1. Fatih Özatay, TOBB-ETÜ and TEPAV Sarajevo, 20 October 2009 tepav Economic Policies in the Aftermath of Financial Crises in Emerging Economies

2. Why? EM are less fragile now, compared to past crises. EM as a whole have given less response to contractory forces than developed countries. Within the EM, considerable differences in the implementation of countercyclical policies have been observed. What are the potential underlying reasons? Aftermath of financial crises Slide 2

3. Fiscal stimulus and macroeconomic indicators Aftermath of financial crises Slide 3

4. Fiscal stimulus vs public debt (EM in G-20 + 3 ) Aftermath of financial crises Slide 4

5. Fiscal stimulus vs fiscal balance (EM in G-20+3 ) Aftermath of financial crises Slide 5

6. Fiscal stimulus vs current account balance (EM in G-20+3) Aftermath of financial crises Slide 6

7. In previous crises… Countercyclical policies were generally not an option for most of the EM countries in previous crises. Asian crisis, The contagious Russian crisis, 2001 Turkey, Argentina… Aftermath of financial crises Slide 7

8. Vulnerability dominance… Capital flows (CF): Portfolio choice CF = f[R rf -ε e R*/ε-kΘ*p] A positive relationship between the real exchange rate and probability of default. Aftermath of financial crises Slide 8

9. Vulnerability dominance: Risk and credit supply CR = L. [CR 0 +P B.B 0 -(D 0 d + ε.D 0 fx )] As p and θ* increases; P B decreases, Real depreciation (ε increases). Credit supply can decrease. Aftermath of financial crises Slide 9

10. Aggregate demand As default probability increases, AD decreases (if the usual NX channel does not offset). Vicious spiral: As p increases R r and ε increases, As R r and ε increases, vulnerabilities increase, Hence, p increases. Aftermath of financial crises Slide 10

11. Countercyclical policies??? Basic principle: Your policy response should decrease default probability and risk aversion. So the main task of the policymakers is to identify the source(s) of existing and potential vulnerabilities that increase p and θ* and address these problems. This is the basic logic behind expansionary fiscal consolidations, for instance. Aftermath of financial crises Slide 11

12. A Case: Turkey 2001 Aftermath of financial crises Slide 12

13. Countercyclical policies??? However, as a response to a contractory crisis, in order a tightening cycle (monetary+fiscal) to work, there should be significant vulnerabilities prevailing. Of course, the appropriate policy response should not only depend on monetary and fiscal mesures. For example, the financial sector can be problematic. Aftermath of financial crises Slide 13

14. Countercyclical polices??? This is no longer the case for many EM countries: These countries are more resiliant to shocks: Healthier financial sectors, Improved fiscal balances, Reduction in government debt, Low inflation, More flexible exchange rate regimes, Insurance: More reserves. Aftermath of financial crises Slide 14

15. EMBI spreads (1998.1 – 2009.9) Aftermath of financial crises Slide 15

16. LAC7: Government debt/GDP (%) Aftermath of financial crises Slide 16

17. LAC7: FX Reserves/GDP (%) Aftermath of financial crises Slide 17

18. Turkey: Government debt /GDP and FX reserves /GDP (%) Aftermath of financial crises Slide 18

19. Response to the global crisis: EM vs developed economies Aftermath of financial crises Slide 19

20. Response to the global crisis: EM vs developed economies In developed countries automatic stabilizers are at work. Nonetheless, their policy responses (fiscal + financial) have been much sharper than EM. Moreover, some extraordinary mesures have been taken. This is striking; excluding countries like China and Korea, it is even more so. Aftermath of financial crises Slide 20

21. Then: Why are some of EM shying off countercyclical polices? Aftermath of financial crises Slide 21

22. Why shying off? Relative to past, less fragile; but still fragile? There are still some country specific problems (dollarization, current account deficits, etc.), But most of the indicators are in the positive side, Powerful memories? They are again implementing unsound polices. Fear of punishment? Aftermath of financial crises Slide 22

23. Why shying off? Less fiscal room? Yes, debt to GDP ratios have declined considerably, But, financial systems of these countries are much shallower than those of developed countries, However, correcting for this fact, for most of these countries still there is room for maneuver. Aftermath of financial crises Slide 23

24. Why shying off? Great uncertainties leading to a wait and see mode? Accumulated FX reserves: however let us do not use them, liquidity situation can get worse? No expertise? Addicted to Washington institutions for designing a policy package? Know how to tighten, but lack of expertise in countercyclical policies? Aftermath of financial crises Slide 24

25. Turkey: What could have been the policy response? Turkey is one of the main victims of this crisis (%6.5 contraction, %15 unemployment). However, did not give a significant policy response. What has been done was put in place too late (March and June 2009) and weak. Aftermath of financial crises Slide 25

26. Turkey: What could have been the policy response? Extraordinary times need extraordinary measures, When most of the countries are taking such measures, risk of punishment decreases, Main problems are drying-up of international liquidity and lack of foreign demand, Aftermath of financial crises Slide 26

27. Turkey: What could have been the policy response? Show that as a policymaker you are doing your best without jeopardizing the future stability, Do not expect too much, but try to mitigate contractionary forces as much as you can. Use your limited fiscal room to get maximum multiplier effect Aftermath of financial crises Slide 27

28. Turkey: What could have been the policy response? To increase demand for domestically produced goods: Target unemployed and poor: Increase unemployment coverage and benefits, Temporary increase in pensions and transfers to poor. Aftermath of financial crises Slide 28

29. Turkey: What could have been the policy response? To trigger credit supply, try to decrease risk perception of banks, Credit guarantee systems (Budget), FX credit guarantee systems: (Budget and CB), Commitment to medium term stability, Fiscal rule? How to widen the tax base? How to increase human capital? Especially for unemployed? Aftermath of financial crises Slide 29

30. Short-run response of the economy to alternative policies (calculated in January 2009) Growth rate (%) Unemployment rate (%) Aftermath of financial crises Slide 30

31. Full response of the economy to alternative policies (calculated in January 2009) Growth rate (%) Unemployment rate (%) Aftermath of financial crises Slide 31

32. Thank you… Aftermath of financial crises Slide 32