FIN 40500: International Finance
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Transcript of FIN 40500: International Finance
FIN 40500: International Finance
Anatomy of a Currency Crisis
What Constitutes a “Crisis” ? Large, rapid depreciation of a
currency Sudden, dramatic, reversal in
private capital flows
Note: The names and dates have been changed to protect the innocent!
The “Crisis” period is typically followed by a recession.
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Per
cen
tag
e D
iffe
ren
ce F
rom
“P
re-C
risi
s” E
xch
ang
e R
ate
Note the short run “overshooting” of the exchange rate!
Crisis Date
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Foreign Direct Investment Portfolio Investment
Note that portfolio investment is quicker to flow out than foreign direct investment
Crisis Period
Cap
ital
Flo
ws
Imagine yourself driving down a straight stretch of road. If the alignment on your car is good, you can let go of the steering wheel and the car stays on the road……
However, if your alignment is not perfect, you need to act to stay on the road. Otherwise…
On the other hand, your alignment could be perfect, but if the road has an unexpected curve….
$D
S
A peg at the equilibrium price can be maintained forever!
A peg above the equilibrium will involve buying your currency (loss of reserves)
A peg below the equilibrium price will involve selling your currency (increase in reserves)
e
e
*e
e
Your pegged exchange rate needs to be consistent with a market equilibrium!!
Foreign currency per $
$
D
S
Suppose that a country is pegging at or near the equilibrium value of its currency
e
*e
An incompatible policy could pull the equilibrium away from the pegged level – this forces a loss in reserves!
$
D
Se
*e
Suppose that a country is pegging at or near the equilibrium value of its currency
alternatively, suppose that demand drops – this lowers the equilibrium exchange rate and forces the central banks to act (buying back currency and losing reserves)
What causes these sudden reversals?
Just the facts ma’am.
•Persistent inflation
•High Money Growth
•Low Economic Growth
•Large Deficits
•Public
•Private
•Political Events
•Natural Disasters
•Market Sentiment
Bad Policy
Bad Luck
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US Average Inflation
Crisis Period
Note the sharp reversal in inflation following the crisis periodIn
flat
ion
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5
10
15
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Crisis Period
Steadily deteriorating growth rates is not a good sign!!
Eco
no
mic
G
row
th
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0
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40
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Crisis Period
Average = 14% Average = 4%
Note the significant drop in money growth after the crisisM
2 M
on
ey
Gro
wth
-60,000
-50,000
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0
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20,000
30,000
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Crisis Period
Note that the government deficit gets worse before it gets betterG
ove
rnm
ent
Def
icit
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0
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Crisis Period
Note the sharp reversal in the trade accounts following the currency crash
Tra
de
Def
icit
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5
10
15
20
25
30
-18 -12 -6 0 6 12 18 24
Crisis Period
Note the rapid drop in the interest rate following the devaluation!O
vern
igh
t L
end
ing
Rat
e
0.00
5,000.00
10,000.00
15,000.00
20,000.00
25,000.00
30,000.00
35,000.00
40,000.00
45,000.00-5
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0
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Foreign Exchange Gold
Note the sharp loss in reserves as the central bank attempts to defend the currency!
FX
Res
erve
s
Go
ld R
eserves
Relative Money Stocks
Relative Outputs
Relative Interest Rates
*
*
* 1
1
i
i
Y
Y
M
Me
Recall, the monetary framework with flexible prices (long run) resulted in the following
yiL ,M
M
P
High money growth and low economic growth generate inflation (Domestic Money Market)
Domestic inflation generates a currency depreciation (PPP)
*% e
Domestic Inflation Foreign Inflation
yiL ,M
M
P
*1% iieE t
If the current depreciation leads to expectations of future depreciations, the domestic interest rate must rise to compensate foreign investors
A rise in the interest rate lowers money demand even further – this causes another round of inflation!
i
i
yIS
LM
0BOP
In the short run, it’s a question of the sustainability of current account deficits (i.e. can the country attract enough foreign capital to finance their CA deficit)
This point is unsustainable!
Rapid money growth pushes interest rates down in the short run and “over-stimulates” domestic consumption – this creates trade deficits that are difficult to finance!
i
i
yIS
LM
0BOP
In the short run, it’s a question of the sustainability of current account deficits (i.e. can the country attract enough foreign capital to finance their CA deficit)
This point is sustainable!
As the IS sector increases (high domestic investment, low savings, large fiscal; deficits), the trade deficits worsen, but interest rates rise – this makes it easier to attract foreign capital
i
i
yIS
LM
0BOP
In the short run, it’s a question of the sustainability of current account deficits (i.e. can the country attract enough foreign capital to finance their CA deficit)
This point is unsustainable!
However, as debts get too big, foreign capital becomes more reluctant to flow in (investors are afraid of the country’s ability to repay.
How big is “too big”? When does a trade deficit become unsustainable?
PV(Lifetime CA) = 0 (all debts must be repaid) We need to examine the country’s ability to run trade surpluses
in the future (i.e. repay its debts!) Generally speaking, a trade deficit greater than 5% of a country’s
GDP is considered “too big”
Productivity measures the ability of a country to transform inputs into output
Revenues
Labor Capital (Shareholders)
Creditors (bondholders)
With high productivity, producers can raise revenues without having to raise prices (high growth with low inflation!)
Labor Productivity =Per Man-hourReal Output = Y
N
Real GDP
Total Hours
$10,397
Real GDP (2004)
Subtract out Farm Output
$8,317
Divide by total hrs (Employment * Average Hrs * 52)
$8,317244.3 = $34/hr
Suppose that Output/hr in 1992 was equal to $28.hr, then
Prod(1992) = 100Prod(2003) = 100*(34/28) = 121.4
Labor Productivity
Multifactor ProductivityLabor productivity doesn’t correct for changes in the capital stock!!
Y = A KβN 1-β (Production function) β = 1/3
Real GDP Capital
LaborMFP
Growth Rate of MFP = y – βk – (1-β)n
Labor Growth
Capital Growth
Real GDP Growth
Multifactor Productivity
Step 1: Estimate capital/labor share of incomeK = 30%N = 70%
Step 2: Estimate capital, labor, and output growth
%Y = 5%%K = 3%%N = 1%
%A = 5 – (.3)*(3) + (.7)*(1)
= 3.4%
0
0.5
1
1.5
2
2.5
3
3.5
1919-1929 1929-1941 1941-1948 1948-1973 1973-1989 1989-2000 1995-2000
Labor Productivity MFP
An
nu
al G
row
thMFP Growth dropped in the 70s and 80s as IT was introduced!
Contagion refers to the transmission of a currency crisis throughout a region The Thai Baht in 1997 was followed shortly by
crises in Malaysia, Indonesia, Korea The Mexican Peso crisis in 1994 spread to
Central and South America (“The Tequila Effect”) The Russian collapse (2000) was followed
immediately by Brazil
Reasons For Contagion Common Shocks Trade Linkages Common Creditors Informational Problems and “Herding”
behavior