Contractionary Currency Crashes in Developing Countries

NBER Working Paper No. 11508
Issued in August 2005
NBER Program(s): IFM

---- Abstract -----

To update a famous old statistic: a political leader in a developing country is almost twice as likely

to lose office in the 6 months following a currency crash as otherwise. This difference, which is

highly significant statistically, holds regardless whether the devaluation takes place in the context

of an IMF program. Why are devaluations so costly? Many of the currency crises of the last ten

years have been associated with output loss. Is this, as alleged, because of excessive reliance on

raising the interest rate as a policy response? More likely it is because of contractionary effects of

devaluation. There are various possible contractionary effects of devaluation, but it is appropriate

that the balance sheet effect receives the most emphasis. Passthrough from exchange rate changes

to import prices in developing countries is not the problem: this coefficient fell in the 1990s, as a

look at some narrowly defined products shows. Rather, balance sheets are the problem. How can

countries mitigate the fall in output resulting from the balance sheet effect in crises? In the shorter

term, adjusting promptly after inflows cease is better than procrastinating by shifting to short-term

dollar debt, which raises the costliness of the devaluation when it finally comes. In the longer term,

greater openness to trade reduces vulnerability to both sudden stops and currency crashes.

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