Download Chapter 10- Finance

Problem Set 2: International Finance
The real exchange rate, both its level and changes in it, can be extremely important for a
country’s economic performance and the distribution of the fruits of that performance. In this
exercise, we will use two case studies to illustrate the role played by the RER. The first will use
the 1997 Asian financial crisis to show the consequences for the real economy of a speculative
attack on the currency. The second will explore China’s well-known reputation as a “currency
manipulator” in comparison to another country that is also pursuing an export-oriented growth
strategy: Brazil.
I. The 1997 Asian financial crisis
In the summer of 1997, Thailand experienced a speculative attack on its currency (the baht),
which was under a fixed exchange rate regime. Unable to meet the demand for its foreign
currency reserves, Thailand was forced to float its currency. This precipitated an economic crisis
not only in that country but also many other East Asian nations, as panic over the financial
stability of those countries led to runs on foreign exchange reserves there as well. The factors
that made these countries vulnerable to speculative attack and currency runs, as well as the
reasons that such attacks had such a negative impact on their economies, are numerous and welldocumented. Corsetti et al. (1999) provide a useful summary.1 Here we will look at some of the
risk factors that allowed a speculative attack to succeed as well as the economic consequences
that followed. To do this, we will use a time series of data (ps2q1.csv) from the World Bank’s
World Development Indicators, including macroeconomic indicators for Thailand, the country in
which the crisis began; Indonesia and South Korea, two countries that were affected in the
subsequent contagion; and China, which was far less affected and serves as a point of contrast.
1.
One risk factor for speculative attack is a large current account deficit, which can occur
when the value of imports far exceeds the value of exports. Explain why, all else equal, a larger
current account deficit makes it harder to fend off a speculative attack.
2.
Were any or all of these countries running large current account deficits? One simple way
to see this is to calculate the balance of trade (BoT = Exports – Imports) and divide that by GDP.
Plot this measure for all four countries from 1990 until 1996. Comment on your findings.
3.
Another risk factor for speculative attack is a small accumulation of foreign exchange
reserves. There are many ways to assess the relative size of reserves. One is to look at the ratio of
the money supply (measured here by “M2”) to the total reserves, making sure the currency units
of the numerator and denominator agree. Plot the M2/reserves ratio for all of the countries from
1990 to 1996. Compared to China, were the crisis-affected countries holding lower reserves
before the crisis?
1
Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. 1999. “What caused the Asian currency and financial
crisis?” Japan and the World Economy 11(3): 305 ̶ 73.
4.
Corsetti et al. (1999) make the point that underlying structural problems in an economy
can be masked when growth is strong. Plot year-over-year real GDP growth in the 1991 ̶ 96 precrisis period. Was growth robust during that time period?
5.
A common question asked about the crisis is “why 1997?” The causes of macroeconomic
crisis can be much deeper and more country-specific than a few basic macroeconomic indicators
can explain. (Otherwise we might be better at heading them off beforehand.) Looking at the three
plots you have constructed so far, do you see any reason that 1997 was more likely to see a
financial crisis than in any of the several years before?
6.
We look now at the consequences of the crisis, made possible or even inevitable by
underlying structural issues in the economy but finally precipitated by speculative attack. First,
confirm that devaluation did occur in the affected countries by plotting the real exchange rate
(normalized to 100 in 1990 for each country) from 1990 to 2005. Do you see a Thai devaluation
in 1997 and subsequent devaluations in the contagion countries?
7.
One reason that devaluation affected the economies was that their corporations held large
amounts of debt that was denominated in foreign currency. Why would this be bad for the
economy in the face of devaluation? To see if the devaluation had a negative impact on the real
economy of crisis nations, plot real GDP growth as you did in question 4, this time extending the
series to include 1991 ̶ 2005. Comment on the magnitude of the changes.
8.
All else equal, what should be the effect of devaluation on the balance of trade? Calculate
the BoT as a percentage of real GDP and plot it from 1990 ̶ 2005. Did it change in the way that
you expected? Looking at the data, did the effect come more from a change in exports or
imports?
9.
In the context of a financial crisis, the effect of devaluation on FDI inflows is difficult to
predict. What is the “mechanical” economic reason that devaluation should increase FDI? Why
might investors have become less likely to invest? Plot net FDI inflows as a percentage of GDP.
Was the effect of the crisis on FDI uniform across affected countries or not?
II. Neo-mercantilism and the real exchange rate
China has been referred to by some as a “currency manipulator”. The objective of this
exercise is to assess to what extent this is the case, and whether the situation is worsening
or improving from the standpoint of the United States. You will also compare China’s
RER performance to that of Brazil, a country that has also been using exports as part of
its growth strategy. The data for this exercise are located in ps2q2.csv.
1.
China’s growth model has been described as neo-mercantilist. Explain how a neomercantilist growth strategy is defined. What is the role of the RER in this strategy? What are the
policy instruments through which this is implemented?
2.
Calculate the real exchange rate for China as an index with base 1987 = 100. Calculate
the GDP as an index with base 1987 = 100. Plot on one graph the GDP and RER indices.
3.
Brazil has also relied heavily on exports, yet has not been exposed as a currency
manipulator. Calculate the real exchange rate for Brazil as an index with base in 1987. Plot on
one graph the GDP and RER indices. Observe and explain the difference in the relative evolution
of GDP and RER in the two countries.
4.
Calculate the balance of trade for China and Brazil, representing it as an index with base
1987 = 100. Plot on the same graph (one for each country) the balance of trade and the RER.
Observe and explain the differences.
5.
How does China maintain its neo-mercantilist model in spite of the long-term success in
running a surplus in its balance of trade? Create an index of FDI net outflows as a percentage of
GDP and graph it against the RER, separately for each country. Do you see a contrasted story
emerging?
6.
Every country needs to find effective demand for its production. China capitalized on an
expanding export demand for its manufacturing goods. Use a graph (plot on the same graph
RER, GDP, exports, and imports) to discuss how well this model worked during the 2008 ̶ 09
world financial crisis.
References:
Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. 1999. “What caused the Asian currency
and financial crisis?” Japan and the World Economy 11(3): 305 ̶ 73.