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1 1 Chapter 7 Currency Crises and Financial Volatility © Pierre-Richard Agénor The World Bank

2 2 l Sources of Exchange Rate Crises l Currency Crises: Recent Experiences l Currency and Banking Crises l Predicting Financial Crises l Sources and Effects of Financial Volatility l Coping with Financial Volatility

3 3 Sources of Exchange Rate Crises l Inconsistent Fundamentals l Rational Policymakers and Self-Fulfilling Factors

4 4 Inconsistent Fundamentals l Conventional or first-generation model of currency crises was formulated by Krugman (1979) and Flood and Garber (1984). l Single (tradable) good, full-employment, small open-economy model with exogenous output. Assumptions: l Foreign-currency price of the good is fixed and domestic price level is equal to the nominal exchange rate due to purchasing power parity. l Perfect foresight agents hold three categories of perfect substitutes assets: domestic money, and domestic and foreign bonds.

5 5 l Demand for money depends positively on output and negatively on the domestic interest rate. l Uncovered interest parity equates the domestic interest rate to the foreign rate plus the expected rate of depreciation of the nominal exchange rate. l There are no private banks, so that the monetary base is equal to the sum of domestic credit issued by the central bank and the domestic-currency value of foreign reserves held by the central bank. The central bank pegs the exchange rate through unsterilized intervention. l Domestic credit expands at a constant growth rate to finance the government budget deficit.

6 6 m d = p + y -  i,  > 0, h s =  d + (1 -  )R, 0 <  < 1, p= e, d =  > 0,. i = i* + e.. m d : nominal money demand; p: price level; y: real output; h s : nominal supply of base money; d: domestic credit; e: spot exchange rate; i*: constant foreign interest rate; i: domestic interest rate; R: domestic-currency value of the foreign reserves held by the central bank.

7 7 l Assume  = 0 and m s = 2h s : m s = d + R. l Money market equilibrium: m s = m d = m. l Assume i* = 0: m - e = y -  e..

8 8 - m = e + y. l When exchange rate is credibly fixed at e = e, e = 0:. - l Under a fixed-exchange-rate regime, the rate of depreciation is zero and real money balances are also constant because output is constant. l In this case official reserves and growth rate of it: R = - .. - R = y + e - d,

9 9 l For the nominal money supply to remain constant and ensure equilibrium of the money market, official reserves must fall at the same rate as the rate of credit expansion. l When  > 0, any finite stock of official reserves will be exhausted in a finite period of time. l Once foreign reserves reach a lower bound (R min ) the central bank will be unable to defend the prevailing parity and will be forced to abandon the pegged-rate regime: natural collapse.

10 10 l With  > 0, rational agents will anticipate that, without speculation, reserves will eventually fall to the lower bound, and will therefore foresee the ultimate collapse of the system. l At that point, the rate of depreciation will jump from zero to a positive value; i will jump upward, and m d will fall. l To maintain money market equilibrium, the real money supply must also fall; and because the nominal money stock cannot change in a discrete manner, the nominal exchange rate must undergo a step depreciation. l Rise in prices imposes therefore a capital loss on agents holding domestic-currency assets.

11 11 l Speculators endowed with perfect foresight will not wait passively to absorb the capital loss; they will attempt to reduce their holdings of domestic assets and in the process will force a crisis before the lower bound on reserves is reached. l Issue: determine the exact moment at which the fixed-exchange-rate regime is abandoned or, equivalently, the transition time to a floating-rate regime. Flood and Garber (1984): this transition time can be calculated through a backward-induction process:

12 12 l In equilibrium, under perfect foresight, agents can never expect a discrete jump in the level of the exchange rate, because a jump would provide them with profitable arbitrage opportunities. l So arbitrage in the foreign exchange market requires the exchange rate prevailing immediately after the attack to be equal to the fixed rate prevailing at the time of the attack. l Time of collapse is found at the point where the shadow floating rate, the exchange rate that would prevail if reserves had fallen to the minimum level and the exchange rate were allowed to float freely, is equal to the prevailing fixed rate.

13 13 l Time of collapse: t c = (R 0 - R min )/  - , R 0 : initial stock of reserves. Implications: l The higher R 0, the lower R min, or the lower , the longer it will take for the collapse to occur. l With no speculative demand for money (  = 0) the collapse occurs when reserves are run down to R min.

14 14 l The interest rate (semi-) elasticity of money demand determines the size of the downward shift in money balances and reserves that takes place when the fixed exchange-rate regime collapses; è nominal interest rate jumps to reflect an expected depreciation of the domestic currency; è the larger  is, the earlier the crisis. l The speculative attack always occurs before the CB would have reached the minimum level of reserves in the absence of speculation.

15 15 l Stock of reserves just before the attack: R t c = R min + . - l Figure 7.1: The path continuing through point A corresponds to the natural collapse (  = 0). l At that point the rate of depreciation of the exchange rate jumps from zero to  and the domestic interest jumps from i* to i* + . l Expected capital loss leads to a speculative attack. l e remains constant at e until the collapse occurs and begins depreciating smoothly at point B. -

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17 17 l The domestic interest rate, as a result of the interest parity condition jumps by  at the moment the attack takes place (from F to F`). l Prior to the collapse, the money stock is constant. l In the postcollapse regime, the money stock is equal to R min plus domestic credit, and grows also at the rate . l After speculative attack both reserves and the supply of money fall by . l The size of the attack, , corresponds exactly to the reduction in money demand induced by the upward jump in the domestic interest rate.

18 18 Extension (Agénor and Flood, 1994): l nature of the fiscal constraint that underlies the assumption of an exogenous rate of credit growth and the factors that may prevent policymakers from adjusting their fiscal and credit policies to prevent a crisis; l nature of the postcollapse exchange-rate regime; l output, real exchange rate, and current account implications of an anticipated exchange-rate crisis; l role of external borrowing and capital controls; l uncertainty over the critical threshold of reserves and the credit policy rule.

19 19 l Ozkan and Sutherland (1995): fixed exchange rate system can survive longer with capital controls. But anticipation of controls may have exactly the opposite effects. l Dellas and Stockman (1993): possibility of introducing capital controls may generate self- fulfilling crises. Introduce uncertainty on domestic credit growth: l sharp increases in domestic nominal interest rates that often precede an exchange-rate crisis can be explained.

20 20 Other implications: l The transition to a floating-rate regime becomes stochastic and collapse time becomes a random variable that cannot be determined explicitly. l There will be a nonzero probability of a speculative attack in the next period, a possibility that in turn produces a forward discount on the domestic currency (peso problem). l Reserve losses tend to exceed increases in domestic credit because of a rising probability of regime collapse. l Reserve depletion tends therefore to accelerate prior to the regime change (as observed in actual crises).

21 21 l Key assumption of the conventional model: money supply falls, in line with money demand, at the moment the currency attack takes place. l But if reserve losses are completely sterilized, there will be no discrete jump in the money supply. Flood, Garber, and Kramer (1996): l In such conditions a fixed exchange rate regime cannot be viable; as long as agents understand that the central bank plans to sterilize an eventual speculative attack, they will attack immediately. l By adding a risk premium, fixed exchange rate can remain viable under sterilized intervention.

22 22 l Risk premium adjusts to keep the m d constant when the attack occurs, just as sterilization maintains m s constant. l Problem: since m s does not change and e cannot jump, the domestic interest rate cannot jump either (in contrast to empirical evidence). l Evidence: currency crises tend to be preceded by a real exchange rate appreciation and growing current account deficits.

23 23 Extension of the model to explain these facts (Willman, 1988): l Assume: two goods, one tradable the other nontradable; nontradable sector prices are set as a markup over wage costs; and nominal wages are forward looking. l Anticipated future depreciation of the nominal exchange rate will translate into higher nominal wages and higher prices of nontradables today. l Because prices of tradables remain fixed until the actual regime change, the real exchange rate appreciates.

24 24 l This reduces the relative price of importables and thus leads to increased imports and a growing current account deficit prior to the collapse.

25 25 Rational Policymakers and Self- Fulfilling Factors l Problem with the conventional model: exact timing of an exchange rate crisis may be difficult to pin down if the inconsistency between fiscal and exchange rate policies is conditional or contingent on the occurrence of a speculative attack. l Key feature of the second-generation literature on currency crises: explicit modeling of policymakers' preferences and policy rules.

26 26 l Policymakers: deriving benefits from pegging the currency and also facing other policy targets (accumulation of foreign reserves, a high level of output, low unemployment, and low domestic interest rates). l Depending on the circumstances, they may find it optimal to abandon the official parity. l Abandonment of the peg is the result of the implementation of a contingent rule for setting the exchange rate. l Each period, the policymaker considers the costs and benefits associated with maintaining the peg for another period, and must decide whether or not to abandon it.

27 27 l This decision depends on the realization of a particular set of domestic or external shock. l Obstfeld (1995): illustrates self-fulfilling crises and multiple equilibria. l Log of output: y = -  (w - e) - u,  > 0. (w - e): real wage; e: log of nominal exchange rate. It is equal to log of domestic price level due to PPP assumption. u: serially independent shocks.

28 28 l Nominal wages are set before the demand shock is observed. Constant expected real wage: w = E -1 e, E -1 : expectations operator conditional on information available at period t-1. l Policymaker’s loss function: L = (1/2)(y - y) 2 +  2 /2,  > 0, y: desired level of output;  : inflation. ~ ~

29 29 Implications: l Under a discretionary policy regime, a fixed exchange rate prevails in equilibrium only if inflation is infinitely costly. l Economy is characterized by a systematic devaluation bias. l First term: cost of deviations from the desired level of output; l Second term: cost of deviating from zero inflation.

30 30 l But although a precommitment to a fixed exchange rate would eliminate the devaluation bias, it would also prevent the policymaker from responding to unpredictable shocks to output. There is therefore a trade-off between credibility and flexibility. l In choosing whether or not to maintain a fixed exchange rate or to devalue, the policymaker will select the alternative that minimizes its loss. l Decision to devalue takes place whenever the policy loss associated with maintaining the exchange rate fixed exceeds the total loss associated with a realignment. l Potential for self-fulfilling speculative attacks arises from a circularity problem.

31 31 l Threshold point U that determines whether the policymaker devalues, depend on prior expectations of depreciation; in turn, these expectations depend on market perceptions of where U lies. l Shift in market expectations, or in the cost of devaluing, c, can lead to a change in the position of U and to a currency crisis. Figure 7.2: l Possibility of multiple devaluation trigger points. l If the private sector adopts the high value u* as the value that will trigger the abandonment of the fixed- exchange rate rule, then high u* will also solve the policymaker's optimization problem.

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33 33 l Similarly, if the private sector adopts the low value u* as the value that it believes will induce an exchange rate regime switch, then it will also be optimal for the policymaker to adopt it as well. l Thus, the economy can jump from one equilibrium to another; the shift in perceptions that triggers the jump can be completely unrelated to the behavior of macroeconomic fundamentals. l Increase in the cost of abandoning the peg may increase the likelihood of a crisis. Other sources of policy trade-offs on self- fulfilling crises: l Agénor and Masson (1999): adverse effects of high interest rates.

34 34 l Example: banks may come under pressure if market interest rates rise unexpectedly. l To avoid a costly bailout, policymakers may want to implement a quick devaluation. l Calvo (1998) and Sachs, Tornell, and Velasco (1996a): it is a large volume of short-term debt (in domestic or foreign currency) that puts a country's exchange rate peg in a vulnerable position. l Large stock of domestic-currency short-term debt: è generate doubts about public-sector solvency; è raise fears that the authorities may inflate to reduce the real value of public debt;

35 35 è impose constraints on the ability of policymakers to use high interest rates to fend off speculative attacks. è These factors may lead creditors to refuse to rollover the existing stock of debt and may increase the currency's vulnerability. l Large stock of foreign-currency short-term debt: è raise concerns about external solvency. è When short-term foreign debt to official reserves ratio is high, the risk of short-term liquidity problems may increase the vulnerability of the exchange rate to a sudden shift in expectations or perceptions.

36 36 Implications: l Flow measures of the adequacy of reserves and vulnerability and long-term solvency indicators have limited usefulness as indicators of exchange rate vulnerability relative to stock measures. l Alternative indicator of short-term vulnerability (Calvo, 1998) is the ratio of broad money to official reserves. l But, this indicator may also understate potential exchange market pressures if, for instance, holders of short-term domestic public debt become concerned about the sustainability of the exchange rate or about the government's ability to service its debt.

37 37 l Generally: possibility of self-fulfilling crises makes any pegged rate regime precarious. l Fundamentals affect the multiplicity of equilibria. l But the policymaker is incapable of enforcing its preferred equilibrium should market expectations focus on an inferior one. l Sunspots could shift the exchange rate from a position where it is vulnerable to only very bad realizations of domestic and external shocks to one where output is so low absent a devaluation and a fall in real wages that even relatively small shocks will induce policymakers to devalue.

38 38 Two important issues remain: l Obstfeld (1995): if currency crises are viewed as a manifestation of possible multiple equilibria, there are no convincing explanations of the mechanisms through which market expectations coordinate on a particular self-fulfilling set of expectations. l Second, the evidence on the role of self-fulfilling factors in exchange rate crises remains limited.

39 39 Currency Crises: Recent Experiences l The 1994 Crisis of the Mexican Peso l The Thai Baht Crisis

40 40 The 1994 Crisis of the Mexican Peso l Between 1988 and 1993, macroeconomic stabilization and economic reform in Mexico led to a sharp reduction in inflation and an improvement in the operational balance of the public sector (Figure 7.3). l Key factor in bringing down inflation: exchange rate policy, which involved the fixing of the Mexican peso-U.S. dollar exchange rate in December 1987, followed by a preannounced narrow margin crawling peg and the adoption in November 1991 of a crawling peg with adjustable bands. l Figure 7.4.

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45 45 l Nominal depreciation over the period was not sufficiently large to prevent a growing appreciation of the real exchange rate. l Figure 7.5. l Surge in capital inflows led to a significant increase in gross international reserves. l In order to sterilize capital inflows, the authorities issued large amounts of short-term treasury bills Certificados de Tesoreria or Cetes bonds) denominated in pesos.

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48 48 l Large capital inflows continued, after the approval of NAFTA. As a result, the interest rate differential between Cetes bonds and interest rates in the United States declined significantly (Figure 7.6): è Currency risk indicator: interest rate differential between Cetes and Tesobonos (short-term dollar liabilities repayable in pesos); è Default risk indicator: Tesobono-U.S. certificate of deposit rate differential. l Expansion in domestic credit and relaxation of the fiscal stance and a series of adverse political events brought the Mexican peso under severe pressure in the second quarter of 1994.

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51 51 l The Cetes-Tesobono interest rate differential rose above 10 percentage points in April (Figure 7.6). l Stock of international reserves fell. l To stem capital outflows, the authorities raised domestic interest rates and allowed the peso to move to the upper limit of the exchange rate band. l Authorities also substituted short-term debt denominated in foreign currency for peso- denominated debt. l Due to these swap operations, the outstanding stock of Tesobonos more than doubled (Figure 7.7). l Current account deficit continued to deteriorate.

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53 53 l Political unrest in Chiapas intensified. l These developments were accompanied by increased exchange rate pressures and large capital outflows. l Official reserves fell further. l Stock of Tesobonos continued to increase. l Continued accumulation of short-term U.S. dollar liabilities offset the movements in reserves but exposed the authorities' debt servicing operations to greater exchange rate risk.

54 54 l Although currency risk and default risk indicators did not deteriorate, Cetes-Tesobono interest rate differential remained significantly above its first quarter level since investors' devaluation expectations were higher. l Exchange rate band was widened (December 20); but Bank of Mexico was unable to hold the exchange rate there. l Widespread investor fears put further pressure on foreign exchange and financial markets and forced the adoption of a floating exchange rate regime. l Between December 20 and January 3, 1995, the peso depreciated by about 30% from its pre- devaluation rate.

55 55 l Domestic interest rates rose sharply. l At end-December 1994, the value of the outstanding stock of Tesobonos was about 29 billion U.S. dollars at the prevailing exchange rate.

56 56 The Thai Baht Crisis l Thailand experienced a surge in capital inflows beginning in 1988 as a response improved economic prospects. Economic reforms: l drop in fiscal deficit; l reduction or elimination of government controls over economic activity; l privatization of state-owned firms; l reduction in tariffs and quantitative import barriers; l removal of capital controls. l Capital inflows were associated with a sharp increase in investment.

57 57 l Public consumption spending fell sharply. l Beginning in 1984 and until the 1997 crisis, the Thai baht was pegged to a weighted basket of currencies of Thailand's major trading partners. l Because inflation in Thailand in the early 1990s exceeded the levels recorded by its trading partners, the pegged exchange rate regime led to a significant real appreciation (17-18%). l Appreciation of the real exchange rate led to a worsening of external accounts. l Figure 7.8. l Public sector fiscal balance, in fact, remained in surplus throughout the 1990s.

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64 64 l In 1996 and early 1997, markets grew increasingly concerned about Thailand's macroeconomic problems and financial sector vulnerability. Factors led to questions about the vulnerability to sudden reversals in capital inflows and the sustainability of Thailand's external deficits: l Merchandise exports slowed down sharply in 1996 and early 1997, reflecting in part the real appreciation of the baht and the loss in competitiveness. l Real output growth dropped to 6.4% in 1996, compared with 8.6% in 1995.

65 65 l There was a perceived shift in regional comparative advantage in some industries to lower-wage countries such as China, India, and Vietnam. l Net private capital inflows into Thailand averaged more than 10% of GDP during the 1990s and reached 13% of GDP in 1995 alone. However, 46% of the flows recorded during 1990-96 were in the form of short-term borrowing. l The early favorable perception of the high levels of investment as a sign of economic strength gave place to questions and concerns about the allocation of capital outlays and their sources of financing.

66 66 l In this case, much of the investment was risky and of low quality, going to low-productivity and speculative activities. l Weaknesses in the banking system began to emerge (large proportion of nonperforming loans). l Financial institutions had exposed themselves to significant risk by relying heavily on short-term borrowing in foreign currency, combined with long-term loans in bahts. l This created a mismatch in terms of both maturity and currency on commercial banks' balance sheets. l Speculative pressures on the Thai baht started around December 1996.

67 67 l During that month, the Central Bank lost about 2.3% of its foreign exchange reserves in defense of the currency. l On February 14, 1997, a massive attack led to a drop in the value of the baht by almost 1% against the U.S $. l The authorities responded to these pressures through sterilized intervention, increases in interest rates, and restrictions on foreign exchange movements. l On May 14-15, 1997, renewed speculative pressures on the baht led to heavy intervention by the Central Bank.

68 68 l But, speculative pressures continued in June, forcing the central bank to intervene to defend the exchange rate. l In June, the Bank lost about $4 billion. l On July 2, it was announced a managed float regime and to seek assistance from the IMF. l The baht was effectively devalued by about 15%. l The ratio of the country's gross short-term liabilities to reserves was in the range of 6 to 8 (potential source of vulnerability). l After flotation of the baht, it was discovered that the financial difficulties faced by financial and nonfinancial firms were far worse than originally thought.

69 69 l This generated uncertainty about the possibility of a full-blown financial crisis developing. l This uncertainty led to a further weakening of the baht. l Between the end of 1996 and September 1997, the baht depreciated relative to the U.S. dollar by 42%. l This worsened the real burden of external debt faced by firms that had borrowed heavily in foreign currency. l The Bank tightened its monetary policy stance and increased interest rates only after the currency had collapsed and after a continuing period of depreciation.

70 70 l Timing of the policy change did nothing but aggravate the financial situation of domestic firms; because the depreciation had already increased sharply the domestic-currency value of their foreign-currency liabilities. l Sharp fall in domestic credit was accompanied with a fall in output, an increase in the bankruptcy rate and the proportion of nonperforming loans. Conclusion: l Thailand's growing external deficits and a weak and poorly supervised financial system were the two main factors triggering the baht crisis.

71 71 l Stability of the fixed exchange rate had a perverse effect: most borrowers did not hedge their foreign- currency liabilities; so they felt the brunt of the devaluation. l Delayed policy response to the mounting problems and the authorities' resistance to an early adjustment of the exchange rate also exacerbated the crisis.

72 72 Currency and Banking Crises

73 73 l Recent evidence on financial crises: existence of close links between currency crises and banking crises. Definitions of banking crisis: Caprio and Klingebiel (1996): l the capital of the banking system is practically exhausted; l nonperforming loans amount to or exceed 15 to 20% of total bank loans; l the cost of resolving these problems amounts to at least 3 to 5% of GDP.

74 74 Kaminsky and Reinhart (1999): l bank run, associated with the closure, merging, or takeover by the public sector of at least one large financial institution; l in the absence of a bank run, the closure, merging, or takeover of, or large-scale government assistance to, at least one important financial institution. Causes of banking crises: Diamond and Dybvig (1983): l Purely self-fulfilling, because depositors think that there will be a significant amount of withdrawals in the very near future.

75 75 l With fractional reserves and a first-come first- served rule, depositors at the end of the sequential service line may suffer losses. l To avoid these losses, all depositors try to place themselves at the head of the line, causing a panic in the process. Diamond-Dybvig model: Assumptions: l Two categories of agents in the economy: households and a financial intermediary. l Number of households is large and there is no aggregate uncertainty. l Three periods, h = 0,1, 2, and a single consumption good available to agents in each period.

76 76 l Each household has an initial endowment of one unit of the consumption good at period 0 and none in subsequent periods. l They all deposit their endowment, C 0, with the bank at period 0 in return for consumption in periods 1 or 2. l They observe in period 1 an idiosyncratic preference shock that is not observed by the bank l Depending on the value of the shock, they decide to either withdraw their deposit and consume now (period 1) or keep their deposit and consume later (period 2). l Households are also able to store consumption between periods 1 and 2, if they so choose.

77 77 l u: utility function; l C h :consumption at period h. l u(C 1 ): type-E agents’ utility function; l u(C 2 ): type-L agents’ utility function; l  : probability that a household to withdraw its endowment and consume now and it is also the proportion of type-E households realized at period 1. u(C 0, C 1, C 2 ) = { u(C 1 ) with probability  u(C 2 ) with probability 1- .

78 78 l The bank accepts a deposit of one unit from each depositor and knows that a fraction  of them will be type-E agents. l In exchange for the deposit, the bank offers each household a contract that allows it to withdraw either C 1 units of consumption at period 1 or C 2 units at period 2. l The bank has access to two investment technologies: è short-term asset, yields one unit of consumption at period 1 for every unit of investment made at the beginning of that period;

79 79 è long-term asset, yields R > 1 units of consumption at period 2 for every unit of investment made in period 1. l In case of withdrawals in period 1, the bank must finance them by liquidating L units (per capita) invested in the long-term asset in period 1, receiving only R(1-L) in period 2.

80 80 l The bank chooses (C 1, C 2, L) to maximize the ex ante expected utility of individual agents: C 1, C 2, L max [  u(C 1 ) + (1-  )u(C 2 )] subject to  C 1 = L; (1-  )C 2 = R(1-L).

81 81 l These equations, together with R > 1, imply that: C 2 > C 1. ~~ l A sufficient condition for C 2 /C 1 to be less than R is to have Cu’(C) decreasing in C. ~~ l Any interior optimum must satisfy: u’(C 1 ) = Ru’(C 2 ), C 1 = L/ , C 2 = R(1-L)/(1-  ). ~ ~~ ~ (35)

82 82 l If u has a coefficient of relative risk aversion greater than unity, type-E households will share in the higher returns of illiquid assets. l Is the first-best allocation achievable? l Key insight of the Diamond-Dybvig analysis is that in attempting to implement (35) the bank faces a coordination problem. l In defining the first-best allocation problem above, it was assumed that only type-E households consumed C 1 and only type-L households consumed C 2. l However, because preference shocks are privately observed, the bank is not able to guarantee this.

83 83 l In fact, the type-L household's decision whether to withdraw C 1 at period 1 and store it for later consumption or to withdraw C 2 at period 2 is a strategic one, which depends on what other households do. Two equilibrium outcomes in this model: l First: only those households with a true preference for early consumption choose to make an early withdrawal. l Second: agents who actually prefer late consumption, fearing withdrawals by others of the same type: è also choose to withdraw early (bank run):

84 84 è costly and inefficient because the bank is forced to liquidate prematurely some of its higher- yielding investments. Primary causes of banking crises in developing countries: Goldstein and Turner (1996): l external and domestic macroeconomic volatility; l lending booms; l rapidly increasing bank liabilities, with large mismatches with respect to liquidity, maturity, and currency denomination;

85 85 l insufficient strengthening of bank supervision and regulation prior to financial liberalization; l heavy government involvement in the banking system and loose controls on connected lending; l weaknesses in the accounting, disclosure, and legal infrastructure; l distorted incentives, such as pressures for regulatory forbearance; l rigid exchange rate regime, such as a currency board;

86 86 Two ways for currency crisis to lead to a banking crisis: l In the absence of sterilization, the large loss in international reserves may cause a sharp decline in the base money stock and the supply of credit. This may have an adverse effect on output and lead to a rise in nonperforming loans, and, in turn, to a banking crisis. l Exchange rate depreciation that accompanies a currency crisis can create solvency problems among banks.

87 87 How does banking crisis lead to a currency crisis? l Related to a situation in which the central bank must inject liquidity to bail out ailing banks or depositors, because of deposit insurance scheme. Two options for the central bank to finance the bailout: l allow an excessive expansion of domestic credit to provide liquidity; this lead to an speculative attack that forces the central bank to abandon the exchange rate peg;

88 88 l issue large amounts of domestic debt as the counterpart to assuming a large portfolio of nonperforming loans; è market participants may perceive that the authorities have an incentive to reduce the burden of the debt through inflation or currency devaluation; è this may lead to a self-fulfilling crisis. l Both currency and banking crises may result from common macroeconomic shocks, such as, unexpected sharp increase in world interest rates.

89 89 Predicting Financial Crises

90 90 l Early warning indicators: to predict currency and banking crises. Kaminsky and Reinhart (1999): l Incidence of both types of crises increased sharply between the early 1980s and 1995. l Figure 7.9: incidence of currency crises during the 1990s was not higher than in the early 1980s. l Currency crises: identified by an index of currency market turbulence (weighted average of exchange rate changes and reserve changes). l The values of the index were at least three standard deviations above the mean were identified as crises.

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92 92 l Banking crisis: either a bank run or the closure, merging, takeover, or large-scale government assistance to at least one important financial institution. l Indicators, such as output and stock prices, financial sector variables, and external sector variables, used to assess the extent to which they help predict banking and balance-of-payments crises. Main conclusions: l banking crises are often preceded by financial liberalization; l banking and currency crises appear to share common causes;

93 93 l best predictors of currency crises are degree of overvaluation of the real exchange rate, adverse movements in exports, an increasing ratio of broad money over official reserves, falling stock prices, and output; l best predictors of banking crises are real exchange rate, the broad money multiplier, the stock market, output, and real interest rates; l earliest signals provided by the best predictors are between 17 months and a year before a currency crisis occurs, and between 18 months and as late as 6 months prior to banking crisis;

94 94 l both currency and banking crises appear to be more severe in Latin America than in other regions; l pre- and postcrisis behavior of most of the indicators show very similar patterns across regions, for both currency and banking crises. Demirgüç-Kunt and Detragiache (1998a): l Banking crises during the period 1980-94 tended to erupt when growth is low, and inflation and real interest rates are high. l Vulnerability to currency crises (as measured by a high ratio of the broad money stock to official reserves) and the existence of an explicit deposit insurance scheme also played a role.

95 95 l Demirgüç-Kunt and Detragiache (1998b): banking crises are more likely to occur in liberalized financial systems. Berg and Pattillo (1998): l Assessed the ability of several empirical models of currency crises to predict the Asian exchange rate crises. l Conclusion: although none of the models reliably predicted the timing of the crises, they had some value in the sense that variables (high credit growth rate, an overvalued exchange rate, and a high ratio of broad money to reserves) did affect positively the probability of a crisis.

96 96 Sources and Effects of Financial Volatility l Volatility of Capital Flows l Herding Behavior and Contagion l The Tequila Effect and the Asia Crisis

97 97 Volatility of Capital Flows Volatility of capital flows related to: l actual or perceived movements in economic fundamentals; l external factors; l investor herding and contagious factors. l actual or expected policy responses. l Evidence: volatility may lead to exchange rate instability, large fluctuations in official reserves and money supply. l Financial volatility may also have adverse effects on the real side: nominal exchange rate volatility, in particular, may hamper the expansion of exports.

98 98 Herding Behavior and Contagion l Portfolio flows tend to be sensitive to herding behavior and contagion effects. l Herding: large movements into certain types of assets, followed by equally large movements out, without no apparent reason. Reasons for herding (Devenow and Welch, 1996): l payoff externalities; l principal-agent considerations; l information cascades.

99 99 è Calvo and Mendoza (1997): with informational frictions, rational herding behavior may become more prevalent as the world capital market grows. è Small rumors can induce herding behavior and lead to large capital outflows and a self-fulfilling speculative attack on the domestic currency. l Financial contagion: massive capital outflows triggered by a perceived increase by international investors in the vulnerability of a country's currency, or, more generally, a loss of confidence in the country's economic prospects, as a result of developments elsewhere. l Examples: Tequila effect and the Asia crisis.

100 100 Other two ways for contagion to occur: l terms-of-trade shocks; l competitiveness effect.

101 101 The Tequila Effect and the Asia Crisis Tequila effect: l Collapse of the Mexican peso on December 20, 1994 triggered exchange market pressures and increased financial market volatility in a number of developing countries. l In Latin America, two economies were hit particularly severely: Argentina and Brazil. l External interest rate spreads rose sharply in Argentina (Figure 7.10). l In both economies, gyrations in market sentiment led in early 1995 to è sharp reduction in net capital inflows,

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103 103 è fall in official reserves, è pressure on asset prices. l Argentina had a fixed exchange rate regime. l Figure 7.11: output contracted significantly in 1995, whereas bank deposits and domestic credit fell dramatically. The unemployment rate increased sharply. l Liquidity crunch led to a sharp rise in bank lending rates and spread between the lending rates widened. l Shift from peso deposits, capital flight and the reduction in new borrowing led to a collapse of foreign reserves, and a dramatic fall in the monetary base.

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107 107 Would a crisis have occurred anyway? l Boom-recession cycle characterizes exchange- rate-based stabilization programs would have indeed predicted an eventual recession. l Current account deficit increased reflecting a sharp increase in consumption and gross domestic investment. l But timing and severity of the economic downturn in Argentina suggests a contagious effect. l Following the Thai baht crisis, currencies of several other Asian countries (Hong Kong, Korea, Malaysia, the Philippines, Singapore, and Taiwan) came under severe speculative pressures.

108 108 l Some of them were forced to abandoned their exchange rate regime. l Despite some positive developments on the macroeconomic side, all of these countries were suddenly viewed by investors as suffering from similar weaknesses in economic fundamentals. l These were overvalued exchange rates pegged to the U.S. dollar, growing current account deficits, declining equity prices, and weak banking systems. l Figure 7.12: nominal exchange rates depreciated significantly and equity prices fell dramatically after the collapse of the Thai baht in all of these countries.

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112 112 l Two factors interacted to transform the initial market turbulences into a vicious circle of currency depreciation and deteriorating confidence in the region's economic prospects: l Overborrowing on world capital markets at short maturities and excessive exposure to foreign exchange risk in the financial and corporate sectors; è Figure 7.13 shows the sharp increase in foreign borrowing by bank and nonbank private sector. è Figure 7.14: short-term external debt exceeded by a large amount the level of official reserves. l Weak asset portfolios of domestic banks (high ratios of nonperforming loans).

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119 119 l These financial fragilities may have led speculators to believe that pegged exchange rate regimes could not be defended very long with high interest rates and led to persistent pressures on foreign exchange markets. l Currency depreciations led to a deterioration of the financial positions of banks and nonfinancial corporations. l This heightened concerns about the viability of domestic banking systems l These factors further undermined confidence--- leading to renewed pressure on foreign exchange markets.

120 120 Coping with Financial Volatility l Macroeconomic Discipline l Information Disclosure l The Tobin Tax

121 121 Macroeconomic Discipline Preventive measures to reduce the risk of sudden changes in market sentiment: l monitoring exchange rate levels to ensure consistency with underlying fundamentals; l implementing appropriate policy adjustments to correct fiscal imbalances; l prevent an excessive buildup of domestic debt; l maintaining a monetary policy consistent with low inflation; l ensuring that the ratio of unhedged foreign debt over official reserves remains sufficiently low.

122 122 l Adequate management of the public foreign- currency debt is an important component of a strategy to reduce the volatility of capital flows. l Large stock of foreign-currency debt may magnify the impact of adverse external shocks on the economy and may constrain the policy options available to policymakers during a financial crisis. l Large, unhedged foreign-currency debt carries risks resulting not only from its maturity profile but also from its currency composition. l Short-term foreign-currency debt at floating rates exposes countries to interest rate risk resulting from abrupt changes in world interest rates.

123 123 Macroeconomic discipline and improved management of foreign debt are not sufficient: l Unwarranted changes in expectations can and do occur, even when underlying economic fundamentals appear strong: example is Chile. l The strengthening of the financial system takes time. l Because of these reasons, short-term controls on capital flows can be used during a transitory period to resort to prevent excessive volatility.

124 124 Information Disclosure l Providing appropriate and timely information to markets may be beneficial in reducing volatility. Two problems: l countries have limited incentives to provide bad news quickly to markets; l markets have limited ability to verify the information that is provided. l Knowing this, countries may be tempted to exploit this advantage by falsifying the information. l Current efforts by multilateral institutions such as the IMF and the WB to encourage countries to provide more timely data and at the same time impose quality standards are important.

125 125 The Tobin Tax l Tobin: Uniformly tax spot transactions in foreign exchange as a way to reduce volatility on world financial markets. l Key feature of the tax: it would reduce noise from market trading while allowing traders to react to changes in economic fundamentals. l By making currency trading more costly, it would discourage speculation. l Spahn (1995): extension of the Tobin tax to a two- tier tax for countries operating flexible exchange rate or band regimes.

126 126 l Impose minimal-rate transaction tax that would not impair market efficiency under normal market conditions, and an exchange surcharge that would be activated only in periods of heavy speculative trading. l During this trading price for a currency crosses an admissible band, consisting of a +/- x percent margin around a target. l When the surcharge is triggered, transactions costs would rise sufficiently to cause some traders to delay transactions, thus smoothing out fluctuations in exchange rates. l Surcharge is thus a variable tax on transactions in foreign exchange.

127 127 Difficulties (Garber, 1996): l These are establishing the tax base, identifying taxable transactions, setting the tax rate, and implementing the tax across borders. Establishing tax base: l Distinguish between normal trading that assures the efficiency and stability of financial markets and destabilizing noise trading, which should be the only target of the tax. l By reducing trading, it may paradoxically lead to less liquid markets and entail greater volatility.

128 128 Identifying taxable transactions: l Applying the Tobin tax only to spot transactions involving foreign currencies is likely to be ineffective, because market operators would eventually avoid the tax by trading in more sophisticated financial instruments. l High degree of substitutability between financial instruments may thus hamper the application of the tax. Setting the tax rate: l Tobin's initial proposal called for a low, uniform tax rate. l In normal times, low rate may represent a significant tax on trading activities.

129 129 l Since some financial transactions are undertaken by several intermediaries, taxes on these transactions may have a cascading effect. l In this case effective tax rate may be significantly higher than the nominal rate applied to a single transaction. l In heavy speculation times, even a higher tax rate is unlikely to deter speculators who expect a significant short-term change in the exchange rate. l The possible benefits in reducing short-term speculative trading would be outweighed by the possible costs associated with impairing the efficiency of financial intermediation.

130 130 Implementing the tax across borders: l Mobility of financial transactions would make the tax easy to avoid. l But universal tax can only be viewed as a remote possibility, in part because of the difficult political and economic issues that the distribution of proceeds raises. l Eichengreen, Tobin, and Wyplosz (1995): tax foreign exchange transactions, which is a tax on lending to nonresidents.

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