FIN 40500: International Finance Anatomy of a Currency Crisis

What Constitutes a “Crisis” ?  Large, rapid depreciation of a currency  Sudden, dramatic, reversal in private capital flows Note: The names and dates have been changed to protect the innocent! The “Crisis” period is typically followed by a recession.

Percentage Difference From “Pre-Crisis” Exchange Rate Note the short run “overshooting” of the exchange rate! Crisis Date

Note that portfolio investment is quicker to flow out than foreign direct investment Crisis Period Capital Flows

Imagine yourself driving down a straight stretch of road. If the alignment on your car is good, you can let go of the steering wheel and the car stays on the road…… However, if your alignment is not perfect, you need to act to stay on the road. Otherwise…

On the other hand, your alignment could be perfect, but if the road has an unexpected curve….

$ D S A peg at the equilibrium price can be maintained forever! A peg above the equilibrium will involve buying your currency (loss of reserves) A peg below the equilibrium price will involve selling your currency (increase in reserves) Your pegged exchange rate needs to be consistent with a market equilibrium!! Foreign currency per $

$ D S Suppose that a country is pegging at or near the equilibrium value of its currency An incompatible policy could pull the equilibrium away from the pegged level – this forces a loss in reserves!

$ D S Suppose that a country is pegging at or near the equilibrium value of its currency alternatively, suppose that demand drops – this lowers the equilibrium exchange rate and forces the central banks to act (buying back currency and losing reserves)

What causes these sudden reversals? Just the facts ma’am. Persistent inflation High Money Growth Low Economic Growth Large Deficits Public Private Political Events Natural Disasters Market Sentiment Bad Policy Bad Luck

US Average Inflation Crisis Period Note the sharp reversal in inflation following the crisis period Inflation

Crisis Period Steadily deteriorating growth rates is not a good sign!! Economic Growth

Crisis Period Average = 14%Average = 4% Note the significant drop in money growth after the crisis M2 Money Growth

Crisis Period Note that the government deficit gets worse before it gets better Government Deficit

Crisis Period Note the sharp reversal in the trade accounts following the currency crash Trade Deficit

Crisis Period Note the rapid drop in the interest rate following the devaluation! Overnight Lending Rate

Note the sharp loss in reserves as the central bank attempts to defend the currency! FX Reserves Gold Reserves

Relative Money Stocks Relative Outputs Relative Interest Rates Recall, the monetary framework with flexible prices (long run) resulted in the following

High money growth and low economic growth generate inflation (Domestic Money Market) Domestic inflation generates a currency depreciation (PPP) Domestic Inflation Foreign Inflation

If the current depreciation leads to expectations of future depreciations, the domestic interest rate must rise to compensate foreign investors A rise in the interest rate lowers money demand even further – this causes another round of inflation!

In the short run, it’s a question of the sustainability of current account deficits (i.e. can the country attract enough foreign capital to finance their CA deficit) This point is unsustainable! Rapid money growth pushes interest rates down in the short run and “over- stimulates” domestic consumption – this creates trade deficits that are difficult to finance!

In the short run, it’s a question of the sustainability of current account deficits (i.e. can the country attract enough foreign capital to finance their CA deficit) This point is sustainable! As the IS sector increases (high domestic investment, low savings, large fiscal; deficits), the trade deficits worsen, but interest rates rise – this makes it easier to attract foreign capital

In the short run, it’s a question of the sustainability of current account deficits (i.e. can the country attract enough foreign capital to finance their CA deficit) This point is unsustainable! However, as debts get too big, foreign capital becomes more reluctant to flow in (investors are afraid of the country’s ability to repay.

How big is “too big”? When does a trade deficit become unsustainable?  PV(Lifetime CA) = 0 (all debts must be repaid) We need to examine the country’s ability to run trade surpluses in the future (i.e. repay its debts!) Generally speaking, a trade deficit greater than 5% of a country’s GDP is considered “too big”

Productivity measures the ability of a country to transform inputs into output Revenues LaborCapital (Shareholders) Creditors (bondholders) With high productivity, producers can raise revenues without having to raise prices (high growth with low inflation!)

Labor Productivity = Per Man-hour Real Output = Y N Real GDP Total Hours $10,397 Real GDP (2004) Subtract out Farm Output $8,317 Divide by total hrs (Employment * Average Hrs * 52) $8, =$34/hr Suppose that Output/hr in 1992 was equal to $28.hr, then Prod(1992) = 100 Prod(2003) = 100*(34/28) = Labor Productivity

Multifactor Productivity Labor productivity doesn’t correct for changes in the capital stock!! Y = A K β N 1-β (Production function)β = 1/3 Real GDP Capital Labor MFP Growth Rate of MFP = y – βk – (1-β)n Labor Growth Capital Growth Real GDP Growth

Multifactor Productivity Step 1: Estimate capital/labor share of income K = 30% N = 70% Step 2: Estimate capital, labor, and output growth %Y = 5% %K = 3% %N = 1% %A = 5 – (.3)*(3) + (.7)*(1) = 3.4%

Annual Growth MFP Growth dropped in the 70s and 80s as IT was introduced!

Contagion refers to the transmission of a currency crisis throughout a region  The Thai Baht in 1997 was followed shortly by crises in Malaysia, Indonesia, Korea  The Mexican Peso crisis in 1994 spread to Central and South America (“The Tequila Effect”)  The Russian collapse (2000) was followed immediately by Brazil

Reasons For Contagion Common Shocks Trade Linkages Common Creditors Informational Problems and “Herding” behavior