Transcript Economics Part II Developing Country Debt Crisis

Economics Part II
Developing Country Debt Crisis
• A Country Leads the Path to Default
- interest and principal not paid
- currency devalues
- other countries follow suit
Economics Part II
Developing Country Debt Crisis
• Solution
• Short currencies
• Purchase puts
• Sell futures
• Sell stocks and bonds
Economics Part II
Developing Country Crisis
• Petrodollar crisis
• Mexico 1982
• Recycling of dollars
• Crash of the dollar
Economics Part II
Can a Crisis Happen?
Financial Crisis in Historical Perspective
• Tulip mania (1636)
• South Sea Bubble (1720)
• East India Company (1772)
Financial Crisis in Historical Perspective
• Large Scale Defaults by financial and nonfinancial institutions (Minsky, 1963)
• Notion of Debt Deflation (Fisher 1933,
Bernanke, (1983)
• Process of Creative Destruction
(Schumpeter, 1934)
Financial Crisis in Historical Perspective
•Corporate Debt
– LBO’s, Overborrowing
•Sovereign Debt
– Government borrowing
– Consumer Borrowing
• mortgages
Financial Crisis
The 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
The Liquidity Factor
A 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
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
Financial Crises in International
Community
• Financial Markets Calm (1982- Present)
– Exceptions: 1987, 2001
– No major recessions
– Inflation decline
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
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
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
Economic Crisis
• International in Scope
– Crisis of 1929-1931
• Started in United States
• Spread to other countries
Two Classic Examples
The French Franc 1920-1926
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No Longer Pegged to Gold
Lost ½ of its value
Fiscal Debt
Could Not Service War Costs
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
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
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
The French Franc 1920-1926
• Developed Life of their Own
• Not Driven by External events
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
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
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
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
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
The French Franc 1920-1926
• Case still influences economists on their
thinking of exchange rates and troubled
currencies
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
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
1929
• Financial Shock was not complete by end of
1929
• Serves as a model for currency crisis
contagions
Stock Market Declines 1929-1932
Country
September 1929 December 1929
December 1929 December 1932
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31.9%
33.5%
10.8%
14.4%
16%
69.4%
72.4%
47.3%
44.9%
24.8%
US
Canada
France
Germany
UK
Source: C.P. Kindleberger, 1973 The World in Depression
1929
• Most of the fall took place after 1929
• US Slump transmitted to the rest of the
world but milder
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
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
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
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
The Role of the Speculator
• Speculators sensing loss
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Bail out of currency
Short futures
Short currency
Accelerate downward trend of currency
Surges of capital flight need not represent
irrational behavior
The Crawling Peg
European Currency Unit 1992
• Crawling Peg
– The Snake
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+/- 6% DM
German Reunification
Inflation in Germany
Recession in Britain, Italy, Sweden and Spain
Denmark and Sweden exit first
Britain is next
The European Currency Unit
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Speculative Attack on the Pound
Speculators gang up on the Pound
Drive it Deeper
Britain exits the ECU
Spain and Italy follows
The Asian Currency Crisis
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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
The Argentine Crisis
• Economic Decline since 1932
• Inflationary and Populist Polices lead to 75
year decline
• To Stop/Arrest Peg Currency to US$
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
Mexico 1982
• Capital flight
• Year
Hard Currency Cap flight
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1978
1979
1980
1981
1982
1983
1984
1985
3.75
6.34
12.69
30.62
10.58
2.27
1.94
-0.18
0.70
0.23
-0.68
9.73
8.23
2.42
2.33
1.92
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
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
Mexican Macroeconomics 1982
• Inflation ensued
• Growth retarded
• Recovery
Macroeconomic Performance in Latin
America (Growth Rates)
• Year
GNP/Capita
CPI
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3.1
-2.6
-3.1
-4.8
1.4
1.4
1.9
0.4
-1.3
39.8
60.8
66.8
108.6
133.0
144.9
87.8
130.0
277.6
1971-1980
1981
1982
1983
1984
1985
1986
1987
1988
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
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)
Anatomy of a Hard Landing
Impact 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
Anatomy of a Hard Landing
Impact on the Economy
1982-1984 US
• Federal Reserve moves to combat inflation
• Abnormally high interest rates
• Longer than normal recession
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.
Anatomy of a Hard landing
The Summers Dilemma
• Greater fiscal tightening
– Leads to a severe downturn
– No Pleasant escape
– The Hard Landing would arrive
Why the US Crisis Has Been Averted
As of Yet
• Crucial economic relationship that creates
the hard landing is the juncture of dollar
depreciation and higher interest rates.
– Cash Flows to United States supporting lower
interest rates
– Foreign Countries Exporting Deflation through
trade
Could It Happen Now
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Equity flows dry up
Central Banks don’t step up to the plate
Political Instability
Investors curtail their purchases of US
assets
What Happens In A Crisis
The Dornbusch Approach
• Three Essential Ingredients For A Crisis
– Vulnerability, Awareness, and Fear
Vulnerability arises from an over expansion of
credit relative to debt service ability
Awareness is the state of mind where market
participants are “trigger happy”
Fear is panic; Ex: “I must get out now”
The Lender of Last Resort
• The Central Bank can issue money and
expand credit, but there may not be anyone
who wants the money.
The Lender of No Resort Or
Stuck Up A Creek Without A Paddle
• Last resort Lending Can Be Made With
Good Collateral - Not Bad Collateral
– Write Off or Work Off
– US May not want to give up power as # 1 to
establish stability
– IMF may be renamed “I May be Forgotten”