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STORIES OF THE TWENTIETH
CENTURY FOR THE TWENTY-FIRST
Liu Jingzhu, Martin Kopeček, Jiří Ruml
Original paper
Pierre-Olivier Gourinchas and Maurice Obstfeld
2012
Institute of Economics Studies
JEM 044 International Finance
Outline of the Presentation
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Introduction
Crisis Types and Emerging Market Vulnerabilities
Some Empirics of Crises: Emerging and Advanced
Economies, Then and Now
 Methodology
 What
Happens Before, During, and After Crises?
 What Determines Crises?
 Related Empirical Research
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Conclusion
Introduction
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After the mid-1970s were generally believed...
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Until the global crisis of 2007-2009
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financial crises were mainly emerging market affairs
crises in advanced economies less frequent and generally less devastating
only EMEs would ever need to seek IMF support
EMEs much more vulnerable to financial crisis because of mutually reinforcing weakness
the mature advanced countries much more robust  big net benefit from liberalized and
open financial markets
some EMEs suffered greatly, but others proved remarkably resilient (often experiencing
smaller output declines and faster recoveries than those in the advanced countries)
The goal of the paper…
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…to compare salient features of economic crises in advanced and developing economies,
as well as differences between past crises (from 1973 to 2006) and the 2007-2009
crisis…
Detrended Real Output Growth, by Regions
(percent p.a.)
Types of Financial Crises
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Three major types of crises (closely interrelated in practice):
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currency crises - in which a managed exchange rate falls to speculative
pressure
banking crises - focus on systemic banking crises, which endanger the entire
economy and through channels of contagion also foreign economies
government default crises - involving default, restructuring or market fears of
default on internal or external public debt
Links between them…
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Banking crises tend to begin ahead of currency crises when the two occur
together
Currency depreciation fears exacerbate (and may themselves cause) banking
problems
A systemic banking crisis, especially if worsen by currency depreciation, can
jeopardize public finance as the government intervenes to guarantee bank
liabilities or inject capital  government default crises
Types of Financial Crises – Crisis Incidence
… in general, crises have been much more prevalent
in EMEs in the past
Emerging Market Vulnerabilities I
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Political and Economic Instability
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political instability => economic instability
macro policies tend to be procyclical due to conflicts over profits in good times
and disability to allocate losses in bad times
inflation is a favoured method of resolving distributional disputes
difficulty in collecting taxes worsens the fiscal position overall
Undeveloped and Unstable Financial Markets
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government restrictions may discourage competition and innovation in financial
markets.
a lack of financial depth limits the economy's ability to absorb economic shocks.
bureaucratic restrictions, corruption, lack of expertise
an expectation that government will bail out failing financial institutions,
confirmed by experience in Latin America or Asia, creates moral hazard
Emerging Market Vulnerabilities II
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Dollarization, Original Sin, and Currency Mismatches
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tendency for financial contracts to be denominated in a stable foreign
currency - the US dollar or euro
the inability to borrow from foreigners in domestic currency is referred
to as "original sin"
at the national level, original sin implies that currency depreciation will
raise the real value of external debt - sharp currency depreciations can
lead to financial crises
Fear of Floating
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emerging markets - less willing to tolerate sharp nominal exchange rate
movements than advanced countries
fear of sharp appreciation and its negative effect on exports
fear of sharp currency depreciation – it can cause debt deflation (in the
presence of currency mismatch) and a jump in inflation
Emerging Market Vulnerabilities III
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Sudden Stops and Debt Intolerance
EMEs have been vulnerable to sudden stops in foreign
lending
 financial fragility and the government's weakness in
generating resources for debt repayment contribute to
volatility in capital flows
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Overregulation of Nonfinancial Markets.
heavy regulation in product and labour markets reduces
flexibility in resource reallocation
 administrative barriers to economic activity, such as licensing
requirements, promote corruption as well as inefficiency
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Empirics: Introduction
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The questions to be answered:
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The analysis focuses on variables that:
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are likely to play causal role in determining probability of crisis
are likely to be affected by crisis
The estimates are computed separately for
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How have crises differed in their precursors and aftermaths?
How does crisis of 2007-2009 differ from earlier crises?
three types of crises – default, banking and currency – and current crisis
advanced countries and emerging markets
The outcomes of analysis are:
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estimates how an economic variables’ conditional expectation depends on temporal distance from crisis
discussion on what extent are these estimates useful to predicting onset of crises
Empirics: Methodology 1/2
For various economic variables’ conditional expectation as a function of temporal distance from
crisis is estimated using the relation
𝑦𝑖𝑡 = 𝛼𝑖 + 𝛽𝑑𝑠 𝛿𝑑𝑠 + 𝛽𝑑𝑠 𝛿𝑑𝑠 + 𝛽𝑑𝑠 𝛿𝑑𝑠 + 𝛽𝑑𝑠 𝛿𝑑𝑠 + 𝜖𝑖𝑡
where
𝑦𝑖𝑡 = economic variable of interest
𝛿𝑑𝑠,𝑏𝑠,𝑐𝑠,𝑔𝑠 = dummy variables for types of crisis (d = default, … )
𝛽𝑑𝑠,𝑏𝑠,𝑐𝑠,𝑔𝑠 = coefficients for crisis type
𝛼𝑖 = fixed effect for country
𝜖𝑖𝑡 = remaining variation in 𝑦𝑖𝑡
𝑖 = numeric country ID
𝑡 = time period
𝑠 = number of periods from crisis 𝑠 ∈ −5,5 ∩ ℤ ,
where 𝑠 = 0 is the beginning of the crisis
Empirics: Methodology 2/2
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Estimated variables by the postulated equations are output,
domestic credit, current account balance, external leverage,
real interest rate, real exchange rate, international reserves
and fiscal variables
The sample of data used comprises of all advanced and
emerging markets countries for which data are available in
either of:
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J. P. Morgan’s EMBIG index
FTSE’s Group of Advanced or Secondary Emerging markets
MSCI-Barra classification of emerging or Frontier Economies
Dow Jones list of Emerging Markets Economies
Together 57 emerging market countries and 22 advanced
economies were examined
Empirics: Real Activity
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Output above trend for banking and
default crises in EM and ADV
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Output below trend for EM and
slightly below trend for ADV
Lower output for all crises compared
to tranquil times
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banking crises are often preceded by
unsustainable levels of economic
activity
relatively less output fall in ADV and
recovers faster in currency crisis
Output of EM recovers in 5 years for
banking crisis, while remaining lower
for ADV
Output gap (log deviation from trend in
percent p.a.)
as a deviation from log trend by HP filter set to 100
Empirics: Inflation Rate
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Inflation rate of EM increases after
crisis
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constraints disappear
inflating away nominal claims
10-15% above normal one year
after currency or banking crisis
For ADV rate remains subdued
In 2008 crisis inflation rate of EM
remained below tranquil-average
Inflation Rate (percent p.a.)
Empirics: Public Finances
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Most of the estimates insignificant
The debt/GDP increases after crisis for
both ADV and EM, however most
dramatically for ADV, Banking
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government bailouts of insolvent domestic
financial sectors
slowdown of economy (lower GDP ⇒
higher debt/GDP ratio)
growing public deficits
In 2008 crisis ADV had high debt/GDP
which increased after crisis
EM had decreasing ratio to around-zero
levels before crisis allowing them to
apply countercyclical fiscal stimuli
Gross Public Debt (percent of GDP)
Empirics: Leverage 1/2
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Significant build-up of credit/GDP
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at peak 25 percent for ADV and 8.6
for EM
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dramatic build-up for ADV in the five
years before 2008 crisis
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build-up also for EMs, but only in
Central and Easter Europe
Domestic Credit (percent of GDP)
as total claims of depository corporations, minus net claims on
central government
Empirics: Leverage 2/2
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Increasing level of external
leverage in ADV before 2008
crisis
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32 percentage points more that
in the tranquil times
External Leverage
as ratio of country’s total assets to its gross equity liabilities
Empirics: Current Account
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Improvements after default and
currency, especially for EM
Largest current account deficits
for ADV prior to banking crises
Current Account (percent of GDP)
Empirics: Real Exchange Rate
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Significant real depreciation
after default and currency crises
and appreciations before those
crises
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especially for EM, but also for
ADV
Real Exchange Rate (log deviation from
trend in percent)
Empirics: Foreign Reserves
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Low reserves prior to currency
crises and rebuild afterwards
Fall prior to default, but remain
to continue down
Large build-up prior to 2008
crisis for EM
Foreign Exchange Reserves (percent of
GDP)
What Determines Crises?
Discrete choice models: commonly used in the “earlywarning” literature on crisis predication:
j---crisis type
t---time period
1≤k≤3
Notes
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Each table reports the overall probability of crisis occurrence p(y=1) evaluated at
the pre-crisis sample mean
For each explanatory variable xi in the vector x, its standard deviation sd(xi) over
the price-crisis sample
And the marginal effect
along with White-robust standard errors, evaluated at the pre-crisis sample mean
∆p reports the change in probability resulting from a one-standard deviation
increase in x, evaluated at the pre-crisis sample mean
,with the corresponding standard error evaluated by the delta method, also at the
pre-crisis sample mean
Findings
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The results are consistent with event-study analysis
and indicate that several of the macro indicators
that appear elevated before crises, notably
domestic credit and real currency strength, also
contain significant predictive power for the
occurrence of crises
Related Empirical Research I
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Face the difficulty of accurately controlling for a
variety of relevant differences across diverse
groups of economies
Predictors of crisis intensity:
 prior
financial liberalization
 prior current account deficits
 short-term external debt levels
 prior domestic credit growth
Related Empirical Research II
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Rose and Spiegel (2011): a useful compendium and critique
of the econometric literature and findings  a set of
univariate regressions  no econometric evidence that
exchange rate pegs played a role but anecdotal evidence
still suggests that exchange rate flexibility was an
advantage  the statistical significance of the preceding
factors is much lower when subsets of them are entered
jointly in various regressions measuring crisis intensity
 supportive
that where EMEs’ showed resilience in the recent crisis
this was due in part to their avoidance of excessive foreign
and domestic leverage
Conclusion
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Emerging and advanced economies’ crises are qualitatively similar
Two most robust predicators of crises: domestic credit growth and real
currency appreciation
A third robust determinant of EMEs’ crisis probabilities: an emerging
country’s level of foreign exchange reserves is a significant factor
determining the probability of future crisis
To the extent that emerging economies escaped the worst of the global
crisis of 2007-2009, they did so in part through economic and institutional
reforms. Some of these reforms resulted in greater economic openness,
although relatively low levels of financial development and financial
globalization may have been advantages in withstanding the forces that
generated the 2007-2009 crisis
It remains to be seen if emerging economies can preserve their financial
and economic stability without reducing current levels of economic openness
Discussion
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Questions or Remarks?