L-3: BALANCE OF PAYMENT CRISES IRINA BUNDA MACROECONOMIC POLICIES IN TIMES OF HIGH CAPITAL MOBILITY VIENNA, MARCH 21 25, 2016

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1 L-3: BALANCE OF PAYMENT CRISES IRINA BUNDA MACROECONOMIC POLICIES IN TIMES OF HIGH CAPITAL MOBILITY VIENNA, MARCH 21 25, 2016 THIS TRAINING MATERIAL IS THE PROPERTY OF THE JOINT VIENNA INSTITUTE (JVI) AND IS INTENDED FOR USE IN JVI COURSES. ANY REUSE REQUIRES THE PERMISSION OF THE JVI.

2 OUTLINE Currency/Balance of Payment Crises IMF Advice on dealing with Capital Outflows Cases of Recent BOP Crises and Adjustment 2

3 OLD-STYLE CRISES (CURRENT ACCOUNT CRISES) o Slow-motion events; o Cycle of overspending and real currency appreciation; o Current account deficit plays the key role. Resources become limited; Demand restraint and devaluations become necessary.

4 NEW-STYLE CRISES (CAPITAL ACCOUNT CRISES) o Fast-action crises, o Doubts about o balance sheet strength of significant part of economy and o the exchange rate, capital flow reversals. Capital account plays the key role: Large capital inflows prior to the crisis; Substantial capital outflows during the crisis.

5 OLD-STYLE VS. NEW-STYLE CRISES o Traditional analysis examination of flow variables (such as current account, fiscal deficit); o The balance sheet approach focuses on stock variables (types of debt, illiquid assets, etc.) Important source of vulnerabilities: composition and size of liabilities and assets.

6 VULNERABILITIES AND TRIGGERS For financial crises to occur there have to be: o financial vulnerabilities o trigger events

7 VULNERABILITIES AND TRIGGERS o Financial markets can be quite forgiving of imprudent behavior and policies and balance sheet weaknesses; o At other times, financial markets can react virulently and act preemptively. o Underlying vulnerabilities can linger for years without triggering a crisis; o Exact timing of crises difficult to predict. o How financial market participants react is influenced by a wide range of factors.

8 VULNERABILITIES Key factor: o Composition and size of assets and liabilities of a country s financial balance sheet. Key balance sheet vulnerabilities: o Maturity mismatches o Currency mismatches o Capital structure weaknesses

9 VULNERABILITIES VERSUS TRIGGERS o Vulnerabilities are largely necessary conditions for crises, o but they are not necessarily sufficient conditions for crises. o It usually takes a trigger event to make the vulnerabilities felt and ignite a crisis. o At what level are vulnerabilities becoming problematic?

10 CRISIS TRIGGERS Neither balance sheet weaknesses nor triggers on their own are likely to cause a crisis. Possible triggers can be: o external o terms of trade shocks, o contagion, o deteriorating market conditions, o domestic o political turmoil o shifts in market sentiment, o reassessment by market participants, o collapse of a market (e.g. the subprime market in U.S.)

11 DEFINITION OF A CURRENCY/BOP CRISIS o A currency crisis occurs when an attack on a country s currency results in a sudden and rapid fall in the value of a currency (large devaluation or depreciation) o Often triggers counter-measures: o Increase in interest rates o Run-down of reserves o Imposing capital controls o A BOP crisis (or sudden stop) occurs when capital inflows reverse and/or international reserves drop sharply 11

12 CURRENCY/BOP CRISES o Definitions of currency crisis and BOP crisis overlapping, and concepts often used interchangeably, but o They do not necessarily occur together: o speculative attacks may fail to trigger devaluations (e.g., successfully resisted by the central bank) & cause a BOP but not a currency crisis. o Theoretical models explain joint currency and BOP crises o Empirical studies usually define them as separate events 12

13 THEORIES OF CURRENCY/BOP CRISES o o A theoretical framework is important for: o identifying the causes of currency/bop crises o providing a list of relevant variables that allows us to develop an early warning system o diagnosing a country s vulnerability o devising appropriate economic policies Models: o First generation models: unsustainable fiscal policy o Second generation models: self-fulfilling expectations (multiple equilibria) o Third generation models: balance-sheet effects 13

14 FIRST GENERATION MODELS o The collapse of a fixed exchange rate regime is caused by unsustainable fiscal policy in presence of high K mobility: o The government runs a persistent primary fiscal deficit o Deficit is often financed by credit from the central bank o At some point, a sudden, a sharp drop in international reserves (speculative attack) occurs, and the fixed regime collapses o Capital flows role is passive o Without policy changes, collapse is inevitable (deterministic) Causes of Currency/BOP crises: Ongoing fiscal deficits, rising debt levels, falling reserves 14

15 HOW GOOD ARE FIRST GENERATION MODELS? o Fairly good explanation for some crises (e.g., Latin America in the 80s, Argentina, 2001) o But, e.g., ERM crisis of 1992/93: o UK had not run out of reserves o No sizeable fiscal deficits o Collapse of peg was not inevitable o But the expected cost of defending the parity (high interest rate and loss of reserves) was considered too large o Thus, need a model that reflects this cost-benefit analysis 15

16 SECOND GENERATION MODELS o Inspired, e.g., by the EMS crisis o References: Flood and Garber (1984) and Obstfeld (1986, 1994) o Crises are expectations-driven and can occur even in the presence of sound fundamentals o The government maximizes an explicit objective function comparing the (ex-ante) benefits and costs of a devaluation given multiple objectives, such as o Price stability, signaling markets to pursue a disciplined monetary policy achieved through nominal anchor of a fixed exchange rate o Limit debt service obligations, lower unemployment, inject liquidity into a troubled banking system achieved through monetary expansion (abandon fixed FX rate) 16

17 SECOND GENERATION MODELS, CONT D o Multiple equilibria: when agents expect a devaluation and higher inflation: o Government needs to raise the policy rate, with negative impact on employment, activity, financial stability; o no devaluation: cost in terms of output loss and unemployment o Devaluation: cost in terms of reputation, inflation anchor, volatility o Once the cost of maintaining the peg become higher than the costs of a devaluation --the government will devalue and validate agents expectations (crisis is self-fulfilling) Causes of Currency/BOP crises: Private sector expectations and government trade-offs 17

18 SECOND GENERATION MODELS, END o Government s policy interacts with expectations o The self-fulfilling crises do not imply that fundamentals do not matter (Bensaid and Jeanne, 1997). There is typically a range of strong fundamentals (where no attack takes place), intermediate (it depends), and weak fundamentals (crisis). o But many currency crises are preceded by/coincide with financial sector problems o Kaminsky-Reinhart (1999): Banking crises often precede currency/bop crises o E.g., East Asia crisis

19 THIRD GENERATION MODELS o Stress the role of the financial sector and balance sheets in causing crises and propagating their effects o Inspired by Asian Crisis o Moral-hazard-driven lending (Krugman, 1998) o Currency crises as the by-product of bank runs (Chang & Velasco, 1998) o Currency and maturity mismatches (dollarized short-term debts) in balance sheets, and the impacts of currency depreciation on balance sheets Causes of Currency/BOP crises: Financial vulnerabilities, including in banking and corporate sectors, and (implicit or explicit) government guarantees 19

20 THIRD GENERATION: Moral Hazard Krugman (1998), Corsetti, Pesenti, Roubini (1998) o Weak financial institutions take too much risk and have too large losses: o E.g., Connected lending o Government guarantees and moral hazard driven lending provided a hidden subsidy to investment the anticipation of a bailout provides a strong incentive to take on more risk contingent liability for the government 20

21 THIRD GENERATION: Liquidity o Bank runs: sudden shifts in confidence o Banks hold long-term assets (loans) and short-term liabilities (deposits). o This makes them vulnerable to liquidity risk: if each depositor starts to worry that other depositors will withdraw their deposits, then a bank run could occur. o Depositors may withdraw funds from banks and from the country currency depreciation pressures o A country s financial system is internationally illiquid if its potential short-term obligations in foreign currency exceed the amount of foreign currency it can have access to on short notice. investors may withdraw capital (and/or not rollover credit) 21

22 Balance sheet mismatches: Currency mismatch Maturity mismatch Capital structure mismatch ANATOMY OF A BALANCE-SHEET CRISIS 22

23 LINKS BETWEEN CURRENCY & BANKING CRISES o Currency crises Banking crises o The central bank defends currency by increasing interest rates a slowdown in growth and deterioration of bank assets o Currency devaluation leads to banking crisis if banks have large unhedged positions in foreign currency or if they have lent in foreign currency to corporations that produce nontradable goods 23

24 LINKS BETWEEN CURRENCY & BANKING CRISES o Banking crises Currency crises o If the central bank bails out financial institutions, its ability to defend the currency is eroded o Bank runs lead to moving deposits abroad (capital flight), leading to a fall in reserves and currency crisis 24

25 LINKAGES ACROSS SECTORS o Financial vulnerability can come from different sources given the inter-linkages across different sectors: o Government Financial Sector: Domestic financial institutions may be large holders of public debt o Financial Sector Government: Deposit insurance/bailout can imply a large fiscal contingent liability 25

26 BANKS-SOVEREIGN FEEDBACK LOOPS Sovereign Debt risk level: Assets:! Sovereign debt Loans to firms Liabilities: Bank debt risk Equity risk Banks Real economy Bailout probability 26

27 TWIN CRISES ARE COSTLY Source: World Economic Outlook (May 1998) 27

28 BUZZ GROUP: ISSUES FOR DISCUSSION o Has your country been faced with a twin (currency and banking) crisis recently? What was the sequence of events? What was the real impact of the crisis? o Was the adjustment internal or external? o If not, is your country vulnerable to such a crisis? Where do the main vulnerabilities stem from? o In the end, designate a group representative to summarize his/her country s experience in front of the class.

29 Sudden Stops and Policy Responses IMF Advice on dealing with Capital Outflows Cases of Recent BOP crises and Adjustment 29

30 IMF POLICY FRAMEWORK FOR MANAGING CAPITAL OUTFLOWS o Outflows should primarily be managed using appropriate macro, structural, and financial sector policies. o If large but no immediate threat of crisis: adjust macroeconomic and financial sector policies o Korea, Russia, and South Africa during o Use CFMs on inflows as a crisis prevention measure during inflow surges o Take preemptive structural and macroprudential measures to improve country s resilience to crisis 30

31 IMF POLICY FRAMEWORK FOR MANAGING CAPITAL OUTFLOWS, CONT D o Controls (CFM) on capital outflows can be considered in crisis or near crisis conditions to prevent the free fall of the exchange rate and the depletion of international reserves o Argentina ( ), Iceland (2008), Ukraine (2008) o CFM may be necessary when countries face domestic or external shocks that cannot be handled by macroeconomic adjustment or financial sector policies alone o The effectiveness of CFMs on outflows can erode quickly 31

32 IMF POLICY FRAMEWORK FOR MANAGING CAPITAL OUTFLOWS, CONT D o Outflow controls can be effective for longer periods if they are well designed and (re)enforced and part of a comprehensive macroeconomic policy adjustment package (see Iceland vs Argentina and Ukraine) o CFMs on outflows adopted in a crisis should be temporary and lifted as soon as certain conditions are met o Macroeconomic stability (especially with respect to the exchange rate and debt sustainability); o Confidence in domestic assets; o Access to international capital markets; o Financial system stability; and o Adequate reserves. 32

33 CAPITAL OUTFLOWS UNDERLYING FACTORS AND POTENTIAL POLICY RESPONSES If the source of the sudden-stop is o External shock (e.g., t-o-t shock) o Let the exchange rate depreciate to its new equilibrium level; o Defend the peg if the shock is temporary and reserves sufficient. o Inconsistent macroeconomic policies o Macroeconomic adjustment necessary; o Temporary CFMs on outflows could provide breathing space for other policies to be implemented. 33

34 CAPITAL OUTFLOWS UNDERLYING FACTORS AND POTENTIAL POLICY RESPONSES, CONT D Financial fragility (e.g., loss of confidence) Step up prudential regulation and supervision, improve deposit guarantee schemes, and provide liquidity support; Temporary CFMs on outflows can provide breathing space. o Global conditions (e.g., increased risk aversion, tighter monetary conditions in advanced economies) o If significant outflows but seen as temporary: adjust the macroeconomic policy mix (e.g., depreciation+ monetary tightening+ fiscal expansion). 34

35 Sudden Stops and Policy Responses IMF Advice on dealing with Capital Outflows Cases of Recent BOP crises and Adjustment 35

36 COUNTRY CASES WITH SIGNIFICANT CAPITAL OUTFLOWS AND POLICY RESPONSES o Argentina : o Corralito system to limit bank withdrawals; o Restrictions on transfers and loans in foreign currency; o External payments suspended; o Peso devalued by 40 percent (early 2002). o Latvia, ; Iceland 2008; o Malaysia 1998 : o Monetary tightening led to economic contraction; o Capital controls to isolate the offshore -onshore ringgit market; o Further measures: controls limiting offshore swap operations, ban on short-selling, strict regulation on offshore operations, 12-month holding period for nonresidents to sell profits from Malaysian securities; approval requirement to invest abroad, etc. 36

37 COUNTRY CASES WITH SIGNIFICANT CAPITAL OUTFLOWS AND POLICY RESPONSES, CONT D o Russia 1998 o Capital controls (freezing the trading of short term treasury bills, lengthening the maturity of domestic debt, practical restrictions on transfers abroad by nonresidents); o Selective debt moratorium; o Stability achieved only when policies to tackle the underlying causes were implemented: close fiscal imbalances, unification of the currency markets, bank restructuring. o Russia, 2008 o Turkey 2001: o No capital controls; o Exchange rate allowed to float (50 percent depreciation); o Stabilization program backed by the IMF: prudent macro policies, significant reforms in the financial sector and privatizations. 37

38 COUNTRY CASES WITH SIGNIFICANT CAPITAL OUTFLOWS AND POLICY RESPONSES o Ukraine 2008: o Regulatory measures and exchange controls to help stem outflows and defend the exchange rate (e.g., restrictions on banking activities, ban on foreign exchange forward transactions, currency controls on foreign investments, etc.) with mixed results. o Uruguay 2002: o No capital controls; o Peg abandoned (25 percent depreciation); o Five-day bank holiday, some banks were nationalized; o Re-profiling and swap of public debt. 38

39 BUZZ GROUP: DEALING WITH CAPITAL OUTFLOWS In small groups, discuss the following issue for about 15 minutes: Are capital controls on outflows the appropriate answer to a sudden stop in capital flows? If yes, under which circumstances? Has your country experienced a sudden stop in capital flows in recent years? What were the main features of the adjustment? In the end designate a group representative who will report back on your group s findings -39-

40 CONCLUSION o o o Manage capital outflows primarily with macroeconomic and financial sector policies. Use structural policies and macroprudential measures to increase the resilience of the financial, corporate, and household sectors to sudden stops; CFM to deal with surges in inflows; Can use CFMs on outflows: o In crisis or near crisis conditions; o To provide breathing space to fundamental policy adjustment When deciding on CFMs: o Consider country-specific circumstances (e.g. administrative capacity), preexisting degree of financial openness; o Should be temporary; o Bear in mind multilateral effects of CFMs on outflows. 40

41 POLICY IMPLICATIONS: PREVENTING FINANCIAL CRISES o The best prevention is still to keep good macro fundamentals Fiscal balance Current account balance Exchange rate alignment Debt sustainability o Countries should be particularly concerned about economic booms accompanied by Rapid credit expansion Loosening of lending standards Large inflows of short term capital Real exchange rate appreciations Boom in asset prices (stock market, real estate) -41-