1. L21: CRISES IN EMERGING MARKETS:
WTP chapter sections: INFLOWS TO EMERGING MARKETS -- Reserves (continued from Lecture 3)
24.2 MANAGING OUTFLOWS -- Early Warning Indicators
24.3 SPECULATIVE ATTACKS (Lecture 20)
24.4 CONTAGION IMF COUNTRY PROGRAMS CONTRACTIONARY EFFECTS OF DEVALUATION (continued from Lect.10)
Breaching the central bank’s defenses.

2. 3 cycles of capital flows to emerging markets:1.
Recycling of petrodollars, via bank loans, to oil-importers
Mexico unable to service its debt on schedule => Start of international debt crisis The “lost decade” in Latin America
New record capital flows to emerging markets 1994, Dec. -- Mexican peso crisis 1997, July -- Thailand forced to devalue & seek IMF assistance => beginning of East Asia crisis (Indonesia, Malaysia, Korea...) 1998, Aug. -- Russia devalues & defaults on much of its debt , Feb. -- Turkey abandons exchange rate target 2002, Jan. -- Argentina abandons 10-yr “convertibility plan” & defaults.
New capital flows into EM countries, incl. BRICs...
Global Fin. Crisis: Iceland; Latvia, Ukraine; Greece, Ireland, Portugal… 2. 3.

3. Capital flowed to Asia during 1990-96 and again 2003-11.
3rd boom
(carry trade & BRICs)
stop (Asia crisis)
2nd boom (emerging markets)
start
start
IMF

4. Capital flowed to Latin America in the 1990s, and again 2004-11
3rd boom
(carry trade & BRICs)
2nd boom
(emerging markets)
start
start
IMF

5. Managing Capital Inflows
Recall alternative ways to manage capital inflows: A. Allow money to flow in B. Sterilized intervention C. Allow currency to appreciate D. Reimpose capital controls
In the boom phase of ,
countries pursued exchange rate targets.
Some experimented with re-imposing controls on capital inflows (Chile & Colombia), but mostly they allowed capital to flow in.
They used part of the inflow to add to foreign exchange reserves, but – as in the earlier cycle – they also used much of it to finance trade deficits. (Calvo, Leiderman, & Reinhart, 1996).

6. Managing capital inflows, cont.
In the boom phase of :
Many countries had more flexible exchange rates than before.
Many reduced the share of capital inflow denominated in forex except in Central & Eastern Europe
Few imposed new controls on the inflows [until Nov. 2009: Brazil…].
This time, a majority of emerging market countries ran current account surpluses rather than deficits.
Thus inflows went into reserve accumulation (in fact, more than 100%).
As a result, reserves reached unprecedented levels.

7. Developing Countries Used Capital Inflows to finance CA deficits in & ; but not
1st boom (recycling petro-dollars)
3rd boom
(carry trade & BRICs)
stop
(international debt crisis)
2nd boom
(emerging markets)
stop (Asia crisis)
start
start
IMF

8. : This time, many countries used the inflows to build up forex reserves, rather than to finance Current Account deficits
boom
boom

9. As a result, reserves reached extreme levels....
…, especially in Asia.
IMF Survey Magazine Oct.8, “Did Foreign Reserves Help Weather the Crisis?”
by O. Blanchard, H.Faruqee, & V.Klyuev

10. Traditional denominator for reserves: imports
Rodrik (2006)

11. New denominator to gauge reserves: short-term debt.
After 2000, many brought their reserves above the level of short-term debt –
the “Guidotti rule.”
s.t. debt / R > 1
<1
Rodrik (2006)

12. • Alternative Ways of Managing Capital Outflows
Allow money to flow out (but can cause recession, or even banking failures)
Sterilized intervention (but can be difficult, & only prolongs the problem)
Allow currency to depreciate (but inflationary)
Reimpose capital controls (but probably not very effective) •

13. Early Warning Indicators of Currency Crashes
Sachs, Tornell & Velasco (1996): Combination of weak fundamentals (Δ RER or credit/GDP) and low reserves made countries vulnerable to tequila contagion.
Frankel & Rose (1996): Composition of capital inflow matters (more than the total): short-term bank debt raises the probability of crash; FDI & reserves lower the probability.
Kaminsky, Lizondo & Reinhart (1998): Best predictors: M2/Res, equity prices, Real Exchange Rate.
Berg, Borensztein, Milesi-Ferretti, & Pattillo (1999), They don’t hold up as well out-of-sample.
Edwards (2002): CA ratios of some use in predicting crises (excl. Africa), contrary to earlier research.
Rose & Spiegel (2009): No robust predictors for who got hit by GFC in
Dominguez & Ito (2012) Reserves do work to predict who got hit, and Frankel & Saravelos (2012): as in earlier studies.

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

15. The IMF and Rose & Spiegel (2009) found that countries with more reserves were not less affected by the crisis:
IMF Survey Magazine Oct.8, “Did Foreign Reserves Help Weather the Crisis?”
by O. Blanchard, H.Faruqee, & V.Klyuev
But Frankel & Saravelos (2012) and Dominguez & Ito (2012) find they were.

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

17. Bottom line for Early Warning Indicators in the 2008-09 crisis Frankel & Saravelos (2012)
Once again, the best predictor of who got hit was reserve holdings (especially relative to short-term debt),
Next-best was the Real Exchange Rate.
This time, current account & national saving too.
The reforms that most EM s (except E. Europe) had made after the 1990s apparently paid off.

18. Are big current account deficits dangerous?
Neoclassical theory: if a country has a low capital/labor ratio or transitory negative shock, a 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 Global Financial Crisis of – CAD dangerous.

19. Appendices: More on predictors of crashes
Definitions (CA reversal, sudden stop, speculative attack…)
Predicting the 1994 Mexican peso crisis
How well did the pre-1997 EWI equations do at predicting the East Asia crisis?
The best Early Warning Indicator: Reserves
How well did the pre-2008 equations do at predicting who got hit in the Global Financial Crisis?

20. Appendix 1: Definitions
Current Account Reversal  disappearance of a previously substantial CA deficit
Sudden Stop  sharp disappearance of private capital inflows, reflected (esp. at 1st) as fall in reserves & (soon) in disappearance of a previously substantial CA deficit. Often associated with recession.
Speculative attack  sudden fall in demand for domestic assets, in anticipation of abandonment of peg. Reflected in combination of  s - res &  i >> (Interest rate defense against speculative attack might be successful.)
Currency crisis  Exchange Market Pressure  s - res >> 0.
Currency crash  s >> 0, e.g., >25%.

21. References Currency account reversals Sudden stops
Edwards (2004a, b) and Milesi-Ferretti & Razin (1998, 2000).
Sudden stops
References: Dornbusch & Werner (1994), Dornbusch, Goldfajn & Valdes (1995); Calvo (1998), Calvo, Izquierdo & Mejia (2003), Calvo (2003), Calvo, Izquierdo & Talvi (2003, 2006), Calvo & Reinhart (2001), Calvo, Izquierdo & Loo-Kung (2006), Calvo, Izquierdo & Loo-Kung (2006);  Caballero & Krishnamurthy (2004); Edwards (2004); Guidotti, Sturzenegger & Villar (2004); Levchenko & Mauro (2006); Arellano & Mendoza (2002), and Mendoza (2002, 2006, 2010).

22. Appendix 2 The early 1990s Calvo, Leiderman & Reinhart
“predict the peso crisis”

23. In the 1990s, capital inflows financed current account deficits.
Calvo, Leiderman & Reinhart:
Source of capital flows was low i* at least as much as local reforms => Could reverse as easily as in 1982.
Dornbusch (1994) said the Mexican peso was overvalued.

24. Appendix 3:
Predictive performance of Early Warning indicators in the1990s crises.
Berg, et al, (1999) did find
that if warning indicator
equation sounds an alarm,
probability of crisis is 70-89%;
but were generally pessimistic on the ability at each round to predict the next crisis. 24

25. Appendix 4: Reserves as Early Warning Indicator
API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

26. API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

27. API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

28. Traditional denominator to gauge reserves: imports
Most Emerging Market countries added rapidly to reserves after the currency crises of the 1990s.
Traditional denominator to gauge reserves: imports
Rodrik (2006)

29. not current account deficits as in the past.
Source: IMF WEO, 2007
: This time, China and India shared in the inflows. But capital inflows to EM s financed only reserve accumulation,
not current account deficits as in the past.

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

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

32. Obstfeld, Shambaugh & Taylor (2009a, b):
Appendix 5: Did the pre-2008 equations predict who got hit in the Global Financial Crisis of Sept. 2008?
Obstfeld, Shambaugh & Taylor (2009a, b):
Finding: A particular measure of countries’ reserve holdings just before the current crisis, relative to requirements (M2), predicts 2008 depreciation.
Current account balances & short-term debt levels are not significant predictors, once reserve levels are taken into account.
Rose & Spiegel (2009a, b) and Blanchard (2009) found no role for reserves in predicting who got into trouble.
Frankel & Saravelos (JIE, 2012): We get stronger results. We define the crisis period to have gone through March 2009.

33. Top 8 categories of Leading Indicators in pre-2008-crisis literature
Table 1
Leading Indicator1
KLR (1998) 2
Hawkins & Klau (2001)3
Abiad (2003)4,6
Others5,6
Total
Reserves a 14 18 13 5 50
Real Exch.Rate b 12 22 11 3 48
GDP c 6 15 1 25
Credit d 8
Current Acct. e 4 10 2
Money Supply f 16 19
Exports or Imports 1a, g 9 17
Inflation 7
Frankel & Saravelos (2012)

34. Next 9 categories of Leading Indicators in pre-2008-crisis literature
Frankel & Saravelos (2012)
Table 1,
 continued
Leading Indicator1
KLR (1998) 2
Hawkins & Klau (2001)3
Abiad (2003)4,6
Others5,6
Total
Equity Returns 1 8 3 13
Real Interest Rateh 2
Debt Compositn1b, i 4 10
Budget Balance 5 9
Terms of Trade 6
Contagionj
Political/Legal
Capital Flows1c, k
External Debtl
Number of Studies 28 20 7 83

35. Notes Frankel & Saravelos (2012)
1, 1a, 1b, 1c Leading indicator categories as in Hawkins & Klau (2000), with exception of 1aincludes imports, 1bdebt composition rather than debt to international banks, 1ccapital flows rather than capital account.
2As reported in Hawkins & Klau (2000), but M2/reserves added to reserves, interest differential added to real interest rate.
3S&P, JP Morgan, IMF Indices, IMF Weo, IMF ICM, IMF EWS studies have been excluded due to lack of verifiability of results. The following adjustments have been made to the authors’ checklist: significant credit variables reduced from 10 to 8 as Kaminsky (1999) considers level rather than growth rate of credit; significant capital account variables reduced from 1 to 0 as Honohan (1997) variable not in line with definition used here; Kaminsky (1999) significant variables for external debt reclassified to debt composition as these variables relate to short-term debt.
410 out of 30 studies excluded from analysis. 7 included in Hawkins & Klau (2000) and 3 due to absence of formal testing of variables.
5Includes Berg, Borenzstein and Pattillo (2004), Manasse and Roubini (2005), Shimpalee and Breuer (2006), Davis and Karim (2008), Bergmen et.al. (2009), Obstfeld, Shambaugh and Taylor (2009), Rose and Speigel (2009a).
6See App. 1 for criteria defining statistical significance in Abiad (2003) and Others studies. For rest see KLR (1998), Hawkins & Klau (2001)
Variables included in the leading indicator categories:
aReserves: relative to GDP, M2, short-term debt, 12m change
hReal Interest Rate: domestic or differential
bReal Exchange Rate: change, over/under valuation
iDebt Composition: commercial/concess./variable-rate/
debt to internat. banks/short-term/multilat./official relative to total external debt. Short-term debt relative to reserves (rather than relative to total external debt) is in the reserves category
cGDP: growth, level, output gap
dCredit: nominal or real growth
eCurrent Account: CA/GDP, Trade Balance/GDP
jContagion: dummies for crisis elsewhere
fMoney Supply: growth rate, excess M1 balances
kCapital Flows: FDI, short-term capital flows
gExports or Imports: relative to GDP, growth
lExternal Debt: relative to GDP

36. F & Saravelos (2010): Bivariate

37. F & Saravelos (2010): Multivariate

38. Actual versus Predicted Incidence of 2008-09 Crisis Frankel & Saravelos (2010)