Crises and Responses
CHAPTER 17
Reinert/Windows on the World Economy, 2005
Introduction




Objective indicators to understand the likelihood of many
(but not all) crises
Possibility of balance of payments crises under fixed
exchange rate systems
 “Old-fashioned” crises
 “High-tech” crises
IMF’s response to crises
Proposals for changing the current “non-system” of
international financial arrangements
 Exchange rate target zones
 Capital controls
 Tobin tax
 Currency boards
Reinert/Windows on the World Economy, 2005
2
Figure 17.1. A Balance of
Payments Crisis
Reinert/Windows on the World Economy, 2005
3
“Old-Fashioned” Balance of
Payments Crises


Have their roots in over-valued, fixed exchange
rates and large current-account deficits
Suppose that Mexico is successful in implementing
an equilibrium exchange rate at e0
 Requires that the expected future exchange rate must

equal the equilibrium rate
• ee = e 0
In turn, requires that the interest rate on the peso must
equal the interest rate on the dollar
• rM = rUS
Reinert/Windows on the World Economy, 2005
4
“Old-Fashioned” Balance of
Payments Crises

Suppose that we find Mexico in a position of a
current account deficit
 Current account deficit is always financed by a capital

account surplus
When a large trade deficit is financed by an inflow of
short-term capital problems will soon develop
• The denomination in dollars exacerbates the problem

Any fall in the value of the home currency inflates the domestic
currency value of the debt
 Many domestic investors were aware of these problems
• Began to sell pesos during 1994
Reinert/Windows on the World Economy, 2005
5
“Old-Fashioned” Balance of
Payments Crises

If a Mexican investor feels that the Mexican
government will have to devalue the peso in order
to suppress the trade deficit, then you think ee > e0
 If rM = rUS and ee > e0 then
e  e
r
 r 
e
M

Expected total return on
peso - denominate d assets
US
e



Expected total return on
dollar - denominate d assets
• You will buy dollars and sell pesos—known as capital flight

Change in expectations shifts the demand for
pesos graph to the left
Reinert/Windows on the World Economy, 2005
6
“Old-Fashioned” Balance of
Payments Crises

In response to such changes, in December
1994, the Mexican government devalued the
peso by 15 percent
 Proved to be too little and fueled speculation of
further devaluations
• Demand for pesos graph in Figure 17.1 shifted further
•
•
to the left
Mexico was forced to let the peso float
In February 1995, international investors began a
sudden and massive portfolio shift out of pesodenominated assets, sending the peso into a deep fall
Reinert/Windows on the World Economy, 2005
7
Figure 17.2. An “Old-Fashioned”
Balance of Payments Crisis
Reinert/Windows on the World Economy, 2005
8
Figure 17.3. A “High-Tech” Balance
of Payments Crisis
Reinert/Windows on the World Economy, 2005
9
“High-Tech” Crises



Typically include some elements of the balance of payments
crises but also include some less-concrete factors that are
often difficult to predict
Combine current account deficits with weak financial sectors
(especially in the banking system) and/or inappropriate
capital account liberalization
By September 1999, Asian crisis had spread to Malaysia
and Indonesia
 Indonesian case was somewhat of a surprise
• Current account deficit was less than 4 percent of GDP

Crisis spread to the Philippines, Hong Kong, South Korea,
and Taiwan.
 Only the Hong Kong dollar escaped devaluation
Reinert/Windows on the World Economy, 2005
10
“High-Tech” Crises

“High-tech” features of the Asian financial crisis
 Financial firms in the region had significant exposures in real estate
and equities
• Both of these markets began to deflate prior to the crisis
 Capital accounts had been liberalized
• Allow firms to take on short-term foreign debt, including debt
denominated in foreign currencies
 In general banks were poorly regulated and supervised
• Were a crucial component of government industrial policies

In some instances, supported systems of “crony” or “access” capitalism,
rather than sound investment policies
 Due to previous confidence in fixed exchange rates, firms were not in
the practice of hedging their foreign exchange exposures

Loss of confidence in the financial sectors of the countries
involved was a central part of the evolution of the crisis
 Banking sector was often the main culprit
Reinert/Windows on the World Economy, 2005
11
The IMF Response

The IMF response to the Asian and Brazilian crises can be
characterized as consisting of
 Interest rate increases
• Tend to increase the equilibrium value of a country’s currency
• Also tend to suppress domestic investment and push debt-burdened
firms (including banks) into default

Some prominent economists consider the interest rates increases a big
mistake
 Fiscal austerity
• Strategies to increase SG
• Strategy was probably misguided both economically and politically
 Structural reforms
• Economic policy changes outside the fiscal and monetary realms
• For example, the IMF required Indonesia to close 16 banks and
dismantle monopolies

Bank closures appear to have exacerbated depositor runs on other banks
Reinert/Windows on the World Economy, 2005
12
The IMF Response


IMF stood by its policies and claimed that they
contributed to the recovery of the countries involved
Called for greater accuracy and timeliness of
published data
 Especially in the areas of currency reserves, government

finances, and banking
By providing international investors with better
information, exchange rates will better track the
fundamentals of the economies involved
• Hard to see that the crises could have been averted simply
through the greater availability of economic data
Reinert/Windows on the World Economy, 2005
13
Exchange Rate Target Zones

Why do countries adopt fixed exchange rate
regimes?
 Flexible exchange rate regimes are often volatile
• Countries do not want to undergo the large changes in
the home-currency prices of trade goods that come
with these excessive exchange rate changes

Some international economists propose to
combine the benefits of both fixed and
floating exchange rate arrangements through
use of exchange rate target zones
Reinert/Windows on the World Economy, 2005
14
Exchange Rate Target Zones

Williamson’s plan suggests the center of the target zone to
be a fundamental equilibrium exchange rate (FEER)
 Could be established by the IMF
 Can consider the FEER to be the purchasing power parity (PPP) rate
• Nominal exchange rate need not equal the real exchange rate and,
•
therefore, the FEER
Williamson terms “misalignments” situations in which e ≠ re = FEER

Can occur as a result of countries’ monetary policies
 Around the FEER, Williamson advocates the use of a broad
exchange rate band, on the order of 10 percent
• Over time, the FEER changes with movements in relative price levels
 Central rate moves slowly over time, and the exchange rate band
moves with it
 Proposes frequent (monthly) realignments of the nominal rate in
situations of misalignment
Reinert/Windows on the World Economy, 2005
15
Exchange Rate Target Zones

Does this proposal make sense?
 Key question is whether the zones will be
credible in practice
• Zones as large as +/-12 percent (and in one case +/30 percent) failed to stem crises in the European
Monetary System
Reinert/Windows on the World Economy, 2005
16
Figure 17.4. An Exchange Rate
Target Zone
Reinert/Windows on the World Economy, 2005
17
Capital Controls

In September 1997, a committee of the IMF made a
recommendation to the Fund’s Executive Board
 IMF take on as an explicit policy the full convertibility of the capital
accounts of all its members
 IMF’s Deputy Managing Director, Stanley Fischer, argued in support
of capital account liberalization

A number of prominent international economists began to
argue against the proposal
 Questioned the goal of capital account liberalization and called for
capital controls of one kind or another
 Excessive borrowing within the short-term portfolio component of the
capital account contributed to Mexican and Asian crises
 Financial capital is prone to panics and manias
 Suggested that controls on the capital account do not appear to
adversely affect the growth and development of countries with the
controls
Reinert/Windows on the World Economy, 2005
18
Capital Controls

What is one to make of this disagreement?
 Must understand that there are different types of capital
controls
• Strict licensing systems such as that in China

Requires a license to convert the yuan into foreign currency

Requires that investments made in its country must be for a
minimum of one year
Requires that 30 percent of the investment must be deposited with
the central bank for that year
• Tax systems such as that used by Chile

 Must understand that different policies can be designed

for different components of the capital account
Capital account liberalization is not an all-or-nothing
proposition
• Should be phased in gradually over time
 Allows investors and
Reinert/Windows on the World Economy, 2005
domestic policy-makers time to adjust
19
Tobin Tax

In 1978, James Tobin proposed that foreign exchange
transactions should be taxed to promote exchange rate stability
 Tax should be set at a very low level—perhaps 0.1 to 0.5 percent
• For an investor moving into long-term assets, this would be negligible
• For an investor moving into and out of assets on a daily basis, it would
•
be significant
To keep a country’s foreign exchange markets from moving to another
country once the tax was imposed, the tax would have to be universal
and uniform

Proponents of the Tobin tax argue that it would

Opponents of the Tobin tax question its feasibility
 Reduce the volatility of flexible exchange rates
 Be easy to administer
 Financial markets are known for finding clever ways to avoid
regulations

At present the Tobin tax remains unused but is frequently
discussed
Reinert/Windows on the World Economy, 2005
20
Currency Boards


Fixed exchange rate regime in which the fixed rate has legal
backing in domestic legislation
Central bank serving as the currency board fully backs up
base money (cash and commercial bank reserves) with
foreign reserves
 In 1999, eight countries utilized currency boards
• For example Argentina introduced a currency board to help stabilize the
country’s economy after a period of hyperinflation


Effective ways to establish sound currencies and to limit
excessive money creation that can fuel inflation
Unclear as to how useful currency boards are in the long run
or if they work effectively for large countries
 Too inflexible for long-term growth and stability
Reinert/Windows on the World Economy, 2005
21