INTRODUCTION
The severe financial and economic crisis that hit Mexico after the devaluation of the peso in December 1994, and the unprecedented ‘Tequila effect’ by which Mexico's financial woes ‘infected’ emerging markets world-wide were a harbinger of a period of intense turbulence in international capital markets. Seven years later, in December 2001, a major crisis broke out in Argentina with an explosive combination of sovereign default, massive currency devaluation and collapse of economic activity. In the seven years separating the Mexican and Argentine crises, similar crises engulfed nearly all of the so-called ‘emerging markets,’ including Hong Kong, Korea, Indonesia, Malaysia, Thailand, Russia, Chile, Colombia, Ecuador, Brazil and Turkey. Interestingly, devaluation itself proved not to be a prerequisite for these crises, as the experiences of Argentina in 1995 and Hong Kong in 1997 showed. ‘Contagion effects’ similar to the ‘Tequila effect’ were also typical, as crises spread quickly to countries with no apparent economic linkages to countries in crisis. A favourite example is the correction in US equity prices in the autumn of 1998 triggered by the Russian default. The systemic nature of this correction forced the US Federal Reserve to lower interest rates and coordinate the orderly collapse of hedge fund Long Term Capital Management.
Emerging markets crises are characterised by a set of striking empirical regularities that Calvo (1998) labelled the ‘Sudden Stop’ phenomenon. These empirical regularities include: (a) a sudden loss of access to international capital markets reflected in a collapse of capital inflows, (b) a large reversal of the current account deficit, (c) collapses of domestic production and aggregate demand, and (d) sharp corrections in asset prices and in the prices of non-traded goods relative to traded goods. Figures 7.1–7.3 illustrate some of these stylised facts for Argentina, Korea, Mexico, Russia and Turkey. Figure 7.1 shows recent time series data for each country's current account as a share of GDP. Sudden Stops are displayed in these plots as sudden, large swings of the current account that in most cases exceeded five percentage points of GDP. Figure 7.2 shows data on consumption growth as an indicator of real economic activity. These plots show that Sudden Stops are associated with a collapse in the real sector of the economy.