Reinert/Windows on the World Economy, 2005 Crises and Responses CHAPTER 17

Reinert/Windows on the World Economy, 2005

Crises and Responses

CHAPTER 17


2

Introduction

Objective indicators to understand the likelihood of many (but not all) crises

Possibility of balance of payments crises under fixed exchange rate systems “Old-fashioned” crises “High-tech” crises

IMF’s response to crises Proposals for changing the current “non-system” of

international financial arrangements Exchange rate target zones Capital controls Tobin tax Currency boards


3

Figure 17.1. A Balance of Payments Crisis


4

“Old-Fashioned” Balance of Payments Crises

Have their roots in over-valued, fixed exchange rates and large current-account deficits

Suppose that Mexico is successful in implementing an equilibrium exchange rate at e0

Requires that the expected future exchange rate must equal the equilibrium rate

• ee = e0

In turn, requires that the interest rate on the peso must equal the interest rate on the dollar

• rM = rUS


5


Suppose that we find Mexico in a position of a current account deficit Current account deficit is always financed by a capital

account surplus When a large trade deficit is financed by an inflow of

short-term capital problems will soon develop• The denomination in dollars exacerbates the problem

Any fall in the value of the home currency inflates the domestic currency value of the debt

Many domestic investors were aware of these problems• Began to sell pesos during 1994


6


If a Mexican investor feels that the Mexican government will have to devalue the peso in order to suppress the trade deficit, then you think ee > e0

If rM = rUS and ee > e0 then

• You will buy dollars and sell pesos—known as capital flight Change in expectations shifts the demand for

pesos graph to the left

assets ddenominate-dollar

on return total Expectedassets ddenominate-peso on return total Expected

e

eerr

e

USM


7


In response to such changes, in December 1994, the Mexican government devalued the peso by 15 percent Proved to be too little and fueled speculation of

further devaluations• Demand for pesos graph in Figure 17.1 shifted further

to the left• Mexico was forced to let the peso float• In February 1995, international investors began a

sudden and massive portfolio shift out of peso-denominated assets, sending the peso into a deep fall


8

Figure 17.2. An “Old-Fashioned” Balance of Payments Crisis


9

Figure 17.3. A “High-Tech” Balance of Payments Crisis


10

“High-Tech” Crises

Typically include some elements of the balance of payments crises but also include some less-concrete factors that are often difficult to predict

Combine current account deficits with weak financial sectors (especially in the banking system) and/or inappropriate capital account liberalization

By September 1999, Asian crisis had spread to Malaysia and Indonesia Indonesian case was somewhat of a surprise

• Current account deficit was less than 4 percent of GDP

Crisis spread to the Philippines, Hong Kong, South Korea, and Taiwan. Only the Hong Kong dollar escaped devaluation


11

“High-Tech” Crises

“High-tech” features of the Asian financial crisis Financial firms in the region had significant exposures in real estate

and equities• Both of these markets began to deflate prior to the crisis

Capital accounts had been liberalized• Allow firms to take on short-term foreign debt, including debt

denominated in foreign currencies In general banks were poorly regulated and supervised

• Were a crucial component of government industrial policies In some instances, supported systems of “crony” or “access” capitalism,

rather than sound investment policies Due to previous confidence in fixed exchange rates, firms were not

in the practice of hedging their foreign exchange exposures Loss of confidence in the financial sectors of the countries

involved was a central part of the evolution of the crisis Banking sector was often the main culprit


12

The IMF Response

The IMF response to the Asian and Brazilian crises can be characterized as consisting of Interest rate increases

• Tend to increase the equilibrium value of a country’s currency • Also tend to suppress domestic investment and push debt-burdened

firms (including banks) into default Some prominent economists consider the interest rates increases a big

mistake Fiscal austerity

• Strategies to increase SG

• Strategy was probably misguided both economically and politically Structural reforms

• Economic policy changes outside the fiscal and monetary realms • For example, the IMF required Indonesia to close 16 banks and

dismantle monopolies Bank closures appear to have exacerbated depositor runs on other banks


13

The IMF Response

IMF stood by its policies and claimed that they contributed to the recovery of the countries involved

Called for greater accuracy and timeliness of published data Especially in the areas of currency reserves, government

finances, and banking By providing international investors with better

information, exchange rates will better track the fundamentals of the economies involved

• Hard to see that the crises could have been averted simply through the greater availability of economic data


14

Exchange Rate Target Zones

Why do countries adopt fixed exchange rate regimes? Flexible exchange rate regimes are often volatile

• Countries do not want to undergo the large changes in the home-currency prices of trade goods that come with these excessive exchange rate changes

Some international economists propose to combine the benefits of both fixed and floating exchange rate arrangements through use of exchange rate target zones


15


Williamson’s plan suggests the center of the target zone to be a fundamental equilibrium exchange rate (FEER) Could be established by the IMF Can consider the FEER to be the purchasing power parity (PPP)

rate• Nominal exchange rate need not equal the real exchange rate and,

therefore, the FEER• Williamson terms “misalignments” situations in which e ≠ re = FEER

Can occur as a result of countries’ monetary policies

Around the FEER, Williamson advocates the use of a broad exchange rate band, on the order of 10 percent

• Over time, the FEER changes with movements in relative price levels Central rate moves slowly over time, and the exchange rate band

moves with it Proposes frequent (monthly) realignments of the nominal rate in

situations of misalignment


16


Does this proposal make sense? Key question is whether the zones will be

credible in practice• Zones as large as +/-12 percent (and in one case +/-

30 percent) failed to stem crises in the European Monetary System


17

Figure 17.4. An Exchange Rate Target Zone


18

Capital Controls

In September 1997, a committee of the IMF made a recommendation to the Fund’s Executive Board IMF take on as an explicit policy the full convertibility of the capital

accounts of all its members IMF’s Deputy Managing Director, Stanley Fischer, argued in support

of capital account liberalization A number of prominent international economists began to

argue against the proposal Questioned the goal of capital account liberalization and called for

capital controls of one kind or another Excessive borrowing within the short-term portfolio component of the

capital account contributed to Mexican and Asian crises Financial capital is prone to panics and manias Suggested that controls on the capital account do not appear to

adversely affect the growth and development of countries with the controls


19

Capital Controls

What is one to make of this disagreement? Must understand that there are different types of capital

controls• Strict licensing systems such as that in China

Requires a license to convert the yuan into foreign currency• Tax systems such as that used by Chile

Requires that investments made in its country must be for a minimum of one year

Requires that 30 percent of the investment must be deposited with the central bank for that year

Must understand that different policies can be designed for different components of the capital account

Capital account liberalization is not an all-or-nothing proposition

• Should be phased in gradually over time Allows investors and domestic policy-makers time to adjust


20

Tobin Tax In 1978, James Tobin proposed that foreign exchange

transactions should be taxed to promote exchange rate stability Tax should be set at a very low level—perhaps 0.1 to 0.5 percent

• For an investor moving into long-term assets, this would be negligible• For an investor moving into and out of assets on a daily basis, it would

be significant• To keep a country’s foreign exchange markets from moving to another

country once the tax was imposed, the tax would have to be universal and uniform

Proponents of the Tobin tax argue that it would Reduce the volatility of flexible exchange rates Be easy to administer

Opponents of the Tobin tax question its feasibility Financial markets are known for finding clever ways to avoid

regulations At present the Tobin tax remains unused but is frequently

discussed


21

Currency Boards

Fixed exchange rate regime in which the fixed rate has legal backing in domestic legislation

Central bank serving as the currency board fully backs up base money (cash and commercial bank reserves) with foreign reserves In 1999, eight countries utilized currency boards

• For example Argentina introduced a currency board to help stabilize the country’s economy after a period of hyperinflation

Effective ways to establish sound currencies and to limit excessive money creation that can fuel inflation

Unclear as to how useful currency boards are in the long run or if they work effectively for large countries Too inflexible for long-term growth and stability

Documents

Reinert/Windows on the World Economy, 2005 Crises and Responses CHAPTER 17