Transcript Anatomy of a Currency Crisis

Anatomy of a Currency Crisis
What Constitutes a “Crisis” ?
Large, rapid depreciation of a
currency price
 Sudden, dramatic, reversal in
private capital flows

The “Crisis” period is typically
followed by a recession.
Note: The names and dates have
been changed to protect the
innocent!
Exchange Rate (per $US)
55
50
45
40
35
30
25
Crisis Date
28
25
22
19
16
13
10
7
4
1
-2
-5
-8
-11
-14
-17
20
Foreign Investment (Millions of $s)
3500
3000
2500
2000
1500
FDI
Portfolio
1000
500
-1000
21
17
13
9
5
1
-3
-7
-11
-15
-19
-500
-23
0
Currency Pegs
Imagine yourself driving
down a straight stretch of
road. If the alignment on
your car is good, you can let
go of the steering wheel and
the car stays on the
road……
Currency Pegs
However, if your alignment is not
perfect, you need to act to stay on
the road. Otherwise…
Currency Pegs
On the other hand, your
alignment could be perfect, but
if the road has an unexpected
curve….
Currency Pegs
A peg above the equilibrium will
involve buying your currency (loss
of reserves)
F/$
Supply
e
A peg at the equilibrium price can
be maintained forever!
e
A peg below the equilibrium price
will involve selling your currency
(increase in reserves)
e
Demand
$
Remember, a country only has a finite
supply of foreign reserves….once their
gone, the game is over!
Liabilities
$ 10,000,000 (Currency)
reserve ratio = 59%
Assets
E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
E 5,000,000
X
1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
Bad Policies…
Initially , a country is pegging at or
near the equilibrium value of its
currency
F/$
Supply
e
Demand
$
An incompatible policy could
pull the equilibrium away
from the pegged level – this
forces a loss in reserves!
Bad Policies…
F/$
Supply
Supply’
e
e
Demand
$
…or Bad Luck!
Initially , a country is pegging at or
near the equilibrium value of its
currency
F/$
Supply
e
Demand
$
or Bad Luck!
F/$
Supply
e
e
Suddenly, demand drops – this
lowers the equilibrium exchange
rate and forces the central banks
to act (buying back currency and
losing reserves)
Demand
Demand’
$
What causes these
sudden reversals?
•Persistent inflation
•High Money Growth
Bad Policy
•Low Economic Growth
•Large Deficits
•Public
Just the facts
ma’am.
•Private
•Political Events
Bad Luck
•Natural Disasters
•Market Sentiment
Inflation Rates (Annualized)
12
10
US
Average
Inflation
8
6
4
2
0
-2
-4
-29 -24 -19 -14 -9
-4
1
6
11
16
21
26
Economic Growth Rates
(Annualized)
12
10
8
6
4
2
0
-2
-4
-6
-8
-4
-3
-2
-1
0
1
2
3
4
5
6
7
M2 Growth (Annualized)
Average = 14%
60
40
20
0
-20
-40
-60
Average = 4%
Government Deficit (Millions)
40,000
30,000
20,000
10,000
0
-10,000
-20,000
-30,000
-40,000
-50,000
Trade Deficit (Millions)
6,000
5,000
4,000
3,000
2,000
1,000
0
-1,000
-2,000
-3,000
-4,000
Interest Rate (Overnight Rates)
30
25
20
15
10
5
0
Official Reserve Assets (Millions of $)
Central Bank Defense of Currency
1000
950
40,000
38,000
36,000
34,000
32,000
30,000
28,000
26,000
24,000
22,000
20,000
900
850
800
750
700
650
600
Gold
Foreign Exchange
Long Run Fundamentals

Recall, the monetary framework with flexible prices
(long run) resulted in the following
(1+i)
M
Y*
e = M* Y (1+i*)
Relative
Money Stocks
Relative
Output
Relative
Interest Rates
Long Run Fundamentals
High money growth and low economic growth
generate inflation (Domestic Money Market)
Domestic inflation generates expectations of a
currency depreciation (PPP)
High inflation raises nominal interest rates. This
further lowers money demand (which creates even
more inflation
Short Run Deficits
Trade Deficits create
excess supply of
currency. This creates
expectations of a
depreciation
Large government deficits
create the fear that the
government might “monetize”
the debt (Pay it off by printing
money)
Both deficits raise domestic interest rates. This makes
domestic investment more expensive. As domestic
investment slows down, so does economic growth
How big is “too big”?



When does a trade deficit become unsustainable?
 PV(Lifetime CA) = 0 (all debts must be repaid)
We need to examine the country’s ability to run trade
surpluses in the future (i.e. repay its debts!)
Generally speaking, a trade deficit greater than 5%
of a country’s GDP is considered “too big”
Productivity
Productivity measures the ability of a
country to transform inputs into output
Revenues
Labor
Capital
(Shareholders)
Creditors
(bondholders)
With high productivity, producers can raise revenues without
having to raise prices (high growth with low inflation!)
Labor Productivity
Real GDP
Labor Productivity =
Real Output
=
Per Man-hour
Y
N
Total Hours
Real GDP (2004)
$10,397
$8,317 = $34/hr
$8,317
244.3
Subtract out
Divide by total hrs
Farm Output
(Employment * Average Hrs * 52)
Suppose that Output/hr in 1992 was equal to $28.hr, then
Prod(1992) = 100
Prod(2003) = 100*(34/28) = 121.4
Multifactor Productivity
Real GDP
Labor productivity doesn’t
correct for changes in the
capital stock!!
Capital
Y = A KβN 1-β (Production function)
MFP
β = 1/3
Labor
Capital Growth
Growth Rate of MFP = y – βk – (1-β)n
Real GDP
Growth
Labor
Growth
Multifactor Productivity
Step 1: Estimate capital/labor
share of income
K = 30%
N = 70%
%A = 5 – (.3)*(3) + (.7)*(1)
Step 2: Estimate capital, labor,
and output growth
%Y = 5%
%K = 3%
%N = 1%
= 3.4%
Productivity Growth in the US
3
2.5
2
1.5
1
0.5
0
1919- 1929- 1941- 1948- 1973- 1989- 19951929 1941 1948 1973 1989 2000 2000
Labor Productivity
MFP
Expectations &
Multiple Equilibria
Suppose a country is under a fixed
regime with the understanding that
they will switch to a float under
“extreme” circumstances
 Further, assume that the country is
currently in a strong economic position

Expectations &
Multiple Equilibria
Case #1

Investors anticipate a
devaluation



Investors require a “risk
premium” to compensate
them for expected
currency losses
Higher interest rates
choke off domestic
investment
The economy slips into a
recession and devalues
Case #2

Investors expect the
peg to be maintained


Interest rates remain low
Domestic investment
continues and the
economy grows. No
devaluation is required
Multiple Equilibria

In the previous example, there exist
two possible equilibrium (one with a
devaluation, and one without). The
economy can then switch between the
two. This switching is driven entirely by
expectations.
Contagion

Contagion refers to the transmission of
a currency crisis throughout a region
The Thai Baht in 1997 was followed shortly
by crises in Malaysia, Indonesia, Korea
 The Mexican Peso crisis in 1994 spread to
Central and South America (“The Tequila
Effect”)
 The Russian collapse (2000) was followed
immediately by Brazil

Reasons For Contagion
Common Shocks
 Trade Linkages
 Common Creditors
 Financial Interdependencies
 Informational Problems and “Herding”
behavior
