Appendix - Harvard University

Lecture 22: Crises in Emerging Markets
• (1) IMF country programs
• (2) An implication of
contractionary devaluation
• (3) The car crash analogy
• (4) Currency wars
• (5) More on predicting crises
• (6) EM conditions in 2014
Appendix 1: Major IMF Country-Programs
Usual 3 components
Country reforms (“conditionality”):
macro policy (often devaluation & expenditure-reduction)
& perhaps structural (in 1990s; controversial).
Financing from IMF.
“Stamp of approval” is as important as its money, or more so.
Private Sector Involvement:
“bailing in” lenders rather than “bailing out”
Rolling over loans, standstills, re-profiling (stretching out maturities),
default, haircuts, restructuring, debt-equity swaps, write-downs…
Why were the real effects of the
East Asia currency crises so severe?
• High interest rates raise default probability.
The IMF may have over-done it –
according to J.Furman & J.Stiglitz; and S.Radelet & J.Sachs;
both in Brookings Panel on Ec. Activity (1998).
• Devaluation may be contractionary.
• Possible channels include:
real balance effect &
balance-sheet effect.
Would some other combination of devaluation vs.
monetary contraction in the 1990s crises have better
maintained internal and external balance?
Textbook version:
When external balance shifts out, there exists an optimal
combination of devaluation and interest rate rise that will
satisfy external finance constraint without causing
1998 version:
Apparently there existed no such combination, if reserves
have been allowed to run low and $ debt to run high.
Textbook version:
there exists a
combination of
devaluation and
interest rate rise
that will satisfy
external finance
constraint without
causing recession.
API-120 - Macroeconomic Policy Analysis I . Jeffrey Frankel, Harvard University
There may exist
no combination
that avoids
recession, if
reserves have
already been
allowed to run
low and dollar
debt to run high.
API-120 - Macroeconomic Policy Analysis I , Professor Jeffrey Frankel Harvard University
Appendix 3: The Car Crash Analogy
[Might cover at end of semester, L25, instead]
Sudden stops:
“It’s not the speed that kills, it’s the sudden stops”
– R.Dornbusch
Modern financial markets get you where you want to go fast,
but accidents are bigger, and so more care is required.
– R.Merton
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.
– L.Summers
Contagion also contributes
to multi-car pile-ups.
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. – M.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.
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
Appendix 4: Currency wars
Brazil’s Finance Minister Guido Mantega
complained in 2010 about Fed easing.
India’s Central Bank Governor Raghuram Rajan
complained in 2014 about Fed tightening.
Origin of phrase “Currency Wars”
• Warning from Mantega:
“We’re in the midst of
an international currency war,
a general weakening of currency. This threatens us
because it takes away our competitiveness” (9/27/2010).
• I.e., countries everywhere are trying
to push down the value of their currencies,
to gain exports & employment,
– a goal that is not globally consistent.
“Currency wars”
must be another way of saying “competitive devaluation”
– a kind of beggar-thy-neighbor policy
• to use language of the 1930s,
• one motive at Bretton Woods
for fixed exchange rates;
– or “manipulating exchange rates…to gain an unfair
competitive advantage over other members…”
• to quote from
IMF Article IV(1)iii.
• If US unemployment is high & inflation low,
the Fed will naturally choose
an easy monetary policy (low i).
• If the macroeconomic situation
is the reverse in Brazil, its central bank
will naturally choose a tight monetary policy (high i).
• Also naturally, capital will flow from the US
to Brazil and will in turn appreciate the Real.
• But that is the beauty of floating rates.
Rajan complains about Fed tightening.
• “International monetary cooperation has broken down…
The U.S. should worry about the effects of
its policies on the rest of the world,” 1/30/14.
• “Central banks should assess spillover
effects from their own actions…
• For example, this would mean that while exiting
from unconventional policies, central banks would
pay attention to conditions in emerging markets…
• [T]he Fed policy statement in January 2014, with no mention
of concern about the emerging market situation, and with
no indication Fed policy would be sensitive to conditions
in those markets sent the probably unintended message
that those markets were on their own.” 4/10/2014 (Brookings)
US Congressional failure to approve IMF reform
• In one respect, at least, China, India & Brazil are right
to complain: the lack of proportionate
representation in international agencies.
• Congress refuses to pass the bill updating the
allocations of IMF quotas among member countries.
Quotas allocations in the IMF determine both monetary contributions of the member states and their voting power.
• The agreement among the IMF members had been
to allocate greater shares to big EM countries,
– coming primarily at the expense of European countries.
Appendix 5: More on predicting crises
(i) Definitions (CA reversal, sudden stop, speculative attack…)
(ii) Predicting the 1994 Mexican peso crisis
(iii) Studies of Early Warning Indicators
(i) Definitions of external financing crises
• Current Account Reversal
 disappearance of a previously substantial CA deficit
• Sudden Stop  sharp disappearance of private capital inflows,
reflected (esp. at 1st) as fall in reserves & (soon) in disappearance
of a previous CA deficit. Often associated with recession.
• Speculative attack  sudden fall in demand for domestic
in anticipation of abandonment of peg.
Reflected in combination of  s - res &  i >> 0.
(Interest rate defense against speculative attack might be successful.)
• Currency crisis  Exchange Market Pressure  s - res >> 0.
• Currency crash  s >> 0, e.g., >25%.
• But falls in securities prices & GDP are increasingly relevant.
• Current account reversals
– Edwards (2004a, b) and
Milesi-Ferretti & Razin (1998, 2000).
• Sudden stops
– References: Dornbusch & Werner (1994), Dornbusch,
Goldfajn & Valdes (1995); Calvo (1998), Calvo, Izquierdo &
Mejia (2003), Calvo (2003), Calvo, Izquierdo & Talvi (2003,
2006), Calvo & Reinhart (2001), Calvo, Izquierdo & LooKung (2006), Calvo, Izquierdo & Loo-Kung
(2006); Caballero & Krishnamurthy (2004); Edwards
(2004); Guidotti, Sturzenegger & Villar (2004); Levchenko
& Mauro (2006); Arellano & Mendoza (2002), and
Mendoza (2002, 2006, 2010).
(ii) More on
predicting crises
The early 1990s
Calvo, Leiderman
& Reinhart
predict the
peso crisis
In the 1990s,
capital inflows
current account
Calvo, Leiderman
& Reinhart:
Source of capital
flows was low i*
at least as much
as local reforms
(push vs. pull)
Could reverse as
easily as in 1982.
Dornbusch (1994) said the
Mexican peso was overvalued.
(iii) Early Warning Indicators of Currency Crashes
Sachs, Tornell & Velasco (1996):
Combination of weak fundamentals (Δ RER or credit/GDP) and low reserves
made countries vulnerable to tequila contagion.
Frankel & Rose (1996):
Composition of capital inflow matters (more than the total):
short-term bank debt raises the probability of crash; FDI & reserves lower the probability.
Kaminsky, Lizondo & Reinhart (1998):
Best predictors: M2/Res, Real Exchange Rate.
Berg, Borensztein, Milesi-Ferretti, & Pattillo (1999),
They don’t hold up as well out-of-sample.
Edwards (2002):
CA ratios of some use in predicting crises (excl. Africa), contrary to earlier research.
Rose & Spiegel (2009): No robust predictors for who got hit by GFC in 2008-09.
Dominguez & Ito (2012)
and Frankel & Saravelos (2012):
Reserves do work to predict who got hit,
as in earlier studies.
Predictive performance
of Early Warning indicators
in the1990s crises.
Berg, et al, (1999) did find
that if warning indicator
equation sounded an alarm,
probability of crisis was 70-89%;
but were generally pessimistic
on the ability at each round
to predict the next crisis.
Are big currentaccount deficits dangerous?
Neoclassical theory: if a country has a low capital/labor ratio
or transitory negative shock, a 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 GlobalFinancialCrisis of 2008-13 – CAD dangerous.
The IMF and Rose & Spiegel (2009) found that countries
with more reserves were not less affected by the 2008-09 crisis:
IMF Survey Magazine
Oct.8, 2009
“Did Foreign Reserves
Help Weather the Crisis?”
by O. Blanchard,
H.Faruqee, & V.Klyuev
But Frankel & Saravelos (2012) and Dominguez & Ito (2012) find they were.
Appendix 6: EM conditions in 2014
EM stocks fell on fears of higher US interest rates
in May-June 2013 & again in January 2014
Source: FT
EMs have had to pay higher interest rates
since the taper tantrum of 2013,
but conditions eased a bit after April 2014.
From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.
Asia is still doing pretty well.
From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.
Capital flows recovered after the taper tantrum.
From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.
IMF WEO, Oct. 2014.