Lecture 18: Crises in Emerging Markets
• Boom-bust cycles of inflows & outflows
• Crashes
Sudden stops
Managing capital outflows
Speculative attacks
• Contagion
• IMF Programs
ITF220 - Prof.J.Frankel
CYCLE in capital flows to emerging markets
Cycle
prophesied by
Joseph
in Egypt:
7 fat years
followed by
7 lean years.
ITF220 - Prof.J.Frankel
Cycle in capital flows to emerging markets
• 1st developing country lending boom
(“recycling petro dollars”): 1975-1981
– Ended in international debt crisis 1982
– Lean years (“Lost Decade”): 1982-1989
• 2nd lending boom (“emerging markets”): 1990-96
– Ended in East Asia crisis 1997
– Lean years: 1997-2003
• 3rd boom (incl. China & India this time): 2003-2008
– Ended in 2008 global financial crisis – at least for the moment.
– Crisis of the Euro periphery: 2010-12
– Will the end of QE hit EMs? 2013-14
ITF220 - Prof.J.Frankel
Alternative Ways of
Managing Capital
Outflows
A. Allow money to flow
out (can cause recession,
or even banking failures)
B. Sterilized intervention
(can be difficult, and only
prolongs the problems)
•
C. Allow currency to
depreciate (inflationary)
Y
D. Reimpose capital
controls (probably not
ITF220 - Prof.J.Frankel
very effective)
SPECULATIVE ATTACKS
The capital outflow is so great
that the central bank loses all its reserves.
Reasons for speculative attacks
3 generations of models:
*Expansionary macro policy
-- Krugman (1979)…
*Excessive speculation: “Multiple equilibria”-- Obstfeld(1994)…
*Domestic financial structure: moral hazard
(“crony capitalism”) -- Dooley (2000)…
ITF220 - Prof.J.Frankel
What’s the difference between a
speculative attack and a regular
balance of payments deficit?
• In Hemingway’s The Sun Also Rises,
a character is asked, "How did you go bankrupt?”
His response is "Gradually ... then suddenly."
ITF220 - Prof.J.Frankel
Traditional pattern:
Reserves gradually run down to zero,
at which point CB is forced to devalue.
ITF220 - Prof.J.Frankel
In 1990s crises, reserves seem to fall off a cliff.
Speculative attack
(See graph for Mexico, 1994.)
An irrational stampede?
Not necessarily.
Rational expectations theory says S can’t jump unless there is news;
at the date of the attack the remaining Res is (just barely) enough
to satisfy the increase in FX demand without a jump in the price S.
ITF220 - Prof.J.Frankel
Exhaustion of Mexico’s Reserves in 1994 Peso Crisis
35000.00
30000.00
25000.00
20000.00
IMF PROGRAM
15000.00
CRISIS
10000.00
5000.00
Level
3m Moving Avg
ITF220 - Prof.J.Frankel
1995M4
1995M3
1995M2
1995M1
1994M12
1994M11
1994M10
1994M9
1994M8
1994M7
1994M6
1994M5
1994M4
1994M3
1994M2
1994M1
1993M12
1993M11
1993M10
1993M9
1993M8
1993M7
1993M6
1993M5
1993M4
1993M3
1993M2
1993M1
1992M12
0.00
Data source: IMF International Financial Statistics.
CONTAGION
In August 1998, contagion from
the Russian devaluation/default jumped oceans.
Source: Mathew McBrady (2002)
ITF220 - Prof.J.Frankel
Categories/Causes of Contagion
• “Monsoonal effects” (Masson, 1999): Common external shocks
• E.g., US interest rates ↑,
• world recession, or
• $ commodity prices ↓ …
• “Spillover effects”
• Trade linkages
• Competitive devaluations
• Investment linkages
• Pure contagion
• Stampede
• Imperfect information (“cascades”)
• Investor perceptions regarding, e.g., Asian model or odds of bailouts
• Illiquidity in financial markets
or reduced risk tolerance
ITF220 - Prof.J.Frankel
THE CAR CRASH ANALOGY
Sudden stops:
“It’s not the speed that kills, it’s the sudden stops”
– Dornbusch
Superhighways:
Modern financial markets get you where you want to go fast,
but accidents are bigger, and so more care is required.
– Merton
ITF220 - Prof.J.Frankel
Is it the road or the driver? Even when many countries
have accidents in the same stretch of road (Stiglitz), their own
policies are also important determinants; it’s not determined
just by the system.
– Summers
Contagion is also a contributor to multi-car pile-ups.
ITF220 - Prof.J.Frankel
THE CAR CRASH ANALOGY
Moral hazard -- G7/IMF bailouts that reduce the impact of a given
crisis, in the LR undermine the incentive for investors and
borrowers to be careful. Like air bags and ambulances.
But to claim that moral hazard means we should abolish the IMF
would be like claiming that drivers would be safer with a spike in
the center of the steering wheel column.
– Mussa
Correlation does not imply causation: That the IMF (doctors)
are often found at the scene of fatal accidents (crises) does not
mean that they cause them.
ITF220 - Prof.J.Frankel
Reaction time: How the driver reacts in the short interval
between appearance of the hazard and the moment of
impact (speculative attack) influences the outcome.
Adjust, rather than procrastinating (by using up reserves
and switching to short-term $ debt) – J Frankel
Optimal sequence: A highway off-ramp should not dump
high-speed traffic into the center of a village before streets
are paved, intersections regulated, and pedestrians learn not
to walk in the streets. So a country with a primitive
domestic financial system should not necessarily be opened
to the full force of international capital flows before
domestic reforms & prudential regulation.
=> There may be a role for controls on capital inflow
(speed bumps and posted limits).
-- Masood Ahmed
ITF220 - Prof.J.Frankel
Major IMF Country-Programs
3 components
•
Country reforms
(macro policy & perhaps structural)
•
Financing from IMF
(& sometimes G-7, now G-20)
•
Private Sector Involvement
ITF220 - Prof.J.Frankel
Addendum 1: Critiques of the IMF
Critics say “The IMF made serious mistakes -- what better
evidence could one want than the severity of the 1997-2001
crises in emerging markets? -- and needs to be reformed.”
But in what specific direction do critics want the IMF to move?
Frankel’s Law: For every plausible and devastating-sounding
critique of the IMF, there exists an opposite critique that is equally
plausible and that sounds equally devastating.
Here, the most common pairs:
1. Need more exchange rate flexibility.
Reluctance to abandon currency targets & devalue in the face of balance
of payments deficits led to crises of 1994-2001.
2. Need more exchange rate stability, including institutional
commitments like currency boards or dollarization to restore monetary
credibility, rather than government manipulation of the exchange rate.
ITF220 - Prof.J.Frankel
Critiques of the IMF, cont.
3. Need more resources available for IMF emergency programs, bailouts,
debt forgiveness (HIPC), & new loans; there was no good reason based in
fundamentals for the Asians to suffer the sudden reversal of inflows.
4. The moral hazard problem is the ultimate source of the crises.
Investors & borrowers alike are reckless when they know they will be
bailed out by IMF & G7.
5. Need to adopt capital controls, to insulate countries from the vagaries
of international investors.
6. Need financial openness, so countries can take advantage of
international capital markets.
7. Need easier monetary & fiscal targets; IMF programs have too much
expenditure-reduction, inflicting needless recessions.
8. Need tighter macroeconomic discipline, since monetary & fiscal
profligacy is source of balance of payments problems; private investors
can’t be persuaded to keep their money in countries lacking sound policies.
ITF220 - Prof.J.Frankel
Critiques of the IMF, concl.
9. Need more customization of conditionality to individual country circumstances; Asia did not have the macro problems familiar from Latin America
10. Conditionality in cases like Indonesia got too far into local details (e.g.,
clove and plywood monopolies). Need standardized and strict rules-based
pre-certification in order for a country to qualify for IMF assistance.
11. Should concentrate loans among poor countries, rather than those that
are successfully developing and able to attract private capital.
Place more emphasis on poverty reduction in each country program
12. Need less subsidy in loans, higher interest rate charges, close to private
market rates. In any case, leave poverty reduction to World Bank.
13. US has disproportionate influence in the IMF.
14.“IMF is directed by European socialists.
US needs to exercise more influence” (US Congress).
ITF220 - Prof.J.Frankel
Addendum 2:
More on crisis in emerging markets
• Cycles of capital flows to developing countries
• Are big current account deficits dangerous?
• More on crises in the 1990s
– Causes of sudden stops
– The Korean pattern (1998) matched Mexico 3 years before
(1995)
– Magnitude of the loss in output in 1998.
• How did the 2003-08 boom differ from past cycles?
ITF220 - Prof.J.Frankel
Cycles of capital flows to developing countries:
1975-81 -- Recycling of petrodollars, via bank loans, to oil-importing LDCs
1982 -- Mexico unable to service its debt on schedule =>
Start of international debt crisis worldwide.
1982-89 -- The “lost decade” in Latin America
1990-96 -- New record capital flows to emerging markets globally
1994, Dec. -- Mexican peso crisis
1997, July -- Thailand forced to devalue and seek IMF assistance =>
beginning of East Asia crisis (Indonesia, Malaysia, Korea...)
1998, August -- Russia devalues & defaults on much of its debt.
=> Contagion to Brazil; LTCM crisis in US.
2001, Feb. -- Turkey abandons exchange rate target
2002, Jan. -- Argentina ends 10-yr “convertibility plan” (currency board)
2002-08 -- New capital flows into developing countries, incl. China, India...
ITF220 - Prof.J.Frankel
Are big current account deficits dangerous?
Neoclassical theory: if a country has low capital/labor ratio or transitory
negative shock, large CAD can be optimal.
In practice: Developing countries with big CADs often get into trouble.
Traditional rule of thumb: “CAD > approx. 4% GDP” is a danger signal
“Lawson Fallacy” -- CAD not dangerous if government budget is
balanced, so borrowing goes to finance private sector, rather than BD.
Amendment after Mexico crisis of 1994 –
CAD not dangerous if BD=0 and S is high,
so the borrowing goes to finance private I, rather than BD or C.
Amendment after East Asia crisis of 1997 –
CAD not dangerous if BD=0, S is high, and I is well-allocated, so the
borrowing goes to finance high-return I, rather than BD or C or empty
beach-front condos (Thailand) & unneeded steel companies (Korea).
Amendment after 2008 – Even countries with CA surpluses are vulnerable.
ITF220 - Prof.J.Frankel
Causes of Sudden Stops
Dec. 1994 – Jan. 2002
• Currency overvaluation (Mexico ’94; Thailand ’97; Argentina ’01)
• Big/procyclical fiscal deficits
(Russia ’98; Brazil ’99; Turkey ’01; Greece 2010)
• Delayed exit from exchange rate target, often due to elections
(Mexico ’94; Korea ’97; Brazil ’98)
• Deeper structural flaws, e.g., “crony capitalism” in East Asia
(Thailand ’97; Indonesia ’98; Korea ’97)
• Domestic political instability (Indonesia’98; Russia’98; Ukraine 2014)
• Moral hazard from earlier bailouts
(Allegedly East Asia ’97, and especially Russia ’98)
• Banking crises (Iceland 2008, Ireland 2008-10, Cyprus 2013…)
• Increase in US interest rates
(Intl.debt crisis 1982, Mexico, ‘94, “Fragile Five” 2013-14).
ITF220 - Prof.J.Frankel
How did the 2003-08 boom differ from past cycles?
• China and India were major recipients of private capital in flows.
• They & most others did not use inflows to finance CA deficits,
• but rather to pile up international reserves,
– most of which have traditionally been US treasury bills,
• Most middle-income countries no longer fix their exchange rate.
• Perhaps as a consequence, many borrowed less in $,
more in their own currency. More FDI.
•
• => less vulnerability to a sudden stop.
• In global crisis of 2008, some developing countries were
relatively “decoupled” from the shock
• The big exception was much of Central &Eastern Europe:
– Ex ante: Lots of borrowing, denominated in € (& even SF)
– Ex post: The worst-hit, in 2008
ITF220 - Prof.J.Frankel
Quantity test shows rising integration
IM
Capital flowed to Latin America
in the 1990s, and again 2004-11
3rd boom
2nd boom
(emerging markets)
sta
rt
IM
(carry trade &
BRICs)
start
Capital flowed to Asia
in the 1990s, and again 2003-11
stop
(Asia
2nd boom (emerging
markets)
sta
rt
IM
crisis)
3rd
boom
(carry trade
& BRICs)
start
Global investor interest in government debt
resumed for some Emerging Markets in 2010
Serkan Arslanalp & Takahiro Tsuda, The Trillion Dollar Question: Who Owns Emerging Market Government Debt, March 5, 2014, iMFdirect
Developing Countries Used Capital Inflows
to finance CA deficits in 1976-1982 & 1990-97;
1st boom
but
not
2003-07.
(recycling
petro-dollars)
3rd boom
stop
(international
debt crisis)
2nd
boom
(emerging markets)
stop
(Asia
crisis)
sta
rt
IMF
start
(carry trade &
BRICs)
FX Reserves in the BRICs, 2000-2011
Neil Bouhan & Paul Swartz, Council on Foreign Relations
Sovereign spreads were historically low in 2007, and then
shot up after the failure of Lehman Brothers in September 2008
Source: Kim Edwards,
SYPA, HKS, March 2010
Data:
Bloomberg,
ITF220
- Prof.J.Frankel
IMF Global Financial Stability Report Oct. 2009
Best and Worst Performing Countries
in Global Financial Crisis -- F&S (2010),
Appendix 4
GDP Change, Q2 2008 to Q2 2009
Lithuania
Latvia
Ukraine
Estonia
Macao, China
Russian Federation
Bo tto m 10
Georgia
Mexico
Finland
Turkey
Australia
Poland
Argentina
Sri Lanka
Jordan
Indonesia
To p 10
Egypt, Arab Rep.
Morocco
64 countries in sample
India
China
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
The variables that show up as the strongest predictors
of country crises in 83 pre-2008 studies are:
(i) reserves and (ii) currency overvaluation
0%
10%
20%
30%
40%
50%
60%
Reserves
Real Exchange Rate
GDP
Credit
Current Account
Money Supply
Budget Balance
Exports or Imports
Inflation
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Political/Legal
Contagion
Capital Account
% of studies where leading indicator was found to be
statistically signficant
(total studies = 83, covering 1950s-2009)
External Debt
Source: Frankel & Saravelos (2012)
70%
When US interest rates rise, the capital flow response
puts downward pressure on Emerging Markets.
In Mundell-Fleming terms, rise in i* shifts up their BP=0 curve .
“Taper talk,” May/June 2013
- Professor J.Frankel
Financial Times, Dec. ITF220
15, 2013