What will happen to an emerging market or developing economy when all of a sudden foreign capital inflows (like foreign investment) into that economy stops as a result of an economic crisis? Immediately, its currency may undergo devaluation. In the coming months, as a result of reduction in investment (because of decline in foreign investment), its GDP growth may decline.
All these possibilities are explained in the sudden stop hypothesis. It says that when a developing economy which is used to live with foreign capital comes to a standstill when foreign capital stops quickly.
Sudden stop describes a swift reversal of international capital flows; either a stopping of capital inflows or sharp capital outflows. The sudden stop problem is characteristic to emerging market economies that tends to depend on capital inflows. The problem is severe in countries which accept hot money or short term private capital which is quickly mobile. A major feature of sudden stop is that the capital outflows are followed by currency crisis (steep depreciation of the currency), fall in investment, output, employment and economic growth in the host countries. Sudden stop tells the story of agony of small developing countries that are susceptible to capital flow reversals.
The phenomenon of sudden stop became a matter of attention after the Mexican crisis of 1994. In a research paper titled ‘Currency Crises and Collapses’ (1995) Rudiger Dornbusch and co-authors quoted that “It is not speed that kills, it is the sudden stop.” The Sudden stop indicates a situation where a developing country after conditioned by sizable capital inflows for a considerable time, is deprived of such funds all of a sudden. As a result, the overall economic activities like investment, production halts, leading to loss of economic momentum and steep fall in economic growth.