Economics Part II Developing Country Debt Crisis

1. Economics Part IIDeveloping Country Debt Crisis • A Country Leads the Path to Default - interest and principal not paid - currency devalues - other countries follow suit

2. Economics Part IIDeveloping Country Debt Crisis • Solution • Short currencies • Purchase puts • Sell futures • Sell stocks and bonds

3. Economics Part IIDeveloping Country Crisis • Petrodollar crisis • Mexico 1982 • Recycling of dollars • Crash of the dollar

4. Economics Part IICan a Crisis Happen?Financial Crisis in Historical Perspective • Tulip mania (1636) • South Sea Bubble (1720) • East India Company (1772)

5. Financial Crisis in Historical Perspective • Large Scale Defaults by financial and non-financial institutions (Minsky, 1963) • Notion of Debt Deflation (Fisher 1933, Bernanke, (1983) • Process of Creative Destruction (Schumpeter, 1934)

6. Financial Crisis in Historical Perspective • Corporate Debt • LBO’s, Overborrowing • Sovereign Debt • Government borrowing • Consumer Borrowing • mortgages

7. Financial CrisisThe Liquidity Factor • Serious Lack of Information • Not consistent with EMH • Suggests that amount of sufficient info available to traders may not be available • Certain conditions for EMH may not be applicable during sharp market declines

8. The Liquidity FactorA Closer Look • In order for “information” and liquidity related explanations to be plausible there must be some friction • If liquidity were freely available to respond to any level of short term trading then the market decline would lose much of its persuasive force • The used car dealer

9. International Financial Crises • International Economy Since 1982 • Paradoxical • Most turbulent since 1930’s • Large day-to-day currency volatility • 1985 $/Y 250; to 125 by 1987 then to 150 by 1989

10. Financial Crises in International Community • Financial Markets Calm (1982- Present) • Exceptions: 1987, 2001 • No major recessions • Inflation decline

11. Financial Crises in International Community • Destabilizing Effect May Catch Intl Community by Surprise • Integrated World Financial System • Trade liberalization, elimination of capital controls, financial deregulation

12. Types of Crisis • Balance of Payments • Loss of confidence by speculators thereby provoking capital flight • Leads to imposition of capital controls • Debt service is limited or impossible

13. Balance of Payment Crisis • Mexico 1984 • Malaysia 1995 • Happens in International Markets but may not be international in scope • Lack of confidence in “real assets” Japan 1989- Land and Equities

14. Economic Crisis • International in Scope • Crisis of 1929-1931 • Started in United States • Spread to other countries

15. Two Classic ExamplesThe French Franc 1920-1926 • No Longer Pegged to Gold • Lost ½ of its value • Fiscal Debt • Could Not Service War Costs

16. The French Franc 1920-1926 • Insisted that Germany pay for war • Due to German Hyperinflation this became a fantasy • Debt at fixed rates • Solution: Inflating Debt Away

17. The French Franc 1920-1926 • Speculators – News that the French Govt would inflate its problems away- The Franc declined • Speculators- Learning that the French Govt would possibly cut expenditures or raise taxes, the Franc would rise

18. The French Franc 1920-1926 • French Franc rose from US 6.25 cents to US 9.23 cents from April 1920 to April 1922 • Flotation of new loans • Raised taxes • Bad diplomatic news and chaos in Germany led to a decline of the French Franc to US 6.86 cents by Nov 1922

19. The French Franc 1920-1926 • Developed Life of their Own • Not Driven by External events

20. The French Franc 1920-1926 • Lack of Confidence led to large debt placement • News of failure drove Franc to US 3.49 cents by March 1924 • Govt announced tax increases • Franc rose to US 6.71 cents

21. The French Franc 1920-1926 • Heavy losses inflicted on speculators as they bet on the wrong direction of the Franc • Two months later Franc declined to US 5 cents

22. The French Franc 1920-1926 • Further lack of confidence in government and new debt issuance • October 1925 - July 1926 • Franc fell from US 4.7 cents in September 1925 to US 2.05 cents in July 1926 • New policies and Finance Minister drove Franc up to US 3.95 cents by December 1926

23. The French Franc 1920-1926 • Substantial Macroeconomic effects • Depreciation led to substantial inflation • Subsequent stabilization led to sharp but brief recession • Object lesson of destabilizing speculation

24. The French Franc 1920-1926 • Exchange rates were found to overshoot and undershoot • Government fiscal problems were much of the cause for the fiscal attack on the French Franc • Failure of the French Franc provided the underpinning of a pegged currency scheme ultimately resulting in the Breton Woods Agreement

25. The French Franc 1920-1926 • Case still influences economists on their thinking of exchange rates and troubled currencies

26. 1929 • Popular Image of 1929 is of a single dramatic moment: the U.S. stock market crashes near to 0 in a few hours and the rest of the world’s stock markets are dragged down with it and immediately throwing the world into a depression

27. 1929 • More complex than the popular vision of people jumping out of windows • The Sharp Business Contraction would have been less severe if not for the general banking collapse

28. 1929 • Financial Shock was not complete by end of 1929 • Serves as a model for currency crisis contagions

29. Stock Market Declines 1929-1932 Country September 1929 - December 1929 - December 1929 December 1932 • US 31.9% 69.4% • Canada 33.5% 72.4% • France 10.8% 47.3% • Germany 14.4% 44.9% • UK 16% 24.8% Source: C.P. Kindleberger, 1973 The World in Depression

30. 1929 • Most of the fall took place after 1929 • US Slump transmitted to the rest of the world but milder

31. Causes of Currency Crisis • Occur when investors lose confidence in the currency • Seek to escape assets denominated in that currency and other assets whose income might be affected by currency controls Examples Asian crisis, Latin American crisis US dollar 1973, Sterling 1975

32. Causes of Currency Crisis • Should a currency problem turn into a crisis? • Rational Speculative attacks • Central Banks that are trying to maintain unsustainable fixed rates • Examples: Gold Exchange Rate, ECU, Argentina

33. Causes of Currency Crisis • Country that has persistent budget deficit • Financed through borrowings • Central bank has to cover loans by printing money • Country experiences persistent inflation and a depreciating currency • Pegging exchange rate

34. Causes of a Currency Crisis • Uses dwindling supply of FX • Temporarily keeps inflation rate at pegged country’s rate • Peg broken • Currency Floated • Inflation ensues

35. The Role of the Speculator • Speculators sensing loss • Bail out of currency • Short futures • Short currency • Accelerate downward trend of currency • Surges of capital flight need not represent irrational behavior

36. The Crawling PegEuropean Currency Unit 1992 • Crawling Peg • The Snake • +/- 6% DM • German Reunification • Inflation in Germany • Recession in Britain, Italy, Sweden and Spain • Denmark and Sweden exit first • Britain is next

37. The European Currency Unit • Speculative Attack on the Pound • Speculators gang up on the Pound • Drive it Deeper • Britain exits the ECU • Spain and Italy follows

38. The Asian Currency Crisis • Thailand runs current account deficit • Debt denominated in $ • Breaks peg to dollar • Asian countries pegged to $ follow suit • Quantum Fund attacks Malaysian Ringgit • Malaysia institutes capital controls • Malaysian PM blames George Soros

39. The Argentine Crisis • Economic Decline since 1932 • Inflationary and Populist Polices lead to 75 year decline • To Stop/Arrest Peg Currency to US$

40. The Argentine Crisis • Monetary Policy Dictated by US Federal Reserve • Argentine Peso fully convertible into US$ • Peg Broken • Debt default • Peso declines 66% within 6 months • Recovery

41. Mexico 1982 • Capital flight • Year Hard Currency Cap flight • 1978 3.75 0.70 • 1979 6.34 0.23 • 1980 12.69 -0.68 • 1981 30.62 9.73 • 1982 10.58 8.23 • 1983 2.27 2.42 • 1984 1.94 2.33 • 1985 -0.18 1.92

42. Mexico 1982 • Typical Currency Problem • Deterioration of world economics • Expectation that LA currencies would be devalued • Investor flight from LA currencies • Lenders afraid debt would not be serviced

43. Lessons from Mexico • US Govt bailout due to heavy lending by US Banks • US financial system in jeopardy • Few economists and bankers believed that Mexico had an excessive debt problem • “Overconfidence” problem • Unforeseen Lesson for today’s environment

44. Mexican Macroeconomics 1982 • Inflation ensued • Growth retarded • Recovery

45. Macroeconomic Performance in Latin America (Growth Rates) • Year GNP/Capita CPI • 1971-1980 3.1 39.8 • 1981 -2.6 60.8 • 1982 -3.1 66.8 • 1983 -4.8 108.6 • 1984 1.4 133.0 • 1985 1.4 144.9 • 1986 1.9 87.8 • 1987 0.4 130.0 • 1988 -1.3 277.6

46. Anatomy of A Hard Landing • Economist Paul Krugman states that • The Hard Landing is the crisis that did not happen • Krugman adds, “It still could” • The withdrawal of capital from the US that finances consumer, government, corporate debt • Withdrawal of investments and accumulated capital • Foreign central banks decline to fill the gap

47. Anatomy of A Hard Landing • Dollar plummets • Expectations that Prices rise 3 to 4% • Interest rates rise about the same amount • Federal Reserve feels compelled to stop the process and pushes nominal interest rates to 13% to 15% range • Confidence levels decline (remember France 1920-1926)

48. Anatomy of a Hard LandingImpact on the Economy • Inflation rises as a direct result of dollar depreciation especially if the economy is near full employment and capacity utilization • Sharply higher interest rates and fiscal tightening pushes economy into recession

49. Anatomy of a Hard LandingImpact on the Economy1982-1984 US • Federal Reserve moves to combat inflation • Abnormally high interest rates • Longer than normal recession

50. Anatomy of a Hard Landing“The Summers Dilemma” • Sharp Rise in Interest Rates Could Trigger Substantial Turmoil in light of: • High leverage • Uncertain loan portfolios • Hence the dilemma • The higher interest rates needed to stop the currency crisis would further intensify the risk of financial disruption while any substantial injection of increased liquidity as the lender of last resort could increase the inflationary spiral and move the dollar lower.