Central European University
Department economics
The roles of fiscal, monetary and exchange rate policies in preventing currency crises and overcoming the consequences
Term paper for the course ‘Comparative macroeconomic policy’
Professor: Jacek Rostowski
Authors: Gregor Langus and Willen Lipatov
Budapest, 2000
CONTENT
Introduction 3
Definitions and the role of government 3
Propagation of crisis 6
Buildup of the crisis in East Asia 7
Causes 7
Crisis outbreak 8
Policy responses 9
The roles of macroeconomic policies in overcoming the consequences 10
Fiscal policy 10
Monetary policy 11
Exchange rate policy 12
Other crisis management policies 13
The role of IMF 13
Prevention issues 14
Conclusion 17
Introduction
The problem of currency crises has been an issue since the introduction of money in national economies. With globalization of financial markets the frequency of crises and their impact on the real economy dramatically increased. This raised interest in crisis prevention and overcoming its consequences. The latest advances of economic theory give a better understanding of crisis mechanism and provide better tools for prevention and post-crisis stabilization.
The availability of modern techniques in dealing with crises puts a greater responsibility on the government's shoulders. However, the literature on currency crises is huge, and this review summarizes the main recommendations for pursuing various government policies. This paper aims to show basic relations between macroeconomic variables that cause crises and those variables that governments can control by adopting proper policies.
Firstly, we define the crisis as an extreme point of instability. We further underline the relevance of official intervention in order to preserve stability. Following that, we discuss what forms official policy responses took in recent Asian crises, and summarize what advantages and disadvantages official measures may have. Next, we turn to the problem of preventing crises, and conclude by stressing importance of maintaining healthy financial system and macroeconomic conditions.
Definitions and the role of government
First of all, there is no commonly accepted definition of financial instability. Obviously, it’s a lack of financial stability, which usually implies, according to A. Crockett (1997), two principal features:
¨ key institutions are stable, that is meet their contractual obligations
¨ key markets are stable, that is prices reflect fundamental forces driving them
There is a couple of problems with this definition. First, it’s not clear what institutions are key ones, and what are not. Second, price stability is not equivalent to market stability, so there is no good measure for the latter. Moreover, it is difficult to distinguish between inability of institutions to meet obligations leading to problems for the whole market system and healthy failures of institutions, which are necessary for functioning of this system. Similarly, it is not simple to determine a degree of price instability that could be considered to be a threshold value between healthy price flexibility (again necessary for the functioning of the markets) and market instability.
Because of these problems another, rather ‘functional’ definition of a crisis is accepted. According to it, absence of financial stability (crisis) causes wide economic damage. Already from this property it is obvious that one should worry about crises, as it is necessary to minimize economic damage caused by them. This is where there can be scope for government activities in overcoming consequences of crises. Moreover, it certainly makes sense to try to prevent crises, as long as prevention measures do not hinder growth potential.
There are some reasons why official intervention is not only possible, but also necessary for crisis management. First of all, financial and asset markets have broad linkages to saving and investment decisions, so instability on these markets has greater potential impact on the economy in general, than instability on markets for goods and services. Second, there are some immanent characteristics of financial institutions that make them vulnerable to crises:
¨ losses are exacerbated due to bank runs, so government can protect potentially solvent institutions and provide pooled monitoring (because of the economies of scale)
¨ there is high probability of contagion and spillover, so financial stability can be considered to be a public good which only government can provide efficiently
Third, there are following major types of costs of financial instability:
¨ budgetary costs to protect depositors and bail out institutions, in other words costs of resolving a crisis
¨ widespread macroeconomic consequences, eventually leading to GDP growth reduction
¨ loss of confidence raises problems of asymmetric information (moral hazard and adverse selection)
Therefore relevance of government intervention for preserving stability of financial institutions is widely accepted.
The situation around preserving stability of financial markets is not so clear. Markets also have instability bias in a sense that any disturbance causes moves in the same direction. The costs of instability of markets include
¨ difficulties to formulate macroeconomic policy, as it is not clear whether a change in a market situation will not bring about obsolescence of current policy
¨ undermining the stability of financial institutions
¨ real economic costs if measures to fight crisis are taken
So, there is no strong reason for direct regulation of markets, as long as government can concentrate on institutions in order to correct market failures. In general, however, official intervention in dealing with crises is desirable. Let’s consider how a crisis can occur even in presence of such an intervention.
Propagation of crisis
In the framework of asymmetric information (analyzed by F. Mishkin (1997)) all crises have four basic reasons:
1. Increases in interest rates.
2. Deterioration of bank balance sheets.
3. Negative shocks to non-bank balance sheets as stock market declines.
4. Increase in uncertainty.
All these factors are interrelated and can cause each other. For example, an increase in interest rates leads to deterioration of balance sheets for both banks (because of maturity mismatch the value of assets is lowered more than the value of liabilities) and non-banks (credit servicing becomes more expensive). Deterioration of non-bank balance sheets also leads to deterioration of bank balance sheets, as non-bank firms are less likely to repay their loans.
The most important thing, however, is that all the four factors worsen the problems of moral hazard and adverse selection. In an emerging-market country that leads to a currency crisis, as speculators realize that defense of domestic country is too costly for the central bank (it can raise the interest rate, but danger of being involved in a vicious circle is very high). A crisis is associated with substantial depreciation or devaluation of the domestic currency. This, taking into account short duration of debt, large foreign currency denominated debt, and lack of inflation-fighting credibility leads to a large-scale financial crisis (Mexico 1994, East Asia 1997, Russia 1998). Interest rate can be raised once more to fight inflation, that deteriorates balance sheets more, and vicious circle appears once again.
Apart from devaluation, decline in economic activity caused by moral hazard and adverse selection problems makes paying-off debts less likely, thus worsening banking crisis in both industrialized and emerging-market countries. This leads to further worsening of problems connected with asymmetric information, and suppresses economic activity more.
The aftermath of a crisis consists in sorting out healthy firms from insolvent ones. This reduces uncertainty, stock market recovers, interest rate goes down, so adverse selection and moral hazard become weaker, and the economy gets conditions to grow. On this stage it is very important to provide efficient mechanism of sorting out solvent institutions, as without it there is no reason to overcome the crisis.
However, in developed economies, as there are no problems with currency devaluation and high inflation, economic downturn can lead to a decline in prices. Then a phenomenon called ‘debt deflation’ can occur: unanticipated deflation leads to deterioration of firms’ net worth and through it to increasing of moral hazard and adverse selection problems. This, in turn, brings about downturn in economic activity, as it happened in the USA in 1873, 1907, during the Great depression, and in Japan in 90s.
So, that’s the way how a crisis evolves in the theoretical framework of asymmetric information. Now let’s see how it happened in reality using the example of East Asian countries.
Buildup of the crisis in East Asia
Causes
Opinions on the causes for the East Asian crisis in 1997 differ, we can, however, identify some agreement between authors (for example: Dornbusch, 1998; BIS 1998; Fischer, 1998) on the following main categories of causes:
- Financial sector weaknesses and inadequately supervised banking systems
- Excessive credit growth and over-expansion of the capital stock.
3. The bubble economy.
4. Rigid exchange rate regimes.
All the stated causes are complementary. Financial sectors in the East Asian countries were unable to efficiently transform massive inflows of foreign funds in 1995 and 1996. This was combined with weak supervision and improper prudential regulation of financial institutions. In an increased competition banks made risky, uncollateralised loans, kept offshore dollar borrowings unhedged and exposed themselves to maturity mismatches.
Following the credit expansion, with foreign funds being channeled into equity investment, stock market values increased and this created asset bubbles. Dowling and Lloyd (2000), also allege increasing inflation as a consequence of capital inflows, partly because of the upward pressures on asset and property prices, but mainly through increased money supply. To this list of causes for the crisis we could also add external influences of changes in international markets (increased competition on export markets, saturation with consumer electronics, drop in price of chips) and some systemic changes, especially in the pattern of financial intermediation with formation of non-bank institutional investors.
However clear the case for the currency crisis in East Asia seems now, it was not so prior to the outbreak. Since 1980 these economies have been growing at an average annual growth rates around 8%, while keeping inflation at moderate levels. There was no sign of worsening fundamentals and macroeconomic policies were kept on a prudent course. Budget deficit was broadly balanced and the monetary policies seemed to have been cautious, judging from substantial stability of prices. Except for the widening current account deficit there was no obvious sign of the upcoming events.
How come then, did the crisis occur? Crockett (BIS 1998, page 35) argues, that the system of governance in all sectors of Asian economies failed to keep pace with the rapid expansion. In a fast growing business environment with high saving rates, investment strategies encompassed risky projects with low returns, consequently leading to overinvestment.
Overinvestment in turn led to conditions of oversupply and the exports started to shrink; additionally the rates of return on investments in new capital were eroding. Moreover, dollar appreciation had negative effects on competitiveness, since real appreciation was transmitted through a pegged exchange rate to Asia. Because of commitments to maintaining exchange rate, monetary policy makers have had less scope to focus on the domestic liquidity requirements and failed to dampen overheating by raising interest rates. Fixed exchange rate policies also gave economic agents a false perception of low exchange rate risk, and as a result they had incentives to take large unhedged exposures in foreign currency.
Crisis outbreak
The first stage of the crises unfolded in Thailand. Investors confidence eroded mainly because of the large and growing current account deficit (8% in 1996). Even though there were no apparent fundamental problems (negligible inflation and conservative fiscal policy with budget surpluses), except for a moderate appreciation over previous few years, the fact that Thailand was vulnerable was enough to face currency attacks and capital flow reversals. As Dornbusch (1998) argues, this vulnerability emerges from the combination of a weak banking system, dollar debts held by its clients, short term structure of debt and lack of transparency with a pervasive overlay of corruption.
On the 2nd July 1997 the Thai baht was let to float. Even though the monetary policy was tightened and interest rates were raised significantly the baht continued its downward path and lost 45% of its value against the dollar, by the end of 1997. Current account deficit narrowed to 2% of GDP in 1997, mainly due to collapse of domestic demand and drop in imports.
Investors sentiments quickly spread over the region, focusing on similar vulnerabilities as in the case of Thailand. The Philippines, Indonesia and Malaysia as well as Taiwan, faced strong pressures and the governments first widened exchange rate bands, but had to let the currencies float by October 1997.
Policy responses
First and direct response to currency attacks in the Asian countries was the adoption of the floating exchange rate regime, followed by tightening of monetary policy. Moreover, fiscal restraints were imposed to tackle with the budget imbalances, but fiscal stances were eased after the depth of the crisis became clearer. Crockett (BIS 1998, page 135) also argues that the degree to which interest rate were raised was not enough to counter attacks. In addition the rates were allowed to fall back after the immediate pressures had subsided. This kind of wavering monetary policy leads to high dependence on heavy intervention.
Financial response to crisis included official liquidity assistance in the form of IMF standby credits and substantial additional multilateral and bilateral assistance. These packages aimed at restoring investors confidence, but this can only be achieved if financial packages are combined with credible policy measures, which was not the case at the outset of stabilization in Asia.
At the core of the South-East Asian crisis was a fragile financial sector and other structural weaknesses and this was the reason that adjustment programs also included institutional and structural reforms, mainly of the banking sector, but also of enterprises.
Meanwhile in the case of Latin America the conventional policy mix – tight monetary and fiscal policy worked well, it was not so in East Asia. The difference is mainly due to the reason, that Latin-American countries have been running lax fiscal policy prior to the crisis, whereas Asia had maintained conservative fiscal policies, hence it did not have so much scope for fiscal maneuvering.
The roles of macroeconomic policies in overcoming the consequences
Because of the high costs of currency crises per se, and costly stabilization policies, the prevention is important and should not be substituted by "fire fighting". On the brim of the currency collapse, however, different macroeconomic policies should be carefully considered in the context of the nature of crisis and the nature of economy. Every adopted measure will namely have both positive and negative effects in the stabilization, depending on the specific relations between macroeconomic and microeconomic variables in the economy. In what follows we will discus the theoretical framework of macroeconomic policies and relate it to the case of East-Asian crisis.