Balance-Of-Payments Crises
Self-Fulfilling Crises
Lecture 9: Exchange-Rate Crises Gregory Corcos Eco572: International Economics
26 November 2014
Twin Banking and ER Crises
Balance-Of-Payments Crises
Self-Fulfilling Crises
Outline
1
Balance-Of-Payments Crises
2
Self-Fulfilling Crises
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Twin Banking and ER Crises
Suggested reading: Feenstra and Taylor, chap.20
Twin Banking and ER Crises
Balance-Of-Payments Crises
Self-Fulfilling Crises
Twin Banking and ER Crises
Introduction: What Are Exchange-Rate Crises?
Large devaluations often cause the collapse of a fixed ER regime, and the introduction of a de facto floating ER regime. Some examples: European Monetary System in 1992: Finland, Spain, Sweden, Italy, Portugal, UK Mexico in 1994 Thailand, Indonesia, South Korea in 1997 Argentina in 2001 Iceland, Hungary, Pakistan in 2008
ER crises can have large economic and political costs.
Balance-Of-Payments Crises
Self-Fulfilling Crises
Twin Banking and ER Crises
Balance-Of-Payments Crises
Self-Fulfilling Crises
Twin Banking and ER Crises
Introduction: the Mundell trilemma
ER crises illustrate the Mundell trilemma, which states that one cannot have simultaneously: 1
fixed ER
2
independent monetary policy
3
full capital mobility
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Balance of Payments crises
Models of BoP crises highlight the inconsistency between monetary expansion at home and a fixed ER under free international capital flows . A monetary expansion causes additional demand for foreign assets and foreign currency. Under a fixed ER, the CB must sell foreign currency to defend the parity. When FX traders realize the CB’s foreign currency reserves are near depletion, they sell home currency massively. As the CB is out of reserves the currency must float.
Balance-Of-Payments Crises
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Twin Banking and ER Crises
A Simplified Central Bank Balance Sheet
Assets Foreign exchange reserves Domestic securities Loans to banks
200 400 400
Liabilities Equity capital Currency in circulation Reserve liabilities to banks
100 850 50
Changes in money supply must be matched by changes in credit to domestic agents and/or FX reserves.
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Pakistan, 2008
Twin Banking and ER Crises
Balance-Of-Payments Crises
Self-Fulfilling Crises
Twin Banking and ER Crises
A BoP Crisis Model (Krugman JMCB 1979) All variables except i and i ∗ in logs.
Demand for money, exogenous constant supply: mt − pt = φy − βit , φ > 0, β > 0 PPP with P ∗ assumed constant, flexible prices: pt = p ∗ − st UIP with i ∗ assumed constant: it = i ∗ − s˙t CB balance sheet: mt = θrt + (1 − θ)dt Exogenous credit growth (due to fiscal deficits or bubbles) dt = d0 + µt, Agents have perfect foresight.
µ>0
Balance-Of-Payments Crises
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Fixed ER solution (st = ¯s ) UIP and PPP imply that i and p, and therefore m is constant. Solving for m, s, rt : m = m0 = (1 − θ)d0 + θr0 ¯s = −m + φy − βi ∗ + p ∗ Reserves dynamics: rt =
1 1−θ (m0 − (1 − θ)dt ) ⇒ rt = r0 − µt θ θ
θ 1 Reserves will be depleted after T = 1−θ µ (r0 − rmin ) periods, where rmin is the lowest acceptable level of reserves.
Keeping money supply constant by selling reserves to offset new loans is known as sterilized intervention.
Balance-Of-Payments Crises
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Twin Banking and ER Crises
Floating ER solution Reserves are exogenous and constant rt = r . Solving for mt , st mt = θr + (1 − θ)(d0 + µt) st − β s˙t = −mt + φy − βi ∗ + p ∗
This implies the following ER dynamics st − β s˙t = ¯s − θ(r − r0 ) − (1 − θ)µt ¯s and r0 correspond to their values in the fixed ER case. Fundamental solution: stf (r ) = ¯s + θ(r0 − r ) − (1 − θ)µt − β(1 − θ)µ t
Bubble solution equal to stf + e β (not considered here).
Balance-Of-Payments Crises
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Under a fixed ER, stf (rmin ) is a ’shadow value’ of the ER. This shadow value falls over time and reaches ¯s at time T0 =
θ r0 − rmin −β =T −β 1−θ µ
At T 0 < T , reserves are still higher than at T ... rT 0 = rmin +
1−θ βµ θ
...but all FX traders holding currency will sell before stf < ¯s . This may be enough to deplete all reserves at time T 0 .
Balance-Of-Payments Crises
Self-Fulfilling Crises
Twin Banking and ER Crises
Balance-Of-Payments Crises
Self-Fulfilling Crises
Twin Banking and ER Crises
Summing up: Under a fixed ER fast credit expansion causes a depletion of reserves, and ultimately makes speculative attacks rational. Interpretation of money supply and credit expansion: fiscal deficits financed by the CB (e.g. Peru, 1986, or in the original Krugman model) credit bubbles: credit grows faster than GDP (captured by y constant and µ > 0)
Due to FX traders’ perfect foresight, a speculative attack will occur exactly when it can drain reserves.
Balance-Of-Payments Crises
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Self-Fulfilling Crises
’BoP crises’ are essentially bank runs against CB reserves. This approach neglects CBs’ ability and willingness to attract reserves by raising the interest rate. The self-fulfilling crisis approach introduces microfoundations for the choice of ER regime. Self-fulfilling crises occur when there are multiple equilibrium ER regimes. A change in FX traders’ expectations can cause the collapse of a fixed ER regime. A key aspect is policymakers’ credibility and commitment.
Balance-Of-Payments Crises
Self-Fulfilling Crises
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A Model of Self-Fulfilling ER Crises
PPP and constant P ∗ p˙t = −s˙t Central Bank’s inflation/output tradeoff min{(yt (s˙t ) − y ∗ )2 + θ(−s˙t )2 }, s˙t
θ>0
Expectations-augmented Phillips curve yt = y 0 + η(s˙te − s˙t ) − ut , where ut is a supply shock
η>0
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Consider the special case without political costs of ER variation. Optimal value of s˙t for the Central Bank: min{(y 0 + η(s˙te − s˙t ) − ut − y ∗ )2 + θ(−s˙t )2 } s˙t
⇒ s˙t =
η 0 ˙te − y ∗ y − u + η s t η2 + θ
Output at the optimal ER policy equals yt =
η θ 0 ˙te + η(ut + y ∗ ) y + θ s θ + η2 θ + η2
Under a fixed ER regime output would be equal to yt = y 0 + η s˙te − ut A floating ER regime is always preferred as Lfloat < Lfix : 2 Lfix = y 0 + η s˙te − ut − y ∗ θ 0 ˙te − ut − y ∗ 2 Lfloat = y + η s θ + η2 But that may not hold with political costs of ER variation...
Balance-Of-Payments Crises
Self-Fulfilling Crises
Twin Banking and ER Crises
Suppose now that fixed political costs of appreciation (c a ) and depreciation (c d ) enter the loss function. In 58% of ER crises the CB Governor and/or the Finance Minister have changed within a year (36% without ER crisis). Large depreciations have ended political careers: Suharto (1997), de la R´ ua, Cavallo (2001), Lamont (1992)
Central Bank’s new inflation/output tradeoff min{(yt (s˙t ) − y ∗ )2 + θ(−s˙t )2 + c(s˙t )}, θ > 0 s˙t
where c(s˙t ) takes value c a if s˙t > 0 and c d if s˙t < 0. There exist values of the supply shock u + and u − such that Lfix (u − ) = Lfloat (u − ) + c a and Lfix (u + ) = Lfloat (u + ) + c d : q 1 ∗ + ˙e 0 e ˙ u (st ) = y + η st − y + (θ + η 2 )c d η q 1 − ˙e 0 ∗ e ˙ u (st ) = y + η st − y − (θ + η 2 )c a η
Balance-Of-Payments Crises
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revalua5on
fixed peg u-‐
Twin Banking and ER Crises
devalua5on ut
u+
Lfix(u)
Lfloat(u)+cd Lfloat(u)+ca Lfloat(u)
u-‐
u+
ut
Figure: Supply shocks and optimal ER regime (when c a < c d ).
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Self-Fulfilling Crises
Twin Banking and ER Crises
Possibility of self-fulfilling crises. start from a fixed ER with a high u and s˙te = 0 (credible peg) expectations of a depreciation (s˙te < 0) are self-fulfilling (u + moving to the left).
In a broader interpretation, u can capture changes in foreign investors’ perceived country risk. To make self-fulfilling crises less likely, one could increase the cost of devaluation c d : currency boards: commitment to full convertibility with reserves equal to the monetary base CBs can build a reputation for reputation for a hard peg
thereby reducing monetary policy independence.
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Figure: Argentine interest rates and country risk during the currency board period.
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Twin Banking and ER Crises
Twin Crises Mutually reinforcing banking/default and ER crises: South-East Asia (1997), Scandinavia (early 1990’s), Iceland (2008) Financial openness allows a mismatch between the maturities and currencies of assets and liabilities. Domestic agents typically borrow short-term in foreign currency, against long-term assets in domestic currency. An ER depreciation raises the cost of debt roll-over and increases the risk of bankruptcy. This encourages the CB to loosen monetary policy, further encouraging depreciation and leading to a twin crisis. The argument applies to banks (banking crises) or governments (sovereign default crises).
Balance-Of-Payments Crises
Self-Fulfilling Crises
Twin Banking and ER Crises
Figure: The ratio measures the capacity to repay short-term foreign debt if lenders stop rolling over that debt. A ratio over 1, which indicates illiquidity and fragility, suggests a strong currency and maturity mismatch. Source: Chang and Velasco (NBER 2000).
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The Case of Iceland in 2008
Figure: Iceland’s increasing illiquidity, 2000-2007, left, and increased CDS spreads (basis points) in 2008, right.
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Figure: EUR/ISK nominal exchange rate, 2007-2008.
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Contagion
Crises spread from one country to the other: Asian crisis: Thailand and S. Korea, Indonesia, Brazil, Russia... 2008 crisis: Hungary, Latvia, Ukraine
How to explain contagion? falling demand for another country’s exports negative effect of depreciation on other countries’ competitiveness portfolio reallocation: selling assets in one country to offset losses in another failure of financial counterparts in other countries
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Figure: Nominal ERs of several Asian countries against USD, 1996-1999. Source: Reuters.
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How to prevent ER crises BoP crises reduce domestic credit growth (µ) and domestic demand IMF structural adjustment programs
Self-fulfilling crises credible commitment by increasing the legal cost of a devaluation (c d ), e.g. currency board accumulation of FX reserves (self-insurance)
Twin crises restrict short-term foreign currency debt: offer extended maturity to creditors, secure foreign banks’ commitment to renew credit lines monitor and maintain bank liquidity secure access to official FX loans through CB swaps (ex.: Fed to Korea, Brazil, Mexico) or IMF loans
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Conclusions
ER crises are episodes of large changes in ERs, often but not always causing the collapse of a fixed ER regime. We have discussed 3 types of ER crises: BoP crises Self-fulfilling crises Joint banking, default and ER crises
Governments must choose 2 of these 3 policy options: a fixed ER, an independent monetary policy and full capital mobility.
