International Financial Crises Refers to exchange rate crises, banking crises or some combination of the two. These are often the variables through which the contagion effects are spread from one country to another
Economic integration = opportunities for growth and development but also = Easier for crises to spread from one country to another e.g. 1992 currency speculation against British pound and other European currencies = near collapse of monetary arrangements in Europe
A banking crisis occurs when The banking system becomes unable to perform its normal lending functions and some or all of a nation’s banks are threatened with insolvency. (net worth is negative = assets are less than liabilities) If banks cannot pay its creditors (depositors) because its debtors (businesses, loans) have gone under or defaulted = Disintermediation
When depositors lose their money (unless they have deposit insurance), Consumption drops, new investments slows down, economy falls into deep vicious circle of recession.
Exchange rate crisis • Sudden and unexpected collapse in the value of a nation’s currency. • May occur in either fixed or flexible regimes but research shows that countries with fixed regime are more vulnerable to this type of crisis • Result is steep recession e.g. A country borrows large amounts in international capital markets. Country’s currency collapses value of debt increases Many banks fail capital outflow and no new I economy goes into deep recession
Banking system is the channel for transmitting recessionary effects Prior to the Asian crisis, banks borrowed dollars in capital markets. When home country currency collapsed, dollar value of debt increased. Many banks failed. Disintermediation took place and economies slid into deep recession
1994, speculation against the Mexican peso = its collapse and spread of “Tequila effect” through out South America. • 1997 several East Asian economies were thrown into recession by a wave of sudden capital outflows • Contagion effect = not a single pattern = different rules of behavior
2 Origins of Financial Crisis Macroeconomic imbalances Volatile flows of financial capital that quickly move in and out a country (sudden changes in investor expectations may be the triggering factor)
Macroeconomic Imbalances -Best example is Third World Debt crisis (1980) -Overly expansionary fiscal policies creating large government deficits financed by high growth of money supply -potential problems of government spending are compounded by inefficient and unreliable tax systems Tax revenue may be insufficient for government expenditure
-Governments resort to selling bonds to finance expenditures but capital markets are underdeveloped -So governments require central banks to buy the bonds -Money supply increase -Inflationary pressure -currency becomes overvalued -everyone tries to sell domestic assets and convert them to foreign exchange -Government begins to run out of international reserves -pressure on currency to depreciate
If exchange rates are fixed serious repercussions on real value of the exchange rate • Capital flight if people begin to think exchange rate is overvalued and correction is likely in future • In addition to large budget deficits and inflationary pressures is a large and growing current account deficit. • People try to sell their domestic assets and acquire foreign ones run on a country’s international reserves
Crisis caused by volatile capital flows Portfolio managers look at actions of each other for information about the direction of the market Herd mentality A small trickle of funds can be fueled by speculations which can lead to a huge capital flight.
When this happens, international reserves disappear, exchange rates tumble and weakens the financial sector A weak financial sector intensifies the problems
Domestic Issues in Crisis Avoidance Steps Countries can take to minimize likelihood of crises and damage they cause when they happen -maintain credible and sustainable fiscal and monetary policies -engage in active supervision and regulation of the financial system -provide timely information about key economic variables such as central bank holding of international reserves
The Mexican Peso Crisis (94/95) Elements of macro imbalances, volatile capital flows and financial sector weakness. Overvalued real exchange rates, current account deficits because domestic savings could not support investments In 1990 – 1993 capital inflows of $91B made up of private investment, direct investment and bank loans
In 1994, interest rate movements led to large losses for banks and investors Investors called for reducing level of exposure to Mexico Dec. 1994, newly elected president, Zedillo, announced a 15% devaluation
Currency speculators had expected a 20 – 30% devaluation Zedillo’s announcement sent financial markets into turmoil More capital fled the country Dollar reserves shrank. Though 2 days after the announcement, Mexico said it would move to a flexible exchange rate, the damage had already been done
Both domestic and foreign capital continue to leave the country By March 1995, peso had lost more than 50% of its value NAFTA and IMF helped in the form of line of credit and loans with conditions of decreasing G and increasing T
1997/1998 Asian Crisis • Began in Thailand in July 1997 and spread to Malaysia, Philippines, Indonesia and South Korea • Symptoms of crisis were fairly similar across countries -currency speculation and steep depreciation -capital flight -financial and industrial sector bankruptcies
Countries had large trade deficits (on average 5.2% of GDP, Thailand had a deficit of 8% of GDP) the year before the crisis Large current account deficits = large capital inflows Because for last 30 years these countries averaged 5% growth in GDP and foreign investors had no reasons to believe otherwise Also, Japan and Europe were losing grounds in growth and investors were looking elsewhere
Exchange rates in the region were pegged to the dollar dollar appreciating in the 90s meant many exchange rates appreciating as well. Exchange rates were harder to sustain because it became more difficult to export. CA deficits increased Financial sector problems because of family ties
Investors lost confidence in Thailand to keep its exchange rate pegged People began to suspect devaluation and refused to hold Thai baht
Many loans to the Thai financial sector were in dollars so this raised the cost of devaluation • Thailand served as a wake-up call to investors in the region • Others think the devaluation in Thailand made exports from other countries less competitive which led them to devalue as well. • Whatever the case, the Thailand experience had a contagion effect
Effect spread to countries as far as Brazil and Russia • With the exception of Singapore and Taiwan, every country affected by the crisis experienced a recession in 1998 • Singapore and Taiwan had had large surpluses so they concentrated on domestic economies rather than defending their currencies • IMF helped with loans and conditions of interest rate hikes. Capital controls were implemented in some countries
Latin American Financial Crises In the 1980s, high interest rates and an appreciation of the US dollar caused the burden of dollar denominated debts in Argentina, Mexico, Brazil and Chile to increase drastically. A worldwide recession and a fall in many commodity prices also hurt export sectors in these countries. In August 1982, Mexico announced that it could not repay its debts, mostly to private banks.
Russia’s Financial Crisis • After liberalization in 1991, Russia’s economic laws were weakly enforced or nonexistent. • There was weak enforcement of banking regulations, tax laws, property rights, loan contracts, and bankruptcy laws. • Financial markets were not well established. • Corruption and crime became growing problems. • Because of a lack of tax revenue, the government financed spending by seignoirage. • Interest rates rose on government debt to reflect high inflation from seignoirage and the risk of default.
Russia’s Financial Crisis (cont.) • The IMF offered loans of official international reserves to try to support the fixed exchange rate conditional on reforms. • But in 1998, Russia devalued the ruble and defaulted on its debt and froze financial asset flows. • Without international financial assets for investment, output fell in 1998 but recovered thereafter, partially due to the expanding petroleum industry. • Inflation rose in 1998 and 1999 but fell thereafter.
Chapter 19 International Monetary Systems
Preview Goals of macroeconomic policies—internal and external balance Gold standard era 1870–1914 International monetary system during interwar period 1918–1939 Bretton Woods system of fixed exchange rates 1944–1973
Preview Collapse of the Bretton Woods system Arguments for floating exchange rates Macroeconomic interdependence under a floating exchange rate Foreign exchange markets since 1973
Macroeconomic Goals “Internal balance” describes the macroeconomic goals of producing at potential output (at “full employment”) and of price stability (low inflation). An unsustainable use of resources (overemployment) tends to increase prices; an ineffective use of resources (underemployment) tends to decrease prices. Volatile aggregate demand and output tend to create volatile prices. Price level movements reduce the economy’s efficiency by making the real value of the monetary unit less certain and thus a less useful guide for economic decisions.
Macroeconomic Goals (cont.) “External balance” achieved when a current account is neither so deeply in deficit that the country may be unable to repay its foreign debts, nor so strongly in surplus that foreigners are put in that position. For example, pressure on Japan in the 1980s and China in the 2000s. An intertemporal budget constraint limits each country’s spending over time to levels that it can repay (with interest).
The Open-Economy Trilemma A country that fixes its currency’s exchange rate while allowing free international capital movements gives up control over domestic monetary policy. A country that fixes its exchange rate can have control over domestic monetary policy if it restricts international financial flows so that interest parity R = R* need not hold. Or a country can allow international capital to flow freely and have control over domestic monetary policy if it allows the exchange rate to float.
The Open-Economy Trilemma (cont.) Impossible for a country to achieve more than two items from the following list: 1. Exchange rate stability. 2. Monetary policy oriented toward domestic goals. 3. Freedom of international capital movements.
Macroeconomic Policy Under the Gold Standard 1870–1914 The gold standard from 1870 to 1914 and after 1918 had mechanisms that prevented flows of gold reserves (the balance of payments) from becoming too positive or too negative. Prices tended to adjust according the amount of gold circulating in an economy, which had effects on the flows of goods and services: the current account. Central banks influenced financial asset flows, so that the nonreserve part of the financial account matched the current account in order to reduce gold outflows or inflows.
Macroeconomic Policy Under the Gold Standard (cont.) Price-specie-flow mechanism is the adjustment of prices as gold (“specie”) flows into or out of a country, causing an adjustment in the flow of goods. An inflow of gold tends to inflate prices. An outflow of gold tends to deflate prices. If a domestic country has a current account surplus in excess of the nonreserve financial account, gold earned from exports flows into the country—raising prices in that country and lowering prices in foreign countries. Goods from the domestic country become expensive and goods from foreign countries become cheap, reducing the current account surplus of the domestic country and the deficits of the foreign countries.
Macroeconomic Policy Under the Gold Standard (cont.) Thus, price-specie-flow mechanism of the gold standard could automatically reduce current account surpluses and deficits, achieving a measure of external balance for all countries.
Macroeconomic Policy under the Gold Standard (cont.) The “Rules of the Game” under the gold standard refer to another adjustment process that was theoretically carried out by central banks: The selling of domestic assets to acquire money when gold exited the country as payments for imports. This decreased the money supply and increased interest rates, attracting financial inflows to match a current account deficit. This reversed or reduced gold outflows. The buying of domestic assets when gold enters the country as income from exports. This increased the money supply and decreased interest rates, reducing financial inflows to match the current account. This reversed or reduced gold inflows.
Macroeconomic Policy Under the Gold Standard (cont.) Banks with decreasing gold reserves had a strong incentive to practice the rules of the game: they could not redeem currency without sufficient gold. Banks with increasing gold reserves had a weak incentive to practice the rules of the game: gold did not earn interest, but domestic assets did. In practice, central banks with increasing gold reserves seldom followed the rules. And central banks often sterilized gold flows, trying to prevent any effect on money supplies and prices.
Macroeconomic Policy Under the Gold Standard (cont.) The gold standard’s record for internal balance was mixed. The U.S. suffered from deflation, recessions, and financial instability during the 1870s, 1880s, and 1890s while trying to adhere to a gold standard. The U.S. unemployment rate was 6.8% on average from 1890 to 1913, but it was less than 5.7% on average from 1946 to 1992.
Interwar Years: 1918–1939 The gold standard was stopped in 1914 due to war, but after 1918 it was attempted again. The U.S. reinstated the gold standard from 1919 to 1933 at $20.67 per ounce and from 1934 to 1944 at $35.00 per ounce (a devaluation of the dollar). The U.K. reinstated the gold standard from 1925 to 1931. But countries that adhered to the gold standard for the longest time, without devaluing their currencies, suffered most from reduced output and employment during the 1930s.
Bretton Woods System 1944–1973 In July 1944, 44 countries met in Bretton Woods, NH, to design the Bretton Woods system: a fixed exchange rate against the U.S. dollar and a fixed dollar price of gold ($35 per ounce). They also established other institutions: The International Monetary Fund The World Bank General Agreement on Trade and Tariffs (GATT), the predecessor to the World Trade Organization (WTO).
International Monetary Fund The IMF was constructed to lend to countries with persistent balance of payments deficits (or current account deficits), and to approve of devaluations. Loans were made from a fund paid for by members in gold and currencies. Each country had a quota, which determined its contribution to the fund and the maximum amount it could borrow. Large loans were made conditional on the supervision of domestic policies by the IMF: IMF conditionality. Devaluations could occur if the IMF determined that the economy was experiencing a “fundamental disequilibrium.”
International Monetary Fund (cont.) Due to borrowing and occasional devaluations, the IMF was believed to give countries enough flexibility to attain an external balance, yet allow them to maintain an internal balance and stable exchange rates. The volatility of exchange rates during 1918–1939, caused by devaluations and the vagaries of the gold standard, was viewed as a source of economic instability.
Bretton Woods System In order to avoid sudden changes in the financial account (possibly causing a balance of payments crisis), countries in the Bretton Woods system often prevented flows of financial assets across countries. Yet they encouraged flows of goods and services because of the view that trade benefits all economies. Currencies were gradually made convertible (exchangeable) between member countries to encourage trade in goods and services valued in different currencies.
Bretton Woods System (cont.) Under a system of fixed exchange rates, all countries but the U.S. had ineffective monetary policies for internal balance. The principal tool for internal balance was fiscal policy (government purchases or taxes). The principal tools for external balance were borrowing from the IMF, restrictions on financial asset flows, and infrequent changes in exchange rates.
Policies for Internal and External Balance Suppose internal balance in the short run occurs when production is at potential output or when “full employment” equals aggregate demand: Yf = C + I + G + CA(EP*/P, A) = A + CA(EP*/P, A) (19-1) An increase in government purchases (or a decrease in taxes) increases aggregate demand and output above its full employment level. To restore internal balance in the short run, a revaluation (a fall in E) must occur.
Policies for Internal and External Balance (cont.) Suppose external balance in the short run occurs when the current account achieves some value X: CA(EP*/P, Y – T) = X (19-2) An increase in government purchases (or a decrease in taxes) increases aggregate demand, output and income, decreasing the current account. To restore external balance in the short run, a devaluation (a rise in E) must occur.
Fig. 19-2: Internal Balance (II), ExternalBalance (XX), and the “Four Zones of Economic Discomfort”