Chapter 15 Emerging Market Crises The Boom Bust Cycles

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Menzie Chinn DO NOT REPRODUCE OR CIRCULATE, Chinn Irwin International Economics Chapter 15 draft 1 1 2015. 1993 1994 1995 1996 1997 1998 1999 2000 2001, Chart 15 2 Annual growth rate of GDP for Thailand blue and Korea red. To understand these phenomena it s useful to have a little background on how the international. financial system has evolved The defining characteristic of the last half century is the increasing. integration of the global economy Ever greater shares of economic activity are engaged in. international trade in goods and services Households devote ever larger proportions of their. spending to imported goods while firms rely more and more on components produced in many. countries However the most remarkable transformation is in finance The ease with which. borrowing and lending now takes place is unprecedented As a consequence productivity and. consumer choice have been enhanced people can now smooth consumption over time. Consequently cross border holdings of assets and liabilities have increased dramatically. These trends have been in play all around the globe but they have been extremely pronounced in. emerging market and developing economies And it s in these countries that the implications of. these developments have become most apparent, In short openness to international trade and particularly finance tends to amplify the boom and. bust cycle In this chapter we trace out the implications of financial globalization and the. challenges they pose for policymakers in emerging market economies That is how to deal with. the good times as well as the bad times which often follow. 15 2 Capital Surges and Reversals, In chapters 12 and 13 we examined situations in which financial capital mobility took on a range. of values One of the characteristics of the modern international economy is the fact that. Menzie Chinn DO NOT REPRODUCE OR CIRCULATE, Chinn Irwin International Economics Chapter 15 draft 1 1 2015.
financial capital is quite mobile moving with ease between countries so that an appropriate. modeling of the economy would take capital mobility if not perfect as very near. As the magnitude of capital flows have increased over the past few decades they have also. tended to reverse direction with surprising regularity That is while capital might on net flow to. a country or set of countries for several years at certain points the flow can reverse The. reversal can occur quite swiftly and if it does it can catch policymakers off guard. Net flows to emerging,developing countries as Real US long term. 1 interest rate 2,share of GDP,left scale right scale. 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12. Chart 15 3 Net financial flows to emerging and developing countries as a share of GDP. blue and US ten year interest rates minus current inflation rate red Source For. flows and GDP IMF World Economic Outlook April 2014 for interest rates Federal. Reserve Board for annual inflation BLS, Notice that capital flows to emerging markets and developing countries follows a cyclical. pattern a surge peaking in1981 a trough in 1984 a long boom that peaks in 1995 a trough. around the turn of the century and then a boom peaking in 2007 There is a final boom in 2010. The relationship is roughly inverse The inflows tend to rise when real returns in the advanced. economies drop proxied in Chart 15 3 by the ten year US interest rate adjusted by inflation. What are the real world implications of these financial flows The financial flows provide more. resources for consumption and investment so it s not surprising that output booms during. periods of net inflows as shown in Chart 15 4,Menzie Chinn DO NOT REPRODUCE OR CIRCULATE. Chinn Irwin International Economics Chapter 15 draft 1 1 2015. 4 Net flows to emerging 7,developing countries as,3 share of GDP 6.
left scale,1 grow th rates 2,right scale, 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12. Chart 15 4 Net financial flows to emerging and developing countries as a share of GDP. blue and real GDP growth in emerging and developing countries purple Source For. flows and GDP IMF World Economic Outlook April 2014. First we discuss the challenges faced during the boom times called capital bonanzas by. Reinhart and Reinhart 1998 Then we address the busts Calvo 2003 popularized the term. sudden stop a term first coined by Dornbusch et al 1995 to events in which financial capital. inflows cease and even reverse This boom bust cycle was aptly described by the title of an. account of the Argentine boom and bust of the 1990 s and 2000 s And the Money Kept Rolling. In and Out 1,15 3 Interpreting the Boom, Capital flow surges to the emerging markets and developing countries occur with some. regularity Why do these surges in flows to the developing countries occur Most economists. would agree that it s a combination of push factors from the advanced economies such as. low interest rates and pull factors in the developing countries The big question is the relative. importance of these sets of factors and here there is much less agreement. Regardless of the exact origins of these cycles changes in capital flows pose a challenge to. policymakers in emerging markets because they force difficult choices even when conditions. appear to be favorable To see exactly what choices consider a country on a fixed exchange rate. with high capital mobility confronted by a sudden drop in rest of world interest rates as in. Blustein 1995 The title is originally a lyric from the musical Evita. Menzie Chinn DO NOT REPRODUCE OR CIRCULATE, Chinn Irwin International Economics Chapter 15 draft 1 1 2015. Figure 15 1 To begin with the economy is in internal and external equilibrium with interest rate. i1 and income level Y1,BP 0 E XP I M P q K A i,i1 BP 0 E XP I M P q K A i. iBP 0 Y1 i,IS A E XP I M P q, Figure 15 1 A drop in rest of world interest rates.
The BP 0 schedule shifts downward as indicated by the dark gray arrow The current interest. rate is then greater than that required for external balance Hence BP 0. Policymakers face four options 1 sterilize the inflows 2 allow the inflows to swell foreign. exchange reserves so the LM shifts out 3 revalue the currency shifting the BP 0 curve back. up and 4 impose capital controls, Consider the first option if the authorities sterilize the increase in foreign exchange reserves. then the economy remains at i1 and Y1 Recall sterilization requires in this case that the central. bank reduces the amount of domestic assets for instance government bonds held by selling. them in open market operations for every foreign currency unit increase in foreign exchange. reserves the central bank must sell a foreign currency unit equivalent s worth of government. bonds This process can continue as long as the central bank has government bonds to sell When. the assets of the central bank are solely foreign exchange reserves then sterilization has to cease. Option 2 is selected by default if no action is taken or if the central bank has no government. bonds left to sell As shown in Figure 15 2 in the absence of sterilization operations by the. central bank the increase in foreign exchange reserves drives upward the money supply thereby. shifting out the LM curve white arrow This process continues until the LM curve shifts out. enough to set the interest rate equal to the one that restores external equilibrium The monetary. authority can also increase the money supply immediately so as to restore external equilibrium. without delay,Menzie Chinn DO NOT REPRODUCE OR CIRCULATE. Chinn Irwin International Economics Chapter 15 draft 1 1 2015. BP 0 E XP I M P q K A i,i1 BP 0 E XP I M P q K A i. IS A E XP I M P q, Figure 15 2 Responding to drop in rest of world interest rates by monetary expansion. This hardly seems like a dilemma to the extent that output increases in response to the drop in. rest of world interest rates The problem arises if for instance full employment output is Y1 or. less so that the increase in money supply leads to overheating of the economy. Another approach is to revalue the currency or if the currency is on a managed float allow a. currency appreciation The revaluation leads to a fall in q to q so that the BP 0 curve shifts up. and the IS curve in white arrows In this case the interest rate and income level are lower than. to begin with,BP 0 E XP I M P q K A i,i1 BP 0 E XP I M P q K A i.
i2 BP 0 E XP I M P q K A i,IS A E XP I M P q,IS A E XP I M P q. Figure 15 3 Responding to drop in rest of world interest rates by currency revaluation. Menzie Chinn DO NOT REPRODUCE OR CIRCULATE, Chinn Irwin International Economics Chapter 15 draft 1 1 2015. It is also possible to respond to the inflows by imposing restrictions on cross border financial. flows called capital controls The controls can take the form of blocking certain types of. financial transactions or applying an explicit or implicit taxes on inflows Such measures have. the effect of decreasing in the BP 0 equation Since the slope of the BP 0 curve is m a. reduction in rotates the curve as shown in Figure 15 4. i BP 0 E XP I M P q K A i,BP 0 E XP I M P q K A i,i1 BP 0 E XP I M P q K A i. IS A E XP I M P q, Figure 15 4 Responding to drop in rest of world interest rates by imposing capital. In Figure 15 4 the imposition of capital controls is calibrated so as to restore internal and. external equilibrium at the original interest rate and income levels In reality there is no. requirement that this outcome should result rather the only certainty is the counter clockwise. rotation of the BP 0 curve, In theory then capital controls can be quite effective at restoring internal and external.
equilibrium However two large questions arise The first is whether capital controls if. implemented are actually effective in stemming the inflow of financial capital If the returns to. saving in the home country are sufficiently high then individuals will work hard to circumvent. those controls The second relates to the costs of imposing controls on economic efficiency. When capital is not allowed to move to the countries and industries where it is most productive. then economic efficiency might be lower than it otherwise would be. 15 4 The Bust Currency Crises Interpreted in the Mundell Fleming Framework. Crises can occur for a variety of reasons One is that foreign interest rates rise drawing away. capital Another is that because of fears that the government will not be able to pay its debt the. Menzie Chinn DO NOT REPRODUCE OR CIRCULATE, Chinn Irwin International Economics Chapter 15 draft 1 1 2015. interest rate required to draw in sufficient financial capital rises In the first case the i term rises. in the BP 0 equation,15 1 BP 0 curve, Notice that if the foreign interest rate goes up the BP 0 curve moves up percentage point for. percentage point, In the second case the financial account equation is written. Where is the premium necessary to induce investors to hold the country s government bonds If. investors feel there is some likelihood the government will default i e not pay interest on the. bonds or pay back the loans increases Then,15 3 BP 0 curve. In both of these cases the BP 0 schedule rises In Figure 15 5 the first case is shown. BP 0 E XP I M P q K A i,iBP 0 Y1 i,BP 0 E XP I M P q K A i.
IS A E XP I M P q, Figure 15 5 Prelude to a currency crisis A balance of payments deficit. It s easiest to think of the crisis arising if the country is on a fixed exchange rate regime Starting. from a point of initial internal and external equilibrium when the BP 0 shifts upward the. balance of payments goes into deficit and foreign exchange reserves are falling This situation. can be accommodated as long as the central bank can sterilize capital outflows by purchasing net. Menzie Chinn DO NOT REPRODUCE OR CIRCULATE, Chinn Irwin International Economics Chapter 15 draft 1 1 2015. domestic assets such as government bonds and foreign reserves are positive However. eventually reserves are exhausted so that the exchange rate peg is unsustainable a crisis occurs. and the country is forced to float the currency, The fixed exchange rate assumption is just an approximation as long as the country manages. the exchange rate so that it s not freely floating and is held stronger rate than would occur in the. absence of central bank intervention the previous analysis holds As shown in Chart 15 1. Thailand and Korea did not maintain hard fixed pegged exchange rates against the US dollar. and yet suffered the balance of payments pressures that led to currency crises. In the real world an exchange rate peg will likely collapse even before the last unit of foreign. exchange is exhausted That s because as foreign exchange participants recognize the eventual. collapse of the peg speculators will try to withdraw their funds earlier to ensure they can obtain. before the currency collapse in order to avoid capital losses The central bank recognizing this. fact accedes to the inevitable even before the exhaustion of reserves 2. This interpretation is often characterized as a first generation model of currency crises and. was developed by Paul Krugman 1979 In contrast third generation crises focus on the. revelation of additional government liabilities so called contingent liabilities that make. prospects of the government successfully servicing its debt highly unlikely so t. Chinn Irwin International Economics Chapter 15 draft 1 1 2015 1 Chapter 15 Emerging Market Crises The Boom Bust Cycles 15 1 International Crises in Emerging Markets In July 1997 the Bank of Thailand was forced off to let the baht float freely it immediately depreciated by 21 percent By January 1998 it was 77 percent weaker against the

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