Anatomy of a Currency Crisis

What Constitutes a “Crisis” ? Large, rapid depreciation of a currency price Large, rapid depreciation of a currency price Sudden, dramatic, reversal in private capital flows Sudden, dramatic, reversal in private capital flows Note: The names and dates have been changed to protect the innocent! The “Crisis” period is typically followed by a recession.

Exchange Rate (per $US) Crisis Date

Foreign Investment (Millions of $s)

Imagine yourself driving down a straight stretch of road. If the alignment on your car is good, you can let go of the steering wheel and the car stays on the road…… Currency Pegs

However, if your alignment is not perfect, you need to act to stay on the road. Otherwise… Currency Pegs

On the other hand, your alignment could be perfect, but if the road has an unexpected curve…. Currency Pegs

F/$ $ Demand Supply e e e A peg at the equilibrium price can be maintained forever! A peg above the equilibrium will involve buying your currency (loss of reserves) A peg below the equilibrium price will involve selling your currency (increase in reserves)

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) E 5,000,000 X 1.30 $/E $ 6,500,000 $ 3,500,000 (T-Bills) $10,000,000 reserve ratio = 59% Remember, a country only has a finite supply of foreign reserves….once their gone, the game is over!

Bad Policies… F/$ $ Demand Supply e Initially, a country is pegging at or near the equilibrium value of its currency

Bad Policies… F/$ $ Demand Supply e e Supply’ An incompatible policy could pull the equilibrium away from the pegged level – this forces a loss in reserves!

…or Bad Luck! F/$ $ Demand Supply e Initially, a country is pegging at or near the equilibrium value of its currency

or Bad Luck! F/$ $ Demand Supply e e Demand’ Suddenly, demand drops – this lowers the equilibrium exchange rate and forces the central banks to act (buying back currency and losing reserves)

What causes these sudden reversals? Just the facts ma’am. Persistent inflation High Money Growth Low Economic Growth Large Deficits Public Private Political Events Natural Disasters Market Sentiment Bad Policy Bad Luck

Inflation Rates (Annualized) US Average Inflation

Economic Growth Rates (Annualized)

M2 Growth (Annualized) Average = 14%Average = 4%

Government Deficit (Millions)

Trade Deficit (Millions)

Interest Rate (Overnight Rates)

Official Reserve Assets (Millions of $) Central Bank Defense of Currency

Long Run Fundamentals Recall, the monetary framework with flexible prices (long run) resulted in the following Recall, the monetary framework with flexible prices (long run) resulted in the following Y M (1+i) = Y* M*(1+i*) e Relative Money Stocks Relative Output Relative Interest Rates

Long Run Fundamentals High money growth and low economic growth generate inflation (Domestic Money Market) Domestic inflation generates expectations of a currency depreciation (PPP) High inflation raises nominal interest rates. This further lowers money demand (which creates even more inflation

Short Run Deficits Trade Deficits create excess supply of currency. This creates expectations of a depreciation Large government deficits create the fear that the government might “monetize” the debt (Pay it off by printing money) Both deficits raise domestic interest rates. This makes domestic investment more expensive. As domestic investment slows down, so does economic growth

How big is “too big”? When does a trade deficit become unsustainable? When does a trade deficit become unsustainable? PV(Lifetime CA) = 0 (all debts must be repaid) PV(Lifetime CA) = 0 (all debts must be repaid) We need to examine the country’s ability to run trade surpluses in the future (i.e. repay its debts!) We need to examine the country’s ability to run trade surpluses in the future (i.e. repay its debts!) Generally speaking, a trade deficit greater than 5% of a country’s GDP is considered “too big” Generally speaking, a trade deficit greater than 5% of a country’s GDP is considered “too big”

Productivity Productivity measures the ability of a country to transform inputs into output Revenues LaborCapital (Shareholders) Creditors (bondholders) With high productivity, producers can raise revenues without having to raise prices (high growth with low inflation!)

Labor Productivity Labor Productivity = Per Man-hour Real Output = Y N Real GDP Total Hours $10,397 Real GDP (2004) Subtract out Farm Output $8,317 Divide by total hrs (Employment * Average Hrs * 52) $8, =$34/hr Suppose that Output/hr in 1992 was equal to $28.hr, then Prod(1992) = 100 Prod(2003) = 100*(34/28) = 121.4

Multifactor Productivity Labor productivity doesn’t correct for changes in the capital stock!! Y = A K β N 1-β (Production function)β = 1/3 Real GDP Capital Labor MFP Growth Rate of MFP = y – βk – (1-β)n Labor Growth Capital Growth Real GDP Growth

Multifactor Productivity Step 1: Estimate capital/labor share of income K = 30% N = 70% Step 2: Estimate capital, labor, and output growth %Y = 5% %K = 3% %N = 1% %A = 5 – (.3)*(3) + (.7)*(1) = 3.4%

Productivity Growth in the US

Expectations & Multiple Equilibria Suppose a country is under a fixed regime with the understanding that they will switch to a float under “extreme” circumstances Suppose a country is under a fixed regime with the understanding that they will switch to a float under “extreme” circumstances Further, assume that the country is currently in a strong economic position Further, assume that the country is currently in a strong economic position

Expectations & Multiple Equilibria Case #1 Investors anticipate a devaluation Investors anticipate a devaluation Investors require a “risk premium” to compensate them for expected currency losses Investors require a “risk premium” to compensate them for expected currency losses Higher interest rates choke off domestic investment Higher interest rates choke off domestic investment The economy slips into a recession and devalues The economy slips into a recession and devalues Case #2 Investors expect the peg to be maintained Interest rates remain low Domestic investment continues and the economy grows. No devaluation is required

Multiple Equilibria In the previous example, there exist two possible equilibrium (one with a devaluation, and one without). The economy can then switch between the two. This switching is driven entirely by expectations. In the previous example, there exist two possible equilibrium (one with a devaluation, and one without). The economy can then switch between the two. This switching is driven entirely by expectations.

Contagion Contagion refers to the transmission of a currency crisis throughout a region Contagion refers to the transmission of a currency crisis throughout a region The Thai Baht in 1997 was followed shortly by crises in Malaysia, Indonesia, Korea The Thai Baht in 1997 was followed shortly by crises in Malaysia, Indonesia, Korea The Mexican Peso crisis in 1994 spread to Central and South America (“The Tequila Effect”) The Mexican Peso crisis in 1994 spread to Central and South America (“The Tequila Effect”) The Russian collapse (2000) was followed immediately by Brazil The Russian collapse (2000) was followed immediately by Brazil

Reasons For Contagion Common Shocks Common Shocks Trade Linkages Trade Linkages Common Creditors Common Creditors Financial Interdependencies Financial Interdependencies Informational Problems and “Herding” behavior Informational Problems and “Herding” behavior