Chapter 24 CRISES IN EMERGING MARKETS
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1 Chapter 24 CRISES IN EMERGING MARKETS The previous chapter extended the IS-LM-BP model to accommodate high capital mobility. Chapter 24 applies that model to the crises that beset some middle-income countries after they made their financial markets more open to international investors. During the early 1990s, these emerging markets attracted large inflows of capital. When capital flows reversed, crises followed. The flow of capital into emerging markets during the early 1990s was due to internal and external factors. Internal factors include capital account liberalization, privatization of state assets, successful monetary stabilization, and other market-oriented policy reforms. External factors include low U.S. interest rates, implementation of the Brady debt reduction plan, and financial innovations that made it easier for investors in rich countries to invest in developing countries. Using the IS-LM-BP framework, the chapter describes possible policy responses to these large capital flows. In response to inflows, a country can: (a) allow reserves to rise (but this may be inflationary); (b) sterilize the inflow (but this cannot be sustained indefinitely); (c) let the currency appreciate (but this may result in recession); (d) restrict capital inflows (but this raises the cost of financing development); or (e) reduce the budget deficit (but this might actually encourage rather than discourage capital inflows). In response to the outflows that must eventually follow, a country has the opposite set of policy options: it can allow the money supply to fall; it can try sterilizing the outflow; it can allow depreciation; and it can restrict outflows. Slow adjustment to capital outflows left countries vulnerable to speculative attack. The chapter discusses three rationales for such attacks. One is that overly expansionary macroeconomic policy depletes reserves, and speculators hold the currency until there are just enough reserves left to redeem their holdings, at which point their mass exit abruptly drives reserves to zero. The possibility of multiple equilibria is an alternative explanation, with abrupt movement from one equilibrium to another producing a crisis. A third view is that, in some countries, firms with privileged connections to government take excessive risks because they expect public bailouts (hence the term crony capitalism ). In this theory, foreign investors all seek to cash in their investments when the government s liabilities are about to exceed reserves. Countries facing speculative attacks had few options. Most turned to the International Monetary Fund and agreed to a set of policy reforms in exchange for an IMF loan. Immediate and sharp recession accompanied these adjustment programs, in part because of the contractionary effects of devaluation. The chapter details a number of devaluation s effects, demand-side and supply-side, that are omitted from the models of earlier chapters. It also considers the merits of capital account restrictions, seen by some countries as an alternative to IMF intervention.
2 The harshness of the recessions in emerging markets suggests that the international financial system has not worked as well as it could. The chapter closes with an overview of proposals to reform the international financial system in ways that would reduce the risk of crises in emerging markets. SHORT-ANSWER QUESTIONS 1. Why might the removal of restrictions on capital outflows increase capital inflows? 2. Identify three ways in which a country could move overnight from a balance of payments surplus to a balance of payments deficit. 3. True or false: a. A country is less vulnerable to financial crisis if its borrowing is short-term rather than long-term. b. A country is less vulnerable to financial crisis if its borrowing is denominated in foreign currency. c. A country is less vulnerable to financial crisis if its borrowing takes the form of bank loans rather than foreign direct investment (FDI). 4. Despite the insignificant trade and financial links between Russia and Latin American countries, the 1998 Russian debt default depressed stock prices in Latin America. Why? 5. Name two ways that moral hazard may have contributed to the crises in emerging markets. 6. Why do some economists argue that the traditional IMF macroeconomic prescriptions were inappropriate in the context of the East Asian crises? 7. Identify three elements of structural conditionality. 8. Explain why the contractionary effect of an ad valorem tariff is magnified by a devaluation.
3 9. In countries with a history of high inflation, wage contracts are sometimes indexed to the price level. Explain how this indexation can be an obstacle to adjustment. 10. Explain why, if devaluation is contractionary, there may not be any combination of interest rate and exchange rate that can return a country to both internal and external balance. PROBLEMS Reasons for Capital Inflows: 1. Imagine that your country s monetary policy is unchanged yet the country starts to experience large capital inflows. (a) An economist tells you that this is because there has been a vertical downward shift of the country s BP=0 curve. What might he be trying to say about other countries monetary policy or business cycles? (b) A second economist disagrees, insisting that inflows are due to the removal of controls on capital outflows. What is this economist claiming has happened to the BP=0 curve? (c) A third economist claims that the capital flows are attributable entirely to the invention of American Depository Receipts. Will her IS-LM-BP diagram resemble that of the first economist or that of the second? 2. Answer the following questions using the IS-LM-BP diagram. (a) Suppose that, all of a sudden, a country s residents wish to make nearly all of their purchases in cash, while keeping the level of their spending constant. Could this give rise to capital inflows? (b) How might the sudden availability of credit cards in this country give rise to capital inflows? (c) Imagine a country in which the government has sold all of its state-owned enterprises (such as power companies, mining operations, or airlines) in quick succession. How might the end of the privatization program affect capital inflows?
4 Managing Capital Inflows: 3. Suppose that your country s recent commitment to a fixed exchange rate has sharply lowered inflation, and that the country has begun to experience large capital inflows as a result. A friend who works in the central bank tells you that the central bank will soon give up its practice of sterilizing the inflows, because the inflows are unlikely to stop in the near future. (a) (b) Would you decrease or increase your holdings of real estate? Would you decrease or increase your holdings of long-term government bonds? 4. Explain why a quasi-fiscal deficit is a problem specific to developing countries. 5. Imagine that you live in a small country that has a floating exchange rate and has begun to experience large capital inflows. You are the local Mercedes dealer, your sister owns a local shoe factory, and your parents own several apartment buildings in the capital city. (a) Whose business is likely to benefit the most from the inflows? (b) Whose business is likely to suffer the most? Speculative Attacks: 6. (a) Given that the crony capitalism of East Asian countries has been in place for decades, does it make sense to blame their financial structures for the crises they experienced in 1997 and 1998? (b) Why might foreign investors remain in a country beyond the day that they conclude that the government s policies are expansionary and will eventually exhaust the country s reserves of hard currency and force it to devalue? (c) In what model of speculative attacks could the unemployment rate be a critical variable? 7. The neoclassical theory of borrowing suggests that the socially optimal level of capital flowing from developed to developing countries should be greater than it is. What does this suggest about the argument that the financial crises in Asia are entirely due to the moral hazard problem created by past international bailouts by the IMF and the G7 countries?
5 International Monetary Fund Adjustment Programs: 8. (a) In what sort of financial crisis does the IMF merely act as the international financial system s lender of last resort? (b) Why does the IMF make demands of private lenders when negotiating a country s rescue package? (c) If recent crises in emerging markets have stemmed largely from defects in countries financial structure, why have the IMF s structural adjustment programs often produced recessions? (d) In the past, IMF country reports were confidential. What are two possible drawbacks of its recent decision to start publishing country reports? Contractionary Effects of Devaluation: 9. (a) List some possible contractionary effects of a devaluation. (b) Which of these effects are likely to be peculiar to low-income countries? (c) Which of these effects do you think may be important immediately following the devaluation but will have less of an impact in the long run? Capital Controls: 10. (a) What does a country gain by taxing domestic banks short-term foreign borrowing more heavily than their longer-term borrowing? (b) What is gained by imposing higher reserve requirements on domestic banks foreign borrowing than on their domestic borrowing?
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