L22: CRISES IN EMERGING MARKETS : 24.1 INFLOWS TO EMERGING MARKETS -- Reserves (continued from Lecture 3) 24.2 MANAGING OUTFLOWS -- Early Warning Indicators 24.3 SPECULATIVE ATTACKS (Lecture 21) 24.4 CONTAGION 24.5 IMF COUNTRY PROGRAMS 24.6 CONTRACTIONARY EFFECTS OF DEVALUATION (continued from Lect.12) 24.7 THE CAR CRASH ANALOGY Breaching the central bank’s defenses.

Cycles of capital flows to emerging markets: Recycling of petrodollars, via bank loans, to oil-importing LDCs Mexico unable to service its debt on schedule => Start of international debt crisis worldwide The “lost decade” in Latin America 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, Aug. -- 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 abandons 10-yr “convertibility plan” New capital flows into developing countries, incl. China, India Global crisis hits: Iceland, Latvia, Ukraine, Pakistan, Greece, Ireland, Portugal…

Managing Capital Inflows Recall alternative ways to manage capital inflows: A. Allow money to flow in B. Sterilized intervention C. Allow currency to appreciate D. Reimpose capital controls In the boom phase of , countries pursued exchange rate targets. Some experimented with re-imposing controls on capital inflows ( e.g., Chile & Colombia), but mostly they allowed capital to flow in. They used part of the inflow to add to foreign exchange reserves, but–as in the earlier cycle – they also used much of it to finance trade deficits, some as large as the capital inflows. (Calvo, Leiderman, & Reinhart, 1996 ).

Managing Capital Inflows, cont. In the boom phase of : Many countries had more flexible exchange rates than before. Many reduced the share of capital inflow denominated in forex except in Central & Eastern Europe Few imposed new controls on the inflows [until Nov. 2009]. This time, a majority of emerging market countries ran current account surpluses rather than deficits. Thus inflows went into reserve accumulation (in fact, more than 100%). As a result, reserves reached unprecedented levels.

This time, many countries used the inflows to build up forex reserves, rather than to finance Current Account deficits

This time, China and India shared in the inflows. But capital inflows financed only reserve accumulation, not current account deficits as in the past. Source: IMF WEO, 2007

IMF Survey Magazine Oct.8, 2009 “Did Foreign Reserves Help Weather the Crisis?” by O. Blanchard, H.Faruqee, & V.Klyuev /2009/num100809a.htm As a result, reserves reached extreme levels.... …, especially in Asia.

Traditional denominator for reserves: imports

New denominator: short-term debt. After 2000, many brought their reserves above the level of short-term debt (the Guidotti rule).

FX Reserves in the BRICs, Neil Bouhan & Paul Swartz, Council on Foreign Relations

Alternative Ways of Managing Capital Outflows A.Allow money to flow out (but can cause recession, or even banking failures) B.Sterilized intervention (but can be difficult, & only prolongs the problem) C.Allow currency to depreciate (but inflationary) D.Reimpose capital controls (but probably not very effective)

Early Warning Indicators of Currency Crashes Sachs, Tornell & Velasco (1996), “Financial Crises in Emerging Markets: The Lessons from 1995”: Combination of weak fundamentals (Δ RER or credit/GDP) and low reserves made countries vulnerable to tequila contagion. Frankel & Rose (1996), "Currency Crashes in Emerging Markets" : 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), “Leading Indicators of Currency Crises” : Best predictors: M2/Res, equity prices, GDP growth, Real exchange rate. Berg, Borensztein, Milesi-Ferretti, & Pattillo (1999), “Anticipating Balance of Payments Crises: The Role of Early Warning Systems”: They don’t hold up as well out-of-sample. Edwards (2002), “Does the Current Account Matter?”: CA ratios of some use in predicting crises (excl. Africa), contrary to earlier research. Rose & Spiegel (2009), “The Causes and Consequences of the 2008 Crisis: Early Warning”: No robust predictors. Frankel & Saravelos (2010): Once again, reserves worked to predict who got hit in

The variables that show up as the strongest predictors of country crises in 83 studies are: (i) reserves and (ii) currency overvaluation Source: Frankel & Saravelos (2010)

IMF Survey Magazine Oct.8, 2009 “Did Foreign Reserves Help Weather the Crisis?” by O. Blanchard, H.Faruqee, & V.Klyuev /survey/so/2009/num100809a.htm The IMF and Rose & Spiegel (2009) found that the countries with more reserves were not less affected by the crisis: But Frankel & Saravelos (2010) and Dominguez & Ito (2011) find they were.

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

F & Saravelos (2010): Bivariate

F & Saravelos (2010): Multivariate

Bottom line for Early Warning Indicators in the crisis Frankel & Saravelos (2010) Once again, reserve holdings were the best predictor (especially relative to short-term debt), followed by the real exchange rate; And, this time, current account / national saving.

Appendices: More on predictors of currency crashes 1.Definitions (CA reversal, sudden stop…) 2.Predicting the 1994 Mexican peso crisis 3.Are big current account deficits per se dangerous? 4.How did the pre-1997 equations do at predicting the East Asia crisis? 5.Did those who held lots of reserves withstand the 2008 global crisis better? 6.The boom-bust cycle reflected in flows or spreads

Appendix 1: Definitions Current Account Reversal  disappearance of a previously substantial CA deficit Sudden Stop  sharp disappearance of private capital inflows, reflected (esp. at 1 st ) as fall in reserves & (soon) in disappearance of a previously substantial CA deficit. Often associated with recession. Speculative attack  sudden fall in demand for domestic assets, 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%.

References Currency account reversals –Edwards (2004a, b) and Milesi-Ferretti & Razin (1998, 2000). Sudden stops –References: Dornbusch, Goldfajn & Valdes (1995); Calvo (1998); Calvo, Izquierdo and Mejia (2003); Arellano & Mendoza (2002), Calvo (2003), Calvo, Izquierdo & Talvi (2003, 2006), Calvo & Reinhart (2001), Calvo, Izquierdo & Loo-Kung ( 2006 ), Guidotti, Sturzenegger & Villar (2004), Mendoza (2002, 2006); Edwards (2004b); Calvo, Izquierdo & Loo-Kung (2006).

Appendix 2 The early 1990s Calvo, Leiderman & Reinhart “predict the peso crisis”

In the 1990s, capital inflows financed current account deficits. Calvo, Leiderman & Reinhart: Source of capital flows was low i* at least as much as local reforms => Could reverse as easily as in 1982.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Emerging Market Crises of 1990s

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

App.3: Are big current account 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 Global Financial crisis of – CAD dangerous.

Appendix 4: Berg, et al, (1999) did find that if warning indicator equation sounds an alarm, probability of crisis is 70-89%.

Appendix 5: Developing countries have felt the need to hold far more reserves