Preventing Currency Crises in Emerging Markets (National Bureau of Economic Research Conference Report)

Economists and policymakers are still trying to understand the lessons recent financial crises in Asia and other emerging market countries hold for the future of the global financial system. In this timely and important volume, distinguished academics, officials in multilateral organizations, and public and private sector economists explore the causes of and effective policy responses to international currency crises. Topics covered include exchange rate regimes, contagion (transmission of currency crises across countries), the current account of the balance of payments, the role of private sector investors and of speculators, the reaction of the official sector (including the multilaterals), capital controls, bank supervision and weaknesses, and the roles of cronyism, corruption, and large players (including hedge funds). Ably balancing detailed case studies, cross-country comparisons, and theoretical concerns, this book will make a major contribution to ongoing efforts to understand and prevent international currency crises. Preventing Currency Crises in Emerging MarketsThe University of Chicago PressCopyright © 2002 the National Bureau of Economic ResearchAll right reserved.ISBN: 978-0-226-18494-4Chapter One Does the Current Account Matter? Sebastian Edwards 1.1 Introduction The currency crises of the 1990s shocked investors, academics, international civil servants, and policy makers alike. Most analysts had missed the financial weaknesses in Mexico and East Asia, and when the crises erupted almost every observer was surprised by their intensity. This inability to predict major financial collapses is viewed as an embarrassment of sorts by the economics profession. As a result, during the last few years macroeconomists in academia, in the multilateral institutions, and in investment banks have been frantically developing crisis "early warning" models. These models have focused on a number of variables, including the level and currency composition of foreign debt, debt maturity, the weakness of the domestic financial sector, the country's fiscal position, its level of international reserves, political instability, and real exchange rate overvaluation, among others. Interestingly, different authors do not seem to agree on the role played by current account deficits in recent financial collapses. While some analysts have argued that large current account deficits have been behind major currency crashes, according to others the current account has not been overly important in many of these episodes. The view that current account deficits have played a limited role in recent financial debacles in the emerging nations is clearly presented by U.S. Treasury Secretary Larry Summers, who argued in his Richard T. Ely lecture that "[t]raditional macroeconomic variables, in the form of overly inflationary monetary policies, large fiscal deficits, or even large current account deficits, were present in several cases, but are not necessary antecedents to crisis in all episodes" (Summers 2000, 7, emphasis added). The purpose of this paper is to investigate in detail the behavior of the current account in emerging economies, and in particular its role-if any-in financial crises. Models of current account behavior are reviewed, and a dynamic model of current account sustainability is developed. The empirical analysis is based on a massive data set that covers over 120 countries during more than twenty-five years. Important controversies related to the current account-including the extent to which current account deficits crowd out domestic saving-are also analyzed. Throughout the paper I am interested in whether there is evidence to support the idea that there are costs involved in running "very large" deficits. Moreover, I investigate the nature of these potential costs, including whether they are particularly high in the presence of other types of imbalances. The rest of the paper is organized as follows: In section 1.2 I review the way in which economists' views on the current account have evolved in the last twenty-five years or so. The discussion deals with academic as well as policy perspectives and includes a review of evolving theoretical models of current account behavior. The analysis presented in this section shows that there have been important changes in economists' views on the subject, from "deficits matter" to "deficits are irrelevant if the public sector is in equilibrium," back to "deficits matter," to the current dominant view that "current deficits may matter." In this section I argue that "equilibrium" models of frictionless economies are of little help in understanding actual current account behavior or assessing a country's degree of vulnerability. In section 1.3 I focus on models of the current account sustainability that have recently become popular in financial institutions, both private and official. More specifically, I argue that although these models provide some useful information about the long-run sustainability of the external sector accounts, they are of limited use in determining if, at a particular moment in time, a country's current account deficit is "too large." In order to illustrate this point, I develop a simple model of current account behavior that emphasizes the role of stock adjustments. In section 1.4 I use a massive data set to analyze some of the most important aspects of current account behavior in the world economy during the last quarter century. The discussion deals with the following issues: (a) the distribution of current account deficits across countries and regions; (b) the relationship between current account deficits, domestic saving, and investment; (c) the effects of capital account liberalization on capital controls on the current account; and (d) the circumstances surrounding major current account reversals. I investigate, in particular, how frequent and how costly these reversals have been. In section 1.5 I deal with the relationship between current account deficits and financial crises. I review the existing evidence and present some new results. Finally, section 1.6 contains some concluding remarks. 1.2 Evolving Views on the Current Account: Models and Policy Implications In this section I analyze the evolving view on current account deficits, focusing on theoretical models as well as policy analyses. I show that economists' views have changed in important ways during the last twenty-five years, and I argue that many of these changes have been the result of important crisis situations in both the advanced and the emerging nations. 1.2.1 The Early Emphasis on Flows In the immediate post-World War II period, most discussions on a country's external balance were based on the elasticities approach and focused on flows behavior. Even authors who fully understood that the current account is equal to income minus expenditure-including Meade (1951), Harberger (1950), Laursen and Metzler (1950), Machlup (1943), and Johnson (1955)-tended to emphasize the relation between relative price changes and trade flows. This emphasis on elasticities and the balance of trade also affected policy discussions in the developing nations. Indeed, until the mid-1970s, policy debates in the less developed countries were dominated by the so-called "elasticities pessimism" view, and most authors focused on whether a devaluation would result in an improvement in the country's external position, including its trade and current account balances. Cooper's (1971a, b) influential work on devaluation crisis in the developing nations is a good example of this emphasis. In these papers Cooper analyzed the consequences of twenty-one major devaluations in the developing world in the 1958-69 period, focusing on the effect of these exchange rate adjustments on the real exchange rate and on the balance of trade. Cooper (1971a) argued that although the relevant elasticities were indeed small, devaluations had, overall, been successful in helping to improve the trade and current account balances in the countries in his sample. In an extension of Cooper's work, Kamin (1988) confirmed the results that, historically, (large) devaluations tended to improve developing countries' trade balance. Authors in the structuralist tradition argued that in the developing nations trade and current account imbalances were "structural" in nature and severely constrained poorer countries' ability to grow. According to this view, however, the solution was not to adjust the country's peg, but to encourage industrialization through import substitution policies. In Latin America this view was persuasively articulated by Raul Prebisch, the charismatic executive secretary of the U.N. Economic Commission for Latin America; in Asia it found its most respected defender in Professor Mahalanobis, the father of planning and the architect of India's Second Five Year Plan; and in Africa it was made the official policy stance with the Lagos Plan of Action of 1980. 1.2.2 The Current Account as an Intertemporal Phenomenon: The Lawson Doctrine and the 1980s Debt Crisis During the second part of the 1970s, and partially as a result of the oil price shocks, most countries in the world experienced large swings in their current account balances. These developments generated significant concern among policy makers and analysts and prompted a number of experts to analyze carefully the determinants of the current account. Perhaps the most important analytical development during this period was a move away from trade flows and a renewed and formal emphasis on the intertemporal dimensions of the current account. The departing point was, of course, very simple and was based on the recognition of two interrelated facts. First, from a basic national accounting perspective, the current account is equal to saving minus investment. Second, since both saving and investment decisions are based on intertemporal factors-such as life cycle considerations and expected returns on investment projects-the current account is necessarily an intertemporal phenomenon. Sachs (1981) forcefully emphasized the intertemporal nature of the current account, arguing that, to the extent that higher current account deficits reflected new investment opportunities, there was no reason to be concerned about them. Theoretical Issues Obstfeld and Rogoff (1996) have provided a comprehensive review of modern models of the current account that assume intertemporal optimization on behalf of consumers and firms. In this type of model, consumption smoothing across periods is one of the fundamental drivers of the current account. The most powerful insight of the modern approach to the current account can be expressed in a remarkably simple equation. Assuming a constant world interest rate, equality between the world discount factor [1/(1 + r)] and the representative consumer's subjective discount factor ��, and no borrowing constraints, the current account deficit (CAD) can be written as (1) [CAD.sub.[t]] = ([Y.sup.*.sub.t] - [Y.sub.t]) - ([I.sup.*.sub.t] - [I.sub.t] ) - ([G.sub.t] - [G.sup.*.sub.t]), where [Y.sub.t], [I.sub.t], and [G.sub.t] are current output, consumption, and government spending, respectively. [Y.sup.*.sub.t], [I.sup.*.sub.t], and [G.sup.*.sub.t], on the other hand, are the "permanent" levels of these variables. The permanent value of Y ([Y.sup.*.sub.t) is defined as (2) [MATHEMATICAL EXPRESSION NOT REPRODUCE IN ASCII]. The sum runs from j = t to infinity. That is, equation (2) defines the permanent value of Y as the annuity value computed at the constant interest rate r. The definitions of [I.sup.*.sub.t] and [G.sup.*.sub.t] are exactly equivalent to that of [Y.sup.*.sub.t] in equation (2). According to equation (1), if output falls below its permanent value, ([Y.sup.*.sub.t] - [Y.sub.t]) > 0, there will be a higher current account deficit. Similarly, if investment increases above its permanent value, there will be a higher current account deficit. The reason for this is that new investment projects will be partially financed with an increase in foreign borrowing, thus generating a higher current account deficit. Likewise, an increase in government consumption above [Gt.sup.*] will result in a higher current account deficit. Although equation (1) is very simple, it captures the fundamental insights of modern current account analysis. Moreover, extensions of the model, including the relaxation of the assumption that the subjective discount factor is equal to the world discount factor, do not alter its most important implications. If, however, the constant world interest rate assumption is relaxed, the analysis becomes somewhat more complicated. In this case, the current account deficit will be fundamentally affected by the country's net foreign assets position and by the relationship between the world interest rate and its "permanent" value, [r.sup.*.sub.t]. With a variable world interest rate, equation (1) becomes (3) [CAD.sub.t] ([Y.sup.*.sub.t] - [Y.sub.t]) - ([I.sup.*.sub.t] - [I.sub.t]) - ([G.sub.t] - [G.sup.*.sub.t]) - ([r.sup.*.sub.t] - [r.sub.t])[B.sub.t] - [[xi].sub.t], where [B.sub.t] is the country's net foreign asset position. If the residents of this country are net holders of foreign assets, [B.sub.t] > 0 (see Obstfeld and Rogoff 1996). The consumption adjustment factor, [[xi].sub.t], arises from the fact that the world discount factor is not any longer equal to the consumers' subjective discount factor. Notice that under most plausible parameter values [[xi].sub.t] is rather small (Obstfeld and Rogoff 1996). An important implication of equation (3) says that if the country is a net foreign debtor ([B.sub.t] > 0) and the world interest rate exceeds its permanent level, the current account deficit will be higher. A number of versions of optimizing models of the current account have appeared in the literature published since 1980. Razin and Svensson (1983), for example, built an optimizing framework to explore the validity of the Laursen-Metzler-Harberger condition developed in the 1950s and concluded that the insights from these early models were largely valid in a fully optimizing, two period, general equilibrium model. Edwards and van Wijnbergen (1986) explored the current account implications of alternative speeds of trade liberalization. They found out that in a framework in which the country in question faced a borrowing constraint, a gradual liberalization of trade was preferred to a cold-turkey approach. Frenkel and Razin (1987) analyzed the way in which alternative fiscal policies affected the current account balance through time. Edwards (1989) introduced nontradable goods in an effort to understand the connection between the real exchange rate and the current account through time. Sheffrin and Woo (1990) used an annuity framework to develop a number of specific testable hypotheses from the intertemporal framework. Ghosh and Ostry (1995) tested the intertemporal model using data for a group of developing countries. They argue that, overall, their results adequately capture the most important features of modern optimizing models of the current account. Numerical simulations based on the intertemporal approach sketched above suggest that a country's optimal response to negative exogenous shocks is to run very high current account deficits. These large deficits are, of course, the mechanism through which the country nationals smooth consumption. An important consequence of this models' result is that a small country can accumulate a very large external debt and will have to run a sizeable trade surplus in the steady state in order to repay it. The problem, however, is that the external accounts and the external debt ratios implied by these models are not observed in reality. Obstfeld and Rogoff (1996), for example, develop a model of a small open economy with Ak technology and a constant rate of productivity growth that exceeds world productivity growth. This economy faces a constant world interest rate r and no borrowing constraint. Under a set of plausible parameters, the steady-state trade surplus is equal to 45 percent of gross domestic product (GDP), and the steady-state ratio of debt to GDP is equal to 15. Needless to say, neither of these figures has been observed in modern economies (on actual distributions of the current account see the discussion in section 1.4 of this paper). Fernandez de Cordoba and Kehoe (2000) developed an intertemporal model of a small economy to analyze the effects of lifting capital controls on the dynamics of the current account. The basic version of their model assumes both tradable and nontradable goods, physical capital, and internationally traded bonds, and no borrowing constraint. An important feature of the model-and one that sets it apart from that of Obstfeld and Rogoff (1996) discussed above-is that the rate of technological progress is equal to that of the rest of the world. The authors calibrate the model for the case of Spain and find that the optimal response to a financial reform is to run a current account deficit that peaks at 60 percent of GDP. As the authors themselves acknowledge, this figure tends to contradict strongly what is observed in reality. Following the financial liberalization reform, Spain's current account deficit peaked at 3.4 percent of GDP. (Continues...) Excerpted from Preventing Currency Crises in Emerging Markets Copyright © 2002 by the National Bureau of Economic Research. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Economists and policymakers are still trying to understand the lessons recent financial crises in Asia and other emerging market countries hold for the future of the global financial system. In this timely and important volume, distinguished academics, officials in multilateral organizations, and public and private sector economists explore the causes of and effective policy responses to international currency crises.

Topics covered include exchange rate regimes, contagion (transmission of currency crises across countries), the current account of the balance of payments, the role of private sector investors and of speculators, the reaction of the official sector (including the multilaterals), capital controls, bank supervision and weaknesses, and the roles of cronyism, corruption, and large players (including hedge funds).

Ably balancing detailed case studies, cross-country comparisons, and theoretical concerns, this book will make a major contribution to ongoing efforts to understand and prevent international currency crises.