Munich Personal RePEc Archive
The Simple Economics of Sudden Stops:Case of Pakistan
Muhammad, Ejaz
School of International Public Affairs, Columbia University
2017
Online at https://mpra.ub.uni-muenchen.de/91181/
MPRA Paper No. 91181, posted 03 Jan 2019 09:09 UTC
(25,000) (20,000) (15,000) (10,000) (5,000) - 5,000 10,000 15,000
FY80 FY82 FY84 FY86 FY88 FY90 FY92 FY94 FY96 FY98 FY00 FY02 FY04 FY06 FY08 FY10 FY12 FY14
Current Account Balances (Millions of USD)
Source: Handbook of Statistics on Pakistan Economy
Fig. 1 Current Account Balances Pakistan
Public Private
The simple economics of Sudden Stops1: Case of Pakistan
The national income can be accounted for by following identity: Y=C+I+NX where Y is the GDP, C refers to aggregate consumption in the economy, I refer to investment and NX is the difference between exports and imports. After some mathematical manipulation the equation can be reduced to NX=S-I in equation (3) below
Y=C+I+NX (1)
Replacing Y=C+S in equation (1) above the equation reduces to
C=Y-S (2)
NX=S-I (3)
Equation (3) shows that the current account can be expressed as a difference between domestic saving and investment. Fig. 1 shows the evolution of Pakistan’s current account using equation (3) for the years 1980-
2015. The balances have been calculated separately for public and private sector. Both public and private balances move in tandem.
Private current account has consistently remained in surplus. It briefly turned negative in FY10. On the contrary, the public balances have persistently remained in deficit.
Both balances converged in FY 2010
but thereafter the paths appear to have diverged. Excess public investments were equally offset by low private investment which is evident post FY10. The trend continued until 2014 when both balances appear to be converging again. What is noteworthy is heightened volatility post global financial crisis that began in 2007 and peaked in 2008.
This volatility in current account or trade balances naturally leads to difficulties in financing it.
It is thought that economies experiencing large current account deficits (CADs) are potentially exposed to ‘large and unexpected’ stops in the financing of the current account gap, or Sudden Stops (SS2) This implies a sudden discontinuity in the flow of international capital. (Izquierdo,
1Inspired by the title of (Calvo, Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops, 1998)
2The term Sudden Stop can be first traced to work by famous economist Dornbusch in his article on Currency Crises and Collapse in 1995, quoting the banker’s adage “it is not speed that kills, it is the Sudden Stop”. (Calvo,
-10000 -5000 0 5000 10000 15000
Jan-82 Oct-83 Jul-85 Apr-87 Jan-89 Oct-90 Jul-92 Apr-94 Jan-96 Oct-97 Jul-99 Apr-01 Jan-03 Oct-04 Jul-06 Apr-08 Jan-10 Oct-11 Jul-13
Fig. 3 External SS using Cavallo et al (2013)
External SS y-o-y change in capital flows
1 std. deviation Band 2 std. deviation Band
2013). The SS have been apparent following Tequilla crises in Mexico and Asian financial crises (occurred in nineties) which
eventually led to painful adjustments in the exchange rates of those countries.
As mentioned earlier, the term Sudden Stop was first introduced by eminent economist Dornbusch in the context of currency crises. (Calvo 1998) Subsequently, (Cavallo et al.
2015) used a comprehensive taxonomy of sudden stops to identify sudden stops that concern most.
They used an empirical strategy to define various sudden stops based on flows. Their strategy included two requirements, which needed to be satisfied for a Sudden Stop episode to occur.
First, the sudden stop signal which is defined as a fall in year-on-year (YoY) flows exceeding two standard deviations below the mean. (Calvo 2004) first proposed this algorithm. It shows Sudden Stop as an episode that begins when change in net external flows falls below one standard deviation of its historical mean (conditional that it subsequently falls below two
standard deviations below the mean) and ends when the series exceeds one standard deviation below the mean. Figure 2 shows this in a graphical form.
This note uses the above algorithm on quarterly series of Current Account flows of Pakistan obtained from IMF-IFS to identify any episodes of SS. Based on this data, the I have calculated net external sudden stop as defined by (Cavallo et. al., 2015.) These authors define net external sudden stop as summation of real exports, imports and changes in real reserves. The purpose here is to see if episodes of sudden stops coincide with exchange rate volatility and thus
Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops, 1998) later formalized this from a different perspective.
-15000 -10000 -5000 0 5000 10000 15000 20000
Mar-86 Oct-87 May-89 Jan-91 Aug-92 Mar-94 Oct-95 May-97 Jan-99 Aug-00 Mar-02 Oct-03 May-05 Jan-07 Aug-08 Mar-10 Oct-11 May-13
Fig. 4 Suddent Stops in Current Account
External SS y-o-y change in capital flows
1 std. deviation Band 2 std. deviation Band
0.000 1.000 2.000 3.000 4.000 5.000 6.000
Jan-80 Oct-81 Jul-83 Apr-85 Jan-87 Oct-88 Jul-90 Apr-92 Jan-94 Oct-95 Jul-97 Apr-99 Jan-01 Oct-02 Jul-04 Apr-06 Jan-08 Oct-09 Jul-11
Figure 5. Pakistan- Fear of Floating
External SS Exchange Rate Variability
prompting a fear of sharp depreciation and/or devaluation. Calvo (2004) term this fear as fear of floating. All the relevant variables have been adjusted for inflation.
Figure 3 shows episodes of external sudden stops. As expected, the sudden stops for Pakistan coincide with Asian financial crises of
1998-99 and great financial crisis, which saw large outflows from emerging markets. The episodes- occurring around 1998-99- can be attributed to capital controls imposed by the country following the events of May 28, 1998. Pakistan became nuclear power on that day which inflicted western economic sanctions on it resulting in lower investor confidence.
Compare this with the situation in Figure 4, which shows sudden stops based on real current account balances. The country experienced continuous episodes of SS around financial crisis of 2007-2009 thus inflicting a big deficit on external sector. The average monthly exchange rate on the eve of September 2007 (when the crisis is believed to have hit the US first) was standing at 60.63 PKR/USD. This parity deteriorated to 84 PKR/USD by December 2009 (when the crisis had appeased following a well
coordinated global monetary policy response. Nevertheless, a key finding is that episodes of SS are associated with deteriorating current account balances and exchanger rate volatility. This volatility can be seen in Figure 5. Clearly, heightened volatility in exchange rate appears to be associated with episodes of sudden stops indicating depreciation
pressures. (Calvo, 2004) concluded that openness3 of a capital account, coupled with domestic liability dollarization4 (DLD) were key determinants of the probability of Sudden Stops. He
3They use large supply of tradable goods that reduces leverage over the current account deficit as a proxy for openness.
termed this combination a dangerous cocktail. In the case of Pakistan, however, SS appear to have occurred due to openness and instead of domestic liability dollarization. This is evident from the fact that share of financing in dollar by domestic borrowers is significantly low compared to borrowing in domestic currency.
References
Calvo, G. A. (1998). Capital flows and capital-market crises: the simple economics of sudden stops.
Cavallo, E., Powell, A., Pedemonte, M., & Tavella, P. (2015). A new taxonomy of Sudden Stops: Which Sudden Stops should countries be most concerned about?. Journal of International Money and Finance, 51, 47-70.
Calvo, G. A., Izquierdo, A., & Mejia, L. F. (2004). On the empirics of sudden stops: the relevance of balance-sheet effects (No. w10520). National Bureau of Economic Research.
4 Liabilities of the private sector with the domestic banking system denominated in foreign currency. A large share of these liabilities relative to GDP is considered a source of vulnerability in the event of Sudden Stops in capital flows accompanied by large real exchange rate depreciation. (Izquierdo, 2013)
