Econ 3551 Lessons of Developing Country Crises The lessons from developing country crises are summarized as: Choosing the right exchange rate regime The central importance of banking The proper sequence of reform measures The importance of contagion

Econ 3552 Defining contagion 1. Some papers have defined contagion as the influence of “news” about the creditworthiness, etc. of a borrower on the spreads charged to the other borrowers or equity prices, after controlling for country specific macroeconomic fundamentals (Doukas, 1989,Kaminsky and Schmukler, 1998) 2. Other studies, such as Valdes (1995), defined contagion as excess comovement across countries in asset returns, whether debt or equity. The comovement is said to be excessive if it persists even after common fundamentals, as well as idiosyncratic factors, have been controlled for. 3. A recent variant to this approach is presented in Arias, Haussmann, and Rigobon (1998) and Forbes and Rigobon (1998), who define contagion more narrowly by requiring an increase in excess comovement in crisis periods. 4. Eichengreen, Rose, and Wyplosz (1996) defined contagion as a case where knowing that there is a crisis elsewhere increases the probability of a crisis at home, even when fundamentals have been properly taken into account.

Econ 3553 Defining Contagion After controlling for country specific macroeconomic fundamentals o The influence of “news” about the creditworthiness, etc. of a borrower on the spreads charged to the other borrowers o Excess comovement across countries in asset returns, whether debt or equity. o An increase in excess comovement in crisis periods. o A case where knowing that there is a crisis elsewhere increases the probability of a crisis at home

Econ 3554 Contagion 1. Why does contagion arise? What are the channels of transmission? 2. Who is vulnerable to sudden reversals of capital flows and contagion? 3. What does the empirical evidence reveal on these issues?

Econ 3555 Contagion Contagion may and usually does intensify during periods of turbulence–but it is not limited to those episodes The evidence suggests that asset prices (bond yields, stock prices, commodity prices) and capital flows exhibit “excess comovement.”

Econ 3556 Table on stock co-movement

Econ 3557 What are the channels of transmission? 1. Trade channels and exchange rate pressures. a. It could be bilateral trade (ex. Chile ) b. or competition for trade with a common third partner (ex. East Asia’s trade with Japan) 2. Integrated financial markets a. Banks are interconnected through loans (Mexican Banks were extending trade credit to Costa Rican banks prior to the 1994 crisis) b. Interconnection through bond holdings. (Korea was holding Brazilian and Russian bonds) c. Liquidity management practices of open end mutual funds (Thai share prices fall–sell Indonesia).

Econ 3558 What are the channels of transmission? 3. The weakening finances of a common creditor (US banks in early 1980s and Japanese banks in 1990s) 4. Reassesment of risk (and/or risk increased risk aversion)–the “wake up call” hypothesis. Possibly affecting countries with similar fundamentals. 5. Information asymmetries 6. Political contagion 7. Herding behavior

Econ 3559

10 Possible channels of transmission

Econ Who is most vulnerable to sudden reversals of capital flows and contagion? 1. Large current account deficits? 2. Substantial real exchange rate appreciation? 3. No capital account barriers? 4. Fixed exchange rate? 5. Weak banking system? 6. “Bad” composition of capital inflows–too much short term debt? 7. Lack of credibility–poor macroeceonomic track record?

Econ Reforming the World’s Financial “Architecture” The Asian crisis convinced nearly everyone of an urgent need for rethinking international monetary relations because of two reasons: The fact that the East Asian countries had few apparent problems before their crisis struck The apparent strength of contagion through the international capital markets

Econ Capital Mobility and the Trilemma of the Exchange Rate Regime The macroeconomic policy trilemma for open economies: Independence in monetary policy Stability in the exchange rate Free movement of capital Only two of the three goals can be reached simultaneously. Exchange rate stability is more important for developing than developed countries. Reforming the World’s Financial “Architecture”

Econ Proposals to reform the international architecture can be grouped as preventive measures or as ex-post measures. “Prophylactic” Measures Among preventive measures are: More “transparency” Stronger banking systems Enhanced credit lines Increased equity capital inflows relative to debt inflows The effectiveness of these measures is controversial. Reforming the World’s Financial “Architecture”

Econ Coping with Crisis The ex-post measures that have been suggested include: More extensive lending by the IMF “Chapter 11” bankruptcy proceeding for the orderly resolution of creditor claims on developing countries that cannot pay in full. Reforming the World’s Financial “Architecture”

Econ A Confused Future In the years to come, developing countries will experiment with: Floating exchange rates Capital controls Currency boards Abolition of national currencies and adoption of the dollar or euro for domestic transactions Reforming the World’s Financial “Architecture”

Econ Summary Despite their excellent records of high output growth and low inflation, key developing countries in East Asia were hit by currency depreciation in Proposals to reform the international architecture can be grouped as preventive measures or as ex-post measures. The architecture that will ultimately emerge is not at all clear.