Contractionary Currency Crashes In Developing Countries Why are devaluations so costly Citations (1972-2003) Lesson Endogeneity of trade/GDP
Mobley, Art, General Manager has reference to this Academic Journal, PHwiki organized this Journal Contractionary Currency Crashes In Developing Countries Mundell-Fleming Lecture, Nov. 5, 2004; Fifth IMF Annual Research Conference. Forthcoming, IMF Staff Papers, 2005. IMF Institute, May 27, 2005. Jeffrey A. Frankel Harpel Professor KSG, Harvard University Why are devaluations so costly Political costs Economic costs If the answer is contractionary effects of devaluation, what is the mechanism And what can a country do to minimize them After a devaluation, leaders lose their jobs Twice as often within 1 yr. (30%) as in control group (14%) in 1960s. R.Cooper, 1971. (Criterion is 10% deval.) Updated to 1970-2003, within 12 mo.s of devaluation (27%), vs, otherwise (21%) within 6 mo.s (19%), vs. as otherwise (12%). Difference is statistically significant at 0.5% level (Criterion is 25% deval, incl. 10% acceleration.)
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Premier 2/3 more likely to lose his job within 6 mos. of currency crash Fin.min.s / governors are even more likely to lose office in yr. Political price of devaluations in developing countries
Citations (1972-2003) Of Cooper (1971): 84 Of Mundell (1963): 319 Of Fleming (1962): 257 Possible reasons currency crashes correlate with change of leadership Elections cause devaluations, rather than the other way around (tho our timing is post-deval.) Devaluation as proxy as long as unpopular IMF austerity programs The government is perceived as having broken a promise High economic costs associated with devaluations. Conditioning on IMF program does not affect leader turnover Dummy variable defined as long as initiation of IMF program within 3 months of currency crash does not raise frequency of leader job loss, relative to other devaluations. Thus conditioning on the IMF dummy variable has no discernible effect on frequency of leader job loss within 6 mo.s: 21.1% with an IMF program, vs. 21.9% without. Both similar to overall rate of job turnover following devaluations (22.8%) in full sample – still almost double the 11.6% rate in normal times.
Executives twice as likely to lose their jobs if the government had said no devaluation. Executives > twice as likely lose their jobs if the government had said no devaluation. Narrowing down source of political costs of devaluation As noted, IMF programs make no difference. Even in those cases where no assurances had been given over preceding month, rate of job loss (20%) still > no devaluation cases (11.6%) (or 33% at 12-month horizon > 20.5%) . Thus, although broken promise effect is there, political costs must also reflect economic pain.
Why did output fall sharply in many recent crises Excessive expenditure-reduction (Sachs & Stiglitz) Excessive fiscal contraction Excessive monetary contraction (high i => default) Versus what alternative More expenditure-switching instead Devaluations were very large as it was. Magical relaxation of external finance constraint Who pays Doesnt change the graph But if devaluations are contractionary, internal balance line slopes the other way New intersection is hard to find May lose output regardless the policy mix. Textbook model: right combination of i & E should attain new adverse external finance constraint, without recession 1990s version: External balance line slopes down, like internal balance line
Possible contractionary effects of devaluation Some require rapid passthrough, from exchange rate to prices of either: imported inputs consumer imports, & so W All TGs, & so the distribution of income CPI, & so M/CPI Other effects do not need passthrough Balance sheet effect The passthrough coefficient has fallen in developing countries. Slow/incomplete passthrough of exchange rate changes has long been a property of US market & other large rich countries. After large devaluations in Asia in addition to other emerging market countries from 1994 (Mexico) to 2001 (Argentina), most observers feared correspondingly large rises in local currency prices. It never happened. Passthrough is greatest as long as prices of imports at dock, but less as long as retail in addition to CPI Source: Frankel, Parsley & Wei (2004) effect within one year
Passthrough as long as less developed countries > as long as rich, historically. Source: Frankel, Parsley & Wei (2004) effect within one year Passthrough to prices of 8 narrow imported products Coefficient initially higher as long as developing countries (.8) than rich (.3), in 1990 Downward trend in coefficient during decade: Significant, regardless of income level Twice as fast as long as developing countries as as long as rich Partly explained, as long as rich, by rising real wages Speed of adjustment (ECM) Initially higher as long as developing countries than rich Significant downward trend as long as developing c.s (only)
Balance sheet effect is most important of the contractionary devaluation effects Analytical literature on balance sheet effect includes: Kiyotaki & Moore (1997), Krugman (1999), Aghion, Banerjee & Bacchetta (2000), Cespedes, Chang & Velasco (2000, 2003), Chang & Velasco (1999), Caballero in addition to Krishnamurty (2002), Christiano, Gust & Roldos (2002), Dornbusch (2001), Mendoza (2002), Calvo, Izquierdo, & Talvi (2003), Cavallo (2004), Eichengreen & Hausmann (1999) in addition to many others. Empirical evidence of its output cost includes: Cavallo, Kisselev, Perri in addition to Roubini (2002) Guidotti, Sturzenneger in addition to Villar (2003) Foreign-denominated debt in crises x real devaluation => Output loss Source: M.Cavallo, K.Kisselev, F.Perri, & N.Roubini, 2002.
Some suggested influences on the balance sheet effect Eichengreen & Hausmann (1999) made the structural inability to borrow in local currencies famous under the name original sin. Is it historical fate Some argue that the culprit is adjustable pegs. Short run: During the procrastination phase, composition of debt typically shifts to $. Medium run: Trade openness affects vulnerability to currency crashes. Procrastination phase period after reserves peak, but be as long as e the speculative attack Typically lasts 6-13 mo.s Frankel & Wei (WB, 2005) E.g., Mexico, 1994 Four ways to gamble as long as resurrection Officials announce wont devalue Run down reserves Shift composition of debt to short-term Shift composition to $-denominated Each ploy may gain time, but raises cost if devaluation comes. Exhaustion of Mexicos Reserves Up to December 1994 Crisis Data source: IMF International Financial Statistics.
Mexicos shift to $-linked debt, in 1992-94 Data source: Mexican Ministry of Finance in addition to Public Credit. Mexicos shift to short-term debt in 1992-94 Data source: Mexican Ministry of Finance in addition to Public Credit. Lesson After inflows cease, adjust to new external balance early while it is still possible to maintain internal balance; Rather than procrastinating by running down reserves & shifting to s.t. $ debt. Because after the crash, any combination of high i & devaluation may be contractionary.
The highway analogy Superhighways are useful, get you where you want to go quicker. But accidents at high speeds are more likely fatal. – Merton Sudden stops: Its not the speed that kills, its the sudden stops Dornbusch sharp disappearance of private capital inflows, reflected (esp. at 1st) in reserve declines, & (soon) in disappearance of previously large CA deficit – Calvo Superhighways: Modern financial markets get you where you want to go fast, but accidents are bigger, in addition to so more care is required. – Merton Is it the road or the driver Even when multiple countries have accidents in the same stretch of road, their own policies are also important determinants; its not just the fault of the system. Summers Contagion is also a contributor to multi-car accidents. Highway analogy, continued Moral hazard – G7/IMF bailouts reduce impact of given crisis in the LR undermine the incentive as long as investors & borrowers to be careful. Like air bags in addition to ambulances. But to claim that moral hazard means we should abolish the IMF would be like claiming that drivers would be safer with a spike in the center of the steering wheel column Mussa. Optimal sequence: Highway off-ramp should not dump high-speed traffic into center of a village be as long as e streets are paved, intersections regulated, & pedestrians learn to walk on sidewalks. So a country with a primitive domestic financial system perhaps should not open to the full as long as ce of international capital flows be as long as e domestic re as long as ms & prudential regulation. Slowing down: There may be a role as long as controls on capital inflow (speed bumps & posted limits). Reaction time: How driver reacts in short interval between appearance of hazard in addition to moment of impact (speculative attack) influences outcome. Adjust, rather than procrastinate by using up reserves & switching to short-term $ debt JF Routine defensive driving: Keeping high reserves in addition to an economy open to trade is like leaving ample following-distance.
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