Economics Part II Developing Country Debt Crisis A Country Leads the Path to Default - interest and principal not paid - currency devalues - other countries follow suit

Economics Part II Developing Country Debt Crisis Solution Short currencies Purchase puts Sell futures Sell stocks and bonds

Economics Part II Developing Country Crisis Petrodollar crisis Mexico 1982 Recycling of dollars Crash of the dollar

Economics Part II Can a Crisis Happen? Financial Crisis in Historical Perspective Tulip mania (1636) South Sea Bubble (1720) East India Company (1772)

Financial Crisis in Historical Perspective Large Scale Defaults by financial and non- financial institutions (Minsky, 1963) Notion of Debt Deflation (Fisher 1933, Bernanke, (1983) Process of Creative Destruction (Schumpeter, 1934)

Financial Crisis in Historical Perspective Corporate Debt –LBOs, Overborrowing Sovereign Debt –Government borrowing –Consumer Borrowing mortgages

Financial Crisis The Liquidity Factor –Serious Lack of Information Not consistent with EMH Suggests that amount of sufficient info available to traders may not be available Certain conditions for EMH may not be applicable during sharp market declines

The Liquidity Factor A Closer Look In order for information and liquidity related explanations to be plausible there must be some friction If liquidity were freely available to respond to any level of short term trading then the market decline would lose much of its persuasive force The used car dealer

International Financial Crises International Economy Since 1982 –Paradoxical –Most turbulent since 1930s –Large day-to-day currency volatility –1985 $/Y 250; to 125 by 1987 then to 150 by 1989

Financial Crises in International Community Financial Markets Calm (1982- Present) –Exceptions: 1987, 2001 –No major recessions –Inflation decline

Financial Crises in International Community Destabilizing Effect May Catch Intl Community by Surprise Integrated World Financial System Trade liberalization, elimination of capital controls, financial deregulation

Types of Crisis Balance of Payments –Loss of confidence by speculators thereby provoking capital flight –Leads to imposition of capital controls –Debt service is limited or impossible

Balance of Payment Crisis Mexico 1984 Malaysia 1995 Happens in International Markets but may not be international in scope Lack of confidence in real assets Japan Land and Equities

Economic Crisis International in Scope –Crisis of Started in United States Spread to other countries

Two Classic Examples The French Franc No Longer Pegged to Gold Lost ½ of its value Fiscal Debt Could Not Service War Costs

The French Franc Insisted that Germany pay for war Due to German Hyperinflation this became a fantasy Debt at fixed rates Solution: Inflating Debt Away

The French Franc Speculators – News that the French Govt would inflate its problems away- The Franc declined Speculators- Learning that the French Govt would possibly cut expenditures or raise taxes, the Franc would rise

The French Franc French Franc rose from US 6.25 cents to US 9.23 cents from April 1920 to April 1922 Flotation of new loans Raised taxes Bad diplomatic news and chaos in Germany led to a decline of the French Franc to US 6.86 cents by Nov 1922

The French Franc Developed Life of their Own Not Driven by External events

The French Franc Lack of Confidence led to large debt placement News of failure drove Franc to US 3.49 cents by March 1924 Govt announced tax increases –Franc rose to US 6.71 cents

The French Franc Heavy losses inflicted on speculators as they bet on the wrong direction of the Franc Two months later Franc declined to US 5 cents

The French Franc Further lack of confidence in government and new debt issuance October July 1926 Franc fell from US 4.7 cents in September 1925 to US 2.05 cents in July 1926 New policies and Finance Minister drove Franc up to US 3.95 cents by December 1926

The French Franc Substantial Macroeconomic effects –Depreciation led to substantial inflation –Subsequent stabilization led to sharp but brief recession –Object lesson of destabilizing speculation

The French Franc Exchange rates were found to overshoot and undershoot Government fiscal problems were much of the cause for the fiscal attack on the French Franc Failure of the French Franc provided the underpinning of a pegged currency scheme ultimately resulting in the Breton Woods Agreement

The French Franc Case still influences economists on their thinking of exchange rates and troubled currencies

1929 Popular Image of 1929 is of a single dramatic moment: the U.S. stock market crashes near to 0 in a few hours and the rest of the worlds stock markets are dragged down with it and immediately throwing the world into a depression

1929 More complex than the popular vision of people jumping out of windows The Sharp Business Contraction would have been less severe if not for the general banking collapse

1929 Financial Shock was not complete by end of 1929 Serves as a model for currency crisis contagions

Stock Market Declines CountrySeptember December December 1929 December 1932 US31.9% 69.4% Canada33.5% 72.4% France10.8% 47.3% Germany14.4% 44.9% UK16% 24.8% Source: C.P. Kindleberger, 1973 The World in Depression

1929 Most of the fall took place after 1929 US Slump transmitted to the rest of the world but milder

Causes of Currency Crisis Occur when investors lose confidence in the currency Seek to escape assets denominated in that currency and other assets whose income might be affected by currency controls Examples Asian crisis, Latin American crisis US dollar 1973, Sterling 1975

Causes of Currency Crisis Should a currency problem turn into a crisis? –Rational Speculative attacks Central Banks that are trying to maintain unsustainable fixed rates Examples: Gold Exchange Rate, ECU, Argentina

Causes of Currency Crisis Country that has persistent budget deficit –Financed through borrowings –Central bank has to cover loans by printing money –Country experiences persistent inflation and a depreciating currency –Pegging exchange rate

Causes of a Currency Crisis Uses dwindling supply of FX Temporarily keeps inflation rate at pegged countrys rate Peg broken Currency Floated Inflation ensues

The Role of the Speculator Speculators sensing loss –Bail out of currency –Short futures –Short currency –Accelerate downward trend of currency –Surges of capital flight need not represent irrational behavior

The Crawling Peg European Currency Unit 1992 Crawling Peg –The Snake +/- 6% DM German Reunification Inflation in Germany Recession in Britain, Italy, Sweden and Spain Denmark and Sweden exit first Britain is next

The European Currency Unit Speculative Attack on the Pound Speculators gang up on the Pound Drive it Deeper Britain exits the ECU Spain and Italy follows

The Asian Currency Crisis Thailand runs current account deficit Debt denominated in $ Breaks peg to dollar Asian countries pegged to $ follow suit Quantum Fund attacks Malaysian Ringgit Malaysia institutes capital controls Malaysian PM blames George Soros

The Argentine Crisis Economic Decline since 1932 Inflationary and Populist Polices lead to 75 year decline To Stop/Arrest Peg Currency to US$

The Argentine Crisis Monetary Policy Dictated by US Federal Reserve Argentine Peso fully convertible into US$ Peg Broken Debt default Peso declines 66% within 6 months Recovery

Mexico 1982 Capital flight YearHard CurrencyCap flight

Mexico 1982 Typical Currency Problem –Deterioration of world economics –Expectation that LA currencies would be devalued –Investor flight from LA currencies Lenders afraid debt would not be serviced

Lessons from Mexico US Govt bailout due to heavy lending by US Banks –US financial system in jeopardy –Few economists and bankers believed that Mexico had an excessive debt problem –Overconfidence problem –Unforeseen Lesson for todays environment

Mexican Macroeconomics 1982 Inflation ensued Growth retarded Recovery

Macroeconomic Performance in Latin America (Growth Rates) YearGNP/CapitaCPI

Anatomy of A Hard Landing Economist Paul Krugman states that –The Hard Landing is the crisis that did not happen – Krugman adds, It still could The withdrawal of capital from the US that finances consumer, government, corporate debt Withdrawal of investments and accumulated capital Foreign central banks decline to fill the gap

Anatomy of A Hard Landing Dollar plummets Expectations that Prices rise 3 to 4% –Interest rates rise about the same amount –Federal Reserve feels compelled to stop the process and pushes nominal interest rates to 13% to 15% range –Confidence levels decline (remember France )

Anatomy of a Hard Landing Impact on the Economy Inflation rises as a direct result of dollar depreciation especially if the economy is near full employment and capacity utilization Sharply higher interest rates and fiscal tightening pushes economy into recession

Anatomy of a Hard Landing Impact on the Economy US Federal Reserve moves to combat inflation Abnormally high interest rates Longer than normal recession

Anatomy of a Hard Landing The Summers Dilemma Sharp Rise in Interest Rates Could Trigger Substantial Turmoil in light of: –High leverage –Uncertain loan portfolios –Hence the dilemma The higher interest rates needed to stop the currency crisis would further intensify the risk of financial disruption while any substantial injection of increased liquidity as the lender of last resort could increase the inflationary spiral and move the dollar lower.

Anatomy of a Hard landing The Summers Dilemma Greater fiscal tightening –Leads to a severe downturn –No Pleasant escape –The Hard Landing would arrive

Why the US Crisis Has Been Averted As of Yet Crucial economic relationship that creates the hard landing is the juncture of dollar depreciation and higher interest rates. –Cash Flows to United States supporting lower interest rates –Foreign Countries Exporting Deflation through trade

Could It Happen Now Equity flows dry up Central Banks dont step up to the plate Political Instability Investors curtail their purchases of US assets

What Happens In A Crisis The Dornbusch Approach Three Essential Ingredients For A Crisis –Vulnerability, Awareness, and Fear Vulnerability arises from an over expansion of credit relative to debt service ability Awareness is the state of mind where market participants are trigger happy Fear is panic; Ex: I must get out now

The Lender of Last Resort The Central Bank can issue money and expand credit, but there may not be anyone who wants the money.

The Lender of No Resort Or Stuck Up A Creek Without A Paddle Last resort Lending Can Be Made With Good Collateral - Not Bad Collateral –Write Off or Work Off –US May not want to give up power as # 1 to establish stability –IMF may be renamed I May be Forgotten