Emerging Market Countries in the Global Financial Crisis Jeffrey Frankel Harpel Professor of Capital Formation & Growth Outline

Emerging Market Countries in the Global Financial Crisis Jeffrey Frankel Harpel Professor of Capital Formation & Growth Outline www.phwiki.com

Emerging Market Countries in the Global Financial Crisis Jeffrey Frankel Harpel Professor of Capital Formation & Growth Outline

Sobczak, Dan, New Media Content Manager has reference to this Academic Journal, PHwiki organized this Journal Emerging Market Countries in the Global Financial Crisis Jeffrey Frankel Harpel Professor of Capital Formation & Growth ‘Insights in Development Thinking – Executive Seminar’ with COMFAMA. Harvard University, May 20, 2010 Outline The crisis of 2008-09 & the 2010 outlook The 3rd capital inflow boom 2003-2008: Was it different Lessons of 1994-2002 on avoiding crises: Did they hold up in 2008 Emerging markets come of age Decoupling The new countercyclical fiscal policy April 21, 2010 The global financial crisis of September 2008 was transmitted to emerging markets.

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Source: Benn Steil, Lessons of the Financial Crisis, CFR, March 2009 The financial crisis was transmitted to emerging markets in September 2008. April 21, 2010 Thus the 3rd cycle of capital flows to emerging economies ended in 2008. Source: WEO, IMF, April 2010 Transmitted also by a collapse of world trade, the global recession soon showed up in emerging economies.

April 21, 2010 Source: WEO, IMF, April 2010 The slowdown in %-points of growth was similar in emerging countries as in advanced, but did not put them literally into negative territory. (Their base was a much higher growth rate.) Source: WEO, IMF, April 2010 April 21, 2010 Emerging economies have recovered far more quickly than developed countries

Source: WEO, IMF, April 2010 The bounce-back has been especially strong in Emerging Asia Source: WEO, IMF, April 2010 April 21, 2010 The recession in Latin America was much milder than in past episodes. The pattern “the farther they fall the stronger they bounce back” has not held in this cycle.

Source: WEO, IMF, April 2010 Global financial market conditions returned to normal by late 2009 (at least until the Greek crisis). Emerging & Devel- 6.1 2.4 6.3 6.5 5.2 6.3 7.3 oping Economies Central & E.Europe 3.0 –3.7 2.8 3.4 1.9 1.3 4.1 Russia 5.6 –7.9 4.0 3.3 –3.8 1.7 4.2 Developing Asia 7.9 6.6 8.7 8.7 8.6 8.9 9.1 China 9.6 8.7 10.0 9.9 10.7 9.4 10.1 India 7.3 5.7 8.8 8.4 6.0 10.9 8.2 ASEAN-5 4.7 1.7 5.4 5.6 5.0 4.2 6.2 Middle East & N.Africa 5.1 2.4 4.5 4.8 Sub-Saharan Africa 5.5 2.1 4.7 5.9 Western Hemisphere 4.3 –1.8 4.0 4.0 Brazil 5.1 –0.2 5.5 4.1 4.3 4.2 4.2 Mexico 1.5 –6.5 4.2 4.5 –2.4 2.3 5.5 Year over Year Q4 over Q4 (2010-2011 are projections) 2008 2009 2010 2011 2009 2010 2011 WEO as long as ecasts, April 2010 April 21, 2010 The outlook is positive as long as Latin America, as as long as other developing countries.

April 21, 2010 Cycles in capital flows to emerging markets 1st developing country lending boom (“recycling petro dollars”): 1975-1981 Ended in international debt crisis 1982 7 Lean years (“Lost Decade”): 1982-1989 2nd lending boom (“emerging markets”): 1990-96 Ended in East Asia crisis 1997 7 Lean years: 1997-2003 3rd boom (incl. China & India this time): 2003-2008 What characteristics have helped emerging markets resist financial contagion in the past High FX reserves in addition to /or floating currency Low as long as eign-denominated debt (currency mismatch) Low short-term debt (maturity mis-match) High Foreign Direct Investment Strong initial budget, allowing room to ease. High export/GDP ratio, Sachs (1985); Eaton & Gersovitz (1981), Rose (2002); Calvo, Izquierdo & Talvi (2003); Edwards (2004); Cavallo & Frankel ( 2008).

Are big current account deficits per se dangerous Neoclassical theory – If a country has a low capital/labor ratio (or transitory negative shock), a large CAD can be optimal. “Lawson Fallacy” (1989) – CAD not dangerous if government budget is balanced, so borrowing goes to finance private sector, rather than BD. Amendment after 1994 Mexico crisis – CAD not dangerous if BD=0 in addition to S is high, so the borrowing goes to finance private I, rather than BD or C. Amendment after 1997 East Asia crisis – CAD not dangerous if BD=0, S is high, in addition to I is well-allocated, so the borrowing goes to finance high-return I, rather than BD or C or empty beach-front condos (Thail in addition to ) & unneeded steel companies (Korea). Amendment after 2008 financial crisis – yes, CADs are dangerous. Some references on statistical predictors of crises among developing countries Jeffrey Sachs, Aaron Tornell & Andres Velasco, “Financial Crises in Emerging Markets: The Lessons from 1995” (1996): Combination of weak fundamentals (changes RER or credit/GDP) in addition to low reserves (relative to M2) made countries vulnerable to tequila contagion. J. Frankel & Andrew Rose, “Currency Crashes in Emerging Markets” (1996): Composition of capital inflow matters (more than the total): short-term bank debt raises the probability of crash; FDI & reserves lower the probability. Graciela Kaminsky, Saul Lizondo & Carmen Reinhart, “Leading Indicators of Currency Crises” (1998). Best predictors: Real ex. rate, M2/Res, GDP, equity prices. A.Berg, E. Borensztein, G.M.Milesi-Ferretti, & C.Pattillo, “Anticipating Balance of Payments Crises: The Role of Early Warning Systems,” IMF (1999). The early warning indicators don’t hold up as well out-of-sample. Lessons of the 1994-2002 crises Many emerging markets after the 1990s learned to (1) float or hold large reserves or both (2) use capital inflows to finance reserve accumulation (“self-insurance”), rather than current account deficits (3) take capital inflows more in the as long as m of FDI or local-currency-denominated debt flows; avoiding the currency mismatch of $ liabilities in addition to avoiding bank loans. The ratio of reserves to short-term debt is the most robust predictor of crisis likelihood & severity. e.g. the Guidotti Rule: Keep ratio >1

This time, many countries used the inflows to build up as long as ex reserves, rather than to finance Current Account deficits 2003-07 boom 1991-97 boom April 21, 2010 A change in the composition of capital inflows: Latin America replaced debt with FDI & equity Did those who obeyed the lessons of 1994-2002 done better in response to the 2008-09 shock Some who had large current account deficits & as long as eign-currency debts did have the most trouble, particularly in Central & E.Europe: Hungary, Ukraine, Latvia Reserves have turned out the ultimate insurance. Aizenman (2009): “The deleveraging triggered by the crisis implies that countries that hoarded reserves have been reaping the benefits.”

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Systematic studies are only starting. Obstfeld, Shambaugh & Taylor (2009a, b): Finding: A particular measure of countries’ reserve holdings just be as long as e the current crisis, relative to requirements (M2), predict 2008 depreciation. Current account balances & short-term debt levels are not statistically significant predictors, once reserve levels are taken into account. Rose & Spiegel (2009a, b) in addition to Blanchard (2009) found no role as long as reserves in predicting who got into trouble. Frankel & Saravelos (May 2010): We get stronger results, because we consider crisis period to have gone thru March 2009. Top 8 categories of Leading Indicators in pre-2008-crisis literature Frankel & Saravelos (2010) Next 9 categories of Leading Indicators in pre-2008-crisis literature Frankel & Saravelos (2010)

Equity prices suggest that the global financial crisis did not begin in earnest until Sept. 2008, nor end until March 2009 whereas Rose & Spiegel, Obstfeld et al, look simply at 2008 Best in addition to Worst Per as long as ming Countries – F&S (2010), Appendix 4

April 21, 2010 April 21, 2010 Employment was unusually sensitive to economic activity in Colombia, as in the US, but not most other countries (neither Latin America nor Europe) April 21, 2010

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