Current Account that materialize in large changes in the Real
Exchange Rate (the relative price of tradables with respect to non-tradables).
 By national accounting, and abstracting from errors and omissions, capital inflows equal
current account deficit plus accumulation of international reserves. Therefore, SS has to
be met by reserve losses or lower current account deficits. In practice, both take place. A
sudden contraction in the current account deficit is likely to lead to a sharp decline in
aggregate demand. The decline in demand, in turn, lowers the demand for tradables and
nontradables. The excess supply of tradables thus created can be shipped abroad, but the
nontradables are, by definition, bottled up at home and, thus, its relative price will have
to fall (resulting in a real depreciation of the currency).
 The importance of RER fluctuations that take place in an EM derive from the amount of
Domestic Liability Dollarization.
 A real currency depreciation materialized in a significant rise in RER makes it more
difficult to repay loans for firms producing non-tradable goods.
 The dimension of the effect depends on the size of the RER fluctuation, the
stock of foreign exchange denominated loans and the ability of firms to switch
in the short run the production of non-tradables into tradables along their
possibilities frontier.
 May trigger substantial uncertainty about the solvency of the banking system
as loans become non-performing, sometimes leading to bank runs and
expectations of bank bankruptcies.
Literature Review:
 Calvo (1999) argues that many of the recent crises were originated by credit
shocks in international markets and as a result of that, he comes upon the
conclusion that measures of crises ought to be more closely connected to large
and unexpected capital account movements rather than to measures that focus
on large nominal currency fluctuations or current account reversals.
 Edwards (2003) looks into the consequences of dollarization and Sudden Stops
on relevant variables such as economic growth and determines that, although
Sudden Stops and Current Account reversals are connected, it is the latter that
causes the drop in output.
 Chari, Kehoe and McGrattan (2005) in a small open economy business model
(standard equilibrium model) in which foreign borrowing is subject to a
collateral constraint sudden stops do not translate into drops in output. Other
factors that overpower the effect of the Sudden Stop need to be considered.
 Edwards (2001) finds that under some definitions of currency crisis, currency
account deficits are a significant determinant of the probability of experiencing
currency crises.
Model:
 The strategy taken here focuses on the valuation effects of domestic
dollarized liabilities (liabilities in terms of tradable goods), so the
interest lies in the real exchange rate fluctuations. Regarding the
Current Account, the focus does not fall on the current account itself,
but rather on the percentage fall of the absorption of tradable goods,
which, as will arise from the model we define later, represents a
summary statistic for the rise in RER following a Sudden Stop.
 I will endogenize RER using a separable intertemporal utility function,
which is also iso-elastic in its arguments in order to show how the
modification in capital flows will affect the real exchange rate.
 Intuitively: a Sudden Stop, being a sizable cut in credit, will cause a fall
in aggregate demand and, consequently, a possibly large increase in the
RER.
 Assume that the demand function for nontradables is:
 where h = log H – logarithm of demand for
nontradable goods,
 z = log Z – logarithm of demand for tradable goods,
 rer = log RER and α, β and δ are parameters.
 The Current Account Deficit (CAD) , in terms
financing of absorption of tradables is:
 Y is the output of tradables and S are factor payments,
remittances, Z being as previously defined the demand
for tradable goods.
 A Sudden Stop will now be considered. The typical situation, is that
prior to a Sudden Stop a country’s Current Account deficit is positive,
starting to decline as the Sudden Stop episode starts to unfold,
approaching zero value or at times even run into positive territory, as
documented for EMs by Calvo (2003).
 given Y and Z:
 By taking first differences in equation (1) and approximating the
relative change in Z by the first difference in logs,
 and assuming that the supply of non-tradables is constant,
 becomes
From relationships (5) and (8):
 The relative change in the Real Exchange Rate is proportional to
the prevailing Current Account Deficit prior to the Sudden Stop
episode taking place, relative to the absorption of tradable goods.
This equation models the part of the change in RER that is likely
to be very difficult to prevent once a Sudden Stop occurs and is
not intended to model the actual change in the actual Real
Exchange Rate.
Sudden Stop: the contagion
effect
 In a situation in which shocks spread from one country to other regions due to
rules in the capital market transactions (margin calls) these may not be related
at all to the countries’ fundamentals. Let’s assume an investor with a diversified
portfolio in certain assets from multiple countries. In Calvo (1999) it is justified
how a liquidity shock to informed investors (say due to a margin call as a result
of the fall of price of assets in a particular country) can result in the sale of
assets from a different country in order to restore liquidity. Encountered with
the phenomenon, a set of uninformed investors faced with a signal-extraction
problem interpret the sale as motivated by anticipated lower returns and
decide to short their assets as well, even though the initial sale of the informed
investors had nothing to do with lower returns but were caused by margin calls.
When this occurs, a country that has few ties to the country at the epicenter of
the crisis is exposed to a large and unexpected liquidity shock.
 Thus, a Sudden Stop episode can be defined as an exogenous initial shock.
 In order to determine Sudden Stop episodes is necessary a measure
that reflects large and unexpected falls in capital inflows that have
costly consequences in terms of disruptions in economic activity,
through the important impact on repayment capacity that leads to
such types of tumults.
Sudden Stops will be defined here as:
 A period that contains at least one observation where the year-on-year
fall in capital flows lies at least 2 standard deviations below its sample
mean (this is what is referred to as the “unexpected” requirement of the
Sudden Stop);
 The Sudden Stop episode ends once the annual change in capital flows
exceeds one standard deviation below its sample mean.
 The beginning of a Sudden Stop episode is determined by the first time
the annual change in capital flows falls one standard deviation below
the sample mean.
 Output contraction during the above mentioned phenomena
Bulgaria
Estonia
Lithuania
 The next question to be addressed is whether large RER depreciations precede
Sudden Stops or do Sudden Stops precede large RER depreciations, in the cases
in which large RER depreciations lie in the neighborhood of a Sudden Stop
(one year window preceding the Sudden Stop episode and one year after).
Analyzing the data available for the sample studied here does not offer a clearcut answer, 50% of the RER depreciations following the decrease of capital
inflows, although it is important to mention that some of the RER
depreciations start before the occurrence of the Sudden Stop episode and carry
out through-out the period. The same happened in the case of Calvo, Izquierdo
and Mejia (2004), where the authors were unable to make a clear decision on
whether Sudden Stops precede large RER fluctuations, in their case though,
61% of the depreciations episodes followed the decrease in capital flows.
 The dynamic of International Reserves in the neighborhood of a Sudden Stop is
significant due to the fact that some countries use the Reserves to smooth out the effect
of a Sudden Stop on the Current Account Deficit. This might prove to be a losing strategy
in the case of highly persistent Sudden Stop episodes; these might lead to the depletion
of the Reserves. Calvo, Izquierdo and Mejia (2004) show that many countries have
engaged in reserve loss strategies in order to avoid an abrupt Current Account
adjustment that might lead to the depreciation of the local currency, perhaps in the hope
that the Sudden Stop would be reversed. As discussed in Calvo (2003), in the occurrence
of a Sudden Stop episode, a Central Bank may have incentives to use its reserves in
crediting non-tradable corporate sectors via credit expansion (a strategy that requires
keeping a quasi-fixed exchange rate). As shown in Appendix Table 2 there is significant
loss in International Reserves prior to a Sudden Stop phase. The countries in the sample
saw an average loss of 16.32% in International Reserves in the period prior to the Sudden
Stop.
 Looking at the Current Account Balance Behavior, also illustrated in Appendix Table 2, it
can be noticed that Sudden Stops bring along Current Account adjustments. The
countries in the sample studied here incurred an average adjustment in Current Account
of 1.59% of GDP in the period preceding the Sudden Stop episode. In 40% of the cases
the countries suffered a Current Account reversal.
 In a world of heterogenous agents, though, full-fledged Sudden Stops could take place
even under Current Account surplus, because there could be key sectors that exhibit a
Current Account deficit while the rest of the economy exhibits an even larger surplus. In
Calvo, Izquierdo and Mejia (2008), 5% of the sample of countries included in the study
go through a Sudden Stop episode under a Current Account surplus the period prior to
the crisis.
 Returning to the model: the increase in RER depends on the
percentage fall in the absorption of tradable goods needed to close the
Current Account gap.
 It can be further inferred that the less leveraged the absorption of
tradable goods, the smaller will be the effect on the RER. In order to do
this CAD/Z can be written as follows:
 Higher values of 1-ω show that a country’s economy relies more on
financing from abroad for its tradables, making it more vulnerable to
RER depreciations that might result from the abrupt decrease of the
Current Account Deficit, the value of 1-ω being defined as openness.
 A Panel Probit model is used as a benchmark due to the
authors’ belief, which was later confirmed by results, that
large and unexpected capital flows have non-linear
effects.The Panel Probit model estimates the probability of
falling into a Sudden Stop episode as function of lagged
values of 1-ω and DLD and also controlling for time effects
by introducing yearly dummy variables.
 The DLD variable has been constructed by adding up bank
foreign deposits and bank foreign borrowing as a share of
GDP, as defined by the authors in the 2004 study.
 The variables used in the regression have been lagged in
order to avoid endogeneity issues.
 The estimation output shows that both the lagged openness variable and the
lagged DLD prove to be significant at the 5% level, highlighting the importance
of openness as an indicator of potential Sudden Stops, taken as a signal of the
potential change in relative prices that could materialize at the time of the
Sudden Stop. Collectively, all the coefficients are statistically significant, since
the value of the LR statistic is 28.16740 with a p-value of 0.000443. Although
the results obtained by Calvo, Izquierdo and Mejia (2004) are statistically
significant at the 1% level, taking into consideration the fact that the sample
size used here is significantly smaller and more diverse than the one used by
the above mentioned authors, the results are still important. We notice the
McFadden R-squared with the 0.276567 value, showing that openness and
Domestic Liability Dollarization have a significant role in explaining the
probability of occurrence of a Sudden Stop episode.
 Looking back on the results obtained by other authors and mentioned in the
Literature Review section of the study, we introduce some macroeconomic
variables and watch for the reaction of the model to them. The results obtained
confirm the importance of openness and DLD (statistical significance at the 5
percent and 10 percent respectively levels), the other variables not returning
statistically significant coefficients.
 The following regression output shows the inclusion of the Terms of Trade
dummy (which takes the value 1 in the case of a terms-of-trade increase and
zero in the case of a decrease) variable in the Panel Probit model. The terms-oftrade variable is included contemporaneously, due to the fact that an
improvement in a nation's terms of trade (the increase of the ratio) is good for
that country in the sense that it has to pay less for the products it imports and
it would influence the RER in the same period.
 It can be noticed that the p-value for TOT comes back as 0.7557, showing that
terms of trade evolution does not prove significant in determining the
probability of the occurrence of a Sudden Stop episode, although the sign of
the estimated coefficient shows the direction of the relationship, indicating
that falls in terms-of-trade growth increase the likelihood of a Sudden Stop
episode. Openness (1-ω) and DLD remain statistically significant at the 10%
level, though. Taking a look at the McFadden R-squared 0.265751 we notice that
the latter case has less explaining power than the previous one, and if we take a
look at the Akaike Information Criterion (0.686794 compared to 0.611195 in the
first regression) this model does not offer a better alternative than the previous
one. in the case of Calvo, Izquierdo and Mejia (2004), which use a sample of 32
countries, the TOT does not prove statistically significant either.
 When the share of Foreign Direct Investment to GDP is included in the
Panel Probit model (Table 5 summary of the Appendix Table 5), we can
state that openness (1-ω) and DLD remain statistically significant at the
10% level while the fluctuation of the Terms of Trade and Foreign
Direct Investment share to GDP do not prove to have statistical
significance in predicting the probability of a Sudden Stop episode
occurring. We notice that the McFadden R-squared 0.269057 has
decreased compared to the compared to the regression output that
includes only openness and Domestic Liability Dollarization, thus the
model does not have better explaining power that the first one.
 The Foreign Direct Investment share to GDP doesn’t prove statistically
significant either, with a p-value of 0.5775. The same conclusion
appeared in Calvo, Izquierdo and Mejia (2004), the authors
determining that the FDI share to GDP does not influence the
probability of the economy going through a Sudden Stop episode. Of
interest is the sign of the coefficient for FDI share to GDP, which
intuitively should be negative. A similar problem appeared in Calvo,
Izquierdo and Mejia (2008) where they are able to prove by including
a financial integration variable that depending on the level of financial
integration, the coefficient for FDI may be different for developing and
developed countries.
 Calvo, Izquierdo and Mejia (2004), looking on the
interaction between openness and Domestic Liability
Dollarization, find that the relationship between the two is
highly non-linear. They find that the effects of openness on
the probability of occurring a Sudden Stop crucially
depend on the degree of Domestic Liability Dollarization.
Low values of ω, which imply a high value of the Current
Account Deficit imply a higher probability of Sudden Stop,
but this is particularly so for dollarized economies.
 The high non-linearity described in the study shows that a
low level of ω (high leverage of financing from abroad for
the absorption of tradable goods) and a high Dollarization
level can be a very dangerous combination, thus potential
balance sheet effects are highly relevant in determining the
probability of a Sudden Stop.
Addressing endogeneity:
Conclusions:
 Large RER fluctuations are a phenomenon that accompanies Sudden Stop episodes in
Emergent and Developing economies.
 Sudden Stops appear in bunches and group countries that are different from several points of
view.
 Sudden Stops are accompanied by large current account adjustments, swings in RER and
reserve losses, suggesting that these phenomena are associated with shifts in the supply of the
capital flows.
 Openness, understood as a large supply of tradable goods relative to the absorption of tradable
goods together with Domestic Liability Dollarization has a significant effect on the probability
of a Sudden Stop.
Issues that need to be addressed:
 It might prove important to look into different exchange rate regimes, taking into account the
diversified nature of the sample of countries used here.
 The definition of Sudden Stop based on output contraction is probably not the best choice,
since there might be domestic factors that could lead to output decrease. Further research of
Calvo regarding Sudden Stop has focused on sudden stops that take place in conjunction with a
sharp rise in aggregate interest-rate spreads.
 It might be important to take a look and include in the sample certain restrictions regarding
transactions denominated in foreign exchange prior to Capital Account Liberalization.
 Monetary policies and sound institutions that might decrease a developing country’s
vulnerability from external capital flow shocks.
Michael D. Bordo: “What emerging countries
really need to do to protect themselves from
Sudden Stops and crises is to grow up and
become an advanced country”.
Thank you for your attention!
References:
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