Econ 355 1

Lessons of Developing Country Crises

The lessons from developing country crises are summarized as: Choosing the right exchange rate regime The central importance of banking The proper sequence of reform measures The importance of contagion

Econ 355 2

Defining contagion1. Some papers have defined contagion as the influence of “news”

about the creditworthiness, etc. of a borrower on the spreads charged to the other borrowers or equity prices, after controlling for country specific macroeconomic fundamentals (Doukas, 1989,Kaminsky and Schmukler, 1998)

2. Other studies, such as Valdes (1995), defined contagion as excess comovement across countries in asset returns, whether debt or equity. The comovement is said to be excessive if it persists even after common fundamentals, as well as idiosyncratic factors, have been controlled for.

3. A recent variant to this approach is presented in Arias, Haussmann, and Rigobon (1998) and Forbes and Rigobon (1998), who define contagion more narrowly by requiring an increase in excess comovement in crisis periods.

4. Eichengreen, Rose, and Wyplosz (1996) defined contagion as a case where knowing that there is a crisis elsewhere increases the probability of a crisis at home, even when fundamentals have been properly taken into account.

Econ 355 3

Defining Contagion

After controlling for country specific macroeconomic fundamentalso The influence of “news” about the creditworthiness,

etc. of a borrower on the spreads charged to the other borrowers

o Excess comovement across countries in asset returns, whether debt or equity.

o An increase in excess comovement in crisis periods.o A case where knowing that there is a crisis

elsewhere increases the probability of a crisis at home

Econ 355 4

Contagion

1. Why does contagion arise? What are the channels of transmission?

2. Who is vulnerable to sudden reversals of capital flows and contagion?

3. What does the empirical evidence reveal on these issues?

Econ 355 5

Contagion

Contagion may and usually does intensify during periods of turbulence–but it is not limited to those episodes

The evidence suggests that asset prices (bond yields, stock prices, commodity prices) and capital flows exhibit “excess comovement.”

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Table on stock co-movement

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What are the channels of transmission?

1. Trade channels and exchange rate pressures. a. It could be bilateral trade (ex. Chile 1997-98) b. or competition for trade with a common third partner (ex. East Asia’s trade with Japan)

2. Integrated financial marketsa. Banks are interconnected through loans (Mexican Banks

were extending trade credit to Costa Rican banks prior to the 1994 crisis)b. Interconnection through bond holdings. (Korea was

holding Brazilian and Russian bonds)c. Liquidity management practices of open end mutual

funds (Thai share prices fall–sell Indonesia).

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What are the channels of transmission?

3. The weakening finances of a common creditor (US banks in early 1980s and Japanese banks in 1990s)

4. Reassesment of risk (and/or risk increased risk aversion)–the “wake up call” hypothesis. Possibly affecting countries with similar fundamentals.

5. Information asymmetries

6. Political contagion

7. Herding behavior

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Econ 355 10

Possible channels of transmission

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Who is most vulnerable to sudden reversals of capital flows and contagion?

1. Large current account deficits?

2. Substantial real exchange rate appreciation?

3. No capital account barriers?

4. Fixed exchange rate?

5. Weak banking system?

6. “Bad” composition of capital inflows–too much short

term debt?

7. Lack of credibility–poor macroeceonomic track

record?

Econ 355 12

Reforming the World’s Financial “Architecture”

The Asian crisis convinced nearly everyone of an urgent need for rethinking international monetary relations because of two reasons: The fact that the East Asian countries had few

apparent problems before their crisis struck The apparent strength of contagion through the

international capital markets

Econ 355 13

Capital Mobility and the Trilemma of the Exchange Rate Regime The macroeconomic policy trilemma for open

economies: Independence in monetary policy Stability in the exchange rate Free movement of capital

Only two of the three goals can be reached simultaneously.

Exchange rate stability is more important for developing than developed countries.

Reforming the World’s Financial “Architecture”

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Proposals to reform the international architecture can be grouped as preventive measures or as ex-post measures.

“Prophylactic” Measures Among preventive measures are:

More “transparency” Stronger banking systems Enhanced credit lines Increased equity capital inflows relative to debt inflows

The effectiveness of these measures is controversial.

Reforming the World’s Financial “Architecture”

Econ 355 15

Coping with Crisis The ex-post measures that have been suggested

include: More extensive lending by the IMF “Chapter 11” bankruptcy proceeding for the orderly

resolution of creditor claims on developing countries that cannot pay in full.

Reforming the World’s Financial “Architecture”

Econ 355 16

A Confused Future In the years to come, developing countries will

experiment with: Floating exchange rates Capital controls Currency boards Abolition of national currencies and adoption of the

dollar or euro for domestic transactions

Reforming the World’s Financial “Architecture”

Econ 355 17

Summary

Despite their excellent records of high output growth and low inflation, key developing countries in East Asia were hit by currency depreciation in 1997.

Proposals to reform the international architecture can be grouped as preventive measures or as ex-post measures. The architecture that will ultimately emerge is not

at all clear.