Theory and History of Financial Crises Programme : M1, FE ACADEMIC YEAR 2012/2013

1. Theory and History of Financial Crises Programme: M1, FE ACADEMIC YEAR 2012/2013 EDHEC May 2013

2. Theory and History of Financial crises Pr Nikolay NENOVSKY University of Picardie Jules Verne Former Member of Bulgarian Central Bank Governing Council EDHEC, Nice, May 2013 EDHEC May 2013

3. Lecture 3 Exchange rate crises • Lecture outline: I Exchange rate regimes (definitions and diversity) II Fixed exchange rate and convertibility III Exchange rate crises and speculative attacks • Fundamental ER crisis (I generation) • Self-fulfilling ER crisis (II generation) IV Empirical issues and early warning indicators

4. I Exchange rate regimes (definitions and diversity)

5. Definitions (external link) The term on which people may exchange domestic currency for foreign currency…. Crawling depreciation (Hungary, 1994) Exchange rate regimes

6. De jure /de facto classifications: Var(F)/ Var (e) Corner solutions and bipolar view … Exchange rate regimes

7. Exchange rate market • Nominal • Quotation: in units of local (national) currency per unit of foreign currency • 1 Euro = 1.32 USD • 1 Euro = 38.75 RUB • 1 Euro = 8.32 CNY (Yuan/Renminbi) • 1USD = 0.76 Euro

8. EDHEC, Nice, April 2011

10. EDHEC, Nice, April 2011

11. Nominal exchange rate 1Usd = 0.75 Euro e ↑ means depreciation of the Euro (0.90) e ↓ means appreciation of the Euro (0.50)

12. EDHEC, Nice, April 2011

14. S (X) S (X+K) e* D (Imp) ER market (volume) deficit Exchange rate market • 1USD = 0.75 Euro • Basic markets (trade flows) • Export (X) • Import (Imp) • Capital movements • Undervaluation • Overvaluation (China case) ?

15. Exchange rate market

16. The case of fixed rate Manipulating trade flows: X and Imp Manipulating directly ER market Exchange rate market

17. Confidence: convertibility and coverage Level of convertibility Full convertibility (CA and K) Partial convertibility (CA) Absence of convertibility (totalitarian state; socialist exchange rate coefficients; ER control for private and commercial operations etc) Level of coverage (CB balance sheet) 1/3; 100%; 105% legal or by CB commitment (promise) Convertibility and coverage

18. Exchange rate regimes • Basic formula • Nominal (e) • Real (er) • Real effective (erf) • Exchange rate (e) – productivity (q) – wages (w) • Elasticity's issues (J curve) • Optical Currency Area (monetary autonomy/K convertibility/fixed exchange rate)

20. ∆p = ∆w - ∆q ∆p* = ∆w* - ∆q* ∆er = ∆е + (∆w* - ∆q*) – (∆w - ∆q) If fixed rate ∆е=0 and ∆w*, ∆q* exogenously determined ∆er = ∆q-∆w Exchange rate (e) – productivity (q) – wages (w)

21. J curve or critical elasticity

22. Linking Monetary and Exchange rate regime e - exchange rate regime , , – fixed, intermediate and flexible m – source of change in monetary base , , – only NFA, NFA and NDA, and only NDA

23. How to explain ER diversity ? • Case study: Post communist Europe • Cost-benefit analyses (Optimal currency area// R. Mundell) • Political economy (sectors, groups, lobbies interests) • Geo-strategy etc… • International Political Economy

24. Dynamics after 1990 • Two archetype (1990 – 2008) • Type 1 “Fixed start” • From fixed rate through intermediate to flexible: Poland, Hungary, Czech, Slovak, Slovenia • From fixed to fixed • Estonia, Lithuania, Latvia, Croatia • Type 2 “Flexible start” • From flexible through intermediate to fixed: Bulgaria • From flexible throw intermediate to flexible: Albania, Romania

25. Start 1990/94 2008 Crisis 1997/98 Fixed – Flexible – Jan Winiecki paper (2004), Post-Communist Economy, 16 (2): 137-152 EDHEC, Nice, April 2011

26. Type 1 “Fixed start” ( + good sequence) Externally oriented Rooted to West (importing credibility), forward looking Higher level of trust, monetary culture Lower level of informal economy Solution to HBC, restructuring and modernizing Fixed rate: solution to the coordination deficiency Domination of creditors Privatization FDI Type 2 “Flexible start” (+ bad sequence) Internally, backward looking Deeply rooted into the past, low level of trust Protection of inefficient industries, SBC Domination of debtors State capture, cronyism, institutional trap (ex. Barter in Russia, pyramids in Albania) Privatization (mass privatization), (conversion of power into money and to ownerships, old networks persistence etc.…) Two strategies

27. Bulgaria/Romania

28. II Fixed exchange rate and convertibility

29. Fixed exchange rates • Fixed and managed-fixed • Degree of fixity • Fixity by law or by Central Bank commitment • Central bank operations • Non sterilization (OMO and ER intervention) • Sterilization (accounting presentation)

30. Fixed (or adjustable) by CB commitment (China ?)

31. Currency Boards Fixed rate + convertibility + coverage Monetary constitution // monetary discretion Confidence (credibility) Adjustment (discipline) cor(∆F, ∆L) = 1 Gold standard (historical perspectives) Classical period (1873-1914) Gold specie Gold bullion Gold exchange Free minting of gold Free X/Imp of gold “Rules of the game” Interwar period (1919-1939) Level of e Monetary conferences (1922/1924/1932) Fixed by law: Currency boards/Gold standard

32. Currency boards Adjustment (automatic mechanism) Macroeconomic presentation CA=X-Imp= o; CA < o →D↓→ R↓ → i↑ → L↓ → (Yd, C)↓ → Md (Y, i)↓ → P (π)↓ → er ↑ → CA↑ Accounting (balance sheets) presentation II generation Currency board Bulgarian case (balance sheet and LLR)

33. Balance sheet of Bulgarian Currency board Issue department Currency board Banking department

34. III Exchange rate crises and speculative attacks

35. Definition: ER crisis (= currency crisis = BoP crisis) We refer to a sharp and sudden devaluation (revaluation) or depreciation (appreciation) of e Loss of foreign reserves Balance of payments crisis ER crisis (classifications, generations I, II, III …) Exchange rate crises …

36. I generation Gold standard stability/ Paul Krugman’s model (1979) IMF stabilization program Basic logic: Fundamental inconsistency between economic policy (monetary and fiscal), and domestic credit growth (ΔL) and e commitment Argentina (2001/2002)//Ireland (2007…) I generation: Fundamental inconsistency

37. I generation ER crisis… IMF model (BoP stabilization) Basic idea: ΔF – intersection of monetary sector and BoP Simple theoretical presentation IMF in practice Guidotti rule

38. Krugman’s model • Graphical presentation • Discussions

39. Krugman’s model μ - rate of growth of credit α – interest rate elasticity of demand for money θ- ration of monetary composites (F, L)

40. I generation • Summarizing: countries faces Exchange rate crisis when government finances fiscal deficit with monetary expansion and at the same time try to peg national currency to enhance trade with a majors trade partners (or to import low inflation form abroad)

42. II generation ER crisisSelf-fulfilling crisis (multiple equilibria) But: • EMS crisis 1993/1994 Fluctuations band widening from +/- 2.25% to +/- 15% • not fundamentals but rather policy choice; dynamic inconsistency about , from the dynamic evolution of the Loss function (costs/benefits from ) + self-fulfilling dynamics… • Difficult to predict, depends of expectations and their interactions (driven by expectations instability)….

43. EMS, ECU mechanism

44. II generation ER crisis • Expectations instability • Contagion/heard behavior • Maurice Obstfeld (1996) • Game theory presentation • Multiple equilibria: results of government reaction and the attack of 2 speculators (traders), and different level of F (high F game 20; low F game 6 and intermediate F game 10); each trader has donation of 6 (total 2x6=12); and transaction costs are 1 • Next slide: reward matrices (payoff) ….

45. Game theory interpretation

46. Strategic interactions between speculators – multiple combination between (i, Δe); how the coordination problem of currency market changes when changing macroeconomic fundamentals… Intermediate F game = f (costs of defending; costs of exit)… Initial shock: Interest rate movements (Δi* or Δi): examples of shocks, 1992: unemployment, France; Italy, debt; Sweden, banking system; UK, household domestic debt… II generation ER crisis

47. Strategic interactions between speculators – multiple combination between (i, Δe); how the coordination problem of currency market changes when changing macroeconomic fundamentals Intermediate F game = f (costs of defending; costs of exit) Initial shock: Interest rate movements (Δi* or Δi): examples of shocks, 1992: unemployment, France; Italy, debt; Sweden, banking system; UK, household domestic debt… Government Loss function (L) and dynamic inconsistency problems exit costs In order to escape this incoherence government can link his hands – C (costs of realignment) II generation ER crisis

48. IVEmpirical Issues of ER crisis

49. Empirical Issues of ER crisis How to measure Pb of attack; early warning indicators Indices (indicators) construction (ponderation by σ) Binary (probit) model (Regressing crises indicator to a set of variables) Signaling approach (critical thresholds)

50. Signaling approach//Errors type I (+‖-) occurred but not recorded//Errors type II (-‖/+) not occurred but recorded by the model