1. 1 Chapter 16 Speculative Attacks and Exchange-Rate Crises © Pierre-Richard Agénor and Peter J. Montiel

2. 2 l Two important models of speculative attacks and exchange rate crises: l “Conventional” models: è inconsistencies between fiscal, monetary and exchange rate policies; è role of speculative attacks in “forcing” the abandonment of a currency peg. l Recent models: è vulnerability of exchange rate systems even in the presence of consistent macroeconomic policies and sound market fundamentals; è account for policymakers' preferences and trade-offs that they face in their policy objectives;

3. 3 è view exchange-rate “crisis” as ex ante optimal decision for the policymaker; è highlight role of self-fulfilling mechanisms, multiple equilibria, and credibility factors.

4. 4 l Conventional Approach. l Optimizing Policymakers and Self-Fulfilling Crises. l A “Cross-Generation” Framework. l Evidence on Exchange-Rate Crises.

5. The Conventional Approach

6. 6 l Viability of a fixed exchange-rate regime requires maintaining long-run consistency between monetary, fiscal, and exchange-rate policies. l “Excessive” domestic credit growth leads to: è gradual loss of foreign reserves; è abandonment of fixed exchange rate, once the central bank becomes incapable of defending parity. Krugman (1979): l Under a fixed exchange-rate regime, domestic credit creation in excess of money demand growth may lead to a sudden speculative attack against the currency. l This forces abandonment of the fixed exchange rate. l This attack occurs before the central bank would have run out of reserves in the absence of speculation, and takes place at a well-defined date.

7. 7 l The Basic Model. l Extensions to the Basic Framework. è Sterilization. è Alternative Post-Collapse Regimes. è Real effects of an Anticipated Collapse. è Borrowing, Controls, and the Postponement of a Crisis.

8. 8 The Basic Model l Small open economy whose residents consume a single, tradable good. l Domestic supply of the good is exogenous, and its foreign-currency price is fixed. l Domestic price level is equal, as a result of purchasing power parity, to nominal exchange rate. l Agents hold three categories of assets: è domestic money, è domestic and foreign bonds (perfectly substitutable). l There are no private banks.

9. 9 l Thus, money stock is equal to the sum of è domestic credit issued by the central bank; è domestic-currency value of foreign reserves held by the central bank. l Foreign reserves earn no interest. l Domestic credit expands at a constant growth rate. l Agents are endowed with perfect foresight.

10. 10 l Model: m – p = y -  i,  > 0, m =  d + (1-  )R, 0 <  < 1, d =  > 0, p = e, i = i* + e, m: nominal money stock; d: domestic credit; R: domestic-currency value of foreign reserves held by the central bank; e: spot exchange rate; p: price level; y: exogenous output; i*: foreign interest rate; i: domestic interest rate; all variables, except interest rates, are in logarithms. (1) (2) (5)(4) (3)..

11. 11 l (1): relates real demand for money positively to y and negatively to i. l (2): log-linear approximation to the identity defining m as stock of reserves and domestic credit, which grows at the rate  (3). l (4) and (5): purchasing power parity and uncovered interest parity. l Setting  = y -  i* and combining (1), (4), and (5) yields m – e =  -  e,  > 0. (6).

12. 12 l Under a fixed exchange-rate regime, e = e and e = 0: m – e = . l (7): central bank accommodates any change in domestic money demand through the purchase or sale of foreign reserves to the public. l Using (2) and (7) yields R = (  + e -  d)/(1-  ). (7). _ _ _ (8)

13. 13 l Using (3), R  -  / ,   (1-  )/ . l (9): if domestic credit expansion is excessive reserves are run down at a rate proportional to the rate of credit expansion. l Thus any finite stock of foreign reserves will be depleted in a finite period of time. l Central bank announces at time t that it will stop defending the current fixed exchange rate after reserves reach a lower bound, R l. l With a positive rate of , rational agents è anticipate that reserves will fall to R l, è foresee the ultimate collapse of the system.. (9)

14. 14 l To avoid losses arising from abrupt depreciation of exchange rate at the time of collapse, speculators will force a crisis before R l is reached. l Issue: determine the exact moment at which the fixed exchange-rate regime is abandoned. l Length of transition period can be calculated by using backward induction (Flood and Garber, 1984). l In equilibrium and under perfect foresight, agents never expect a discrete jump in the level of exchange rate. l Reason: jump would provide them with profitable arbitrage opportunities. l Thus, arbitrage in foreign exchange market requires exchange rate that prevails immediately after the attack to equal fixed rate prevailing at the time of the attack.

15. 15 l Time of collapse: at the point where the “shadow floating rate,” is equal to prevailing fixed rate. l Shadow floating rate: exchange rate that would prevail with the current credit stock if è reserves had fallen to R l and è exchange rate were allowed to float freely. l As long as fixed exchange rate is more depreciated than shadow floating rate, fixed-rate regime is viable. l If shadow floating rate falls below prevailing fixed rate: è speculators would not profit from driving stock of reserves to R l ; è because they would experience instantaneous capital loss on their purchases of foreign currency.

16. 16 l If the shadow floating rate is above fixed rate, speculators would experience capital gain. l Neither anticipated capital gains nor losses at an infinite rate are compatible with a perfect-foresight equilibrium. l Speculators compete with each other to eliminate such opportunities. l This leads to an equilibrium attack. l This incorporates arbitrage condition: pre-attack fixed rate should equal post-attack floating rate. l Shadow floating exchange rate: e =  0 +  1 m,  0 and  1 : as-yet-undetermined coefficients; m =  d + (1-  )R l from (2). (10)

17. 17 l Taking the rate of change of (10) and noting from (2) that under a floating-rate regime m =  d yields e =  1 . l In post-collapse regime, exchange rate depreciates steadily and proportionally to . l Substituting (11) in (6) yields, with  = 0, e = m +  1 . l Comparing (12) and (10) yields  0 = ,  1 = 1.. (11).. (12)

18. 18 l From (3), d = d 0 +  t. l Using definition of m and substituting in (12) yields e =  (d 0 +  ) + (1 -  )R l +  t. l Fixed exchange-rate regime collapses when the prevailing parity, e, equals the shadow floating rate, e. l From (13) exact time of collapse, t c, is obtained by setting e = e, so that t c = [e -  d 0 - (1-  )R l ]/  - . (13) _ _ _

19. 19 l Since, from (2) and (7) e =  d 0 + (1-  )R 0, t c =  (R 0 - R l )/  - , R 0 : initial stock of reserves. l The higher R 0, the lower the critical level. l The lower , the longer it will take before the collapse occurs. l With no “speculative” demand for money,  = 0, and the collapse occurs when reserves are run down to R l. l Interest rate elasticity of money demand determines size of downward shift in money balances and reserves when fixed exchange-rate regime collapses. l The larger  is, the earlier the crisis. (14) _

20. 20 l Implication: speculative attack occurs before the central bank would have reached R l without speculation. l Using (8) with  = 0 yields the stock of reserves just before the attack: R t  lim R t = (e -  d t )/(1-  ), d t = d 0 +  t c, so that R t = [e -  (d 0 +  t c )]/(1-  ). l Using (14) yields e -  d 0 =  (t c +  ) + (1-  )R l. c cc __ ttcttc _ _ _ c c _ _ _ _ _ _

21. 21 l Finally, combining (15) and (16) yields R t = R l +  / . l Figure 16.1: process of a balance-of-payments crisis, under the assumption that R l = 0. l Top panel: behavior of reserves, domestic credit, and the money stock before and after the regime change. l Bottom panel: behavior of exchange rate. l Prior to the collapse at t c, money stock is constant, but its composition varies since domestic credit rises at the rate  and reserves decline at the rate  / . l Instant before the regime shift, speculative attack occurs, and both reserves and the money stock fall by  / . c _

22. 22

23. 23

24. 24 l Because R l = 0, money stock is equal to domestic credit in the post-collapse regime. l Exchange rate remains constant at e until the collapse occurs. l Path continuing through AB and taking discrete exchange-rate jump BC: “natural collapse” scenario (  = 0). l With speculation, transition occurs at A, preventing a discrete change in exchange rate from occurring. l Speculators avoid losses that would result from discrete exchange-rate change by attacking the currency at the point where the transition to the float is smooth. _

25. 25 Extensions to the Basic Framework l Alternative assumptions regarding post-collapse exchange-rate regime: case of a temporary post- collapse period of floating followed by repegging. l Real effects of an exchange-rate collapse. l Role of foreign borrowing. l Imposition of capital controls as policy measures aimed at postponing the occurrence of a balance-of-payments crisis.

26. 26 Sterilization l Key assumption of the Krugman-Flood-Garber 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, such a discrete jump will not take place. l Flood, Garber, and Kramer (1996) studied this case. l Fixed exchange-rate regime is not viable; as long as agents understand that the central bank plans to sterilize speculative attack they will attack immediately. l Consider the money market equilibrium condition (6) with  = 0.

27. 27 l If money stock is constant as a result of sterilized intervention (m = m S ) and exchange rate is fixed, this condition becomes m S – e = 0. l In the post-attack floating-rate regime, with e =  : m S – e = - . l Subtracting the second expression from the first yields e – e =  > 0. _ _.

28. 28 l Thus, if m supply does not change when the attack takes place, e will always exceed e, thereby provoking an immediate attack. l By adding risk premium, Flood, Garber, and Kramer (1996) show that the model with sterilization can be compatible with a fixed exchange rate. l Risk premium adjusts to keep demand for money constant, just as sterilization maintains money supply constant. l Since m supply does not change, and exchange rate cannot jump, domestic interest rate cannot jump either. _

29. 29 Alternative Post-Collapse Regimes l After breakdown of fixed-rate system, central bank can è devalue the currency, è implement a dual-exchange-rate arrangement, or è adopt a crawling peg regime. l Timing of a crisis depends on exchange-rate arrangement that agents expect the central bank to adopt after abandonment of initial fixed rate. l Obstfeld (1984): after allowing currency to float for a certain period of time, central bank è returns to foreign exchange market, and è fixes exchange rate at a new, more depreciated level.

30. 30 l Assume: length of transitory period of floating, T, and level e H > e to which exchange rate will be pegged at the end of transition are known with certainty. l t c is calculated by a process of backward induction. l This principle imposes two restrictions: è initial fixed rate e must coincide with relevant shadow floating rate, that is, e = e t ; è at time t c + T, preannounced new fixed rate e H must also coincide with the interim floating rate, e H = e t +T. l When central bank's policy was assumed to involve abandonment of fixed rate and adoption of permanent float, e was given by (12). __ _ _ _ _ c c

31. 31 l Under a transitory floating regime, shadow rate e =  0 +  1 m + C exp(t/  ), t c  t  t c + T C: undetermined constant. l Complete solution must specify t c and C. l These values are obtained by imposing e = e t and e H = e t +T on (18). l Solutions for t c and C are t c = (e -  -  d 0 -  )/ , C =  exp(-t c /  ), where  = [(e H - e) -  T]/[exp(T/  ) - 1]. c (18) c __ _ __ (19) (20)

32. 32 l (19): collapse time is linked to the magnitude of the expected devaluation (e H - e) and length of transitional float. l Crises occur earlier the greater the anticipated devaluation. l Relationship between collapse time and length of floating-rate interval: negative for small T and positive for large T. l If transitional float is sufficiently brief, speculative attack on the domestic currency will occur as soon as private agents realize that current exchange rate cannot be enforced indefinitely. __

33. 33 Real Effects of an Anticipated Collapse l Evidence: balance-of-payments crises are associated with large current account movements during the periods preceding, and following, such crises. l Large external deficits emerge as agents, in anticipation of crisis, adjust their è consumption pattern, è composition of their holdings of financial assets. l Movements in real exchange rate and current account may explain why speculative attacks are preceded by a period during which official foreign reserves are lost at accelerating rates.

34. 34 Willman (1988): l Convenient framework for examining real effects of exchange-rate crises. l Domestic output is demand determined, positively related to real exchange rate, and inversely related to real interest rate. l Trade balance depends positively on real exchange rate but is negatively related to aggregate demand. l Prices are set as a mark-up over wages and imported input costs. l Nominal wages are determined through forward-looking contracts.

35. 35 l When the collapse occurs: è inflation jumps up, è rate of depreciation of real exchange rate jumps down, è real interest rate falls. l Since wage contracts are forward looking, anticipated future increases in prices are discounted back to the present and affect current wages. l Thus, prices start adjusting before the collapse occurs. l Real interest rate falls gradually and jump downward at the moment the collapse takes place. l Two opposite effects on domestic activity: è Decline in real interest rate has an expansionary effect on domestic activity before the collapse occurs.

36. 36 è Rise in domestic prices results in appreciation of domestic currency, which has an adverse effect on economic activity. l If relative price effects are strong, net impact of an anticipated collapse on output may be negative. l Continuous loss of competitiveness: trade balance deteriorates in the periods preceding the collapse of fixed exchange-rate regime. l Trade deficit increases further when the crisis occurs. l Then, due to gradual depreciation of real exchange rate, it returns to its steady-state level. Kimbrough (1992): l Role of intertemporal substitution effects in understanding real effects of exchange-rate crises.

37. 37 l Optimizing framework in which money reduces transactions costs. l Effects of anticipated speculative attack on current account depends on difference between è interest elasticity of the demand for money and è intertemporal elasticity of substitution in consumption. l If the latter exceeds the former, anticipated speculative attack, è raises consumption and real balances at the moment agents realize that fixed exchange rate will collapse, è leads to continued deterioration of current account until the attack takes place.

38. 38 l If the former exceeds the latter, è reduction in consumption and real money balances, è immediate and continued improvement in current account until the time of the speculative attack. l Implication: anticipated speculative attacks may not be associated with similar real effects in all countries and at all times. l But, for several Latin American countries, speculative attacks and balance-of-payments crises have been associated with large current account deficits.

39. 39 Borrowing, Controls, and the Postponement of a Crisis l Countries facing balance-of-payments difficulties: è external borrowing to supplement reserves available to defend the official parity; è restrictions on capital outflows to limit losses of foreign exchange reserves. Borrowing: l Assumption of the basic model: there is a critical level, known by everyone, below which foreign reserves are not allowed to be depleted. l But, this binding threshold may not exist.

40. 40 l Perfect access to capital international markets: central bank reserves can be negative without violating government's intertemporal solvency constraint. l This could postpone or avoid a regime collapse. l But rate of growth of domestic credit cannot be maintained above world interest rate, because it causes violation of the government budget constraint. l Thus, over-expansionary credit policy would lead to the collapse of fixed exchange-rate regime. l Even with perfect capital markets, timing of borrowing matters for the nature of speculative attacks. l Suppose: interest cost of servicing foreign debt exceeds interest rate paid on reserves.

41. 41 è If borrowing occurs before fixed exchange rate would have collapsed without borrowing, the crisis can be postponed. è If borrowing occurs long enough before exchange- rate regime would have collapsed without borrowing, the crisis would occur earlier. l Collapse is brought forward due to servicing cost of foreign indebtedness on the public sector deficit, which raises rate of growth of domestic credit. l In practice, most developing countries face borrowing constraints on international capital markets. l This has implications for inflation in an economy where agents are subject to intertemporal budget constraint.

42. 42 l Example: country that has no opportunity to borrow externally and in which the central bank transfers its net profits to the government. è If speculative attack occurs, the central bank will lose its reserves, and its post-collapse profits from interest earnings on those reserves will be zero. è Thus, net income of the government will fall and budget deficit will deteriorate. è If the deficit is financed by increased domestic credit, post-collapse inflation rate will exceed prevailed rate in pre-collapse fixed exchange-rate regime. è This raises inflation tax revenue to compensate for fall in interest income.

43. 43 Capital controls: l Controls imposed either permanently or temporarily è after the central bank had experienced significant losses, or è when domestic currency came under heavy pressure on foreign exchange markets. l Agénor and Flood (1994): è with permanent controls, the higher the degree of capital controls, the longer it will take for fixed exchange rate to collapse. è Reason: controls dampen the size of expected future jump in domestic nominal interest rate and associated shift in demand for money.

44. 44 l Bacchetta (1990): è Temporary restrictions on capital movements may have pronounced real effects. è In perfect-foresight world, agents will anticipate the introduction of controls. l Critical to distinguish è case in which timing of the policy change is perfectly anticipated; è case in which it is not. l If controls take agents by surprise, è capital outflows will be replaced by higher imports once such controls are put in place; è this leads to deterioration in the current account until a “natural” collapse occurs;

45. 45 è thus, accelerated rate of depletion of foreign reserves through the current account will precipitate the crisis. l If capital controls are preannounced, or if agents guess exact time at which controls will be introduced, è speculative attack may occur just before the controls are imposed, as agents attempt to readjust their portfolios and evade restrictions; è this defeats purpose of capital controls and may in fact precipitate regime collapse. l Directions in which the theory of balance-of-payments crises has been extended: uncertainty and regime switches.

46. 46 Uncertainty: l Uncertainty on domestic credit growth provides explanation on sharp increases in domestic nominal interest rates. l Transition to floating-rate regime becomes stochastic: collapse time is a random variable. l There will be a nonzero probability of a speculative attack in the next period, producing forward discount on the domestic currency. l Degree of uncertainty about the central bank's credit policy plays an important role in the speed at which reserves of the central bank are depleted.

47. 47 Endogenous adjustment of fiscal and credit policies: l Example: central bank may float the currency and abandon prevailing fixed exchange rate at the moment reserves hit their critical lower bound. l Drazen and Helpman (1988) and Edwards and Montiel (1989): authorities choose to adjust exchange rate instead of altering underlying macroeconomic policy. l If new exchange-rate regime is inconsistent with underlying fiscal policy process, there will be a need for a new policy regime. Possibility of multiple equilibria: l Implication of endogenous credit policy rule.

48. 48 l Obstfeld (1986c): è Domestic growth is consistent with indefinite viability of fixed exchange rate as long as the regime is maintained (  = 0). è But contingent on collapse of fixed exchange rate, loss of discipline causes domestic credit growth rate to increase (   0). l In such a setting, multiple equilibria may emerge. è Fixed exchange rate can survive if asset holders believe that it will not collapse. è If private agents believe that collapse will occur, run on official reserves will bring the regime down, 4 triggering contingent shift in domestic credit growth, 4 validating the attack.

49. 49 l Consider the case where  = 0: è from (14), t c = , è regime survives indefinitely. l Consider that contingent on collapse of fixed exchange rate: è agents expect  c > 0, and  (R 0 - R l )/  c < , so that t c < 0; è immediate attack will take place. l Result: private agents' beliefs about viability of fixed exchange rate become a key element in determining timing of the crisis. l Shifts across alternative equilibria may be self-fulfilling.

50. Optimizing Policymakers and Self-Fulfilling Crises

51. 51 l Key feature of the recent literature on currency crises: è multiple equilibria, è explicit modeling of policymakers' preferences and policy rules. l Policymakers are viewed as è deriving benefits from pegging the currency; è facing other policy objectives (level of unemployment and domestic interest rates). l Thus, depending on circumstances, policymakers may find it optimal to abandon the official parity. l Occurrence of exchange rate “crisis” is è not related to existence of sufficient level of reserves; è related to implementation of a contingent rule for setting exchange rate.

52. 52 l Each period, policymaker considers costs and benefits of maintaining the peg for another period, and decides whether or not to abandon it. l This decision depends on realization of domestic or external shocks. l For a given cost associated with abandoning currency peg, there exists a range of values for the shocks that makes maintaining the peg optimal. l But, for sufficiently large realizations of shocks, loss in flexibility may exceed loss incurred by abandoning peg.

53. 53 l The Output-Inflation Tradeoff. l Public Debt and Self-Fulfilling Crises. l Credibility, Reputation, and Currency Crises.

54. 54 The Output-Inflation Tradeoff l Obstfeld (1996): “rational” policymakers and role of self- fulfilling factors and emphasis on output-inflation tradeoff. l Government's loss function: L = (y - y) 2 +  e 2 + c,  > 0 y: output; y: policymaker's output target; e: exchange rate; c: fixed cost associated with changes in official parity. (21) ~ ~

55. 55 l Output is determined by expectations-augmented Phillips curve y = y +  (  -  a ) - u, y: “natural” level of output,    e,  a : domestic price-setters' expectation of , u: zero-mean shock. l Assume that y > y. l Price setters form their expectations prior to observing shock u. l Policymaker chooses e after observing the shock. l Devaluation bears a cost of c d, and revaluation cost of c r. ~ _ _ _

56. 56 l Ignore c in (21). l With  a predetermined, policymaker chooses l Output:  =  (y – y + u) +  2  a  2 +  ~ _ y = y +  2 (y – y) -  -  a  2 +  _ _ ~ (23)

57. 57 l Policy loss (D for discretionary): l If the government foregoes use of the exchange rate, policy loss: L F = (y – y + u +  a ) 2. l Consider now fixed cost c. l When fixed costs exist, (23) is operative only when u is è so large that L D + c d < L F, or è so low that L D + c r < L F.  2 +  (y – y + u +  a ) 2  L D = ~ _ ~ _

58. 58 l Devaluation (revaluation) takes place for u > u d (< u r ): l Suppose that u is uniformly distributed in (- ,  ).  1 c d (  2 +  ) - (y – y) -  a u d =  ~ _  1 c r (  2 +  ) - (y – y) -  a u r = -  ~ _

59. 59 l Rational expectation of next period's , given price setters expectation  a : E  = E(  | u < u r ) Pr(u < u r ) + E(  | u > u d ) Pr(u > u d ). l Using (23):  2 +   E  = (y – y +  a ) - u d – u r 22 1 - u d2 – u r2 44 () ~ _

60. 60 l In full equilibrium, E  =  a. l Figure 16.2: Equation (24). l Slope of the curve is given by, setting  =  2 +  : dEdE dada =  2  -1 for u r > -   2  -1 [(  /2)+(  /2 )(y – y +  2 )] for u r = -   2  -1 for u d = -  l Three possible equilibria corresponding to three different probabilities of devaluation and realignment magnitudes conditional on a devaluation taking place. l These equilibria are denoted by points A, B, and C. ~ _

61. 61

62. 62 l Once  a is sufficiently high for u d to remain at - , è government's reaction function is given by (23) and è expected depreciation rate is the same as under a flexible exchange rate regime. l Expected depreciation rate is obtained by setting  =  a in (23):  = [  (y – y + u)/  ]. l To ensure that equilibrium C exist, necessary condition for multiplicities to exist, requires  -1  (y – y) -    -1 c d . ~ _ ~ _ 

63. 63 l If private agents form expectation of average depreciation rate of floating exchange rate it will materialize, as long as fixed devaluation cost is not too high.

64. 64 Public Debt and Self-Fulfilling Crises l Cole and Kehoe (1996): role of short average term of public external debt in allowing temporary loss of investor confidence to produce severe and persistent economic crisis. l Implication: financial crises can be avoided if governments diversify term structure of their debt to ensure that small portion of it matures during any particular interval of time. l Government inherits a certain amount of foreign debt that it must either retire, refinance, or repudiate.

65. 65 l Initial stock of public debt is so large that it is either è not feasible to repay it in one period or è can be immediately retired only at the cost of significant loss in welfare. l But, repudiating the debt, although costly, may be preferable to retiring or refinancing the debt under some circumstances. l Government cannot credibly commit itself to refusing to repudiate the debt at a future date if repudiation turns out to be the “best” strategy at that date. l If initial debt is large enough it is possible to admit multiple equilibrium outcomes, depending on the nature of foreign lenders' expectations.

66. 66 è If foreign lenders expect government to be able to service its debts, 4 government bonds will sell at a moderate price; 4 it will be optimal for the government to refinance them. è If lenders believe that government will not be able to service its debts, 4 they will be unwilling to lend to the government; 4 it may be optimal to repudiate the debt and crisis may occur. l Thus, foreign lenders' expectations that government will not be able to service its debt are self-fulfilling. l This situation can arise stochastically.

67. 67 l “Bad” states of nature are tied to adverse realization of a spurious indicator variable. l There can be only one crisis, because after government has repudiated its debt it has no reason to borrow. l Financial crisis can occur only if the debt that needs to be rolled over at that particular date is large. l As a result, changing maturity structure of debt can prevent crises from occurring. l Even if lenders believe that government will not be able to refinance its debt, government can retire maturing debt without incurring welfare costs large enough to give it incentive to repudiate its debt.

68. 68 l Then, equilibrium in which self-fulfilling beliefs by lenders that government will fail to repay does not exist and a crisis cannot occur. l Other source of policy trade-offs: effects of higher interest rates. l Example: è Banks may come under pressure if market interest rates rise unexpectedly. è To avoid a costly bailout, the policymaker may want to implement a quick devaluation. l Ozkan and Sutherland (1998): è With sticky domestic prices, a hike in nominal interest rates may imply hikes in short-term real rates. è These may generate self-fulfilling devaluation pressures.

69. 69 l In all of these models: è “fundamentals” affect multiplicity of equilibria; è but policymakers are incapable of enforcing its preferred equilibrium; è “sunspots” could shift exchange rate 4 from a position where it is vulnerable to only very bad realizations of a shock 4 to one where output is so low absent devaluation that even “small” shocks will induce authorities to devalue.

70. 70 Credibility, Reputation, and Currency Crises l Drazen and Masson (1994): role of credibility and reputational factors in models of currency crises with optimizing policymakers. l Credibility consists of two elements: è assessment of the policymaker's “type”; è assessment of the probability that a policymaker will stick to announced policies in the presence of adverse shocks. l Policy commitment: maintain exchange rate peg in the face of shocks to reserves. l Agénor and Masson (1999): extension of the Drazen- Masson approach.

71. 71 l Figure 16.3: structure of the Agénor-Masson model. l Policymaker's one-period loss function: L = (i - i) 2 +  e,  > 0 i: interest rate on domestic-currency denominated assets (with i its desired level), e: (logarithm of) nominal exchange rate;  : two values  w and  T, for weak and tough governments respectively, with  T >  w. ~ ~ (25)

72. 72

73. 73 l Change in official reserves:  R =  (i – i* -  a ) +  (e + p -1 * - p -1 ) - u 1, ,  > 0. i*: foreign interest rate;  a : expected devaluation, u: random shock, p (p*): logarithm of domestic (foreign) prices. l Domestic interest rate is determined by the equilibrium condition of the domestic money market: i =  0 – h. (26) (27)

74. 74 l h: (logarithm of the) base money stock defined in proportion of nominal output at the previous period h =  1 h -1 +  R + u 2, 0 0, u 2 : random term. l Normalizing constant terms to zero, (26), (27), and (28) yield i =  -1 {-  1 h -1 +  (i* +  a ) -  (e + p -1 * - p -1 ) + u}, where  = 1 + , and u   u 1 -  u 2. l L F : value of loss function if exchange rate is kept fixed. l L D : value of loss function when exchange rate is devalued. (28) (29)

75. 75 l Government devalues when L D – L F < 0. l From (29) if  e = 0, i is at the level: i F =  -1 {-  1 h -1 +  (i* +  a ) -  z -1 + u}, z = e + p* - p: competitiveness. l If e = e -1 + d (d is devaluation size), then i: i D – i = (i F - i) -  -1  d. l Domestic interest rates are lower relative to their desired value when the authorities devalue. ~ ~

76. 76 l Substitute out the previous expression in (25): l It can be shown that L D – L F < 0 only when  >    1 h -1 +  -  (i* +  a ) +  z -1, where  =  i +  d/2 +  2 /2 . l Since  can take on two values,  t (through  ) depends on policymaker's type. l Expected devaluation rate: product of the devaluation probability  and devaluation size d. L D – L F = +  d. - 2(i F - i)  d   ~ ~ ~ (31)

77. 77 l Private sector's assessment of  :  =  w + (1-  )  T,  w : probability that weak government will devalue;  T : probability that tough government will devalue. l Expected devaluation rate is  d   a = [  w + (1 -  )  T ]d. l From (31),  h can be defined as follows, for h = w, T:  h = Pr(u > u h ). ~ (32) (33) (34)

78. 78 l If u is assumed to follow a uniform distribution in the interval (-v, v), with 2v >  d, then  h = (v - u h )/2v. l Using (31) to (34), we can solve for  d: where  T >  w.  a = 1 -  d/2v d [v -  T -  1 h +  i* -  z -1 ] 1 2v2v  (  T -  w ) 2v2v + ~

79. 79 l Equation for expected devaluation rate to be estimated is given by  a = a 0 + a 1  + a 2 i* + a 3 z -1 + a 4 h -1 + , where a 1 > 0, a 2 > 0, a 3 < 0, a 4 < 0, and  is error term. l Updating equation for the probability of a weak government  is derived from Bayesian updating:  -1.  = (1 -  -1 )  -1 + (1 -  -1 )(1 -  -1 ) 1 -  -1 w T w (37)

80. 80 l Substitution of (34) for  w and  T in (37) and linearizing:  = b 1  -1 + b 2 i -1 * + b 3 z -2 + b 4 h -2 +  ’, where 0 0, b 4 > 0, and  ’ is error term.

81. A “Cross-Generation” Framework

82. 82 l Flood and Marion (1999): “cross-generation” framework for the analysis of currency crises. l Key difference between “old” and “new” approaches: è former assumes that commitment to fixed exchange is state invariant, è in the latter it is state dependent. l To link the two generations of models, make R l in conventional approach a function of variable that captures state of the business cycle (e.g. unemployment or inflation). l Implication of endogenizing R l : policymaker may affect shadow exchange rate through its choice of the level of reserves that it wants to commit to defend the parity. l Potential profits to be realized by speculators remain the driving force behind speculative attacks.

83. 83 l But state of the economy also influences the timing of currency crises. l Cross-generation framework restricts large degree of arbitrariness that characterizes the timing of speculative attacks in second-generation models. l There are ranges in which multiple equilibria do occur, but this happens only if fundamentals are sufficiently out of line. l From the point of view of policymakers, this is more sensible prediction than simply emphasizing the role of “sunspots.”

84. Evidence on Exchange-Rate Crises

85. 85 l The 1980s. l The 1994 Crisis of the Mexican Peso. è Background: Structural Reform and the Solidarity Pact. è Policy Responses to Capital Inflows, 1989-1993. è The Balance-of-Payments Crisis. l The Thailand’s Currency Crisis. è Background. è Triggering Events. è Emergence and Management of the Crisis.

86. 86 The 1980s Argentina: l In December 1978 authorities adopted a stabilization program aimed at è containing soaring inflation and è enormous public sector deficit. l Key aspect of the program: setting of the exchange rate, which was adjusted based on a preannounced declining rate of crawl. l Following a period of relative success, bank failures in early 1980 touched off a financial crisis. l Rate of increase of credit to the financial sector increased sharply in early 1980. l This undermined confidence in exchange-rate regime.

87. 87 l Large and increasing reserve losses coincided with increase in domestic credits. l Loss in confidence was reflected in a sharp increase in interest rates on peso deposits relative to foreign rates. l Period prior to the collapse was marked by è steep rise in the parallel market premium; è very high inflation rates; è sustained appreciation of real exchange rate. l Current account balance: è surplus of $1.9 billion in 1978; è deficits of $0.5 billion in 1979 and $4.8 billion in 1980. l Crawling peg policy was abandoned in June 1981. l Temporary adoption of dual exchange-rate regime adapted.

88. 88 Brazil: l Cruzado crisis occurred in October 1986, eight months after the Cruzado Plan was launched in February of that year. l Plan attempted to fix all prices, including nominal exchange rate. l Through 1986 domestic credit expanded by more than 40%. l Net foreign reserves declined by $5.8 billion. l Cruzado Plan was abandoned in October 1986 with devaluation of the cruzado. l Parallel market premium increased from 30% in March 1986 to more than 100% in the month preceding the devaluation.

89. 89 Chile: l Chilean peso crisis occurred in June 1982 and was precipitated by banking failures. l Central bank responded with sharp increases in domestic credit. l Real exchange rate appreciated and foreign reserve losses increased by the central bank for some months prior to actual exchange-rate collapse. l Eroding confidence was reflected in è widening spread between spot and forward rates for the Chilean peso and è rising parallel market premium prior.

90. 90 Mexico: l Crisis that occurred in February 1982 was accompanied by devaluation of 28% against the U.S. dollar. l Turbulence in foreign exchange market was preceded by è increases in central bank credit creation; è reserve losses for some months prior to the collapse. l Quarterly reserve losses of the central bank were estimated as 39 billion pesos, 44 billion pesos, and 140 billion pesos in the last three quarters of 1981. l Percentage spread between spot and forward peso rates widened during the final quarter of 1981. l Acceleration in inflation rate led to è appreciation of real exchange rate;

91. 91 è deterioration of the current account deficit, which reached $16 billion in 1981, compared with $10.7 billion in 1980. l On February 12, 1982, the authorities abandoned quasi- fixed exchange-rate system and allowed exchange rate to float freely. l Continuing capital outflows led to 67% depreciation of the peso by the end of February 1982. l In August 1982, with the central bank out of reserves, dual-exchange-rate regime was put in place. Similarities in processes leading to exchange rate crises in developing countries: l In the periods leading to crisis, domestic inflation is high and international reserves fall at an increasing rate, reflecting

92. 92 è over-expansionary credit policy, è rising current account deficits, è heightened perceptions of ultimate collapse of the regime. l Anticipations of a crisis translate into è forward premium or parallel market premium that may rise to high levels in the periods preceding the regime collapse; è as a result, domestic interest rates rise substantially. l Real effects associated with balance-of-payments crises: è real exchange rate appreciates during the transition period; è behavior of real exchange rate and interest rates affects domestic output.

93. 93 The 1994 Crisis of the Mexican Peso l When the international debt crisis struck, Mexico was the largest developing country debtor. l This crisis triggered by Mexico's announcement of its inability to service external debt in August of 1982. l Beginning of its end was the agreement of a Brady deal between Mexico and its external bank creditors in 1989. l Mexico was accounted for 30% of total portfolio flows to developing countries over 1989 to mid-1993. l These flows came to an end in December of 1994, when Mexico experienced a severe financial crisis.

94. 94 Background: Structural Reform and the Solidarity Pact l Expansionary fiscal policies associated with the oil bonanza after 1976 resulted in high inflation, capital flight, and accumulation of external debt. l Mexico's announcement of its inability to service external debt in 1982 triggered international debt crisis. l This ushered in three years of poor macroeconomic performance, triple-digit inflation and negative growth. l Thorough-going program of reform and orthodox stabilization was undertaken in 1985. l Structural reform was including fiscal adjustment, privatization, trade and financial liberalization, and reform of the foreign investment regime.

95. 95 l Key macroeconomic policy objectives: è inflation stabilization; è reactivation of growth based on improvements in economic efficiency. l After an initial orthodox program of inflation stabilization yielded disappointing results, Mexico switched to a heterodox approach in 1987. l Key heterodox component: agreement among the government, business, and labor to break inflation inertia by setting three nominal anchors. l Government restricted increases in public-sector prices and exchange rate, in exchange for restraint by workers and managers in the setting of wages and prices.

96. 96 l Exchange-rate component resulted in a system of preannounced daily mini-devaluations of an officially determined exchange rate. l Liberalization and institutional reform in the financial sector were central components of structural reforms. Financial liberalization: l Quantitative limits on bankers' acceptances were eliminated (November 1988). l In April of 1989: è controls on interest rates and maturities on traditional bank instruments were abolished; è non interest-bearing reserve requirements were replaced by 30% liquidity ratio; è restrictions on lending to private sector were removed,

97. 97 è mandatory bank lending to public sector at preferential interest rates was discontinued. l In September of 1991: liquidity ratio was lowered on deposits at the end of August, and eliminated for new deposits. l Constitutional amendment enacted in mid-1990 allowed full private ownership of banks. l Formation of financial holding companies: by July of 1992, 18 government-owned banks privatized. Capital flow: l Capital inflows on a broad scale in the second half of 1989. l Overall capital account surplus exceeded 8% of GDP over 1991-93.

98. 98 l Foreign direct investment led the surge in 1989 and remained important throughout the inflow episode. l Portfolio flows increased rapidly and dwarfed FDI by 1991. l Important components of these short-term flows: è certificates of deposits in privatized Mexican banks; è short-term peso-denominated government bonds.

99. 99 Policy Responses to Capital Inflows, 1989- 1993. l Response was influenced by objective of sustaining stabilization effort. l Government adhered to its exchange-rate-based stabilization strategy, è maintaining downward trajectory of nominal depreciation; è attempting to stem domestic price-level increases through sterilized intervention in foreign exchange market. l Figure 16.4: inflation fell steadily, but it continued to exceed rate of depreciation of the peso, resulting in mounting real appreciation.

100. 100

101. 101

102. 102

103. 103 l Exchange-rate band (end of 1991): è floor for the value of the dollar was established at the value reached on November 11; è subsequent devaluations defined a ceiling. l At the time the band was introduced, daily depreciation rate was lowered from 40 to 20 cents. l These measures è lowered maximum rate of depreciation of exchange rate; è gave it more room to move in a downward direction. l New exchange-rate policy implied: more appreciated and more variable nominal rate. l Inflation fell into the single-digit range by 1993.

104. 104 l But it continued to exceed rate of nominal depreciation, and the peso continued to appreciate in real terms. l Figure 16.4: deterioration in the current account in spite of steadily-improving public sector finances. l This deterioration arose from excess of private investment over saving. l Mexico did not sustain acceleration in economic growth when capital inflows surged. l After rising above 4% in 1990, growth slowed.

105. 105 The Balance-of-Payments Crisis. Three sets of factors: l initial conditions at the beginning of 1994; è slow growth, è fragile financial system, è persistently high current account deficit, è reduction in the national saving rate, è appreciated real exchange rate; l external and domestic shocks that materialized during the course of the year; l nature of the policy responses to those shocks.

106. 106 Initial conditions l Mexican peso appreciated strongly in real terms during 1988-93, and current account deficit was high. l Reforms instituted after 1985 did not result in a rapid and sustained resumption of economic growth in the short run, partly, due to tight monetary policy. l Fragile state of the financial system: è newly privatized and liberalized financial system experienced rapid expansion during 1991-94; è loans grew at annual rate of 24% in excess of the rate of growth of nominal GDP; è broad money multiplier increased rapidly; è quality of many loans was questionable;

107. 107 è 18% of bank deposits were denominated in U.S. dollars, making bank liabilities sensitive to exchange- rate changes. l Dornbusch and Werner (1994) attributed Mexico's growth performance to è demand-reducing effects of real appreciation in the home goods sector; è high real interest rates. l High real interest rates and low growth caused deterioration in firms' balance sheets, and therefore those of banks.

108. 108 Shocks l November of 1993: approval of NAFTA legislation by the United States Congress. l Approval was not foregone conclusion, and Mexico lost substantial foreign exchange reserves in October, as external creditors hedged against a failure of ratification. l Mexico's accession to GATT, OECD, and NAFTA was viewed as an institutional commitment that would tend to be perceived by the private sector as “locking in” Mexico's economic reforms. l Importance: convince potential investors that acquisition of real capital in Mexico was a good bet. l Expectation by approval of NAFTA: previous reforms would begin to bear fruit in the form of accelerated pace of fixed investment.

109. 109 l But, unfavorable shocks followed: è Chiapas uprising on January 1; è in February, succession of interest rate increases engineered by the Fed; è assassination of ruling-party presidential candidate on March 23. l Economic effects of these shocks: è higher rates of return in the United States; è increased political and economic uncertainty in Mexico increased the risk-adjusted rates on return in U.S. relative to Mexican assets. l Portfolio adjustments resulted in both price and quantity adjustments, taking the following forms:

110. 110 è Three-month CETES yield increased to 18% from March until August; the yield subsided thereafter, but remained at 15% until December. è Foreign exchange reserves peaked at U.S. $29 billion during the first quarter of 1994 but it dropped by U.S. $12 billion from February to April. è Exchange rate, which were in the middle of its band at the end of 1993, jumped to the top of the band at the end of March and remained there. l Events of the first quarter caused creditors to fear both è devaluation and è default on its obligations by the Mexican government. l Evidence on the former: sharp increase in the spread between peso-denominated CETES bonds and dollar- indexed Mexican government bonds (tesobonos).

111. 111 l Evidence on the latter: è uptick in yields on Mexican Brady bonds; è yield spread between tesobonos and United States Treasury bills of similar maturities.

112. 112 Policy Response l These reserve losses can be interpreted as the prelude to a full-blown speculative attack. l Possible responses: defend the peg with tighter credit or to abandon it. l If Mexican and foreign-interest-bearing assets had been perfect substitutes by private capital markets in 1994: è tight credit would have reduced nominal interest rates, due to elimination of devaluation expectations and exchange rate risk; è with sufficient inertia in inflation process, real domestic interest rates would also have fallen. l With imperfect substitutability: tight credit would have è raised real interest rates;

113. 113 è slowed growth of interest-sensitive components of aggregate demand; è caused contraction in supply; è deepened the recession with negative effects on investment, upward pressure on the price level and stress on financial system. l Abandoning the peg would have represented major revision of anti-inflation strategy. l These options were unpalatable especially in the context of presidential election. Government responded to the events in two ways: l Monetary policy: hold to its exchange-rate path and sterilize foreign-exchange outflows. è Reaction function of monetary authorities was stable over the course of 1994.

114. 114 è Sterilization: substantial increase in lending activities by the development banks, financed by credit from the central bank. è Figure 16.4: substantial net credit expansion to the public sector. l Debt management: è Fiscal implications of exchange-risk premia were avoided by replacing maturing CETES with short- term dollar-indexed debt (tesobonos). è Because the CETES were relatively short-term, transformation in the structure of debt was rapid (Figure 16.4). è Increase of tesobonos in domestic debt from 5% at the beginning of the year to 55% by its end.

115. 115 l Justification for this strategy: hope that post-NAFTA or post-election investment boom and improvements in productivity performance would è generate resurgence of economic growth; è validate real exchange rate; è render the current account deficit sustainable. l Plausibility of this view was enhanced by è strong growth of nonoil exports; è large share of capital goods in Mexican imports.

116. 116 The Crisis l Speculative pressures were building up in 1994 was indicated by: è behavior of capital flows; è premia for exchange-rate and default risk. l Unsustainable current account made adjustment inevitable. l Expenditure reduction and switching would be needed if post-NAFTA growth boom did not materialize. l Key point: returns on assets invested in Mexico would depend on what form that adjustment took.

117. 117 l Combination of è fiscal and monetary contraction and è nominal devaluation would have been required to produce the requisite adjustment. l Enormous fiscal adjustment already undertaken. l Thus, probability that adjustment would feature nominal devaluation was raised by è threat of financial crisis that would be posed by a severe domestic recession, è large cumulative real appreciation of peso.

118. 118 l Magnitude of devaluation would be large because: è costs of devaluing in terms of foregone credibility for the authorities were not very sensitive to the size of the ultimate devaluation; è perceived degree of overvaluation was large. l Critical issue related to timing of the crisis: change in political administration following presidential elections. l Commitment of the new administration to disinflation strategy was unknown. l Given this uncertainty, any signal that new administration was likely to consider a revised exchange-rate policy could trigger a speculative attack. l Several such signals were sent by both administrations over the course of the year.

119. 119 è Evolution of both fiscal and exchange-rate policies suggested that outgoing administration was likely to consider an adjustment in nominal exchange rate. 4 Substantial capital outflows did not trigger an adjustment in the primary surplus. 4 Exchange rate was allowed to depreciate to the top of its band during the second quarter (nominal depreciation of about 8%). è New finance minister after the election was expected to give greater weight to allocative role of exchange rate, as opposed to its role as nominal anchor. l Result of these events was further reserve losses between August and December. l By the beginning of December: è reserves had fallen to $10 billion;

120. 120 è vulnerability index (ratio of net liquid foreign-currency assets to monetary base) had fallen to the lowest levels reached during the 1990s. l On December 20, upper level of the Mexican exchange rate band was increased by 15%. l This was perceived by the markets as too little, too late. l Result: è final speculative attack was triggered; è after two days of rapid reserve losses, the peso was forced to float.

121. 121 Thailand’s Currency Crisis l Key ingredients in Mexican currency crisis: è overvalued exchange rate implied the necessity of adjustment; è fragile financial system circumscribed the form that adjustment could take. l But, these ingredients did not prove to be sui generis: shortly after the Mexican crisis, a similar set of circumstances produced similar results in Thailand.

122. 122 Background l Capital inflows to Southeast Asia increased sharply in the early 1990s, with short-term inflows playing larger role. l Rising inflation and increasing current account deficits increased concerns about macroeconomic overheating. l Domestic macroeconomic policy response consisted of tight monetary policies. l Because countries in the region continued to pursue nominal exchange-rate targets, tight money meant sterilization of balance-of-payments surpluses. l Thailand: intensity of sterilization was increased in 1993, when it experienced an upsurge in private capital inflows related to establishment of BIBF.

123. 123 l Implication of a policy mix relying on monetary policy to restrain expansion of aggregate demand: intensification of short-term inflows. l Demand for loans was sustained despite high domestic real interest rates due to asset price inflation. l Legacy of this situation: financial system with borrowers whose creditworthiness and value of whose collateral was dependent on inflated asset values. l This made net worth of these institutions vulnerable to downward correction of domestic asset prices. l Correction could come about in two ways: è negative reassessment of the earning streams associated with these assets; è increase in discount rates applied to these earning streams.

124. 124 l Inappropriate financial liberalization put strains on domestic asset values and increased short-term external liabilities. l In Thailand, in the absence of negative shocks, a crisis would have been avoidable. l But, mistake in exchange-rate management policy pushed vulnerability to the breaking point. l Maintenance of competitive real exchange rate was a cornerstone of development strategy in Southeast Asia since the mid-1980s. l In Thailand during 1994-95, domestic inflation rate was higher than those of the country's trading partners. l Failing to offset this inflation differential by nominal depreciation would have implied real exchange rate appreciation and loss of competitiveness.

125. 125 Triggering Events Medium-Term Developments l Key development: loss of external competitiveness during the first half of the 1990s. l Key factor: emergence of China as a major exporter of labor-intensive manufactured goods. l To remain competitive, Thailand would have had to export at lower prices. l Implication: long-run equilibrium real exchange rate would depreciate. l This implies growing gap between actual and long-run equilibrium real exchange rates given mild appreciation of the actual bilateral real exchange rate.

126. 126 l Figure 16.5 illustrates this (Tanboon, 1998). è Solid line shows Thailand's estimated equilibrium real effective exchange rate: sharp depreciation due to increased competition from China (Tanboon, 1998). è Actual real effective exchange rate (REER) is relatively stable, implying that by 1995, overvaluation of the Thai baht was approximately 30%.

127. 127

128. 128 Short-Term Developments l Shock that preceded the Thai currency crisis: collapse in export growth. l Poor export performance materialized throughout the Southeast Asian region in 1996. Implications of poor export growth: l Reduced GDP growth. This è reduced income streams expected to be associated with domestic assets, è dampened domestic asset values. l Introduced noise into medium-term competitiveness calculations such that gap between actual and equilibrium real exchange rates may have been larger.

129. 129 Why did export growth slow? l Loss of competitiveness due to è inflationary effects of overheating; è growth in Chinese export capacity. l Appreciation of U.S. dollar against Japanese yen after mid-1995 implied è appreciation of actual REER in South East Asian countries; è widening of the gap between actual and equilibrium real exchange rates. l Collapse in semiconductor prices blamed by è press on worldwide overcapacity; è weak market for personal computers due to poor growth performance in Japan and Western Europe.

130. 130 Negative shocks during 1996 had two effects: l Widened perceived gap between actual and equilibrium values of the REER, both through è appreciation of the actual REER; and è depreciation of the perceived equilibrium REER; l increased the vulnerability of financial sectors by è depressing asset values; and è weakening balance sheets of financial institutions. Factors for inevitable nominal exchange-rate adjustments: l Implication of misalignments: nominal exchange rate adjustments might be forthcoming. l Implication of fragility in financial sector: costs of resisting this misalignment were prohibitively high.

131. 131 Emergence and Management of the Crisis l It was prudent for agents to hedge against possibility of devaluation by moving assets out of baht. l Since this fact would magnify exchange rate-movement, other agents would have opportunity to make money by borrowing baht. l Whether such transactions would be profitable ex ante depended on markets' expectations of authorities' resolve in maintaining the value of the currency. l Vulnerability of domestic financial system and domestic economic slowdown play key roles as in Mexico. l It would have been perceived that fighting off speculative attack through traditional methods would have been too costly by the authorities.

132. 132 l Reason: high interest rates would have impaired both balance sheets and cash flows of domestic financial institutions. l By mid-1996, the region's export problems were beginning to receive widespread attention. l First hints of currency problems in Thailand emerged during late July and early August 1996, triggered by worries over export competitiveness in the region. l Following a bleak report on economic prospects, the central bank was forced to spend U.S. $1 billion to support the baht. l In September Moody's downgraded Thailand's short- term foreign debt, noting financial-sector problems and rapid accumulation of foreign debt during 1995.

133. 133 l Crisis in Thailand took almost a year before it culminated in abandonment of exchange-rate parity. l As growth slowed and domestic interest rates were maintained at high levels to defend the currency, stock market fell. l Government made key mistakes in both areas of vulnerability: exchange-rate policies and financial sector policies.

134. 134 Exchange Rate Policy l Government's biggest mistake: hold nominal value of the baht for almost a year. l Devaluation expectations resulted in è large capital outflows; and è very high domestic interest rates. l Through their effects on government's liquidity position and balance sheet of financial system, they magnified uncertainty and instability. l Despite the pressure on the currency, Bank of Thailand reported foreign exchange reserves of U.S. $38 billion, unchanged from the July 1996 level. l By the time the baht was floated in July 1997, reserves had officially fallen only to U.S. $33 billion.

135. 135 l But, reserves were maintained through large swap transactions, leaving the Bank with a stock of future dollar liabilities in excess of U.S. $ 23 billion. l Loss of liquidity created uncertainty in the market after the baht was floated as to whether è country would be able to meet its large short-term external obligations; è this perceived vulnerability to liquidity crisis undermined the value of the currency after the float. l Government increased the cost of keeping the value of the baht fixed almost a year by sending signals that its commitment to the exchange-rate peg was not firm. l Example: in January 1997, government announced its intention to reevaluate exchange rate regime when the economy regained strength.

136. 136 Financial Sector Policy l Second key mistake: postpone resolution of problems of financial system. l Government initially denied vulnerability of country's 15 commercial banks and 90 finance companies. l High domestic interest rates continued to undermine the value of assets held by financial system. l Effect was to jeopardize solvency of finance houses and banks, which added to è stock of nonperforming assets in financial sector; è cost of resolving the sector's difficulties. l Increase in this cost impaired government's fiscal position.

137. 137 l This unresolved liability overhang was a second source of uncertainty which è increased instability after the currency was allowed to float; è magnified fiscal burden associated with the crisis. l As the end of 1996 approached, financial-sector share prices reflected extreme lack of confidence. l Government's initial policy response was inadequate, consisting of a regulation imposed in December 1996 requiring è banks to disclose their bad loans; è adoption in January 1997 of series of measures seeking to artificially prop up property values rather than

138. 138 4 recognizing and allocating losses of bank and finance company capital; 4 recapitalizing financial sector under more stringent supervisory and regulatory regime. l In January 1997, the Cabinet announced the creation of government fund to purchase a portion of their bad property debt from finance companies. l Measure backfired because è it signaled the government's intention to bail out some of these companies, è it revealed policy disarray within the government. l By late February 1997, depositors engaged in a run on Thai finance companies, transferring deposits to safer banks and moving money abroad.

139. 139 l Thus, renewed pressure on the baht emerged in February. l Bank of Thailand responded by tightening monetary policy. l High interest rates resulted in a succession of financial crises triggered by falling property values. l Central bank extended credits to these institutions (estimated to total U.S. $15.7 billion). l But, finance company liquidity crisis culminated in the failure of country's largest finance company. l After this failure: è stringent provisioning requirements were imposed on all financial institutions; è 10 small finance companies were required to increase their capital;

140. 140 è but, public disclosure of bad loan portfolio among finance companies was not required. l Further measures were adopted in May: è Capital controls were imposed in the form of instructions to local banks not to sell baht to foreigners in the swap market. è Expenditure cuts were announced to offset shortfalls in tax revenue due to the economic slowdown. è Bank-financed fund was set up to buttress stock market. l Government began to signal a tougher stance toward financial sector in late June: è Merger laws to accommodate the takeover of companies in difficulties were eased.

141. 141 è 16 finance companies were ordered to suspend operations and seek merger partners within 30 days. è Troubled finance companies that failed to merge would be allowed to go under. l But, these measures proved to be too little too late. l The baht was floated on July 2. l In a month, it depreciated by over 25%. l Despite the float, problems were not over: è Shortage of liquidity and nonperforming loans in financial sector left significant uncertainty; è authorities intervened to avoid excessive depreciation of the baht; è central bank raised its discount rate rather than moving toward lower domestic interest rates.

142. 142 l Thailand began negotiations with IMF on July 28, and program was agreed one week later.