Macroeconomics Chamberlin and Yueh

Macroeconomics Chamberlin and Yueh
Chapter 15 Lecture slides Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

International Financial Markets and Currency Crises
The Internationalisation of Financial Markets Currency Crises First Generation Models: Latin America, Second Generation Models: ERM, 1992; Mexico, Third Generation Models: Asian Crises, Preventing Currency Crises Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Use with Macroeconomics
Learning Objectives Learn about the internationalisation of financial markets Determine the causes of currency crises around the world Assess policy options to combat currency crises Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

International Financial Market
Since the 1980s, though, there has been a dramatic reduction in exchange controls throughout the world, leading to a large rise in international capital mobility. The consequence is that financial markets in different countries have become increasingly interlinked, given rise to what can be described as an international financial market. In addition, the scale of international trading has risen dramatically. The majority of this is short term and highly liquid, known as “hot money,” which can move quickly in and out of different markets in different countries. This explains how financial markets have come to be increasingly linked together, giving rise to what is known as the international financial market. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Currency Crises During the last decades, there have been various episodes of high volatility in currency markets. A currency crisis arises when a currency comes under huge selling pressure forcing a very large and dramatic devaluation. Developing and transition countries have traditionally been the victims, especially in Latin America and more recently in Asia. However, the collapse of the Exchange Rate Mechanism (ERM) in the early 1990s aptly demonstrates that developed nations can also be prone to these crises. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Currency Crises Currency crises can be extremely damaging to developing and transition economies. Increasing openness has meant that shocks that happen in one country can quickly spread around the world. The process by which shocks can be transmitted across countries is known as contagion. One solution would be to reimpose capital controls, but this would also make the advantages of international financial markets unattainable. Therefore, policy makers have become increasingly concerned about designing the international financial architecture to maintain high capital mobility, but to also to deal with these instabilities. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

The Internationalisation of Financial Markets
International capital mobility has increased substantially. Since the 1970s, the growth in international financial transactions has far outstripped that of GDP. There are three main reasons which have promoted the development of the international financial market: the historical change in exchange rate regimes; the growth in offshore banking and currency trading; and a change in ideology. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Changing Exchange Rate Regimes
Trilemma of policy: The government can only choose two of the following: fixed exchange rates, control of monetary policy, and capital mobility. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Offshore Banking and Currency Trading
Offshore banking refers to the business that banks undertake in their foreign offices. Offshore currency trading has grown hand-in-hand with this, enabling people to trade a nation’s currency outside of that country. This has steadily reduced the effectiveness of exchange controls and has also been an important factor in accounting for their demise. If capital controls can be easily circumvented, then they become essentially useless. Global Applications 15.1 Eurocurrency Markets Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Changing Ideology The abolition of exchange controls and the increasing freedom to make international financial transactions have often mirrored the deregulation in domestic financial markets. The previous arguments are somewhat negative. They suggest that increasing capital mobility is simply a consequence of no longer needing controls to help maintain a fixed exchange rate, or that they are becoming increasingly irrelevant due to the scale of currency trading taking place outside of a nation’s borders. However, a positive argument is that openness in financial markets might be something that is demanded in its own right. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

An International Financial Market: the Advantages
Facilitating International Trade Portfolio Diversification Promoting an Efficient Allocation of Resources: Global Applications 15.2 Feldstein-Horioka Debate A Disciplining Device on Policy-Making Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Currency Crises Currency crises are sharp depreciations in a nation’s currency brought about by large amounts of selling on international foreign exchange markets. In almost all instances, it involves nations which have endeavoured to fix their exchange rate, but are then forced into a very sudden and sharp devaluation when defending the parity becomes impossible or too costly. The recent prevalence of currency crises has been linked to the international foreign exchange markets. Recent currency crises of note which will be discussed are: The Latin American crisis, The ERM crisis, 1992 The Mexican crisis, The Asian crisis, Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Why attack a currency: how do speculators make money from devaluations? If a speculator thinks that a currency will devalue, then they can submit an order to the markets to sell the currency now and buy it back at a later date. If, in the meantime, the exchange rate depreciates, it means that the speculator is selling the currency for far more than which it is being bought back at, representing in many cases a sizeable trading profit. For example, if the currency devalues by 50%, then this is the size of the capital gain that the speculator will make. Conventional models argue that a currency crisis will emerge when the government runs out of reserves and is no longer able to defend the fixed exchange rate against heavy selling by speculators. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Why attack a currency: how do speculators make money from devaluations? The heavy selling by speculators is a vital part of the anatomy of a crisis. Remember that speculators can profit from a devaluation, but by their selling actions, they can help create this by exhausting the governments reserves. Therefore, speculators know that when the government is low on reserves, they may be able to force a devaluation and profit from their own actions. To maintain a fixed exchange rate, the government must use its gold and foreign exchange reserves to intervene in the currency markets. If a devaluation occurs, then the source of speculator profit will be the capital losses that governments make on their interventions. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Example: High Reserve Game
Suppose there are two traders, 1 and 2, who can either sell or hold their currency holdings, each having six units. The cost of undertaking a sell order is 1, whereas holding costs are 0. Suppose the government has reserves of 20 with which to defend the currency. If a devaluation is forced, then the exchange rate will depreciate by 50%. In this case, the pay-off each trader receives given the action of the other can be represented in the following figure. The equilibrium in this game is for both traders to hold, no matter what the other does. This is because, individually or together, the speculators do not cannot exert enough pressure to overwhelm the government, so any action would be unsuccessful and cost 1 unit. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Example: Low Reserve Game
However, suppose the government’s reserves are low, and are only 6. In this case, either speculator has the ability to force a devaluation since they can completely exhaust the government’s reserves by their selling actions. The following pay-off matrix will result. If one trader sold while the other did not, a profit of 2 will be made. If both traders sell, then the trading revenue of 3 is shared between them, each receiving 1.5 units each. They then both pay the transaction charge of 1 to leave a possible profit of 0.5. Therefore, as any sell action would yield a profit, no trader would ever wish to hold, so both traders selling would be the equilibrium of the game. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Under what conditions then is a currency likely to come under attack?
Balance of Payments Crisis: The government runs down its reserves in the official financing of current account deficits. Because reserves are limited, official financing cannot sustain deficits forever. Inflation: In a fixed exchange rate regime, runaway inflation will erode competitiveness, as there will be no offsetting exchange rate depreciations. This will lead to the exchange rate being overvalued compared to its PPP level, and the erosion of competitiveness would put pressure on the current account. Government deficits: A government running a substantial debt may be encouraged to produce some inflation (seigniorage revenues) in order to reduce the real value of its debt. Therefore, large deficits may be seen as inflationary, with consequences for competitiveness and the balance of payments. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Example: Low Reserve Game
Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

First generation models
The first generation of currency crises models links the onset of the crisis to one of these problems. All of them are expected to lead to a demise in the external competitiveness of the nation and in a fall in reserves. The eventual exhaustion of reserves would lead to a collapse in the fixed rate. The timing of the crisis will be as soon as speculators believe that it will be successful, and this is when the government is down to some critical level of reserves. The fixed rate is ultimately unsustainable because of fundamental factors; the actions of speculators just bring its eventual demise forward. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Latin America, This is a conventional example of a first generation currency crisis. The economies of Chile, Brazil, Mexico and Argentina were operating a fixed exchange rate against the $US. These were collectively known as the Tablitas, which was a pre-announced schedule of depreciations against the US dollar known as a crawling peg. However, a substantial inflation differential between these Latin American nations and the U.S. meant that inflation rose in excess of the currency depreciations, which eroded their competitiveness and put pressure on their balance of payments. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Second generation models
An extension to the game introduced above is the following, where the government has resources of 10 (medium reserve game). Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Second generation models
The feature of this game is that no trader on his own can initiate a crisis, but both working together can. If both hold, then the payoffs are obviously zero. If one held and one sold, the seller would lose 1 unit. However, if both sold, then the government would commit its reserves and make a 50% loss, so the trading revenue would be 5, or 2.5 each. After paying the trading fee, residual profits are 1.5 each. As each trader’s optimal decision is to do what the other did, this game has two solutions. Either both will sell, or both will hold. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Self-fulfilling crises
The interesting feature of this game is that a currency crisis may hit one nation, whereas a similar country can escape such a situation. If speculators decide to attack and can coordinate their actions, then the attack will be successful in forcing a devaluation. In this case, there is a degree of arbitrariness about a speculative attack. The end of the peg is not pre-ordained. There may be no worsening trend in fundamentals, and no reason as to why a currency should necessarily be subject to attack. There is a range of fundamentals where a crisis may happen, but not necessarily must do. In such a situation, a crisis can become a self-fulfilling event. Coordination among speculators is required for pessimism to become self confirming. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Self-fulfilling crises
The situation in which a crisis could happen, but need not presents speculators with a one way bet. They will reap a huge capital gain by selling currency if the exchange rate regime collapses, but will make no losses (apart from transaction costs) if the collapse fails to materialise. If self-fulfilling crises are a possibility, then what can create the coordination dynamics that can set them off? Herding is the simple idea that speculators will all move in the same direction because the behaviour of one will influence the behaviour of others in the same direction. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Herding There are several explanations as to why this might happen. 1) A bandwagon effect induced by the presumption that an investor has private information. 2) Behavioural finance models. This relates to the psychology of fund managers who are compensated on their relative performance. They have strong incentives to act alike. 3) Market manipulation. As currency crises are such a profitable event for speculators, one would suspect that they would play the market strategically in order to induce a crisis. An influential speculator may try to instigate a crisis from which they benefit by a combination of public statements and very clear large selling. George Soros’ attack on the Sterling in the ERM is a classic case in point. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

1st and 2nd generation models
What is common to both first and second generation models of currency crises is that a speculative attack is most likely to work when the policy maker is not prepared to defend the currency. In the first generation model, it is because something fundamental about the economy ultimately makes the fixed parity unsustainable. A speculative attack just brings forward the inevitable. In the second generation model, a speculative attack may or may not happen, but what is likely to make speculators attack a particular country? This will be when the policy maker may be unwilling to defend the parity of the currency. This is most likely to be the case (as we’ll see with the ERM and Mexican crises) when such a commitment would require measures that the policy maker would rather not take. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Why might the exchange rate be so hard to peg?
Capital market deregulation has led to an explosion in hot money flows. A common misperception is that daily trading of currencies is too large – exceeding $1 trillion per day – and that no government could hope to defend their currency against such an attack. The largest individual hedge funds command enough resources to wipe out the foreign exchange reserves of all but 20 central banks. For example, in 1994, Soros Management reported investment capital of $11 billion and Tiger management of more than $6 billion. An estimate of total hedge fund reserves was $ billion. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Despite the existence of these large funds, there is no insurmountable obstacle to fixing the exchange rate. This is simply because a monetary authority can use the interest rate to defend the currency. From UIP, we know that the exchange rate will change unless: So, this has to be the minimum interest rate that the government can offer. ρ reflects the relative risk premium of domestic and foreign assets. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

The risk premium largely reflects the probability of a devaluation (as a devaluation will result in capital losses for foreign investors). Consequently, as the expectation of a devaluation becomes larger, the risk premium rises, which requires a larger interest rate to attract the necessary inflows. However, high interest rates will have an adverse impact on the rest of the economy. The government is then faced with a choice: it can either accept the higher rate with its effects on the domestic economy, or it can abandon the fixed rate and let the currency depreciate. The government’s resolve to defend the currency will be influenced by its ability to accept higher interest rates. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Under what conditions might the rise in interest rates required be intolerable? Unemployment – significant unemployment will make rises in interest rates more unbearable. Public debt – highly indebted countries with short term debt will find the chances of fiscal insolvency are greatly increased if the threat of devaluation drives up interest rates, e.g., Italy in 1992. Banks – higher interest rates may lead to corporate and personal bankruptcies which will increase the number of non-performing loans held by creditors, perhaps precipitating a banking crisis. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

A conventional model of a currency crisis
Three ingredients which lead to a potential crisis: 1) A reason as to why the government may wish to abandon the fixed exchange rate. 2) A reason as to why the government would wish to defend the exchange rate; so there is a degree of conflict between its objectives. 3) The cost of defending a currency must increase when people expect that the rate might be abandoned. These three factors taken together is all that is required to generate a conventional model of a currency crisis. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

A nation may have reasons to defend the currency: Fixed exchange rate is important for facilitating international trade and investment. A way of introducing inflation discipline/credibility into the economy. However, if under pressure of a devaluation, the cost of defending the currency becomes too great, the policy maker may be prepared to let go of the fixed parity. A speculative attack on the currency may then become likely as speculators are prepared to gamble on the resolve of the policy maker to sustain the high interest rates necessary to defend the currency. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

ERM crisis, 1992 In 1992, massive speculation led to the exit of Britain, Spain and Italy from the ERM. All these countries fit the second generation model well, but the UK example is particularly illuminating. The UK’s decision to join the ERM (Exchange rate Mechanism) was the cornerstone of its anti-inflation policy. By fixing the pound (£) against the German Deutschmark (DM), Germany’s low inflation discipline could be imported, and for a time, it worked as UK inflation came under control from its peak in 1990. However, maintaining the fixed exchange rate against the DM required UK interest rates to follow German levels. German reunification was largely paid for by borrowing rather than tax cuts, and in order to prevent inflation, the German Bundesbank substantially increased German interest rates. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

UK interest rates: upward push in 1990-91

ERM crisis, 1992 However, the UK needed lower interest rates in order to try and invigorate the economy and reduce unemployment. As this was impossible for as long the UK belonged to the ERM and there was no movement in German interest rates, there was a clear argument for abandoning the fixed exchange rate. Speculative pressure on the pound arose because simply because of this conflict of policy objectives. If the pound came under heavy selling pressure, it would seem a very reasonable policy for the UK to simply let the pound devalue and sacrifice ERM membership. This is because to defend the pound would require higher and higher interest rates, which would be intolerable for domestic reasons. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

ERM crisis, 1992 George Soros accumulated a $15 billion short position against the pound. On Black Wednesday, a brief defence of the pound was undertaken: interest rates rose from 10% to 12%, and then further to 15%. This did not avert the attack, but the UK could have imposed higher interest rates if it really wanted to. (For example, Swedish overnight interest rates jumped to 500% at one point). However, when 15% did not work, the UK government gave up the parity, prompting a collapse in the £ against the DM. Exit from the ERM, though, wasn’t necessarily such bad news. Firstly, it enabled UK interest rates to come down quite sharply and the depreciation in the exchange rate boosted UK competitiveness. The result was that the UK economy began to grow, and unemployment fell. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Anatomy of the ERM crisis

Mexico crisis, Prior to the collapse, the Mexican peso had been operating a fixed parity against the $US. However, leading up to the end of 1994, there were several underlying weaknesses in the Mexican economy which led speculators to question the sustainability of the peg. Concerns originated from PPP calculations, which indicated that prices/costs had risen in excess of trading partners, implying that the fixed exchange rate was overvalued. This was the cause of a growing current account deficit, rising from 7% of GDP in 1993 and 8% in 1994. Central bank reserves were running down and defending the currency was requiring higher interest rates, which there was high unemployment. There was political pressure for a devaluation. Mexico had a history of devaluing in election years. Civil unrest at the hard economic conditions culminated in the assassination of Luis Donaldo Colosio, the ruling party’s presidential candidate. Monetary policy was relaxed in the build-up to elections and, at the same time, the election year rise in public spending had weakened the government’s fiscal position. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

The collapse of the Mexican peso against the $US in 1994

Mexico crisis, The growing need for a devaluation, though, was initially ignored by policy makers. Even if it made sense to devalue, the cost in terms of credibility would be high. The fixed exchange rate regime and price stability would, if the present difficulties could be tolerated, would yield the conditions that are favourable to long term investment – a due consideration for an emerging market economy that is largely dependent on outside investment. The falling peso threatened to create a large spike in inflation (due to more expensive imports) requiring a very large increase in short term interest rates, leading to a substantial fall in aggregate demand and output. GDP fell by 7%. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

ERM and Mexico Crises The general principle behind attacks seems to be the inconsistency in policy making and that ultimately governments are prepared to forsake long term political or inflation credibility for a short run economic expansion. The Latin American crisis shares some common features with the ERM collapse, but the most striking difference was in the aftermath. The countries that were forced to parachute out of the ERM performed well; the depreciation injected competitiveness, and the freedom to reduce interest rates was exercised. However, the Mexican economy suffered severe downturns following devaluation. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Third generation models: Asian Crises, 1997-98
The Asian five – Thailand, Malaysia, South Korea, Indonesia and the Philippines – all suffered from a collapse in the currency brought on by large scale outflows of financial capital. Up until this time, these currencies were held relatively fixed against the $US. It is clear that the rapid drop in the exchange rate is a similar feature to the crises already described, but that is where the comparisons finish. Although there were those who questioned the extent of Asia’s economic miracle, it was largely unthinkable that the region would suffer the crisis that it did. True, current account deficits were rising, but these were offset by a healthy capital account. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Balance of Payments 1990-96 (% of GDP)
Korea Indonesia Malaysia Philippines Thailand Current Account Capital Account Account Reserve Assets Source: IMF Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Asian Crises, There appeared to be no reason for the crisis that could be explained by conventional first and second generation models. On the eve of the crisis, inflation was low and there was no excessive fiscal deficit. The set of five Asian economies were also considered as the model for emerging economies to follow. Terms such as tiger economies or the Asian miracle were readily applied. Leading up to the crisis, these economies had posted impressively large and sustained economic growth figures. The growing economy and low unemployment suggested that there was no real incentive to abandon the fixed rate. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Asian Crises, In addition, the crisis was relatively unpredicted. Most risk assessments of the area in mid 1996 showed no expectation of what was to come in the following months. The conventional (1st and 2nd generation) currency crisis models tend to fit the Asian experience badly because the currency crisis was simply part of a larger financial crisis. Collapses in the currency were joined with collapses in asset prices and bank failures. The crisis also spread infectiously across the entire region, the MIT (Malaysia, Indonesia, and Thailand) economies were strongly linked by trade, but South Korea was not and still suffered. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Asian Crises, An analysis of the crisis appears to go along these lines: The emerging markets in Asia in the proceeding years had received large inflows of capital, much of which had been loaned to Asian banks who were poorly regulated and had invested badly in speculative real estate, amongst other things. This led to an asset price bubble. Therefore, the impressive growth figures masked deep underlying fragilities. This was particularly true in the banking system where the bubble in domestic asset prices and over exposure to foreign creditors made the economy vulnerable to a financial panic. In general terms, a panic arises when short term debts exceed short term assets. If a run starts, investors know that there are insufficient funds to pay all creditors. This encourages quick liquidation in order to avoid losses. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Asian Crises, Several triggering factors led to a quick withdrawal of investor funds in the region. The main element of the currency crisis was the sudden reversal of the large private capital flows that had previously flowed into the region. The problem with such panics is that they may involve some degree of disorderly workout. This is when an insolvent or an illiquid borrower provokes a creditor grab even though the borrower is worth more as an ongoing enterprise. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Capital Flows into and out of the Asian 5
In 1996, private net flows into these economies were $93 billion. The majority of this (92%) was accounted for by private creditors and portfolio investment. Direct physical investment (factories, etc.) made up a very small part of the inflow. These large scale inflows were encouraged by several factors: Continuing and high economic growth gave confidence to foreign investors. Wide-ranging deregulation enabled banks and domestic corporations to tap into foreign finance for domestic investments. Nominal exchange rates were pegged to the $US and hence the removal of exchange rate uncertainty encouraged inward investment. Governments gave special incentives that encouraged foreign borrowing, e.g., no reserve requirements for foreign exchange rate loans. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Capital Flows into and out of the Asian 5
The crisis was brought on by the sudden reversal of a long and sustained period of inflows. In 1997, net inflows into the Asian five (Indonesia, Korea, Malaysia, Philippines and Thailand) dropped from $93 billion to -$12 billion, a swing of $105 billion which is about 11% of collective GDP. Foreign direct investment remained constant at about $7 billion, so most of the decline came from these private short-term paper money flows or “hot money.” But, why did this sudden reversal take place? This involves an analysis of how the large inflows led to increasingly fragility, and then the triggering factors that resulted in financial panic and large outflows. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Moral Hazard and Increasing Economic Risk
Given the boom-bust behaviour in asset prices and the general banking collapse which were striking features of the Asian crisis, financial intermediaries may have been central players. In Thailand, finance companies borrowed short-term money (often in $US) and then lent to long term speculative investors, particularly in real estate. The problem with these intermediaries, though, was that they were seen to have a government guarantee, a problem known as moral hazard. The banking system in many Asian countries was somewhat murky. Although there were no explicit government guarantees, most banks had strong political connections and there was a belief that if there was a default, the government would bail them out to prevent a banking collapse. Such a system is likely to lead to risky investments. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Logic of moral hazard Safe Risky Return in good state Return in bad state Expected return Expected return to owner Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Logic of moral hazard The table shows the options facing the owner of a financial intermediary who raised $100 million from creditors. No capital of his own needs to have been put up, and bankruptcy has no personal cost. There are two investments options: one yields a certain outcome of $107 million, whereas the other yields a 50:50 gamble between £120 million and $80 million, depending on whether conditions are good or bad. The risky investment has expected returns of $100 million. The financial intermediary sees these options and knows that if the good state arises, then the investment will yield a $20 million profit. However, in the bad state, it isn’t the case that a $20 million loss is made, as the intermediary can just walk away without any cost – the return is hence just $0. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Logic of moral hazard Given this state of affairs, the risky investment yields an expected return of $10 million, whereas the safe investment delivers just $7 million. Therefore, moral hazard leads to a distortion in investment. Riskier projects are undertaken, and the inefficient choice is taken. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Risky bank lending led to an asset price boom, particularly in real estate and share prices. High asset prices and high equity values meant that property companies and the corporate sector could use these highly valued assets as collateral on further loans. Therefore, the banking system was prepared to borrow from overseas and provide further loans. The extent of bank lending meant that the real estate and corporate sectors became increasingly indebted to banks who were themselves increasingly indebted to foreign creditors. However, the fragility was masked by these high asset prices giving a sense that all loans were collateralised and that even if anything did go wrong there would be a government rescue package. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

The fragility of the banking sector became apparent with the bursting of the asset price bubble. Banks had advanced many loans on what they perceived to be good collateral, but with falling prices, this meant that the collateral disappeared and banks ended up holding loans with little security. These banks had also borrowed substantially from overseas, so the reserves to short-term debt ratio had risen. Now everything was set up for a potential crisis. If foreign investors had a loss of confidence, they would call in the loans made to Asian banks. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

With short-term debt being relatively high compared to reserves, the banking sector would have to liquidate some of its loans but the security supporting these loans no longer existed. Therefore, any attempt by the banking sector to liquidate firm assets would lead to a succession of corporate bankruptcies and non performing loans (as the value of these loans is greater than the collateral/assets used to secure them). Worried that loans may be defaulted upon, foreign creditors would panic and attempt to salvage as much as possible by withdrawing as quickly as possible – an action which would then lead to a quick downward spiral of bankruptcies, default and further panic. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Triggering Events The triggering events are factors that would lead to a loss of confidence in foreign investor confidence, which when combined with the fragile economic conditions will lead to panic and large outflows. There may be several examples of specific triggering factors. In Korea, it appeared to be increasing incidents of corporate failure. In Thailand, Samprasong Land missed payments on its foreign debts, signalling the demise of the property market and the beginning of the end for the Thai finance companies that lent heavily to property investors. In addition, there was political uncertainty with elections in Korea, Thailand and the Philippines. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Aftermath: Contagion, Bankruptices and Growth
The Asian crisis also shows a substantial degree of contagion. Creditors appeared to treat the region as a whole, which meant that the collapse of the Thai bath was the spark for the crisis in Malaysia, Philippines and Indonesia. It is clear that the financial crisis had a stinging effect on growth in Much of this demise came through a very large number of bankruptcies. It is also clear that a lack of bankruptcy laws created disorderly workout problems. In the panic to salvage bad loans, many viable firms were probably forced to close. However, the crisis was certainly V-shaped, in that from 1999, positive growth re-emerged. The large currency depreciations increased the export competitiveness of these nations, and therefore generated large improvements in the current account following the crisis. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Global Applications 15.6 Contagion Contagion refers to the process whereby a shock or a crisis that originates in one country can spread to others. How does risk aversion contribute to contagion? Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Preventing Currency Crises
The Lender of Last Resort In all three generations of currency crisis model, a speculative attack on a fixed exchange rate will occur when the policy maker has few reserves to defend the currency. When the currency comes under selling pressure, the policy maker finds it either impossible or just too costly to defend the parity. If there were, though, a cheap and plentiful source of currency reserves that could be mobilised to the defence, then the high reserve game should always be the outcome. This source of reserves could come from an international lender of last resort. However, there are issues that need to be considered, including moral hazard and good collateral. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Capital Controls Capital controls could rule out the bad equilibrium the high reserve game by force majeur. Extensive capital controls would prevent large flows of hot money. There are both pros and cons of re-establishing capital controls. On the pro side, they would prevent instability brought on by hot money flows and exert more control over domestic monetary policy, and a greater ability to set interest rates. On the con side, interrupting the flow of international capital could result in problems and inefficiencies, such as dealing with current account shocks, and result in a sub-optimal worldwide allocation of capital. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Tobin Taxes Tobin argued that short term capital movements (hot money) is the main culprit in injecting volatility into foreign exchange markets. Long-term capital movements are less volatile. The solution, to reduce hot money flows without unduly affecting longer term foreign direct investment, is a tax on any short-term international transactions. This would discourage active speculation against a currency. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Medium Reserve Game: Revised

To see why, reconsider the revised game. This time, making a transaction again costs 1 unit, but is now also subject to a tax of 2 units. Therefore, selling costs a total of 3 units whereas holding continues to be free. It is clear that the only solution to this game is now for both traders to hold. Previously, a speculative attack would have worked if coordinated, but this simple tax is sufficient to now rule out this possibility. A Tobin tax seems like a simple effective solution to the increasing volatility of international foreign exchange markets without adversely affecting foreign direct capital. However, there are problems with its implementation, which has led many to believe that it could never work in practice. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Exchange Rate Regimes A fixed exchange rate regime is regarded by many as being ultimately unsustainable. As speculators are offered a one-way bet, an attack is always an eventual outcome. In this respect, there are two alternatives for policy makers: 1) Floating exchange rate regimes: Obviously the exchange rate is market determined, hence the opportunities for speculators to mount an attack is diminished. The floating vs. fixed debate, though, then arises. 2) Monetary union: If fixed rates are irrevocably unworkable, then full monetary union would see a single currency and the abolition of exchange rates. The overall debate must be analysed in the context of optimal currency area theory. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Banking Regulation Possible Solutions: Reserve requirements Lender of last resort Capital requirements and asset restrictions Banking supervision Deposit insurance Difficulties in regulating international banking,e.g., Basel Committee (1974), Currency boards, Global Applications 15.7 The Pros and Cons of Dollarization Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Summary We have seen how a dramatic reduction in exchange controls throughout the world has led to a large rise in international capital mobility. The consequence is that financial markets in different countries have become increasingly interlinked, given rise to what can be described as an international financial market. In addition, the scale of international trading has risen dramatically. The majority of this is short term and highly liquid, known as “hot money,” which can move quickly in and out of different markets in different countries. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Summary We reviewed various episodes of high volatility in currency markets, where developing and transition countries have traditionally been the victims, especially in Latin America and more recently in Asia. However, the collapse of the Exchange Rate Mechanism (ERM) in the early 1990s demonstrates that developed nations can also be prone to these crises. Increasing openness has meant that shocks that happen in one country can quickly spread around the world, so the economic progress of one country can be adversely affected by a development in another country. We learned that the process by which shocks can be transmitted across countries is known as contagion. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Summary We investigated solutions, such as imposing capital controls, but this would also make the advantages of international financial markets unattainable. Therefore, policy makers have become increasingly concerned about designing the international financial architecture to maintain high capital mobility and also to deal with these instabilities. Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN © 2006 Cengage Learning

Macroeconomics Chamberlin and Yueh

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Macroeconomics Chamberlin and Yueh

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