Understanding the World Economy Master in Economics and Business. Financial crisis. Nicolas Coeurdacier

Transcription

1 Understanding the World Economy Master in Economics and Business Financial crisis Lecture 12 Nicolas Coeurdacier

2 Lecture 12 : Financial crisis 1. Currency crisis: first generation 2. Self fulfilling currency crisis 3. Sovereign debt crisis

3 Currency crisis Often just seen as a large devaluation Speculative attack with sudden loss of confidence in the central bank promise to keep the exchange rate fixed: run on the central bank foreign reserves : to defend the fixed exchange rate the central bank sells its reserves But not all attacks succeed distinguish between currency crash (large devaluation) and crisis, when authorities defend exchange rate peg - with sharp spike in interest rates - sharp fall in foreign exchange reserves

4 The dangers of managed exchange rates

5 And 11 years later Iceland ISK/EUR

6 And 11 years later Pakistan Current account Reserves and exchange rate (up is depreciation) Reserves in billions of dollars Billions of dollars % of GDP Rupee/dollar IMF

7 Currency crises are common Most fixed exchange rate regimes eventually come under severe strain (and flexible rates can also suffer sudden depreciation) Currency crises have been frequent in the past and also since the 1990s 1992/1993 : European Monetary system and the attack on Pound 1994 : Mexico 1997/1999 : Thailand, South Korea, Indonesia, Brazil, Russia 2000/2001 : Turkey, Argentina 2008 : Iceland, Pakistan, Hungary, Baltic states

8 Zimbabwe Venezuala Uruguay Turkey Thailand Some countries experience repeated crises Number of Currency Crises ( ) Taiwan Sri Lanka South Africa Singapore Phillipines Peru Paraguay Pakistan Nigeria New Zealand Mexico Malaysia Korea Jamaica Israel Ireland Indonesia India Iceland Egypt Ecuador Costa Rica Colombia China Bangladesh

9 Currency crises are costly

10 Models of currency crisis 1) «Fundamental» balance of payments crisis (Krugman, 1979) 2) Crisis with self-fulfilling expectations and multiple equilibria (Obstfeld, 1994, Krugman, 1999) We start with 1).

11 Fundamentals based crises (Krugman, 1979) The fixed exchange rate is «fundamentally» inconsistent with macro policy (fiscal and monetary) : monetary policy too expansionary (CB buys domestic assets) E.g., CB finances budget deficit; buys T-Bills For ER to remain fixed, r = r*, money supply M S remains fixed: CB must sell reserves at the same rate as it buys T-Bills : Central bank balance sheet: M S = Reserves + Domestic assets Does the fixed ER collapse when CB has no more reserves? Rational speculators understand that at some point reserves will be exhausted and fixed ER will be abandoned. Crisis will come before (speculative attack): run on CB reserves (all speculators want to sell domestic currency and buy reserves of the CB). Looks like panic but the result of rational speculators who understand the fundamental inconsistency of the fixed ER.

12 Exchange rate, E E S T Shadow floating exchange rate: E s t Shadow floating E that would prevail if no foreign reserves and the CB lets the exchange rate float E F E S T T T T time Falling reserves Central bank fixes exchange rate at E F ; domestic assets increase over time (CB buys TBs); shadow exchange rate depreciates over time Foreign reserves of the CB: F

13 The logic and timing of the crisis - Are reserves depleted at T? If so, ER jumps from E F to E S T (currency depreciates from fixed exchange rate to shadow ER consistent with level of money supply): not possible as all speculators know this (rational); they could make money by buying all reserves (before they hit zero) at price E F and sell at E S T - Are reserves depleted at an earlier time T? No because if so, ER jumps (currency appreciates) from E F to E S T : speculators will not buy reserves at that price as they would loose money. They would sell home currency at low price or buy foreign currency at a high price.

14 The logic and timing of the crisis - The run on reserves comes exactly at T when E F = E S T - At T: all speculators go to the central bank sell domestic currency and buy foreign reserves - Looks like panic (all speculators rush to sell domestic currency) but this is a fundamental based speculative attack with rational agents.

15 Lecture 12 : Financial crisis 1. Currency crisis: first generation 2. Self fulfilling currency crisis 3. Sovereign debt crisis

16 Strategic foundations of financial crises: speculative attacks with self-fulfilling expectations So-called second & third generation crises: Models with self-fulfilling expectations bank run: speculation against a fixed ER regime generates the objective conditions that make the crisis possible Multiple equilibria: the determination of the realized equilibrium (crisis with devaluation or no crisis and no devaluation) does not depend only on fundamentals but also on speculators expectations

17 Balance sheet effects: the international channel Third generation crises (Krugman, 1999): To explain Asian crises of Russia ( ) Argentina (2001) More recently: Iceland (2008) Danger of debts (private and public) in foreign currency Currency mismatch: economic agents (banks, firms, households) borrow in foreign currency but their assets and incomes are in domestic currency.

18 Reasons for the currency mismatch Original Sin : to borrow abroad, firms, banks, governments in developing countries cannot borrow in their own currency (long memory of markets of very large depreciations of their currency). Lack of reputation of Central Bank. Might be desirable sometimes to make exchange rate regime more credible. Original sin has weakened since the crisis

19 Original sin: Share of foreign debt in foreign currency (OSIN1) is falling but still very high ; source Hausmann and Panizza (2010)

20 A simple model with balance sheet effect (Krugman 1999) AA curve Investment I Demand for domestic currency Appreciation E appreciates as I CC curve Credit constraints: firms borrow to invest, but borrowing is constrained by the expected value of the firm V e = collateral in case of default Balance sheet effect: I = λ. V e = λ (π e d D E e. d F ) Profit debt payment in domestic currency debt payment in foreign currency Key mechanism Expected depreciation (E e ) value of foreign denominated debt E e. d F value of firm (collateral in case of default) : banks their lending investment; CC curve: I decreases as E e If E e > E crash : Firms value <0 (default) ; I = 0

21 E and E e The case of a unique equilibrium The case of share of private debt in foreign currency is small : CC is almost vertical CC: investment does not depend much on E e AA : E appreciates with investment I or credit

22 E and E e Multiple equilibria The case of large share of debt in foreign currency E crash Crash: I =0, big depreciation, firms default, stock market crash, sudden stop 3 equilibria, 2 only are stable : crash and boom Multiple equilibria driven by expectations! Boom: I high, ER is appreciated CC : investment decreases as expected depreciation E e AA : E appreciates with investment I or credit

23 Circular mechanism: the crisis equilibrium Expected crisis and depreciation Credit and investment crisis (sudden stop), demand Balance sheet effect: value of foreign debt in domessc currency Value of collateral of households, firms and banks

24 Similar mechanism with banks (Iceland) Banks lend massively to firms (I) and households (real estate) : assets of three main banks = 10 x Iceland GDP Banks in Iceland borrow massively in foreign currency ( ): collateral of the banks is based on the value of their net assets : decreasing Icelandic Krona depreciates. Expected depreciation (E e ) collateral of banks banks cannot borrow on international markets Economic, financial, real estate, credit and currency crisis. Again, circular mechanism

25 Icelandic Banking Sector Assets and liabilities of the three main banks compared to GDP (m. ISK.) Increasein leverage and size of the Icelandic banking sector Source: Buiter and Sibert (2008)

26 Icelandic Banking Sector 800% Foreign currency liabilities of banks and CB forex reserves september % 600% 750% GDP 500% 400% 300% 200% CB forex reserves: 21% GDP CB swaps and credit lines: 14% GDP 100% 0% Foreign currency liabilities of the banks CB forex liquidity and highly vulnerable to a currency crash

27 Icelandic Crash ISK/EUR Currency Crash

28 : : : : : : : : : : : : : : : 3 Icelandic Crash Share price indices U.S. U.K. Spain Ireland Iceland 3 0 / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / / 0 9 / / 0 3 / (2000Q1=100) House price indices Source: Benediktsdottir et al. (2010)

29 Balance sheet effects in the recent crisis: the domestic channel (households) See Lecture 7. Households borrow using their house as collateral: if negative shock on house prices borrowing falls house purchases fall house prices fall Collateral value fall further house prices fall further Again, circular mechanism

30 Balance sheet effects in the recent crisis: the domestic channel (banks) See Lecture 7. Banks lend long-term (think mortgages) and borrow shortterm (extensively before the crisis): maturity mismatch Vulnerable to balance-sheet effects: as asset/house prices fall, fall in the value of bank assets Cannot borrow short-term (decrease in the value of their assets and collateral/increase in uncertainty/fear of bankruptcy ). Need to sell assets (deleveraging) Banking assets prices fall further Vicious circle!

31 Circular mechanism: the domestic channel (Expected) drop in (long-term) asset values Deleveraging (credit crunch propagates to the real economy) Balance sheet effect: cost of borrowing Value of collateral of households and banks

32 Lecture 12 : Financial crisis 1. Currency crisis: first and second generation 2. Currency crisis: balance-sheets effects 3. Sovereign debt crisis

33 Sovereign debt crisis Sovereign - no international enforcement of debt contracts (difficult for creditors to seize assets, no collateral, no bankruptcy court) What is default? Missing any contractual payment: - outright complete default (rare) - repudiation or moratorium - restructuring: renegotiation (with terms less favorable to the lender: haircut) Serial default (long history): a widespread phenomenon

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35 What is the cost of sovereign default? Gain (wealth transfer) against reputation costs Greece default (1826): no access to international capital markets for 53 years More recently: Uruguay (2003) restructured its debt (stretching maturity dates 5 years). Returned to capital markets a month later. The haircut, or loss to bondholders, was small (13.3%, in net present value) orderly sovereign workouts are possible (not the case of Argentina)

36 Broader macroeconomic costs Triggers or worsen banking crisis Triggers currency crisis Both together generate large output losses Trade disruption (Rose, 2005): countries in default face very high risk premia to finance simple trade activities; disruption of trade credit

37 Understanding defaults: some basic theory

38 Understanding defaults: some basic theory

39 Understanding defaults: some basic theory

40 From financial crisis to sovereign default Typical stages of financial crises (Reinhart and Rogoff, 2009) 1) private debt surges (domestic banking credit growth + external borrowing) 2) banking crises often precede sovereign debt crises (bail outs + collapsing revenues: government debts rise by about 86% in the 3 years after financial crisis): See Ireland (bail out of banks: public debt increased by 20 % point of GDP) 3) public borrowing accelerates ahead of a sovereign debt crisis ; government often has hidden debts (Greece) 4) On eve of banking and debt crises composition of debt shifts toward short-term maturities

41 (Source Reinhart and Rogoff)

42 Cumulative increase in public debt after the financial crisis (selected countries) Source Reinhart and Rogoff

43 Sustainable debt - reminder To keep debt levels constant fiscal policy needs to generate primary surplus/gdp = If > government has to run a primary surplus in order to control the Debt/GDP ratio. If < then government can run a deficit (of a certain size) without seeing Debt/GDP ratio increase. Shifts in interest rates and growth rates have big impact on government debt dynamics. If r increases with Debt/GDP and higher r leads to lower g then countries can rapidly find their public finances deteriorating

44 Sovereign debt crisis in Argentina ( ) Context: The Convertibility Plan , President Carlos Menem takes office. Monthly inflation > 200%. Output plummeting April 1991, Finance Minister Domingo Cavallo implements the Convertibility Plan, including the policy of a Currency Board: Fixed Exchange Rate of 1 Peso / $1 People free to buy and sell Dollars. Implication: Central Bank no longer controls monetary policy. gradual loss of competitiveness as no longer possible to depreciate the currency and inflation still high

45 (Hyper)Inflation in Argentina Inflation Rate % change per year Stabilization Policy in Argentina in early nineties breaks down hyperinflation.

46 In 2000 Argentina does not stand out as hopeless

47 Indicators of Fiscal Sustainability Argentina s crisis caused not by high debt (around 50% GDP) but high r and falling g! (source: Perry & Serven, WB03)

48 Sustainable Debt - Argentina To stabilize the debt to GDP ratio, one needs: (r-g)d/y=pdf/y. D(dec 2001) = 140 bn. Pesos Y(2001) = 269 bn Pesos g( ) = -2.9 % (2001: -4.4%; 2000: -0.8, 1999: -3.5) r = 8.7 % (high but including risk premium) Required primary surplus = (140/269)*(11.6) = 6%! (actual primary surplus in 2000 = 0.3%) If negative growth is seen as persistent, this is unsustainable. Unless fiscal policy is adjusted, debt will rise continuously.

49 Sustainable Debt - Argentina Simple calculations but firm implications: (a) Although debt was not extraordinarily high, the low growth (and high interest rates) quickly makes the debt burden unsustainable (b) If growth prospects turn around, no major problems, but that requires reforms (c) Default is only a temporary relief, unless growth picks up and fiscal policy changes

50 Currency Mismatch and Balance Sheets Effects

51 The Unravelling recession exacerbated government s fiscal position investor fears that currency board would be abandoned fear of devaluation pushed up yield spreads dramatically increasing fiscal burden from interest payments, banking system increasingly based around dollars peso devaluation even more expensive with election focused on economic policy, capital inflows dried up. In December 2000, IMF offered $40bn subject to fiscal conditions Very costly debt exchange in mid-2001, then Argentina convinced US to get IMF to offer a further $8bn But by December 2001, the conditions had not been met, IMF pulled the plug, and government introduced outright default on public debt and exchange controls, abandoned peg, let currency float. Forced pesification of dollar bank deposits at 1.40 Peso to $, dollar loans converted at 1-1, banks foreign exchange reserves confiscated huge balance sheet blow to the banks

52 Run on Banks and Capital Outflows $US billion $US billion IVQ 2000 IQ 2001 IIQ 2001 IIIQ 2001 IVQ IVQ 2000 IQ 2001 IIQ 2001 IIIQ 2001 IVQ 2001 Bank Deposits Balance of Payments-Non Financial Private Sector Capital Account Source: Argentine Central Bank and Ministry of Economy

53 2002:1 2003:1 2004:1 2001: Exchange Rate: Peso / $ (inverted scale) 1995:1 1996:1 1997:1 1998:1 1999:1 2000:1 1994:1 1993:1 1992:1 1991:1

54 The Hair Cut March 4, 2005 NY Times It took more than three years of stop-and-go negotiations, threats, political maneuvers and court battles, but the largest government debt default in history ended here Thursday, as the Argentine government announced that 76 percent of its creditors had accepted a proposal that will pay them at most 30 cents. This was the biggest haircut or loss on principal, for investors of any sovereign bond restructuring in modern times.

55 The euro sovereign debt crisis Investor fear of sovereign debt and default. Confidence/liquidity crisis = Similar mechanism of self-fulfilling expectations Demand higher interest rates to cover risk of default. High interest rate more difficult to pay if the debt-gdp ratio is high. Even more so if growth is low. Default could be caused by the belief that a country can t repay debt --- validating expectations ex-ante. Fear of break-up of the euro ECB role = attempt to manage the confidence/liquidity crisis

56 The euro sovereign debt crisis Confidence/liquidity crisis Circular causality with self-fulfilling expectations. remedy --- break the expectations = ECB intervention and creation of financial safety nets Solvency crisis: some countries will not be able to repay (whatever markets reactions) remedy --- restructure sovereign debt. When? How much?

57 Summary Currency crisis are a common phenomenon in countries with pegged exchange rates. They can be due to misaligned policies but also to self-fulfilling expectations combined with weak fundamentals. Borrowing in foreign currency and lending in domestic currency makes countries vulnerable to self-fulfilling crashes due to balance sheet effects. Similar balance-sheet effects might arise when borrowing short-term and lending longterm. This makes highly leveraged banks very vulnerable to liquidity shocks. Sovereign risk can lead to sovereign debt crisis when public debt becomes unsustainable. Changes in interest rates and growth rates have large impact on debt sustainability.