Contagion from the Russian default: currency crisis jumped oceans in August 1998. Country risk premiums 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

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 (“risk off” vs. “risk on”)

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 A textbook case were depreciation was expansionary: 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 (de facto) Source: Cezary Wójcik, 2010

API-120 . Professor Jeffrey Frankel, Harvard University But – After a devaluation, heads of state in developing countries lose 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) API-120 . Professor Jeffrey Frankel, Harvard University 6

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, tho reversed after 8 months.

CONTRACTIONARY EFFECTS OF DEVALUATION Carry-over from LECTURE 10: 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?

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 may be contractionary: 10 possible channels, including: real balance effect & balance-sheet effect.

Are devaluations contractionary? Empirical evidence  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 contractionary only for the fifth of developing countries with (external $ debt)/GDP > 84%; it is expansionary for the rest. Cavallo, Kisselev, Perri & Roubini (2002)  API-120 - Macroeconomic Policy Analysis . Professor Jeffrey Frankel, Harvard University

The balance sheet effect In currency crises, loss in output depends on foreign-denominated debt times real devaluation. API-120 - Macroeconomic Policy Analysis I. Professor Jeffrey Frankel, Harvard University

Would some other combination of devaluation vs 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 existed no such combination, if reserves have been allowed to run low and $ debt to run high. API-120 - Macroeconomic Policy Analysis I. Professor Jeffrey Frankel, Harvard University

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 14

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. ? ? API-120 - Macroeconomic Policy Analysis I , Professor Jeffrey Frankel Harvard University 15

Why do debtor countries develop such weak balance sheets (currency mismatch)? “Original sin:” Investors in rich countries are unwilling to acquire exposure in currencies of developing countries. -- Hausmann (1999) Adjustable currency pegs create a false sense of security: only currency volatility persuades borrowers to avoid unhedged $ liabilities. -- Eichengreen (1999), Velasco (2001) Moral hazard: borrowing in $ is a way well-connected locals can put the risk onto the government. -- Dooley (2000); Krugman (1999); Wei & Wu (2002)... Procrastination of adjustment: when foreign investors suddenly lose enthusiasm, the government postpones adjustment by shifting to short-term & $-denominated debt. 16

In the months leading up to the Dec In the months leading up to the Dec. 94 Mexican peso attack, debt composition shifted... from peso-denominated (Cetes) to $-linked (tesobonos)... 1992-94 Shocks Peso crisis

…and from longer term to shorter. Shocks Peso crisis API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

“The time is different” Emerging Markets in the most recent cycle Many emerging market / developing countries learned lessons from the crises of the 1980s & 1990s, which stood them in good stead in the most recent cycle. During the boom years of 2002-2008: They used capital inflows to add to reserves, not to finance TDs. And yet they also had greater exchange rate flexibility, & less $-denominated debt (vs. local-denominated, or FDI). They ran stronger budget positions (often primary surpluses). As a result, they were much less vulnerable to the “North Atlantic financial crisis” (GFC) of 2008-09. The major exceptions were European countries (CEE & periphery).

Appendices The car crash analogy Contractionary effects of devaluation. 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 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 High import bill and low elasticities Real balance effect 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, e.g., oil Rise in W, e.g., where indexed to CPI Rise in cost of firms’ working capital

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 circum-stances; 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 pre-certification 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).