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  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 CONTAGION24.5 IMF COUNTRY PROGRAMS24.6 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: 1. 1975-81--Recyclingofpetrodollars, via bankloans, 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 crisis1997, 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 target2002, Jan. -- Argentina abandons 10-yr “convertibility plan” & defaults 2003-07 -- New capital flows into developing countries, incl. China, India... 2008-12-- GlobalFin.Crisis:Iceland,Latvia,Ukraine, Pakistan, Greece,Ireland,Portugal… 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 inflowsto build up forex reserves, rather than to finance Current Account deficits 2003-07boom 1991-97 boom

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

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

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

  9. 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)

  10. Early Warning Indicators of Currency Crashes Sachs, Tornell & Velasco(1996),“Financial Crises in Emerging Markets: The Lessons from 1995”:Combination of weak fundamentals (ΔRER 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. The IMF and Rose & Spiegel (2009) found that countries with more reserves were not less affected by the 2008-09 crisis: IMF Survey MagazineOct.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 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 crisisFrankel & 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, currentaccount & nationalsaving too. The changes that most EMs (except E. Europe) had made after the 1990s apparently paid off.

  15. Are bigcurrentaccountdeficits 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=0and 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 Cor empty beach-front condos (Thailand) & unneeded steel companies (Korea). Amendment after GlobalFinancialCrisis of 2008-11 – CAD dangerous.

  16. 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 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 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 >> 0. (Interest rate defense against speculative attack might be successful.) • Currency crisis  ExchangeMarketPressure  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 performanceof 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. Appendix4: Reserves as EarlyWarningIndicator API-120 - Macroeconomic Policy Analysis IProfessor Jeffrey Frankel, Kennedy School of Government, Harvard University

  23. API-120 - Macroeconomic Policy Analysis IProfessor Jeffrey Frankel, Kennedy School of Government, Harvard University

  24. API-120 - Macroeconomic Policy Analysis IProfessor Jeffrey Frankel, Kennedy School of Government, Harvard University

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

  26. Source: IMF WEO, 2007 2003-07: This time, China and India shared in the inflows.But capital inflows to EMs financed only reserve accumulation, not current account deficits as in the past.

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

  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. Top 8 categories of Leading Indicators in pre-2008-crisis literature Frankel & Saravelos (2012)

  30. Next 9 categories of Leading Indicators in pre-2008-crisis literature Frankel & Saravelos (2012)

  31. F & Saravelos(2010):Bivariate

  32. F & Saravelos (2010):Multivariate

  33. Actual versus Predicted Incidence of 2008-09 CrisisFrankel & Saravelos (2010)