Vulnerability Among Emerging Markets

SSgA Institute Conference Harvard Faculty Club

October 9, 2014, 10:30

Jeffrey Frankel Harpel Professor of Capital Formation and Growth

Harvard University

Outline: Vulnerability Among Emerging Markets

• Boom & bust in EM capital flows – despite differences across countries. – The Joseph cycle.

• External shocks (push factors)

• Which countries withstand shocks well (pull factors)? – The statistical record of Early Warning Indicators:

• In currency crises of the 1980s & 90s; • in GFC of 2008-09; • in 2013 “taper tantrum”.

• Appendices:

• EM complaint: Currency wars • The choice of monetary regimes.

3 waves of capital flows to Emerging Markets:

IIF http://www.iif.com/press/press+406.php

• late 1970s, ended in the intl. debt crisis of 1982-89;

• 1990-97, ended in East Asia crisis of 1997-98;

• and 2003-2008, ended … when?

?

The Joseph cycle

Joseph prophesied 7 years of plenty, with abundant harvests from a full Nile -- followed by 7 lean years of drought & famine.

The Pharaoh empowered his technocratic official (Joseph) to save grain in the 7 years of plenty,

building up stockpiles to save the Egyptian people from starvation during the bad years.

-- a valuable lesson for today’s public officials

in advanced & developing countries alike. 4

Biblical cycle, cont.

For emerging markets, the first phase of 7 years of plentiful capital flows occurred in 1975-1981,

recycling petrodollars as loans to developing countries.

The international debt crisis that began in Mexico in 1982 was the catalyst for the 7 lean years,

known in Latin America as the “lost decade.”

The turnaround year, 1989, saw the 1st Brady bond issue.

5

Biblical cycle, cont.

The second cycle of 7 fat years was the period of record capital flows to emerging markets in 1990-96.

The 1997 “sudden stop” in East Asia was then followed by 7 years of capital drought.

The third cycle of inflows, often identified with BRICs & carry trade came in 2004-2008

and persisted even through the Global Financial Crisis.

Is it time for another sudden stop of capital flows to emerging markets?

6

The role of US monetary policy

• Low US real interest rates contributed to EM flows in late 1970s, early 1990s, and early 2000s.

• The Volcker tightening of 1980-82 precipitated the international debt crisis of 1982.

• The Fed tightening of 1994 helped precipitate the Mexican peso crisis of that year. – as predicted by Calvo, Leiderman & Reinhart (1993).

But the relationship between the Fed’s interest rate and EM capital flows does not always hold.

Kristin Forbes, 2014 http://www.voxeu.org/article/understanding-emerging-market-turmoil

Notes: Data on private capital flows and policy rates from IMF's IFS database, Dec. 2013 version. Capital flows are private financial flows to emerging markets and developing economies. Policy rates measured at end of period. Data for 2013 are estimates.

Stronger relationship:

When implicit volatility is high (↓ in graph),

capital flows to EMs fall: “Risk off”

Kristin Forbes, 2014 http://www.voxeu.org/article/understanding-emerging-market-turmoil

Notes: Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets and developing economies. Volatility index measured by the Chicago Board's VIX or VXO at end of period. 2013 data are estimates.

See K.Forbes & F.Warnock (2012), “Capital Flow Waves: Surges, Stops, Flight and Retrenchment”, J. Int.Ec.

2008 GFC

After Fed “taper talk” in May 2013, capital flows to Emerging Markets reversed again.

Jay Powell, 2013, “Advanced Economy Monetary Policy and Emerging Market Economies.” Speech at the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Nov. http://www.frbsf.org/economic-research/publications/economic-letter/2014/march/federal-reserve-tapering-emerging-markets/

Taper talk was followed by greater depreciation

among a group of fragile EMs than others. Aizenman, Binici & Hutchison, ”The Transmission of Federal Reserve Tapering News to Emerging Financial Markets,”

March 2014 www.nber.org/papers/w19980.pdf

“We group emerging markets into those with ‘robust’ fundamentals (current account surpluses, high international reserves and low external debt) and those with ‘fragile’ fundamentals and, intriguingly, find that the stronger group was more adversely exposed to tapering news than the weaker group. News of tapering coming from Chairman Bernanke is associated with much larger exchange rate depreciation, drops in the stock market, and increases in sovereign CDS spreads of the robust group compared with the fragile group.

A possible interpretation is that tapering news had less impact on countries that received fewer inflows of funds in the first instance.”

EM stocks fell on fears of higher US interest rates in both May-June 2013 & January 2014

Source: FT

Which EMs are hit the hardest in crises?

• In past studies of past crises, incl. 1982, 1994, & 1997-98,

• Early Warning Indicators that worked well include: – Foreign exchange reserves

• especially relative to short-term debt;

– Currency overvaluation (i.e., real appreciation);

– Current account deficits.

– Composition of capital inflows.

• E.g., – Sachs, Tornell, & Velasco (1996) ”Financial crises in emerging markets: the lessons from 1995,” BPEA.

– Frankel & Rose (1996) "Currency Crashes in Emerging Markets," JIE.

– Kaminsky, Lizondo, & Reinhart (1998) “Leading Indicators of Currency Crises," IMF Staff Papers.

– Kaminsky & Reinhart (1999) "The twin crises," AER.

The variables that showed up as significant predictors most often in pre-2008 country crises:

0% 10% 20% 30% 40% 50% 60% 70%

Reserves

Real Exchange Rate

GDP

Credit

Current Account

Money Supply

Budget Balance

Exports or Imports

Inflation

Equity Returns

Real Interest Rate

Debt Profile

Terms of Trade

Political/Legal

Contagion

Capital Account

External Debt

% of studies where leading indicator was found to be statistically signficant(total studies = 83, covering 1950s-2009)

Source: Frankel & Saravelos (2012)

(i) reserves and (ii) currency overvaluation

Many EM countries -- excl. CEE -- learned lessons from the crises of the 1990s,

which better prepared them to withstand the 2008-09 GFC.

• More flexible exchange rates

• Higher reserve holdings

• Less fx-denominated debt • More local-currency debt

• More equity & FDI

• Fewer Current Account deficits

• Less pro-cyclical fiscal policy. • Stronger government budgets in 2003-08 boom.

China & other EM countries built up foreign exchange reserves

Aizenman, Cheung & Ito (2014) --------------- “International Reserves Before and After the Global Crisis: Is There No End to Hoarding?” NBER WP 20386, Aug . ----------------

EM borrowers moved from fx-denominated debt to local-currency debt over the last 10 years.

Wenxin Du & Jesse Schreger, Harvard U., Sept. 2014,

“Sovereign Risk, Currency Risk, & Corporate Balance Sheets,” Fig.2, p.19 .

Share of External Debt in LC (Mean of 14 sample countries)

Best and Worst Performing Countries in Global Financial Crisis of 2008-09-- F&S (2012), Appendix 4

-25% -20% -15% -10% -5% 0% 5% 10%

China

India

Morocco

Egypt, Arab Rep.

Indonesia

Jordan

Sri Lanka

Argentina

Poland

Australia

Turkey

Finland

Mexico

Georgia

Russian Federation

Macao, China

Estonia

Ukraine

Latvia

Lithuania

GDP Change, Q2 2008 to Q2 2009

Top 10

Bottom 10

64 countries in sample

Foreign exchange reserves are useful

• One purpose is dampening appreciation in the boom, – thus limiting current account deficits.

• Another is the precautionary motive:

Reserves were the best predictor of who got hit in the 2008 Global Financial Crisis.

• Dominguez, Hashimoto & Ito (2012) ”International Reserves and the Global Financial Crisis,” JIE.

• Frankel & Saravelos (2012), “Are Leading Indicators Useful for Assessing Country Vulnerability?” JIE.

– This was the same Warning Indicator that also had worked in the most studies of earlier crises.

Other predictors (besides fx reserves)

of who got into trouble† in 2008-09 GFC

• Current Account

• National Savings

• Bank credit growth, vs. bank reserves

• Short-term debt / exports † Criteria for “trouble”: loss of GDP, loss of IP, currency market, equity market & need to go to the IMF.

Source: Frankel & Saravelos (2012), “Are Leading Indicators Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Financial Crisis,” J.Int.Ec.

The next clean experiment:

Which EM countries were hit the hardest by the “taper tantrum” of May-June 2013?

• Those with big current account deficits,

• or with inflation/exchange rate overvaluation. • Less evidence that reserves helped this time.

• Very recent studies: – Eichengreen & Gupta (2014), “Tapering Talk: The Impact of Expectations of Reduced

Federal Reserve Security Purchases on Emerging Markets.,” UCB & World Bank, Jan.

– Hill (2014), “Exploring Early Warning Indicators for Financial Crises in 2013 & 2014,” HKS, April.

– Mishra, Moriyama, N’Diaye & Nguyen (2014), “Impact of Fed Tapering Announcements on Emerging Markets,” IMF, June.

– Aizenman, Cheung, & Ito (2014), “International Reserves Before and After the Global Crisis: Is There No End to Hoarding?” NBER WP 20386, Aug.

Countries with current account deficits were hit in the spring of 2013.

Kristin Forbes, 2014

http://www.voxeu.org/article/understanding-emerging-market-turmoil

The “Fragile

Five”

Countries with worse current accounts were hit by greater currency depreciation after May 2013.

Mishra, Moriyama, N’Diaye & Nguyen, “Impact of Fed Tapering Announcements on Emerging Markets,”

IMF WP 14/109 June 2014

Inflation had also risen in Brazil & Turkey.

Gerald D. Cohen | Jan. 2014, Brookings http://www.brookings.edu/blogs/up-front/posts/2014/01/29-emerging-markets-taper-tantrum-cohen

Countries with higher inflation rates were hit by greater currency depreciation after May 2013.

Mishra, Moriyama, N’Diaye & Nguyen, “Impact of Fed Tapering Announcements on Emerging Markets,”

IMF WP 14/109 June 2014

Countries with high inflation rates suffered depreciation & bond yield increases, in the year starting May 2013.

Taper Tantrum or Tedium:

How U.S. Interest Rates

Affect Financial Markets

in Emerging Economies

A.Klemm, A.Meier & S.Sosa, IMF, May 2014

Countries hit in April-July, 2013, had experienced

real appreciation

B. Eichengreen & P. Gupta (2013) “Tapering Talk: The Impact of Expectations of Reduced Federal

Reserve Security Purchases on Emerging Markets,” Working Paper. http://eml.berkeley.edu/~eichengr/tapering_talk_12-16-13.pdf

and big capital inflows.

Currency

depreciation

(%, vs. $)

in 2013

Reserves in excess of what is predicted

by some determinants, estimated for 2010-12.

Countries that held excess fx reserves in 2012 suffered

smaller depreciations in 2013, the taper tantrum year.

Joshua Aizenman, Yin-Wong Cheung & Hiro Ito, 2014, “International Reserves Before and After the Global Crisis:

Is There No End to Hoarding?” NBER WP 20386, Aug.

has continued to shift from fx-denomination to local currency in the case of public debt,

Wenxin Du & Jesse Schreger, Harvard U., Sept.17, 2014,

“Sovereign Risk, Currency Risk, & Corporate Balance Sheets” p.18

Warning sign: Currency composition,

but has reversed in the case of corporate debt, in some EMs.

Conclusion

• Many EMs learned lessons from the 1980s & 1990s, and by 2008 were in a stronger position to withstand shocks: – More flexible exchange rates

– More fx reserves

– Less fx-denominated public debt

– Stronger budget positions

– Stronger current account positions.

• Some backsliding since 2009: – Weaker budgets

– Current account deficits

– Inflation

– The return of fx-denominated private debt.

Appendix 1: Currency wars

Brazil’s Finance Minister Guido Mantega complained in 2010 about Fed easing.

India’s Central Bank Governor Raghuram Rajan complained in 2014 about Fed tightening.

32

• Warning from Mantega:

“We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness” (9/27/2010).

• I.e., countries everywhere are trying to push down the value of their currencies, to gain exports & employment,

– a goal that is not globally consistent.

Origin of phrase “Currency Wars”

“Currency wars” must be another way of saying “competitive devaluation”

•

– a kind of beggar-thy-neighbor policy

• to use language of the 1930s,

• one motive at Bretton Woods for fixed exchange rates;

– or “manipulating exchange rates…to gain an unfair competitive advantage over other members…”

• to quote from IMF Article IV(1)iii.

33

• If US unemployment is high & inflation low, the Fed will naturally choose an easy monetary policy (low i).

• If the macroeconomic situation is the reverse in Brazil, its central bank will naturally choose a tight monetary policy (high i ).

• Also naturally, capital will flow from the US to Brazil and will in turn appreciate the Real.

• But that is the beauty of floating rates.

34

Rajan complains about Fed tightening.

• “International monetary cooperation has broken down… The U.S. should worry about the effects of its policies on the rest of the world,” 1/30/14.

• “Central banks should assess spillover effects from their own actions…

• For example, this would mean that while exiting from unconventional policies, central banks would pay attention to conditions in emerging markets…

• [T]he Fed policy statement in January 2014, with no mention of concern about the emerging market situation, and with no indication Fed policy would be sensitive to conditions in those markets sent the probably unintended message that those markets were on their own.” 4/10/2014 (Brookings)

US Congressional failure to approve IMF reform

• In one respect, at least, China, India & Brazil are right to complain: the lack of proportionate representation in international agencies.

• Congress refuses to pass the bill updating the allocations of IMF quotas among member countries.

• Quotas allocations in the IMF determine both monetary contributions of the member states and their voting power.

• The agreement among the IMF members had been to allocate greater shares to big EM countries,

– coming primarily at the expense of European countries.

Appendix 2: The Choice of Monetary Regimes

for Emerging Markets

I. How are EMs structurally different from Advanced Economies?

II. Choice of exchange rate regime

III. Alternative anchors for monetary policy

I. How are EMs different from Advanced Economies?

1. Monetary policy-maker has more need of credibility a) due to high-inflation histories, b) absence of credible institutions, c) or political pressure to monetize big budget deficits.

2. Economy is more exposed to supply shocks a) such as natural disasters, b) other weather events, c) strikes and social unrest, d) productivity shocks.

3. More exposed to terms of trade shocks because country tends to be price-taker a) Volatility in price of export commodity on world markets b) Volatility in price of imports like oil on world markets.

Trade & Supply Shocks are More Common in Emerging Markets & Low-Income Countries

IMF SPRD & World Bank PREM, 2011, “Managing Volatility in Low-Income Countries:

The Role and Potential for Contingent Financial Instruments,” approved by R.Moghadam & O.Canuto

II. What is the desirable exchange rate regime?

Very small, very open, economies will continue to

want to fix their exchange rates, in most cases.

Most countries are in between,

particularly middle-sized middle-income countries.

• Most of these countries should have intermediate exchange rate regimes, – neither firm fixing nor free floating.

– They include band & basket arrangements.

Distribution of EM exchange rate regimes

Atish Ghosh, Jonathan Ostry & Mahvash Qureshi, 2013, “Exchange

Rate Management and Crisis Susceptibility: A Reassessment,” IMF ARC , Nov..

The big rise is in the “managed float” category

}

Distribution of Exchange Rate Regimes in Emerging Markets, 1980-2011

(percent of total)

So I reject the Corners Hypothesis.

But Stan Fischer has a good point: giving speculators a target to shoot at is often a losing proposition (“disastrous”),

• such as the boundary of a declared band.

• A particular intermediate regime could be useful, a systematic sort of managed floating:

• A rule could say that for every 1% of Exchange Market Pressure, the central bank takes x % as an appreciation of the currency and (1-x) % as an increase in reserves (relative to the monetary base).

– This arrangement, tho rather obvious, has seldom been formalized. – The parameter x calibrates exchange rate flexibility,

• and can range from 0 (fixing) to close to 1 (full flexibility).

– Thus one can have ½ monetary independence + ½ exchange rate stability.

• refutes the corners hypothesis, – but without capital controls, – without violating the Impossible Trinity, – and even without giving speculators

a line to shoot at.

≈ what some central banks do anyway. Attempts at econometric estimation:

Adler & Tovar, 2011, “Foreign Exchange Intervention: A Shield Against Appreciation Winds?” IMF WP 11/165.

Frankel & Xie, 2010, “Estimation of De Facto Flexibility Parameter and Basket Weights in Evolving Exchange Rate Regimes,” AER.

Systematic managed floating

Systematic managed float (“leaning against the wind”):

Kaushik Basu & Aristomene Varoudakis, Policy RWP 6469, World Bank, 2013, “How to Move the Exchange Rate If You Must: The Diverse Practice of Foreign Exchange Intervention by Central Banks and a Proposal for Doing it Better” May, p. 14

Turkey’s central bank buys lira when it depreciates, and sells when it is appreciates.

Korea & Singapore took them mostly in the form of reserves,

GS Global ECS Research

less-managed floating

more-managed floating

Example: Renewed capital inflows to Asia in 2010

while India & Malaysia took them mostly in the form of currency appreciation.

Slope = 1/x

Renewed inflows to Latin America in 2010

less-managed floating

more-managed floating

but as appreciation in Chile & Colombia. were reflected mostly as reserve accumulation in Peru,

Source: GS Global ECS Research

Slope = 1/x

III: If the exchange rate is not to be the anchor for monetary policy, what is?

• The need for an alternative anchor led many EMs to IT, – after the currency crises of the late 1990s

pushed them off exchange rate targets.

• IT (Inflation Targeting) was in many ways successful.

• Two problems with IT: – Neglect of asset bubbles – Neglect of exogenous supply & trade shocks.

• Remember the textbook maxim: the exchange rate should accommodate terms of trade shocks.

• If IT targets the CPI, it doesn’t allow the exchange rate to rise & fall with the terms of trade.

• When the world price of imported oil rises, a literal CPI target says to tighten monetary policy enough to appreciate the currency, – the opposite of accommodating the adverse trade shock.

Nominal GDP Targeting

• NGDPT is more robust with respect to supply shocks & terms of trade shocks, – compared to the alternative of IT.

• The logic holds whether the immediate aim is

– Disinflation (as in 1980s, and today among some EMs);

– monetary stimulus (as among big ACs recently);

– or just staying the course.

Figure 2: When a Nominal GDP Target Delivers a Better Outcome than IT

Supply shock is split between output & inflation objectives rather than falling exclusively on output as under IT (at B).

NGDPT for EMs

• The proponents of Nominal GDP Targets have focused on the biggest countries.

• But middle-size, middle-income countries are better candidates.

• Why? They suffer bigger supply shocks & trade shocks.

• Some evidence suggests the AS curve is indeed steep enough so that NGDPT minimizes quadratic loss function: – “Nominal GDP Targeting for Middle-Income Countries,”

Central Bank Review (CBRT), Sept. 2014.

• Conclusion: EMs should consider NGDPT as a serious alternative to IT & exchange rate targeting.

Appendix 3: More indications of strengthened EM policies after 2001

• Less pro-cyclical fiscal policy

• Current account surpluses

• Higher reserve holdings

• Ability to predict who got hit

– in 2008-09.

53

Correlations between Gov.t Spending & GDP 1960-1999

pro

cyclical

G always used to be pro-cyclical for most developing countries.

cou

ntercyclical

Adapted from Kaminsky, Reinhart & Vegh (2004)

Pro-cyclical spending

Counter- cyclical spending

54

In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:

Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (JDE, 2013)

pro

cyclical co

un

tercyclical

Correlations between Government spending & GDP 2000-2009

Developing Countries Used Capital Inflows to finance CA deficits in 1976-1982 & 1990-97;

but not 2003-08.

IMF

1st boom (recycling

petro-dollars)

start

stop (international

debt crisis) stop (Asia crisis)

2nd boom (emerging markets)

3rd boom (carry trade & BRICs)

start

EM countries used post-2003 inflows to build foreign exchange reserves

Chairman Ben S. Bernanke, 6th ECB Central Banking Conference, Frankfurt, Nov.19, 2010,” Rebalancing the Global Recovery”

EM countries used post-2003 inflows to build international reserves

M. Dooley, D. Folkerts-Landau & P. Garber, “The Revived Bretton Woods System’s First Decade,”

NBER WP 20454, Sept. 2014

57

Actual versus Predicted Incidence of 2008-09 Crisis Frankel & Saravelos (JIE, 2012)

Appendix 4: EM conditions in 2014

From IMF WEO: Legacies, Clouds, Uncertainties, October 2014.

EMs have had to pay higher interest rates

since the taper tantrum of 2013, but conditions eased a bit after April 2014.

From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.

Asia is still doing pretty well.

From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.

Capital flows recovered after the taper tantrum.

From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.

IMF WEO, Oct. 2014.

GDP growth rates

IMF WEO, Oct. 2014.