Download Anatomy of a Currency Crisis

FIN 40500: International
Finance
Anatomy of a Currency Crisis
What Constitutes a “Crisis” ?
 Large, rapid depreciation of a
currency
 Sudden, dramatic, reversal in
private capital flows
The “Crisis” period is
typically followed by a
recession.
Note: The names and dates have been
changed to protect the innocent!
Note the short run “overshooting” of the exchange rate!
80
Percentage Difference From
“Pre-Crisis” Exchange Rate
70
60
50
40
30
20
10
0
-18
-14
-10
-6
-2
2
6
10
14
-10
Crisis Date
18
22
26
Note that portfolio investment is quicker to flow out than foreign direct
investment
3500
Crisis Period
3000
Capital Flows
2500
2000
1500
1000
500
0
-23
-19
-15
-11
-7
-3
1
5
9
13
17
-500
-1000
Foreign Direct Investment
Portfolio Investment
21
Imagine yourself driving down
a straight stretch of road. If
the alignment on your car is
good, you can let go of the
steering wheel and the car
stays on the road……
However, if your alignment is
not perfect, you need to act to
stay on the road. Otherwise…
On the other hand, your alignment could be
perfect, but if the road has an unexpected
curve….
Your pegged exchange rate needs to be consistent with a market
equilibrium!!
Foreign
currency per $
A peg above the equilibrium will
involve buying your currency
(loss of reserves)
e
S
e
A peg at the equilibrium price
can be maintained forever!
e*
A peg below the equilibrium
price will involve selling your
currency (increase in reserves)
e
D
$
Suppose that a country is
pegging at or near the
equilibrium value of its currency
e
S
e*
D
$
An incompatible policy could
pull the equilibrium away
from the pegged level – this
forces a loss in reserves!
Suppose that a country is
pegging at or near the
equilibrium value of its currency
e
S
e
*
alternatively, suppose that
demand drops – this lowers the
equilibrium exchange rate and
forces the central banks to act
(buying back currency and losing
reserves)
D
$
What causes these
sudden reversals?
Bad Policy
•Persistent inflation
•High Money Growth
•Low Economic
Growth
•Large Deficits
•Public
•Private
Just the facts
ma’am.
•Political Events
Bad Luck
•Natural Disasters
•Market Sentiment
Note the sharp reversal in inflation following the crisis period
14
12
10
Inflation
8
6
4
US Average
Inflation
2
0
-29
-23
-17
-11
-4
1
7
-2
-4
Crisis Period
13
19
25
Steadily deteriorating growth rates is not a good sign!!
15
Economic
Growth
10
5
0
-4
-3
-2
-1
0
1
2
-5
-10
Crisis Period
3
4
5
6
7
Note the significant drop in money growth after the crisis
60
Average = 14%
Average = 4%
40
M2 Money
Growth
20
0
-37
-31
-25
-19
-13
-7
-1
5
11
-20
-40
-60
Crisis Period
17
23
29
34
Note that the government deficit gets worse before it gets better
50,000
40,000
30,000
Government
Deficit
20,000
10,000
0
-10,000
-16
-12
-8
-4
0
-20,000
-30,000
-40,000
-50,000
-60,000
Crisis Period
4
8
Note the sharp reversal in the trade accounts following the currency
crash
6,000
5,000
4,000
Trade Deficit
3,000
2,000
1,000
0
-1,000
-18
-12
-6
0
-2,000
-3,000
-4,000
-5,000
Crisis Period
6
12
Note the rapid drop in the interest rate following the devaluation!
30
25
Overnight
Lending Rate
20
15
10
5
0
-18
-12
-6
0
Crisis Period
6
12
18
24
Note the sharp loss in reserves as the central bank attempts to
defend the currency!
45,000.00
1200
40,000.00
1000
800
25,000.00
600
20,000.00
15,000.00
400
10,000.00
200
5,000.00
Foreign Exchange
Gold
56
51
46
41
36
31
26
21
16
11
6
1
-4
-9
-14
-19
-24
-29
-34
-39
-44
-49
0
-54
0.00
-59
FX Reserves
30,000.00
Gold Reserves
35,000.00
Recall, the monetary framework with flexible prices
(long run) resulted in the following
*
 M  Y  1  i 
e   *  
* 
 M  Y  1  i 
Relative Money
Stocks
Relative
Outputs
Relative
Interest Rates
P
M
Li, y 
High money growth and low
economic growth generate
inflation (Domestic Money Market)
M
Domestic inflation generates a currency depreciation (PPP)
%e     *
Domestic Inflation
Foreign Inflation
E %et 1   i  i *
If the current depreciation leads to expectations of future
depreciations, the domestic interest rate must rise to compensate
foreign investors
P
M
Li, y 
A rise in the interest rate lowers
money demand even further – this
causes another round of inflation!
M
In the short run, it’s a question of the sustainability of current account
deficits (i.e. can the country attract enough foreign capital to finance
their CA deficit)
i
LM
BOP  0
i
IS
y
This point is unsustainable!
Rapid money growth pushes
interest rates down in the
short run and “overstimulates” domestic
consumption – this creates
trade deficits that are difficult
to finance!
In the short run, it’s a question of the sustainability of current account
deficits (i.e. can the country attract enough foreign capital to finance
their CA deficit)
This point is sustainable!
i
LM
BOP  0
i
IS
y
As the IS sector increases
(high domestic investment,
low savings, large fiscal;
deficits), the trade deficits
worsen, but interest rates rise
– this makes it easier to
attract foreign capital
In the short run, it’s a question of the sustainability of current account
deficits (i.e. can the country attract enough foreign capital to finance
their CA deficit)
This point is unsustainable!
i
LM
BOP  0
i
IS
y
However, as debts get too big,
foreign capital becomes more
reluctant to flow in (investors
are afraid of the country’s
ability to repay.
How big is “too big”?



When does a trade deficit become unsustainable?
 PV(Lifetime CA) = 0 (all debts must be repaid)
We need to examine the country’s ability to run trade surpluses in
the future (i.e. repay its debts!)
Generally speaking, a trade deficit greater than 5% of a country’s
GDP is considered “too big”
Productivity measures the ability of a
country to transform inputs into output
Revenues
Labor
Capital
(Shareholders)
Creditors
(bondholders)
With high productivity, producers can raise revenues
without having to raise prices (high growth with low
inflation!)
Labor Productivity
Labor Productivity = Real Output =
Per Man-hour
Real GDP
Y
N
Total Hours
Real GDP (2004)
$10,397
$8,317 = $34/hr
$8,317
244.3
Subtract out
Divide by total hrs
Farm Output
(Employment * Average Hrs * 52)
Suppose that Output/hr in 1992 was equal to $28.hr, then
Prod(1992) = 100
Prod(2003) = 100*(34/28) = 121.4
Multifactor Productivity
Real GDP
Capital
Labor productivity doesn’t
correct for changes in the
capital stock!!
Y = A KβN 1-β (Production function)
MFP
β = 1/3
Labor
Capital Growth
Growth Rate of MFP = y – βk – (1-β)n
Real GDP
Growth
Labor
Growth
Multifactor Productivity
Step 1: Estimate capital/labor
share of income
K = 30%
N = 70%
%A = 5 – (.3)*(3) + (.7)*(1)
Step 2: Estimate capital, labor,
and output growth
%Y = 5%
%K = 3%
%N = 1%
= 3.4%
MFP Growth dropped in the 70s and 80s as IT was introduced!
3.5
3
Annual Growth
2.5
2
1.5
1
0.5
0
1919-1929
1929-1941
1941-1948
1948-1973
Labor Productivity
1973-1989
MFP
1989-2000
1995-2000

Contagion refers to the transmission of a
currency crisis throughout a region



The Thai Baht in 1997 was followed shortly by
crises in Malaysia, Indonesia, Korea
The Mexican Peso crisis in 1994 spread to
Central and South America (“The Tequila Effect”)
The Russian collapse (2000) was followed
immediately by Brazil
Reasons For Contagion




Common Shocks
Trade Linkages
Common Creditors
Informational Problems and “Herding”
behavior