1. ITF220 - Prof.J.Frankel Lecture 18: Crises in Emerging Markets Boom-bust cycles of inflows & outflows Crashes Sudden stops Managing capital outflows Speculative attacks Contagion IMF Programs

2. ITF220 - Prof.J.Frankel CYCLE in capital flows to emerging markets Cycle prophesied by Joseph in Egypt: 7 fat years followed by 7 lean years.

3. ITF220 - Prof.J.Frankel Cycle in capital flows to emerging markets 1 st developing country lending boom (“recycling petro dollars”): 1975-1981 –Ended in international debt crisis 1982 –Lean years (“Lost Decade”): 1982-1989 2 nd lending boom (“emerging markets”): 1990-96 –Ended in East Asia crisis 1997 –Lean years: 1997-2003 3 rd boom (incl. China & India this time): 2003-2008 –Ended in 2008 global financial crisis – at least for the moment. –Crisis of the Euro periphery: 2010-12 –Will the end of QE hit EMs? 2013-14

4. ITF220 - Prof.J.Frankel Alternative Ways of Managing Capital Outflows A.Allow money to flow out (can cause recession, or even banking failures) B.Sterilized intervention (can be difficult, and only prolongs the problems) C.Allow currency to depreciate (inflationary ) D.Reimpose capital controls (probably not very effective) Y

5. ITF220 - Prof.J.Frankel Reasons for speculative attacks 3 generations of models: * Expansionary macro policy -- Krugman (1979)… * Excessive speculation: “Multiple equilibria” -- Obstfeld (1994)… * Domestic financial structure: moral hazard (“crony capitalism”) -- Dooley (2000)… SPECULATIVE ATTACKS The capital outflow is so great that the central bank loses all its reserves.

6. ITF220 - Prof.J.Frankel What’s the difference between a speculative attack and a regular balance of payments deficit? In Hemingway’s The Sun Also Rises, a character is asked, "How did you go bankrupt?” His response is "Gradually... then suddenly."

7. ITF220 - Prof.J.Frankel Traditional pattern: Reserves gradually run down to zero, at which point CB is forced to devalue.

8. ITF220 - Prof.J.Frankel In 1990s crises, reserves seem to fall off a cliff. (See graph for Mexico, 1994.) An irrational stampede? Not necessarily. Rational expectations theory says S can’t jump unless there is news; at the date of the attack the remaining Res is (just barely) enough to satisfy the increase in FX demand without a jump in the price S. Speculative attack

9. Exhaustion of Mexico’s Reserves in 1994 Peso Crisis Data source: IMF International Financial Statistics. ITF220 - Prof.J.Frankel

10. CONTAGION In August 1998, contagion from the Russian devaluation/default jumped oceans. Source: Mathew McBrady (2002)

11. ITF220 - Prof.J.Frankel Categories/Causes of Contagion “Monsoonal effects” (Masson, 1999 ): Common external shocks E.g., US interest rates ↑, world recession, or $ commodity prices ↓ … “Spillover effects” Trade linkages Competitive devaluations Investment linkages Pure contagion Stampede Imperfect information (“cascades”) Investor perceptions regarding, e.g., Asian model or odds of bailouts Illiquidity in financial markets or reduced risk tolerance

12. ITF220 - Prof.J.Frankel THE CAR CRASH ANALOGY Sudden stops: “It’s not the speed that kills, it’s the sudden stops” – Dornbusch Superhighways: Modern financial markets get you where you want to go fast, but accidents are bigger, and so more care is required. – Merton

13. ITF220 - Prof.J.Frankel Is it the road or the driver? Even when many countries have accidents in the same stretch of road (Stiglitz), their own policies are also important determinants; it’s not determined just by the system. – Summers Contagion is also a contributor to multi-car pile-ups.

14. ITF220 - Prof.J.Frankel THE CAR CRASH ANALOGY Moral hazard -- G7/IMF bailouts that reduce the impact of a given crisis, in the LR undermine the incentive for investors and borrowers to be careful. Like air bags and ambulances. But to claim that moral hazard means we should abolish the IMF would be like claiming that drivers would be safer with a spike in the center of the steering wheel column. – Mussa Correlation does not imply causation: That the IMF (doctors) are often found at the scene of fatal accidents (crises) does not mean that they cause them.

15. ITF220 - Prof.J.Frankel Optimal sequence: A highway off-ramp should not dump high-speed traffic into the center of a village before streets are paved, intersections regulated, and pedestrians learn not to walk in the streets. So a country with a primitive domestic financial system should not necessarily be opened to the full force of international capital flows before domestic reforms & prudential regulation. => There may be a role for controls on capital inflow (speed bumps and posted limits). -- Masood Ahmed Reaction time: How the driver reacts in the short interval between appearance of the hazard and the moment of impact (speculative attack) influences the outcome. Adjust, rather than procrastinating (by using up reserves and switching to short-term $ debt) – J Frankel

16. ITF220 - Prof.J.Frankel Major IMF Country-Programs 3 components Country reforms (macro policy & perhaps structural) Financing from IMF (& sometimes G-7, now G-20) Private Sector Involvement

17. ITF220 - Prof.J.Frankel Addendum 1: Critiques of the IMF Critics say “The IMF made serious mistakes -- what better evidence could one want than the severity of the 1997-2001 crises in emerging markets? -- and needs to be reformed.” But in what specific direction do critics want the IMF to move? Frankel’s Law: For every plausible and devastating-sounding critique of the IMF, there exists an opposite critique that is equally plausible and that sounds equally devastating. Here, the most common pairs: 1. Need more exchange rate flexibility. Reluctance to abandon currency targets & devalue in the face of balance of payments deficits led to crises of 1994-2001. 2. Need more exchange rate stability, including institutional commitments like currency boards or dollarization to restore monetary credibility, rather than government manipulation of the exchange rate.

18. ITF220 - Prof.J.Frankel Critiques of the IMF, cont. 3. Need more resources available for IMF emergency programs, bailouts, debt forgiveness (HIPC), & new loans; there was no good reason based in fundamentals for the Asians to suffer the sudden reversal of inflows. 4. The moral hazard problem is the ultimate source of the crises. Investors & borrowers alike are reckless when they know they will be bailed out by IMF & G7. 5. Need to adopt capital controls, to insulate countries from the vagaries of international investors. 6. Need financial openness, so countries can take advantage of international capital markets. 7. Need easier monetary & fiscal targets; IMF programs have too much expenditure-reduction, inflicting needless recessions. 8. Need tighter macroeconomic discipline, since monetary & fiscal profligacy is source of balance of payments problems; private investors can’t be persuaded to keep their money in countries lacking sound policies.

19. ITF220 - Prof.J.Frankel Critiques of the IMF, concl. 9. Need more customization of conditionality to individual country circum- stances; Asia did not have the macro problems familiar from Latin America 10. Conditionality in cases like Indonesia got too far into local details (e.g., clove and plywood monopolies). Need standardized and strict rules-based pre-certification in order for a country to qualify for IMF assistance. 11. Should concentrate loans among poor countries, rather than those that are successfully developing and able to attract private capital. Place more emphasis on poverty reduction in each country program 12. Need less subsidy in loans, higher interest rate charges, close to private market rates. In any case, leave poverty reduction to World Bank. 13. US has disproportionate influence in the IMF. 14.“IMF is directed by European socialists. US needs to exercise more influence” (US Congress).

20. ITF220 - Prof.J.Frankel Addendum 2: More on crisis in emerging markets Cycles of capital flows to developing countries Are big current account deficits dangerous? More on crises in the 1990s –Causes of sudden stops –The Korean pattern (1998) matched Mexico 3 years before (1995) –Magnitude of the loss in output in 1998. How did the 2003-08 boom differ from past cycles?

21. ITF220 - Prof.J.Frankel Cycles of capital flows to developing countries: 1975-81 -- Recycling of petrodollars, via bank loans, to oil-importing LDCs 1982 -- Mexico unable to service its debt on schedule => Start of international debt crisis worldwide. 1982-89 -- The “lost decade” in Latin America 1990-96 -- New record capital flows to emerging markets globally 1994, Dec. -- Mexican peso crisis 1997, July -- Thailand forced to devalue and seek IMF assistance => beginning of East Asia crisis (Indonesia, Malaysia, Korea...) 1998, August -- Russia devalues & defaults on much of its debt. => Contagion to Brazil; LTCM crisis in US. 2001, Feb. -- Turkey abandons exchange rate target 2002, Jan. -- Argentina ends 10-yr “convertibility plan” (currency board) 2002-08 -- New capital flows into developing countries, incl. China, India...

22. ITF220 - Prof.J.Frankel Are big current account deficits dangerous? Neoclassical theory: if a country has low capital/labor ratio or transitory negative shock, large CAD can be optimal. In practice: Developing countries with big CADs often get into trouble. Traditional rule of thumb: “CAD > approx. 4% GDP” is a danger signal “Lawson Fallacy” -- CAD not dangerous if government budget is balanced, so borrowing goes to finance private sector, rather than BD. Amendment after Mexico crisis of 1994 – CAD not dangerous if BD=0 and S is high, so the borrowing goes to finance private I, rather than BD or C. Amendment after East Asia crisis of 1997 – CAD not dangerous if BD=0, S is high, and I is well-allocated, so the borrowing goes to finance high-return I, rather than BD or C or empty beach-front condos (Thailand) & unneeded steel companies (Korea). Amendment after 2008 – Even countries with CA surpluses are vulnerable.

23. ITF220 - Prof.J.Frankel Causes of Sudden Stops Dec. 1994 – Jan. 2002 Currency overvaluation (Mexico ’94; Thailand ’97; Argentina ’01) Big/procyclical fiscal deficits (Russia ’98; Brazil ’99; Turkey ’01; Greece 2010) Delayed exit from exchange rate target, often due to elections (Mexico ’94; Korea ’97; Brazil ’98) Deeper structural flaws, e.g., “crony capitalism” in East Asia (Thailand ’97; Indonesia ’98; Korea ’97) Domestic political instability (Indonesia ’98; Russia ’98; Ukraine 2014) Moral hazard from earlier bailouts (Allegedly East Asia ’97, and especially Russia ’98) Banking crises (Iceland 2008, Ireland 2008-10, Cyprus 2013…) Increase in US interest rates (Intl. debt crisis 1982, Mexico, ‘94, “Fragile Five” 2013-14).

24. ITF220 - Prof.J.Frankel How did the 2003-08 boom differ from past cycles? China and India were major recipients of private capital in flows. They & most others did not use inflows to finance CA deficits, but rather to pile up international reserves, –most of which have traditionally been US treasury bills, Most middle-income countries no longer fix their exchange rate. Perhaps as a consequence, many borrowed less in $, more in their own currency. More FDI. => less vulnerability to a sudden stop. In global crisis of 2008, some developing countries were relatively “decoupled” from the shock The big exception was much of Central &Eastern Europe: –Ex ante: Lots of borrowing, denominated in € (& even SF) –Ex post: The worst-hit, in 2008

25. Quantity test shows rising integration IM F

26. Capital flowed to Latin America in the 1990s, and again 2004-11 IM F sta rt 2 nd boom (emerging markets) 3 rd boom (carry trade & BRICs)

27. IM F Capital flowed to Asia in the 1990s, and again 2003-11 sta rt stop (Asia crisis) 2 nd boom (emerging markets) 3 rd boom (carry trade & BRICs)

28. Global investor interest in government debt resumed for some Emerging Markets in 2010 Serkan ArslanalpSerkan Arslanalp & Takahiro Tsuda, The Trillion Dollar Question: Who Owns Emerging Market Government Debt, March 5, 2014, iMFdirectTakahiro Tsuda The Trillion Dollar Question: Who Owns Emerging Market Government Debt

29. Developing Countries Used Capital Inflows to finance CA deficits in 1976-1982 & 1990-97; but not 2003-07. IMF 1 st boom (recycling petro-dollars) sta rt stop (international debt crisis) stop (Asia crisis) 2 nd boom (emerging markets) 3 rd boom (carry trade & BRICs)

30. FX Reserves in the BRICs, 2000-2011 Neil Bouhan & Paul Swartz, Council on Foreign Relations

31. ITF220 - Prof.J.Frankel Source: Kim Edwards, SYPA, HKS, March 2010 Data: Bloomberg, IMF Global Financial Stability Report Oct. 2009 Sovereign spreads were historically low in 2007, and then shot up after the failure of Lehman Brothers in September 2008

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

33. The variables that show up as the strongest predictors of country crises in 83 pre-2008 studies are: Source: Frankel & Saravelos (2012) (i) reserves and (ii) currency overvaluation

34. When US interest rates rise, the capital flow response puts downward pressure on Emerging Markets. Financial Times, Dec. 15, 2013 In Mundell-Fleming terms, rise in i* shifts up their BP=0 curve. “Taper talk,” May/June 2013 ITF220 - Professor J.Frankel