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TURMOIL IN EMERGING MARKET ECONOMIES Central Lessons

TURMOIL IN EMERGING MARKET ECONOMIES Central Lessons. Guillermo Calvo Ankara, Turkey, September 11, 2006. Sudden Stop, SS: Key Observation. Since the 1990s crises provoked by Sudden Stop (of capital inflows) have become more frequent.

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TURMOIL IN EMERGING MARKET ECONOMIES Central Lessons

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  1. TURMOIL IN EMERGING MARKET ECONOMIESCentral Lessons Guillermo Calvo Ankara, Turkey, September 11, 2006

  2. Sudden Stop, SS: Key Observation • Since the 1990s crises provoked by Sudden Stop (of capital inflows) have become more frequent. • SS involves large real currency depreciations, and have grave output and employment effects if the crisis involves the domestic banking system. • Empirical studies show that this dangerous combination is more likely to take place the larger is Domestic Liability Dollarization, DLD, • i.e., foreign-exchange denominated loans from domestic banks as a share of GDP.

  3. SS: Further Empirical Analysis • DLD is dangerous because • banks tend to have short-term dollar liabilities (maturity mismatch). • DLD deteriorates banks’ balance sheets after large real depreciations (currency-denomination mismatch on the part of bank debtors). • Real depreciation is likely to be higher • the larger is the Current Account Deficit • the smaller is the share of Tradable Goods in output. • To prevent deleterious effects of bank runs under DLD it is necessary to have an effective Lender of Last Resort in dollars.

  4. Probability of SS Probability of SS All Sample 3.35% 2001 2005 Turkey 44.65% 27.90% Argentina 55.00% 0.75%

  5. GDP at constant prices, 1998=100 140 Turkey 130 120 Argentina 110 100 90 80 1998 1999 2000 2001 2002 2003 2004 2005 2006 f

  6. 1997/1998: A Global SS for EMs • The Asian 1997 and Russian 1998 crises coordinated a major SS in most EMs. • It resulted in • much higher interest rates • large real currency depreciation • lower output growth and investment. • Its effects were long-lasting, and resulted in a transitory shrinkage of the EM bond market, and EM debt de-leveraging.

  7. 150000 100000 50000 0 -50000 -100000 -150000 Jan-91 External Financial Conditions for EMs (EMBI sovereign spread & Current Account Balance in EMs, millions of USD, last four quarters) Tequila Crisis Asian Crisis Russian Crisis 2500 2000 1500 EMBI spread (basis points) Current Account (millions of USD) 1000 500 0 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Note: Includes Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Slovak Republic, South Africa, Thailand, Turkey and Venezuela.

  8. LAC 7: INVESTMENT (LAC-7, s.a. Investment, 1998.II=100) 110 Russian Crisis Annualized growth: 10.6%2002.IV-2004.III Annualized growth: 7.4% 100 1990.I-1998-II 90 80 Annualized growth: - 4.1% 1998.II-2002-IV 70 60 50 1994.I 2002.I 1990.I 1991.I 1992.I 1993.I 1995.I 1996.I 1997.I 1998.I 1999.I 2000.I 2001.I 2003.I 2004.I

  9. LAC 7: GROWTH (LAC-7, s.a. GDP, 1998.II=100) Russian Crisis 115 Annualized growth: 5.5% 2002.IV-2004.III 110 105 100 95 Annualized growth: 4.4% 1990.I-1998.II Annualized growth: 0.2%1998.II-2002.IV 90 85 80 75 70 65 1996.I 2001.I 1990.I 1991.I 1992.I 1993.I 1994.I 1995.I 1997.I 1998.I 1999.I 2000.I 2002.I 2003.I 2004.I

  10. 130 120 Asian Crisis Russian Crisis Asian Crisis Russian Crisis Annualized growth : 6.06% 1993.I-1997.II 110 120 Annualized growth: 5.4% 1998.III-2004.III 100 110 90 Annualized growth: 7.25%1993.I-1997.II 100 Annualized growth: 5.9% 1998.III-2004.III 80 90 Annualized growth: - 37% 1997.II-1998.III 70 Annualized growth: -10.6% 1997.II-1998.III: 80 60 50 70 1993.I 1996.I 1999.I 2002.I 1993.I 1996.I 1999.I 2002.I 1995.II 1998.II 2001.II 2004.II 1995.II 1998.II 2001.II 2004.II 1994.III 1997.III 2000.III 2003.III 1994.III 1997.III 2000.III 2003.III 1993.IV 1996.IV 1999.IV 2002.IV 1993.IV 1996.IV 1999.IV 2002.IV Emerging Asia: Investment and Economic Growth (s.a. Investment and GDP, 1997.II=100) Investment Economic Growth Includes Indonesia, Korea, Malaysia, Philippines and Thailand.

  11. Asia/Russia Crises: Implications • External factors cannot be ignored, and may be crucial. • Financial globalization places EMs in the equivalent of a SS Tornado Alley, SS-TA. • Individual countries cannot move away from SS-TA, unless they become financially autarkical—which carries high costs. • Therefore, the relevant domestic policy options are • Lowering domestic financial vulnerabilities (e.g., de-dollarization), • Self-insurance (large stock of international reserves and/or contingent credit lines).

  12. LIFE AFTER SS Phoenix Miracles

  13. Emerging Markets Turkey 2001 Collapse Recovery Collapse Recovery 105 105 110 110 RER (vis à vis US Dollar) 100 100 108 108 95 95 90 106 106 RER* (vis à vis US Dollar) GDP 85 90 GDP GDP RER (vis a vis USA) RER (vis a vis USA) 104 104 80 85 75 102 GDP 102 80 70 100 100 75 65 2000 2001 2002 t-2 t-1 t t+1 t+2 *Median Real Exchange Rate (Average 3S Episode)

  14. Emerging Markets Turkey 2001 Collapse Recovery Collapse Recovery 3 3 110 110 2 2 1 1 108 108 GDP 0 0 GDP 106 106 -1 -1 Current Account GDP GDP Current Account (%GDP) Current Account (%GDP) -2 -2 Current Account 104 104 -3 -3 -4 -4 102 102 -5 -5 100 -6 100 -6 t-2 t-1 t t+1 t+2 2000 2001 2002 Current Account & Output (Average 3S Episode, CA in % of GDP)

  15. Emerging Markets Turkey 2001 Collapse Recovery Collapse Recovery 130 121 110 110 120 116 108 108 GDP GDP 110 111 106 106 100 GDP GDP Bank Credit Bank Credit 106 104 104 90 Credit Credit 102 101 102 80 100 70 96 100 2000 2001 2002 t-2 t-1 t+1 t+2 t Bank Credit & Output (Average 3S Episode, Bank credit deflated by CPI)

  16. Emerging Markets Turkey 2001 Collapse Collapse Recovery Recovery 185 110 180 110 175 170 108 165 108 160 155 GDP GDP 150 106 106 145 GDP GDP 140 Investment Investment 135 104 104 Investment 130 125 115 120 102 102 105 Investment 110 100 95 100 100 t t-2 t-1 t+1 t+2 2000 2001 2002 Investment & Output (Average 3S Episode, annual Investment)

  17. Phoenix Miracles: Implications • Phoenix Miracles suggest that SS is associated with drastic “capacity underutilization,” likely linked to financial factors. • It also suggest that crises are not “solvency crises,” but rather “liquidity crises.” • This reinforces earlier conclusion that relevant domestic policy options are • Lowering domestic financial vulnerabilities (e.g., de-dollarization), • Self-insurance (large stock of international reserves and/or contingent credit lines).

  18. WHAT IF SS HITS?

  19. Monetary Policy • In essence, the problem is not monetary. • International credit suffers a drastic cut. • This cannot be offset by expanding credit from the central bank. • Unless central bank makes international reserves available to the rest of the economy: public or private sector. • This gives a rationale for the policy—clearly followed in Asia—of accumulating a large stock of international reserves as a form of self-insurance.

  20. Monetary Policy (cont’d) • Empirical evidence shows that actually central banks’ reserves collapse after SS, much independently of the adopted exchange rate system • which, as noted, is a natural response to SS. • Typically, central banks lose international reserves by foreign exchange intervention, even though otherwise they prefer not to. • But this policy response is not necessarily first-best, e.g., because of market segmentation it could just give rise to Capital Flight. • Central bank could, alternatively, lend dollars to the export sector (like Brazil 2002).

  21. Monetary Policy (cont’d) • Expansionary monetary policy through open market operations jacks up the nominal exchange rate and, in the short run, also the real exchange rate. • The latter has a positive impact on net exports and, on that account, alleviates the effects of SS (see Korea 1997/98, and Chile 1998/99). • However, under large DLD, real devaluation may worsen financial difficulties, resulting in lower output and employment.

  22. Tight monetary policy? • Experience suggests that tight monetary policy has not interfered with necessary real exchange rate adjustment. • In all cases, in the short run the RER has exhibited large increase and overshooting. • However, excessive tightness may destroy domestic credit, unnecessarily deteriorating output and employment. (“You can’t push on a string but you can pull on a string!”); • but inflation is not an answer, because it also destroys real domestic credit, and has negative effect on output.

  23. Tight monetary policy? (cont’d) • Domestic interest rates are not reliable indicators for assessing tightness because of • e.g., increase and volatility in country risk factors and inflationary expectations after SS. • Neither is output a good indicator because, e.g., typically SS is associated with changes in output levels and composition. Thus, “full-capacity output” is hard to assess. • Thus, in the short run after SS it may be desirable not to target interest rates or capacity utilization. • To prevent excessive tightness it may be advisable to temporarily peg the exchange rate to a sustainable level, and let money supply be endogenously determined. • For sustainability it is advisable to make sure that banks’ bailouts will not be needed.

  24. Fiscal Policy • Expansive fiscal policy, especially credit to private sector, could alleviate the effects of SS. • However, typically both public and private sectors are subject to SS. • In which case the public sector can only implement expansionary fiscal policy on the strength of its stock of internationally liquid assets(e.g., international reserves), or international credit lines.

  25. Government Policy: Need & Risks • Gov’t is a big player and major determinant of country risk. • Thus, e.g., a large stock of international reserves may send a strong signal that gov’t will use them to bail out banks and, thus, avoid interruption of domestic payments system. • Gov’t could implement ex post contracts that would be optimal ex ante, but that would be too costly to write ex ante. • However, the above policies may cause Moral Hazard on the part of the private sector. • Effective bank regulation is key to prevent Moral Hazard in that sector. • Moral Hazard justifies charging high interest rates during a SS • which should, however be significantly lower than the market’s.

  26. TURMOIL IN EMERGING MARKET ECONOMIESCentral Lessons Guillermo Calvo Ankara, Turkey, September 11, 2006

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