ITF220 - Prof.J.Frankel Lecture 18: Crises in Emerging Markets Boom-bust cycles of inflows & outflows Crashes Sudden stops Managing capital outflows Speculative

ITF220 - Prof.J.Frankel

Lecture 18: Crises in Emerging Markets

• Boom-bust cycles of inflows & outflows

• CrashesSudden stopsManaging capital outflows

Speculative attacks

• Contagion

• IMF Programs


CYCLE in capital flows to emerging markets

Cycle prophesied by

Joseph in Egypt:

7 fat years followed by 7 lean years.


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


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)

D. Reimpose capital controls (probably not very effective)Y

•


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)…

SPECULATIVE ATTACKS

The capital outflow is so greatthat the central bank loses all its reserves.


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."


Traditional pattern: Reserves gradually run down to zero, at which point CB is forced to devalue.


In 1990s crises, reserves seem to fall off a cliff.

(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.

Speculative attack

Exhaustion of Mexico’s Reserves in 1994 Peso Crisis

Data source: IMF International Financial Statistics.

0.00

5000.00

10000.00

15000.00

20000.00

25000.00

30000.00

35000.00

1992

M12

1993

M1

1993

M2

1993

M3

1993

M4

1993

M5

1993

M6

1993

M7

1993

M8

1993

M9

1993

M10

1993

M11

1993

M12

1994

M1

1994

M2

1994

M3

1994

M4

1994

M5

1994

M6

1994

M7

1994

M8

1994

M9

1994

M10

1994

M11

1994

M12

1995

M1

1995

M2

1995

M3

1995

M4

Level 3m Moving Avg

CR

ISIS

IMF P

RO

GR

AM



CONTAGION In August 1998, contagion from the Russian devaluation/default jumped oceans.

Source: Mathew McBrady (2002)


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


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


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.


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.


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

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


Major IMF Country-Programs3 components

• Country reforms (macro policy & perhaps structural)

• Financing from IMF (& sometimes G-7, now G-20)

• Private Sector Involvement


Addendum 1: Critiques of the IMF Critics say “The IMF made serious mistakes -- what better evidence could one want than the severity of the 1997-2001crises 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 circum-stances; 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).


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?


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...


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.


Causes of Sudden StopsDec. 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).


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

Quantity test shows rising integration

IMF

Capital flowed to Latin America in the 1990s, and again 2004-11

IMF

start

start

2nd boom(emerging markets)

3rd boom(carry trade &

BRICs)

IMF

Capital flowed to Asiain the 1990s, and again 2003-11

start

start

stop(Asiacrisis)2nd boom (emerging

markets)

3rd boom

(carry trade& BRICs)

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

http://blog-imfdirect.imf.org/bloggers/serkan-arslanalp/



http://blog-imfdirect.imf.org/bloggers/takahiro-tsuda/

http://blog-imfdirect.imf.org/bloggers/takahiro-tsuda/

http://blog-imfdirect.imf.org/2014/03/05/the-trillion-dollar-question-who-owns-emerging-market-government-debt/

Developing Countries Used Capital Inflows to finance CA deficits in 1976-1982 & 1990-97;

but not 2003-07.

IMF

1st boom(recycling

petro-dollars)

start

start

stop(internationaldebt crisis) stop

(Asiacrisis)

2nd boom(emerging markets)

3rd boom(carry trade &

BRICs)

FX Reserves in the BRICs, 2000-2011

Neil Bouhan & Paul Swartz, Council on Foreign Relations

ITF220 - Prof.J.FrankelSource: Kim Edwards, SYPA, HKS, March 2010 Data: Bloomberg, IMF Global Financial Stability Report Oct. 2009

Sovereign spreads were historically low in 2007, and then shot up after the failure of Lehman Brothers in September 2008

Best and Worst Performing Countries in Global Financial Crisis -- F&S (2010), Appendix 4

-25% -20% -15% -10% -5% 0% 5% 10%

China

India

Morocco

Egypt, Arab Rep.

Indonesia

Jordan

Sri Lanka

Argentina

Poland

Australia

Turkey

Finland

Mexico

Georgia

Russian Federation

Macao, China

Estonia

Ukraine

Latvia

Lithuania

GDP Change, Q2 2008 to Q2 2009

Top 10

Bottom 10

64 countries in sample

The variables that show up as the strongest predictors of country crises in 83 pre-2008 studies are:

0% 10% 20% 30% 40% 50% 60% 70%

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

External Debt

% of studies where leading indicator was found to be statistically signficant(total studies = 83, covering 1950s-2009)

Source: Frankel & Saravelos (2012)

(i) reserves and (ii) currency overvaluation

When US interest rates rise, the capital flow response puts downward pressure on Emerging Markets.

Financial Times, Dec. 15, 2013

In Mundell-Fleming terms, rise in i* shifts up their BP=0 curve .

“Taper talk,” May/June 2013

ITF220 - Professor J.Frankel

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ITF220 - Prof.J.Frankel Lecture 18: Crises in Emerging Markets Boom-bust cycles of inflows & outflows Crashes Sudden stops Managing capital outflows Speculative