FIN 40500: International Finance

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! Percentage Difference From “Pre-Crisis” Exchange Rate Crisis Date

Note that portfolio investment is quicker to flow out than foreign direct investment Crisis Period Capital Flows

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!! A peg above the equilibrium will involve buying your currency (loss of reserves) Foreign currency per $ S A peg at the equilibrium price can be maintained forever! A peg below the equilibrium price will involve selling your currency (increase in reserves) D $

Suppose that a country is pegging at or near the equilibrium value of its currency S An incompatible policy could pull the equilibrium away from the pegged level – this forces a loss in reserves! D $

Suppose that a country is pegging at or near the equilibrium value of its currency S 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? • Persistent inflation • High Money Growth • Low Economic Growth • Large Deficits • Public • Private • Political Events • Natural Disasters • Market Sentiment Bad Policy Just the facts ma’am. Bad Luck

Note the sharp reversal in inflation following the crisis period Inflation US Average Inflation Crisis Period

Steadily deteriorating growth rates is not a good sign!! Economic Growth Crisis Period

Note the significant drop in money growth after the crisis Average = 14% Average = 4% M2 Money Growth Crisis Period

Note that the government deficit gets worse before it gets better Government Deficit Crisis Period

Note the sharp reversal in the trade accounts following the currency crash Trade Deficit Crisis Period

Note the rapid drop in the interest rate following the devaluation! Overnight Lending Rate Crisis Period

Note the sharp loss in reserves as the central bank attempts to defend the currency! FX Reserves Gold Reserves

Recall, the monetary framework with flexible prices (long run) resulted in the following Relative Money Stocks Relative Interest Rates Relative Outputs

High money growth and low economic growth generate inflation (Domestic Money Market) Domestic inflation generates a currency depreciation (PPP) Domestic Inflation Foreign Inflation

If the current depreciation leads to expectations of future depreciations, the domestic interest rate must rise to compensate foreign investors A rise in the interest rate lowers money demand even further – this causes another round of inflation!

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) Rapid money growth pushes interest rates down in the short run and “over-stimulates” domestic consumption – this creates trade deficits that are difficult to finance! This point is unsustainable!

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! 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! 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 Real GDP Real Output Y Total Hours Labor Productivity = = N Per Man-hour Real GDP (2004) $8,317 = $34/hr $10,397 $8,317 244.3 Subtract out Farm Output Divide by total hrs (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 Labor productivity doesn’t correct for changes in the capital stock!! Real GDP Capital Y = A KβN 1-β(Production function) β = 1/3 Labor MFP Capital Growth Growth Rate of MFP = y – βk – (1-β)n Real GDP Growth Labor Growth

Step 1: Estimate capital/labor share of income K = 30% N = 70% Step 2: Estimate capital, labor, and output growth %Y = 5% %K = 3% %N = 1% %A = 5 – (.3)*(3) + (.7)*(1) = 3.4% Multifactor Productivity

MFP Growth dropped in the 70s and 80s as IT was introduced! Annual Growth

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

FIN 40500: International Finance