NBER Reporter: Spring 2001
Currency Crisis Prevention
An NBER conference on Currency Crisis Prevention organized by Sebastian
Edwards, NBER and University of California, Los Angeles, and Jeffrey A.
Frankel, NBER and Harvard University, took place on January 11-13. This
conference is part of a larger NBER project on Currency Crises in Emerging
Market Countries. More information about the other parts of the project is
available at the NBER website at www.nber.org/crisis.
An inability to foresee the currency crises of the 1990s led to the development of "crisis early warning models." These models focused on a number of variables, including the level and currency composition of foreign debt, debt maturity, the weakness of the domestic financial sector, the country's fiscal position, its level of international reserves, political instability, and real exchange rate overvaluation. Edwards specifically investigates the behavior of the current account in emerging economies and its role, if any, in financial crises. He develops a dynamic model of current account sustainability and bases his empirical analysis on a massive dataset that covers over 120 countries during more than 25 years. He also analyzes important controversies related to the current account, including the extent to which current account deficits crowd out domestic savings.
Céspedes, Chang, and Velasco consider optimal interest rate policies in an open economy model, with balance sheet effects and overlapping wage contracts. They conclude that the optimal "flexible inflation targeting" policy under discretion involves a floating exchange rate and the partial reaction of home interest rates to external shocks. This policy yields higher welfare than one of strictly fixed nominal exchange rates. Other optimal inflation targeting policies under discretion also dominate fixed rates. These results hold in spite of the credibility advantage of fixing, and in spite of the presence of dollar liabilities and balance sheet effects.
Central banks typically respond to pressures on their currencies by a combination of foreign exchange market intervention and interest rate changes. Lahiri and Végh build a simple model of a small open economy in order to understand this observed policy response and to investigate the optimal mix of these two policy instruments. Their model has two crucial features. First, the presence of nominal wage rigidities provides an incentive for the policymaker to prevent nominal exchange rate fluctuations. Second, the dependence of some firms on bank finance implies that higher domestic interest rates extract an output cost. The output effect of interest rate changes implies that, in general, policymakers would choose some combination of interest rate policy and direct market intervention to insulate the economy. Moreover, in the presence of costly intervention, the optimal policy response also involves allowing some currency fluctuation.
"Sudden stops" of capital inflows during emerging-markets crises have triggered unusually large declines in private expenditures, production, asset prices, and prices of nontradeable goods relative to tradeable goods. Mendoza suggests that these occurrences may be features of the equilibrium dynamics of a flexible-price economy with imperfect credit markets. Sudden stops occur when real or policy-induced shocks make liquidity constraints suddenly binding. Sudden stops are not reflected in long-run business cycle co-movements, but even so, their welfare costs can be significant. Mendoza offers an asset-pricing variation of his model as one explanation of the asset-pricing implications of sudden stops.
During recent episodes of financial turmoil, both policymakers and international institutions have voiced concerns about aggressive and possibly manipulative practices by high-leveraged institutions and large traders. Corsetti, Pesenti, and Roubini address these concerns by considering the role of large players in currency crises. The presence of a large trader may increase a country's vulnerability to a crisis. As small investors become more aggressive in their trading, a large trader's impact on the market depends not only on size, but also on reputation for quality of information. The authors present new econometric evidence on the correlation between exchange rate movements and the portfolio positions of big players, and undertake a comparative analysis of several recent crisis episodes in Thailand, Hong Kong, Malaysia, Australia, and South Africa. This evidence is largely consistent with the theory and does not contradict the conventional wisdom about aggressive practices by large traders. However, the question of whether and to what extent such practices are destabilizing requires further analysis.
Using bank-specific data on U.S. bank claims on individual foreign countries since the mid-1980s, Goldberg characterizes the size and portfolio diversification patterns of the U.S. banks engaging in foreign lending. She also explores the determinants of fluctuations in U.S. bank claims on a broad set of countries. Goldberg finds that U.S. bank claims on Latin American and Asian emerging markets, and on industrialized countries, are sensitive to U.S. macroeconomic conditions. When the United States grows rapidly, there is substitution between claims on industrialized countries and claims on the United States. The pattern of response of claims on emerging markets to U.S. conditions differs across banks of different sizes and across emerging market regions. Moreover, Goldberg finds that unlike U.S. bank claims on industrialized countries, claims on emerging markets are not highly sensitive to local country GDP and interest rates.
The empirical literature on contagion has mainly used daily stock markets, interest rates, and exchange rates to measure the propagation of shocks across countries. Rigobon evaluates some of the techniques that frequently have been used to measure contagion. He argues that if the data suffer from heteroskedasticity (conditional or not), omitted variables, and simultaneous equation problems, then the conclusions drawn from most of the procedures could be biased. He therefore summarizes two new procedures developed to cope with these problems. One is aimed at testing for the stability of parameters, while the other estimates the contemporaneous relationship across countries consistently. Finally, Rigobon estimates the contemporaneous transmission mechanism between emerging stock markets and bond markets. He finds that regional variables, as well as trade linkages, provide one explanation for the strength of the propagation of shocks across bond markets, but these variables are not as important in stock markets.
Forbes examines the importance of trade in the international transmission of financial crises. She explains that trade can transmit crises via three distinct, and possibly counteracting, channels: a competitiveness effect (when changes in relative prices affect a country's ability to compete abroad); an income effect (when a crisis affects growth and the demand for imports); and, a bargain effect (when a crisis reduces import prices and acts as a positive supply shock). She then develops a series of statistics that measure each of these trade effects for a sample of 48 countries during 16 crises between 1994 and 1999. Of particular interest is the competitiveness statistic, which calculates how each crisis affects exports from other countries. Her results suggest that countries that compete with exports from a crisis country and also export to the crisis country (that is, experience both the competitiveness and income effects) had significantly lower stock market returns than other countries. Although trade does not fully explain stock market returns during recent crises, these trade effects are economically important and have a much larger impact than other macroeconomic variables.
The Asian financial crisis of 1997-8 wreaked havoc with the economies of some of the world's most successful performers. Three of the worst affected countries (Thailand, South Korea, and Indonesia) were forced to call in the International Monetary Fund (IMF). In return for financial assistance, these countries committed to many structural reforms. Malaysia took a different path, though. Instead of going to the IMF, Malaysian authorities imposed sweeping controls on capital-account transactions, fixed the exchange rate at a rate that represented a 10 percent appreciation relative to the level at which the ringgit had been trading, cut interest rates, and embarked on a policy of reflation. Kaplan and Rodrik ask whether the Malaysian gamble paid off. While Malaysia has recovered nicely since the crisis, so have Korea and Thailand, two countries that took the orthodox path. They conclude that some of the more pessimistic prognostications about the consequences of capital controls have not been borne out, though.
In September 1998, Malaysia stepped up its restrictions on capital outflows and mandated the repatriation of offshore holdings in order to defend the currency and to free monetary policy from high offshore rates and low rates at home. Dornbusch asks whether Malaysia's performance was different from that of other crisis countries. Specifically, did the imposition of capital controls make for a less-hard landing? Dornbusch believes not. The controls were imposed late in the Asian crisis, when the situation in crisis countries had started to improve. Malaysia looked no different from the averages of Korea, Thailand, Indonesia, and the Philippines. However, Malaysia's balance sheet situation was so much worse than that of the other countries that perhaps, if not for the controls, the outcome would have been far worse. Dornbusch reluctantly concludes that Malaysia is not a good candidate for examining the capital controls question; there is no evidence that controls did short-term damage, nor that they generated short-term benefits. However, there is ample evidence that capital controls shifted attention away from the leadership struggle.
Crony capitalism and self-fulfilling expectations by international creditors are often suggested as two rival explanations for currency crisis. Wei and Wu examine a possible link between the two that so far has not been explored: corruption may affect a country's composition of capital inflows in a way that makes it more likely to experience a currency crisis triggered or aided by international investors' self-fulfilling expectations. Using data on bilateral foreign direct investment (FDI) and bilateral bank loans, the authors find that corrupt countries tend to have a particular composition of capital inflows that is relatively light in FDI. Earlier studies have indicated that a country with such a capital inflow structure is more likely to run into a subsequent currency crisis (in part through self-fulfilling expectations of the international creditors). Thus, the authors illustrate one particular channel through which crony capitalism can increase the chance of a currency or financial crisis.
Dekle and Kletzer develop a model of the domestic financial intermediation of foreign capital inflows based on agency costs. In their model, a crisis evolves endogenously as the banking system becomes increasingly vulnerable through the renegotiation of firm debts. Firm revenues are subject to idiosyncratic firm-specific technology shocks, but there are no aggregate shocks. The model generates dynamic relationships between foreign capital inflows, domestic investment, firm debt, and the value of firm and bank equity. Prior to a crisis, foreign capital inflows and bank debt rise relative to investment and domestic production. The aggregate portfolio of the banking sector deteriorates, and the total value of bank equities declines progressively in proportion to the portfolio for goods producers. The authors compare the model's implications for the behavior of the economy before and after crisis to the experience of five East Asian countries. The comparison of three crisis countries--Korea, Thailand, and Malaysia--to two near crisis countries--Taiwan and Singapore--lend support to the model.
Recent crises frequently have erupted in emerging markets without a major external shock and with seemingly strong macroeconomic fundamentals. In these episodes, a small incipient reduction in capital inflows has been followed by a significant real exchange rate depreciation. Since debt was largely denominated in foreign currency, the depreciation induced widespread bankruptcies and a collapse of new lending. Tornell presents a conceptual framework for evaluating some of the seemingly destructive financial and monetary policies implemented in emerging markets. He emphasizes that the policies implemented in countries that have experienced crises reflect neither sheer incompetence nor outright corruption. Moreover, he argues that some of the policies adopted were second-best-optimal given the environment faced by emerging economies. Crises were simply bad draws that did not have to happen; they were the price that had to be paid to attain faster growth.
Krueger and Yoo focus on the Korean experience and trace the roles of the chaebol, the earlier history of credit rationing and the buildup of domestic credit and foreign indebtedness prior to the crisis, the opening of the capital account, and the impact of exchange rate depreciation on financial crisis. The authors stress the role of each of the key variables. For example, if exchange rate depreciation were the largest factor leading to the deterioration of the banks' portfolios, then resorting to a genuinely floating exchange rate or preventing uncovered liabilities denominated in foreign exchange would greatly reduce the likelihood of future crises. Likewise, if bank lending practices resulted in a rapidly increasing proportion of nonperforming loans in the banking system, even if the exchange rate was not a significant factor, then improving bank lending practices as a preventive measure for future crises becomes much more important. And, if rigidities in the banking or financial system resulting from failure to liberalize or regulate sufficiently were a major contributor, then the policy lessons might focus on the urgent need for liberalizing and strengthening banking and financial systems in emerging markets.
These papers will be collected in a conference volume, Preventing Currency Crises in Emerging Markets, forthcoming from the University of Chicago Press and edited by Edwards and Frankel. In advance of publication, some of the papers will be available at "Books in Progress" on the NBER's web site, www.nber.org.