Transcript Net foreign lending

INTERNATIONAL
CRISES
Professor Lawrence Summers
October 20, 2015
Agenda
• International crises: theory
• International crisis response and the IMF
International borrowing and sudden stops
• (Under any exchange rate regime)
A country’s foreign borrowing is equal to its current account deficit:
S-I = X-M
• What happens if foreign investors stop lending?
Net foreign lending
(S-I)
Lenders
Borrowers
Country A
Producers
(exporters)
Consumers
(importers)
Current account
deficit
(X-M)
International borrowing and sudden stops
• (Under any exchange rate regime)
A country’s foreign borrowing is equal to its current account deficit:
S-I = X-M
• What happens if foreign investors stop lending?
Net foreign lending has fallen –
so the current account deficit
must fall. If foreign lending
totally stops, the current
account must go into surplus.
• Exports rise
• Imports fall
Domestic savings/investment
need to adjust:
• Savings rise; and/or
• Investment falls
 Fall in aggregate demand
Net foreign lending
(S-I)
Lenders
Borrowers
Country A
Producers
(exporters)
Consumers
(importers)
Current account
deficit
(X-M)
How are exchange rates determined?
• Under floating exchange rates, the exchange rate is allowed to
fluctuate in response to changing economic conditions.
• Examples: US Dollar, Japanese Yen, GBP, Euro
• Under fixed exchange rates, the central bank trades domestic for
foreign currency at a predetermined price.
• Example: gold standard. Variants:
• Pegs: Set exchange rate to another currency, e.g. US dollar.
• Crawling Peg: Set exchange rate target, allow limited fluctuation.
• Currency/monetary union: All member countries have single currency.
• Example: the Eurozone
Currency crises
• Country A has a fixed exchange rate.
What happens if foreign investors think that it will devalue its
currency?
Investors
believe A will
devalue
currency
Capital flight:
Investors sell
or short-sell
currency
More difficult for
central bank to
continue to
maintain exchange
rate in future
Selling puts
pressure on the
currency to
depreciate
Central bank
forced to raise
interest rates and
sell foreign
reserves
Justified by fundamentals,
or
A self-fulfilling crisis?
3 types of crises tend to reinforce each
other
A domestic banking
crisis can precipitate
an attack on the
currency.
A currency devaluation –
or interest rate rises to
prevent it – can trigger
banking crises
Currency
crisis
Banking
crisis
A sudden reduction in
external capital can
trigger crisis in the
domestic financial
system.
A sudden reduction in
external capital can
increase downward
pressure on the
currency.
Belief that a fixed
exchange rate will
break can reduce
capital inflows.
Sudden
stop
Domestic bank
problems can trigger a
sudden stop of
external capital.
Liquidity and solvency: also key distinction in
country crises
• “To avert panic, central banks
should lend early and freely
(i.e. without limit), to solvent
firms, against good collateral,
and at ‘high rates.’”
• Walter Bagehot (Lombard
Street, 1877. chapter 7)
• Do not lend in the face of
insolvency!
• But: who is the lender of
last resort in a country
crisis?
Agenda
• International crises: theory
• International crisis response and the IMF
The IMF
• Among other roles, the IMF provides emergency lending
Global financial
crisis
Asian crisis
LatAm crisis
Source: Reserve Bank of Australia, IMF
Review: the Prisoners’ Dilemma
• 2 prisoners, accused of jointly committing a crime, are interrogated
separately.
• Each prisoner can choose to cooperate with his partner by staying silent, or
defect and betray his partner by confessing.
Better than the Nash equilibrium
Prisoner B stays silent
(cooperates)
Prisoner B betrays
(defects)
Prisoner A stays silent
(cooperates)
1,1
3,0
Prisoner A betrays
(defects)
0,3
2,2
Nash equilibrium
The numbers in the boxes are the number of years each prisoner will have to serve in jail
under each outcome
IMF Conditionality
• IMF and recipient countries are in a similar Prisoners’ Dilemma situation:
Country
Adjust
Don’t adjust
Support
1,1
3,0
Don’t support
0,3
2,2
IMF
Nash equilibrium is worse than if the country adjusts policies and IMF
provides financial support.
• As a result, IMF conditionality: countries required to pursue economic
adjustment policies as condition of assistance.
• Helps reduce moral hazard: countries less likely to rely on IMF support if
have to pursue painful structural adjustment.
Typical adjustment conditions
• “Stabilization” conditions reduce domestic consumption, which
can lead to recession. “Adjustment” is intended to counteract
this shock and accelerate growth.
• Devaluation of the local currency increases exports – export
income helps to repay foreign debt
• The policy reform - “structural” adjustment - element aims to
raise steady state output:
• Privatization
• Trade liberalization
• Banking sector reform
• De-regulation
But : the Samaritan’s Dilemma
• If you know that someone will bail you out when you’re in trouble – do you
behave less prudently as a result?
• The Samaritan’s dilemma (Buchanan 1975):
•
Caring about the recipient creates moral hazard.
• Imposing strict conditions is unlikely to be credible.
Implication:
“Countries know that, faced with underperformance and a weak economy, the
IMF is unlikely to impose strict conditionality, because it is concerned with the
borrowing country's welfare. Simply put, penalties established in advance
have limited credibility because they are unlikely to be enforced.”
IMF Finance and Development- 2002