1. L21: CRISES IN EMERGING MARKETS : WTP chapter sections: 24.1 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 24.5 IMF COUNTRY PROGRAMS 24.6 CONTRACTIONARY EFFECTS OF DEVALUATION (continued from Lect.12) 24.7 THE CAR CRASH ANALOGY Breaching the central bank’s defenses.

2. 3 cycles of capital flows to emerging markets: 1975-81 -- Recycling of petrodollars, via bank loans, to oil-importing LDCs 1982 -- Mexico unable to service its debt on schedule => Start of international debt crisis. 1982-89 -- The “lost decade” in Latin America 1990-96 -- New record capital flows to emerging markets globally 1994, Dec. -- Mexican peso crisis 1997, July -- Thailand forced to devalue and seek IMF assistance => beginning of East Asia crisis (Indonesia, Malaysia, Korea...) 1998, Aug. -- Russia devalues & defaults on much of its debt. => Contagion to Brazil. 2001, Feb. -- Turkey abandons exchange rate target 2002, Jan. -- Argentina abandons 10-yr “convertibility plan” & defaults 2003-07 -- New capital flows into developing countries, incl. China, India... 2008 - 12 -- Global Fin. Crisis: Iceland, Latvia, Ukraine, Pakistan, Greece, Ireland, Portugal… 1. 2. 3.

3. 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 1990-1996, 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 1975-1981 – they also used much of it to finance trade deficits, some as large as the capital inflows. (Calvo, Leiderman, & Reinhart, 1996 ).

4. Managing capital inflows, cont. In the boom phase of 2003-2007: 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]. 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.

5. 2003-07: This time, many countries used the inflows to build up forex reserves, rather than to finance Current Account deficits 2003-07 boom 1991-97 boom

6. IMF Survey Magazine Oct.8, 2009 “Did Foreign Reserves Help Weather the Crisis?” by O. Blanchard, H.Faruqee, & V.Klyuev http://www.imf.org/external/pubs/ft/survey/so /2009/num100809a.htm As a result, reserves reached extreme levels.... …, especially in Asia.

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

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

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

10. Early Warning Indicators of Currency Crashes Sachs, Tornell & Velasco (1996), “Financial Crises in Emerging Markets: The Lessons from 1995”: Combination of weak fundamentals (Δ RER or credit/GDP) and low reserves made countries vulnerable to tequila contagion. Frankel & Rose (1996), "Currency Crashes in Emerging Markets" : 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), “Leading Indicators of Currency Crises” : Best predictors: M2/Res, equity prices, GDP growth, Real Exchange Rate. Berg, Borensztein, Milesi-Ferretti, & Pattillo (1999), “Anticipating Balance of Payments Crises: The Role of Early Warning Systems”: They don’t hold up as well out-of-sample. Edwards (2002), “Does the Current Account Matter?”: CA ratios of some use in predicting crises (excl. Africa), contrary to earlier research. Rose & Spiegel (2009), “The Causes and Consequences of the 2008 Crisis: Early Warning”: No robust predictors. Frankel & Saravelos (2012): Once again, reserves work to predict who got hit in 2008-09.

11. 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 (2010)

12. IMF Survey Magazine Oct.8, 2009 “Did Foreign Reserves Help Weather the Crisis?” by O. Blanchard, H.Faruqee, & V.Klyuev http://www.imf.org/external/pubs/ft /survey/so/2009/num100809a.htm The IMF and Rose & Spiegel (2009) found that countries with more reserves were not less affected by the 2008-09 crisis: But Frankel & Saravelos (2010) and Dominguez & Ito (2011) find they were.

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

14. 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 changes that most EM s (except E. Europe) had made after the 1990s apparently paid off.

15. 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 2008-11 – CAD dangerous.

16. Appendices: More on predictors of crashes 1.Definitions (CA reversal, sudden stop, speculative attack…) 2.Predicting the 1994 Mexican peso crisis 3.How well did the pre-1997 EWI equations do at predicting the East Asia crisis? 4.The best Early Warning Indicator: Reserves 5.How well did the pre-2008 equations do at predicting who got hit in the 2008-09 Global Financial Crisis?

17. Appendix 1: Definitions Current Account Reversal  disappearance of a previously substantial CA deficit Sudden Stop  sharp disappearance of private capital inflows, reflected (esp. at 1 st ) 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 >> 0. (Interest rate defense against speculative attack might be successful.) Currency crisis  Exchange Market Pressure  s -  res >> 0. Currency crash   s >> 0, e.g., >25%.

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

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

20. 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.

21. 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.

22. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Appendix 4: Reserves as Early Warning Indicator

23. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

24. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

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

26. 2003-07: 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. Source: IMF WEO, 2007

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

28. 28 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.

29. 29 Table 1 Leading Indicator 1 KLR (1998) 2 Hawkins & Klau (2001) 3 Abiad (2003) 4,6 Others 5, 6 Total Reserves a 141813550 Real Exch.Rate b 122211348 GDP c 6151325 Credit d 586322 Current Acct. e 4106222 Money Supply f 2161019 Exports or Imports 1a, g 294217 Inflation571215 Top 8 categories of Leading Indicators in pre-2008-crisis literature Frankel & Saravelos (2012)

30. 30 Table 1, continued Leading Indicator 1 KLR (1998) 2 Hawkins & Klau (2001) 3 Abiad (2003) 4,6 Others 5,6 Total Next 9 categories of Leading Indicators in pre-2008-crisis literature Frankel & Saravelos (2012) Equity Returns 183113 Real Interest Rate h 282113 Debt Compositn 1b, i 442010 Budget Balance 35109 Terms of Trade 26109 Contagion j 15006 Political/Legal 32106 Capital Flows 1c, k 30003 External Debt l 01113 Number of Studies 28 20783

31. 31 Notes Frankel & Saravelos (2012) 1, 1a, 1b, 1c Leading indicator categories as in Hawkins & Klau (2000), with exception of 1a includes imports, 1b debt composition rather than debt to international banks, 1c capital flows rather than capital account. 2 As reported in Hawkins & Klau (2000), but M2/reserves added to reserves, interest differential added to real interest rate. 3 S&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. 4 10 out of 30 studies excluded from analysis. 7 included in Hawkins & Klau (2000) and 3 due to absence of formal testing of variables. 5 Includes 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). 6 See 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: a Reserves: relative to GDP, M2, short-term debt, 12m change h Real Interest Rate: domestic or differential b Real Exchange Rate: change, over/under valuation i Debt 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 c GDP: growth, level, output gap d Credit: nominal or real growth e Current Account: CA/GDP, Trade Balance/GDP j Contagion: dummies for crisis elsewhere f Money Supply: growth rate, excess M1 balances k Capital Flows: FDI, short-term capital flows g Exports or Imports: relative to GDP, growth l External Debt: relative to GDP

32. F & Saravelos (2010): Bivariate

33. F & Saravelos (2010): Multivariate

34. 34 Actual versus Predicted Incidence of 2008-09 Crisis Frankel & Saravelos (2010)