1. Lecture 18: Crises in Emerging Markets Boom-bust cycles of inflows & outflows Crashes Sudden stops Managing capital outflows Speculative attacks Contagion IMF Programs

2. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Indications that financial markets do not always work as well in practice as in theory [from Lecture 12] Crises => Financial markets work imperfectly  the 1982 international debt crisis;  1992-93 crisis in the European ERM;  1994-95 Mexico;  1997 East Asia; 1998 Russia; 2000 Turkey; 2001 Argentina  2007-09 global financial crisis; 2008 Iceland, Latvia…; 2010 Greece. It is difficult to argue that investors punish countries when and only when governments follow bad policies:  Large inflows often give way suddenly to large outflows, with little news appearing in between to explain the change in sentiment.  Second, contagion sometimes spreads to where fundamentals are strong.  Recessions hitting emerging markets in such crises have been so big, it is hard to argue that the system is working well.

3. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Indications that financial markets do not always work as well in practice as in theory [from Lecture 12], continued More generally, capital flows have:  often been procyclical, not countercyclical,  sometimes been the source of the disturbance, rather than the smoother;  not on average gone from rich (high K/L) to poor (low K/L) countries – The “Lucas paradox.”

4. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Cycle in capital flows to emerging markets Cycle prophesied by Joseph in Egypt: 7 fat years followed by 7 lean years.

5. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Cycle in capital flows to emerging markets 1 st developing country lending boom (“recycling petro dollars”): 1975-1981 –Ended in international debt crisis 1982 –Lean years (“Lost Decade”): 1982-1989 2 nd lending boom (“emerging markets”): 1990-96 –Ended in East Asia crisis 1997 –Lean years: 1997-2003 3 rd boom (incl. China & India this time): 2003-2008 –Ended in 2008 global financial crisis – at least for the moment.

6. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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)

7. Speculative Attacks in the 1990s Exhaustion of Mexico’s Reserves Up to December 1994 Crisis Data source: IMF International Financial Statistics.

8. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Reasons for speculative attacks 3 generations of models Expansionary or procyclical macro policy Excessive speculation: “Multiple equilibria” Domestic financial structure: moral hazard (“crony capitalism”)

9. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Contagion In August 1998, contagion from the Russian devaluation/default jumped oceans. Source: Mathew McBrady (2002)

10. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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

11. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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

12. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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.

13. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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.

14. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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

15. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Major IMF Country-Programs 3 components Country reforms (macro policy & perhaps structural) Financing from IMF (& sometimes G-7, now G-20) Private Sector Involvement

16. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Addendum 1: Critiques of the IMF Critics say “The IMF made serious mistakes -- what better evidence could one want than the severity of the 1997-2001 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.

17. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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.

18. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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).

19. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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) matches Mexico 3 years before (1995) –Magnitude of the loss in output in 1998. How did the 2003-08 boom differ from past cycles?

20. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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...

21. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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.

22. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Causes of Sudden Stops in Emerging Markets: Dec. 1994 – Jan. 2002 Currency overvaluation (Mexico ’94; Thailand ’97; Argentina ’01) Big/procyclical fiscal deficits (Russia ’98; Brazil ’99; Turkey ’01) 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) Moral hazard from earlier bailouts (Allegedly East Asia ’97, and especially Russia ’98) Waves of speculator over-optimism followed by over-pessimism (All. And esp. the international financial crisis of 2007-09.)

23. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Through a combination of devaluation and expenditure-reduction, Mexico in 1995 and Korea in 1998 managed to convert large trade deficits quickly to large trade surpluses.

24. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Mexico and Korea managed to rebuild reserves fairly soon

25. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University But the declines in investment & growth in East Asia were sharp. Source: Calvo, BIS, 2006

26. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Unemployment rose very sharply, but peaked after 8 months.

27. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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, though some early diversification into other assets. Most middle-income countries no longer fix their exchange rate. Perhaps as a consequence, many have been able to borrow less in $, more in their own currency. More FDI. Collective action clauses in lending contracts more common. => less vulnerability to a sudden stop. The big exception was much of Central &Eastern Europe: –Lots of borrowing, denominated in € (& even SF)

28. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Source: 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