MGE 15.1

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• Session 15 Financial Crises (The Role of the
  IMF and Lessons Learned)
• Currency boards (Application the Argentine
  Crisis)
• Learning from the Asian Crisis (Origins of the
  Crisis and Contagion)
• How to fix it?
• The IMF solution (Presentations Are IMF
  reforms necessary? )
• Criticisms of the IMF are they justified?
• Summary Lessons learned?

Loïc Sadoulet Macroeconomics in a Global
Economy P3 Jan-Feb. 2004
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Currency Boards

• Country (unilaterally) declares its currency back
  up by USD
• Anybody who comes to HK CB with 7.8HK can get 1
  USD
• Anybody who came to Argentine CB with 1 Peso
  could get 1 USD
• Rule for conduct of monetary policy money supply
  moves 1-to-1 with reserves of USD
• Every time someone comes to CB to trade in Peso
  for USD, CB burns the Peso.

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Currency Boards
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Currency Boards
CB buys Pesos at board rate
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Argentina 2002

• Tequila effect loss of confidence in emerging
  economies since 1994
• Brazil fixed exchange rate
• Maintain exchange rate by issuing high-yield
  bonds (35 a year!)
• 30 depreciation (increased competitiveness)
• Jan 99 default despite IMF help
• Argentina currency board
• Capital outflows but cannot issue government
  bonds (would raise interest rates)
• Contraction of money supply despite recession
  (because of currency board)
• Huge debt eventually breaks currency board by
  using reserves to service debt
• (OOPS! Not good!)

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Argentina 2002

• December 2001 restrictions on withdrawals from
  banks and foreign currency transactions
• 2 January 2002 Government confiscates dollars
  and converts them to pesos and then to bonds
  (issued to pay bills)
• and lets the peso devaluate on 7th January 2002

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Solutions for Argentina?

• Lets turn to lessons from the Asian Crisis

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What led to the Asian Crisis?

• 1990s Credit Boom
• Bank and non-bank lending growth gt GDP growth
• Mainly short-term and Dollar-denominated credit
• Directed to real estate and equities (speculative)

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Credit out of Control
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Credit out of Control

• Why?
• Bountiful liquidity conditions (low r in Japan)
• ASEAN among most attractive sovereign borrowers
• High growth rates
• Financing I, not C ? building repayment capacity
• Disciplined fiscal position (not a
  savings-investment deficit)
• Note stable e to the ? -denominated debt
  didnt seem like a bad idea

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Origins of the Crisis

• Mid 90s
• Export slowdown Trade growth 9 (95) ? 5.6
  (96)
• Real exchange rates appreciating due to loose MP
  in Japan
• Global overproduction in key Asian industries
• (chips, automobiles, petrochemicals, lumber,
  frozen chickens,)
• Overheating economies with high demand for
  imports
• Need to defend fixed exchange rates

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Defending the Currency
Nominal exchange rate (price of domestic currency
/dom
D (exports, Cap. inflows)
S (imports, Cap. outflows)
e
Decline in export demand
Tight MP / Sales of FR
Domestic Currency exchanged
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Interest Rate hikes and Short-term loans

• Mismatched maturities
• Financing loan-term projects with short-term
  loans
• Higher interest rates increase proportion of
  non-performing loans
• Overproduction and break-even line

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Interest Rates and Non-performing Loans
Interest rate
Break-even line
Old r
I
Investment
Undertaken I (at old r)
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Overcapacity and Non-performing Loans
Interest rate
overcapacity
Break-even line
Old r
I
Investment
Undertaken I (at old r)
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Non-Performing Bank Loans
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Banking and Financial Sector Weakness

• Crony Capitalism loans to directors/mgrs
• Lax loan classifications (concentration of risk)
• Government Ownership of Banks
• (Quasi-fiscal agents assistance for ailing
  industries)
• Previous bailouts ? Excessive risk-taking

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International Worries

• Shift of comparative advantage to China
• US protectionism backlash

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What Happened?

• July 1, 1997 Thai Baht is floated

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What Happened?

• July 1, 1997 Thai Baht is floated

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Equity Markets Plunge
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Exchange Rates Plunge
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Economies in Severe Recessions
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Contagion from Thailand to the Region

• ASEAN 5
• (Indonesia, Malaysia, Philippines, Singapore)
• North Asia
• (South Korea, Taiwan, Hong Kong, Japan)
• Other Emerging Economies
• (Brazil, Russia,)

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Why Contagion?(Thailand is small, after all)

• Wake-up call
• Poor prudential supervision
• Large external deficits
• Appreciating real exchange rates
• Declining quality of investments

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Why Contagion?(Thailand is small, after all)

• Wake-up call
• Loss of Confidence of International Investors
• Recall Mexican crisis (Session 12)
• Competitive dynamics of devaluation and
  Speculative Attacks
• Recall ERM crisis (Session 12)
• Trade links

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Trade Links
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Special Cases

• Japan
• Lots of bad loans to Emerging Asian Countries
• (43 of Japanese banks capital vs. 27 for G7 as
  a group)
• High proportion of NPLs domestically
• Fall in exports (40.9 to Asia)
• Russia, Brazil
• SK banks held lots of Russian and Brazilian bonds
• Expectations

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The IMF Solution

• Reduction of structural public deficits
• Reform of Financial Sector
• No fixed exchange rates for foreseeable future
• Fix Japans economy to boost the region

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The IMF Solution

• Reduction of structural public deficits
• Reform of Financial Sector
• Encourage exit of financing firms (to reduce
  capacity)
• Shut down insolvent banks
• Recapitalize solvent but illiquid banks (foreign
  ownership?)
• Injection of public funds, but
• Equity holders must lose their stake
• Managers need to be fired
• Adoption of BIS Standards (Basel Convention)

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The IMF Solution

• Reduction of structural public deficits
• Reform of Financial Sector
• No fixed exchange rates for foreseeable future
• High interest rates are not credible
• Banking sector needs to be restructured
• Negative aspect more volatility
• Note HK was able to maintain currency board due
  to earlier reforms

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The IMF Solution

• Reduction of structural public deficits
• Reform of Financial Sector
• No fixed exchange rates for foreseeable future
• Fixing Japan to boost the region
• Domestic-led demand recovery ? higher imports
• Simultaneous contractionary monetary policy to
  revalue
• Reestablish a better competitive advantage for
  other economies
• Less thread of US protectionism backlash
• (but did not work)

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Presentations The IMF and Currency Crises

• Are IMF reforms necessary?
• What are their impact on
• Growth
• Unemployment rates
• Financial liberalization

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Critiques of IMF

• Ill-advised strong medicine?
• IMF not necessary let exchange rates do the work
• Exacerbated crisis with high r and credit crunch
• IMF creates a moral hazard prob (lender of last
  resort bailing out western banks)

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IMF Ill-advised strong medicine?
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Critiques of IMF

• Ill-advised strong medicine?
• Countries were fine before crisis Just
  temporary setback
• No, they were not
• Financial Sector weaknesses
• External balance problems
• Public deficits
• However, IMF must take into account social
  problems

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Critiques of IMF

• Ill-advised strong medicine?
• IMF not necessary let exchange rates do the work
• No need recapitalization of solvent banks with
  temporary liquidity problems
• Culture of rolling over loans

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Critiques of IMF

• Ill-advised strong medicine?
• IMF not necessary let exchange rates do the work
• Exacerbated crisis with high r and credit crunch
• True High r are not sustainable (e.g. Sweden in
  ERM crisis)
• However, need high r to diminish capital outflows
• Bank closures were necessary to restore
  confidence in system
• (16 bank closures in Indonesia only 5 of total
  banking assets)

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Critiques of IMF

• Ill-advised strong medicine?
• IMF not necessary let exchange rates do the work
• Exacerbated crisis with high r and credit crunch
• IMF creates a moral hazard prob. (lender of last
  resort)
• True bail-out insurance ? excessive risk taking
• But
• Need to rebuild international reserves,
  recapitalize solvent banks
• Political constraints national gvts would have
  done it, weakening their fiscal position even
  further
• Small depositors need to be protected
• Large uninsured depositors still took large hit
  (bailout, but costly)
• Developing countries cannot borrow on
  international market

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Lessons learned?

• Social/Political Aspects of Crisis Management
• Vested interests and resistance to reform
  (Cronies)
• Complementary Basic needs and Safety net
  programs
• Lessons from Bankruptcy laws?
• Recapitalization in exchange for
  control/oversight
• Unloading debt pressure from system
• Sustainable debt eliminate global LDC debt in
  15 yrs
• Cost 0.1 tax on developed economies (15 hours
  of work/year)

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Still unanswered questions

• Clean up system, but how?
• 4 tenants of good institutional environment
• Rule of Law
• Quality of bureaucracy
• Freedom from government repudiation of contracts
• Freedom from expropriation
• How to fix?
• Set up quality institutions
• Eliminate incentives for corruption

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Recall Marketing is important!