Contagion
Contagion from the Russian default /
devaluation jumped oceans in August 1998.
Source: Mathew McBrady (2002)
The Global Financial Crisis was quickly transmitted
to emerging markets in September 2008.
Source: Benn Steil, Lessons of the Financial Crisis, CFR, March 2009
2
Categories/Causes of Contagion
• “Monsoonal effects” (Masson, 1999): Common external shocks
• E.g., US interest rates ↑,
• world recession, GFC, or
• $ commodity prices ↓ …
• “Spillover effects”
• Trade linkages
• Competitive devaluations
• Investment linkages
• Pure contagion
• Stampede of herd
• Imperfect information (“cascades”):
investor perceptions regarding, e.g., Asian model or odds of bailouts
• Illiquidity in international financial markets or reduced risk tolerance
Major IMF Country-Programs
traditional 3 components
•
Country reforms (“conditionality”):
–
–
•
macro policy (often devaluation & expenditure-reduction)
& perhaps structural (controversial).
Financing from IMF.
–
•
“Stamp of approval” is often as important, or more so.
Private Sector Involvement:
“bailing in” lenders rather than “bailing out”
–
–
Rolling over loans, stretching out maturities, standstills…
Haircuts, restructuring, debt-equity swaps, write-down, default…
Devaluation
Poland, the only continental EU member with a floating
exchange rate, was also the only one to escape
negative growth in the global recession of 2009
% change in GDP
Poland
Lithuania
Latvia
Estonia
Slovakia
Czech Republic
2006
2007
2008
2009
2010
6.2 6.8 5.1 1.7 3.5f 7.8 9.8 2.9 -14.7 -0.6f 12.2 10.0 -4.2 -18.0 -3.5f 10.6 8.5 6.8 6.9 10.6 -5.1 6.2 -13.9 0.9f -4.7 2.7f 6.1 2.5 -4.1 Source: Cezary Wójcik, 2010
1.6f Exchange Rate
Floating
Fixed
Fixed
Fixed
Euro
Flexible
(de facto)
The Polish exchange rate increased by 35%.
The depreciation boosted net exports; contribution to GDP growth > 100%
4,7
Source:
Cezary Wójcik
28,0
4,5
zlotys / $
23,0
4,2
Contribution of Net X to GDP:
4,0
2009: 2,5
3,4
3,2
3,4
18,0
> 100% of
GDP growth rate:
3,7
3,5
1,7
kroon / $
Estonia
13,0
lats / $
Latvia
3,2
8,0
I
III
V
VII
2008
IX
XI
I
III
V
VII
2009
IX
XI
I
III
V
2010
VII
IX
After a devaluation, heads of state
in developing countries lost their jobs...
…in the 1960s, twice as often within 1 year of devaluation
(30%) as compared to control group (14%)
-- Richard Cooper (1971).
(Criterion was 10% devaluation)
Updated to 1971-2003:
twice as often within 6 months of devaluation
(43 cases out of 109 = 23%) as otherwise (12%).
Difference is highly significant statistically at 0.5% level.
(Criterion is 25% devaluation, incl. 10% acceleration, and 3-yr. window.)
Source: -- Frankel, “Contractionary Currency Crashes,” (2005)
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Why were devaluations so unpopular?
• The public feels their leaders have misled them?
• Passthrough to import prices & inflation?
• Contractionary impact on the real economy
– such as via balance sheet effect?
Frankel (2005)
In both cases the loss of jobs was severe, but reversed in 8 months
Carry-over from
LECTURE 13: DEVALUATION IN SMALL, OPEN ECONOMIES
CONTRACTIONARY EFFECTS OF
DEVALUATION
Question:
In the standard model, devaluation raises price
competitiveness, thereby boosting TB. Why, then,
is devaluation so often associated with loss of GDP?
CONTRACTIONARY EFFECTS
OF DEVALUATION
Why were the real effects of the
East Asia currency crises so severe?
• High interest rates raise default probability.
The IMF may not have sufficiently realized this –
according to J.Furman & J.Stiglitz; and S.Radelet & J.Sachs;
both in Brookings Panel on Ec. Activity, 1998.
• Devaluation is contractionary: 10 possible channels,
including real balance effect & balance-sheet effect.
Empirical evidence:
Are devaluations contractionary?
Edwards (1986):
In 12 LDCs, devaluation is contractionary
in 1st year, then expansionary; neutral in LR.
Kamin (1988):
No evidence of contractionary effects.
Calvo & Reinhart (2001):
Exports do not increase at all after a devaluation,
but rather fall for first 8 months. Credit constraints?
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Empirical evidence:
Are devaluations contractionary? (continued)
In the 1990s currency crises, devaluations apparently
were contractionary due to the balance sheet effect.
• Guidotti, Sturzenegger & Villar (2003)
• Bebczuk, Galindo & Panizza (2006):
Devaluation is only contractionary for the fifth of
developing countries with (external $ debt)/GDP > 84%;
it is expansionary for the rest.
• Cavallo, Kisselev, Perri & Roubini (2002)
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
The balance
sheet effect
In currency
crises,
loss in output
depends on
foreigndenominated
debt times
real
devaluation.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
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
recession.
1998 version:
Apparently there exists no such combination, if reserves
have been allowed to run low and $ debt to run high.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Textbook version:
there exists a
combination of
devaluation and
interest rate rise
that will satisfy
external finance
constraint without
causing recession.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Lesson-of-1998
version:
There may exist
no combination
that avoids
recession, if
reserves have
already been
allowed to run
low and dollar
debt to run high.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
?
?
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Why do debtor countries develop
such weak balance sheets (currency mismatch)?
1. “Original sin:” Investors in rich countries
are unwilling to acquire exposure in currencies
of developing countries. -- Hausmann (1999)
2. Adjustable currency pegs create a false sense of security:
only currency volatility persuades borrowers to avoid
unhedged dollar liabilities. -- Eichengreen (1999), Velasco (2001)
3. Moral hazard: borrowing in $ is a way well-connected
locals can put the risk onto the government.
-- Dooley (2000); Krugman (1999); Wei & Wu (2002)...
4. Procrastination of adjustment: when foreign
investors suddenly lose enthusiasm, the government
postpones adjustment by shifting to short-term
& $-denominated debt.
Copyright 2007 Jeffrey Frankel, unlesstherwise noted
In the months leading up to the Dec. 94 Mexican peso attack,
1992-94
debt composition shifted...
from peso-denominated (Cetes) to $-linked (tesobonos)...
Shocks
Peso crisis
…and from longer term to shorter.
Shocks
Peso crisis
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Appendices
• The car crash analogy
• Why were the recessions
in the Asia crisis so severe?
• Critiques of the IMF
THE CAR CRASH ANALOGY
[Might cover at end of semester, L24, instead]
Sudden stops:
“It’s not the speed that kills, it’s the sudden stops”
– R.Dornbusch
Superhighways:
Modern financial markets get you where you want to go fast,
but accidents are bigger, and so more care is required.
– R.Merton
THE CAR CRASH ANALOGY, continued
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.
THE CAR CRASH ANALOGY, continued
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
Why were the real effects of
the Asian currency crises so severe?
Continued
The balance sheet effect:
$-denominated debts are difficult to service after a large
devaluation => layoffs, closures, & bankruptcies
Some of the many references:
Paul Krugman, 1999, “Balance Sheets, the Transfer Problem and Financial Crises,”
in International Finance and Financial Crises, P.Isard, A.Razin, & A.Rose, eds.
Roberto Chang & Andres Velasco, 2000, “Liquidity Crises in Emerging Markets: Theory and Policy,”
in NBER Macro Annual (MIT Press).
More: Aghion, Banerjee & Bacchetta (2000), Bebczuk, Galindo & Panizza (2006), Caballero &
Krishnamurty (2002), Dornbusch (2001), Calvo, Izquierdo, & Talvi (2003), Calvo, Izquierdo & Meija;
Cespedes, Chang & Velasco (1999, 2000, 03, 04), Christiano, Gust & Roldos (2002), Dornbusch (2001,
02), Eichengreen & Hausmann (1999), Guidotti, Sturzenegger & Villar (2003), Kiyotaki & Moore
(1997), Jeanne & Zettelmeyer (2005), Kiyotaki & Moore (1997), Mendoza (2002), and Schneider &
Tornell (2001),
10 POSSIBLE CONTRACTIONARY EFFECTS
OF DEVALUATION (3 slides repeated from L12)
•
High import bill and low elasticities
•
Real balance effect (MABP)
•
Distribution effect: Diaz-Alejandro (1963) (MPC workers > MPC landowners)
•
Balance sheet effect: difficulty servicing $-denominated debts
•
End of speculative buying: Cooper (1971)
•
Simultaneous monetary/fiscal contraction (correlation, not causation)
•
Tariff revenue rise: Krugman-Taylor (1978)
•
Rise in Pimported inputs,
•
Rise in W, e.g., where indexed to CPI
•
Rise in cost of firms’ working capital
e.g., oil
Appendix on the Balance Sheet Effect
M.Cavallo, K.Kisselev, F.Perri, & N.Roubini, 2002.
Appendix 3: 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.
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.
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 has gone too far into local details (e.g., clove & plywood
monopolies in Indonesia, 1998). Need standardized & strict rules-based precertification qualifying countries for uncondnitional IMF assistance
(as Contingent Credit Lines, reincarnated in 2008 as short-term loan facility ).
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 run by European socialists.
US needs to exercise more influence” (-- US Congress).