Dooley and frankel (eds ) managing currency crises in emerging markets (2001)

Managing Currency Crises in
Emerging Markets


A National Bureau
of Economic Research
Conference Report


Managing Currency Crises
in Emerging Markets

Edited by

Michael P. Dooley and
Jeffrey A. Frankel

The University of Chicago Press
Chicago and London


M P. D is a research associate of the National Bureau of
Economic Research and a managing editor of the International Journal
of Finance and Economics. Professor Dooley joined the faculty at the
University of California, Santa Cruz, in 1992 following more than
twenty years’ service at the Board of Governors of the Federal Reserve
System and the International Monetary Fund. J A. F
is the James W. Harpel Professor of Capital Formation and Growth at
the Kennedy School of Government and director of the International
Finance and Macroeconomics program at the National Bureau of

Economic Research.

To Rudiger Dornbusch, from whom we have
learned so much.

The University of Chicago Press, Chicago 60637
The University of Chicago Press, Ltd., London
© 2003 by the National Bureau of Economic Research
All rights reserved. Published 2003
Printed in the United States of America
11 10 09 08 07 06 05 04 03 1 2 3 4 5
ISBN: 0-226-15540-4 (cloth)
Chapter 8, “An Evaluation of Proposals to Reform the International
Financial Architecture” by Morris Goldstein © 2001, Institute for
International Economics.
Comment by Edwin M. Truman on chapter 11, “IMF and World Bank
Structural Adjustment Programs and Poverty” by William Easterly
© 2001, Institute for International Economics.
Library of Congress Cataloging-in-Publication Data
Managing currency crises in emerging markets / edited by Michael P.
Dooley and Jeffrey A. Frankel
p. cm. — (A National Bureau of Economic Research
conference report)
Proceedings of a conference held in Monterey, Calif., in March
2001.
Includes bibliographical references and index.
ISBN 0-226-15540-4 (cloth : alk. paper)
1. Currency question—Developing countries—Congresses.
2. Foreign exchange rates—Developing countries—Congresses.
3. Financial crises—Developing countries—Congresses. I. Dooley,

Michael P. II. Frankel, Jeffrey A. III. Series.
HG1496 .M36 2003
332.4'91724—dc21
2002018126
o The paper used in this publication meets the minimum requirements of
the American National Standard for Information Sciences—Permanence
of Paper for Printed Library Materials, ANSI Z39.48-1992.


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Contents

Acknowledgments

xi

Introduction
Michael P. Dooley and Jeffrey A. Frankel

1

I. T D
1. Interest Rates and Exchange Rates in the Korean,
Philippine, and Thai Exchange Rate Crises
Dongchul Cho and Kenneth D. West
Comment: Robert Dekle
Discussion Summary
2. Interest Rate Defense against Speculative
Attack as a Signal: A Primer
Allan Drazen
Comment: Robert P. Flood
Discussion Summary
3. Does It Pay to Defend against a Speculative
Attack?
Barry Eichengreen and Andrew K. Rose
Comment: Richard Portes

Discussion Summary

11

37

61

vii


viii

Contents

II. T P
4. The International Lender of Last Resort:
How Large Is Large Enough?
Olivier Jeanne and Charles Wyplosz
Comment: Olivier Blanchard
Discussion Summary
5. Rescue Packages and Output Losses
Following Crises
Michael P. Dooley and Sujata Verma
Comment: Andrew Powell
Discussion Summary

89

125

6. Financial Restructuring in Banking and CorporateSector Crises: What Policies to Pursue?
147
Stijn Claessens, Daniela Klingebiel, and
Luc Laeven
Comment: Peter B. Kenen
Discussion Summary
7. On the Fiscal Implications of Twin Crises
A. Craig Burnside, Martin Eichenbaum, and
Sergio Rebelo
Comment: Kenneth Kletzer
Discussion Summary
8. An Evaluation of Proposals to Reform the
International Financial Architecture
Morris Goldstein
Comment: Andrew Berg
Discussion Summary

187

225

III. T I
9. Recovery and Sustainability in East Asia
Yung Chul Park and Jong-Wha Lee
Comment: Richard Portes
Discussion Summary
10. A Cure Worse Than the Disease? Currency
Crises and the Output Costs of IMF-Supported
Stabilization Programs

Michael M. Hutchison
Comment: Gian Maria Milesi-Ferretti
Discussion Summary

275

321


Contents

11. IMF and World Bank Structural Adjustment
Programs and Poverty
William Easterly
Comment: Edwin M. Truman
Discussion Summary
12. Impacts of the Indonesian Economic Crisis:
Price Changes and the Poor
James Levinsohn, Steven Berry, and
Jed Friedman
Comment: Lant Pritchett
Discussion Summary
Contributors
Author Index
Subject Index

ix

361

393

429
433
437



Acknowledgments

This volume consists of papers that were presented at a National Bureau of
Economic Research Conference, held in Monterey, California, in March
2001, together with comments and discussion. A preconference held in
Cambridge in July 2000 kept everyone on track. The main purpose of the
conference was to bring together a group of academics, officials in the multilateral organizations, and public- and private-sector economists to discuss
issues related to the management of financial crises in the emerging-market
countries.
A companion conference was held two months earlier to discuss what
can be done to avoid or minimize crises in emerging-market countries in
the first place. The corresponding volume is Preventing Currency Crises in
Emerging Markets, edited by Sebastian Edwards and Jeffrey A. Frankel.
These two conferences were part of a larger NBER project on exchange rate
crises in emerging markets, directed by Frankel together with Martin Feldstein. The editors would like to thank the Ford Foundation for support and
Feldstein for originating the entire project.
Michael P. Dooley is a research associate of the National Bureau of Economic Research and a managing editor of International Journal of Finance
and Economics. Professor Dooley joined the faculty at the University of
California, Santa Cruz in 1992 following more than twenty years’ service at
the Board of Governors of the Federal Reserve System and the International Monetary Fund. Jeffrey A. Frankel is the James W. Harpel Professor
of Capital Formation and Growth at the Kennedy School of Government
and director of the International Finance and Macroeconomics program of

the National Bureau of Economic Research.

xi



Introduction
Michael P. Dooley and Jeffrey A. Frankel

The management of financial crises in emerging markets is a high-stakes
and contentious problem for public policy. Policy interventions must be implemented quickly and under the worst possible economic circumstances.
After the dust settles it is difficult to construct a convincing counterfactual
in order to evaluate alternative policies.
An example, addressed directly by the first two chapters in this volume, is
the debate over the proper use of interest rates to limit exchange rate depreciation in the midst of a crisis. Senior officials of the International Monetary Fund (IMF) and the World Bank have taken different sides in this debate, even though these institutions have not been well known for allowing
internal debate to spill into the public press in the past. This public controversy underscores the importance of the issues involved and the depth of the
uncertainty within the economics profession concerning the nature of good
policy in this area. These problems are not solving themselves. As the papers in this volume were being written, further crises were brewing in Turkey, Argentina, and perhaps elsewhere, and the hot debate about the role of
the official sector has intensified.
The papers collected in this volume were presented at a conference in
March 2001. The main purpose was to bring together a group of academics, officials in the multilateral organizations, and public- and private-sector
Michael P. Dooley is a research associate of the National Bureau of Economic Research and
a managing editor of International Journal of Finance and Economics. Professor Dooley joined
the faculty at the University of California, Santa Cruz in 1992 following more than twenty
years’ service at the Board of Governors of the Federal Reserve System and the International
Monetary Fund. Jeffrey A. Frankel is the James W. Harpel Professor of Capital Formation and
Growth at the Kennedy School of Government and director of the International Finance and
Macroeconomics program of the National Bureau of Economic Research.

1

2

Michael P. Dooley and Jeffrey A. Frankel

economists to discuss issues related to the management of financial crisis in
the emerging market countries. (A companion conference produced the
volume Preventing Currency Crises in Emerging Markets, edited by Sebastian Edwards and Jeffrey Frankel.) In commissioning a series of original papers, the editors and Martin Feldstein, the originator of the National Bureau of Economic Research’s project on Exchange Rate Crises in Emerging
Markets, called on economists who have contributed to the academic literature and, in many cases, have participated in the policy process.
The volume is divided into three parts, which can be viewed almost
chronologically, as three phases counting forward from the moment that a
country is hit by a crisis: first, the initial attempt to defend the currency; second, the IMF rescue program; and, third, the impact of the crisis and rescue program on the real economy. The first three chapters focus on the immediate defense of the regime under attack. The important issue here is
whether unnecessary damage to economies can be avoided by the right response in the first few hours and days of a financial crisis. The next five
chapters examine the adjustment programs that follow crises. It is now clear
that crises have long-lasting negative effects on economic growth. Adjustment programs supported by financial assistance are designed to shorten
the recovery phase and minimize the probability of further difficulties. Finally, the third group of four papers provides empirical evaluation of adjustment programs. Do they accomplish what they are designed to accomplish? Do they impose disproportionate costs on the poorest members of
society?
It would be nice to believe that these difficult questions are resolved in the
pages that follow. That goal is surely unrealistic. However, we hope that
scholars and policy makers will find the work presented useful in thinking
about how to reduce the frequency and costs of financial crises in the years
to come.
The Defense
In “Interest Rates and Exchange Rates in the Korean, Philippine, and
Thai Exchange Rate Crises,” Dongchul Cho and Kenneth D. West consider
the relationship between exchange rates and interest rates immediately after the onset of a crisis. They propose a two-equation model for exchange
rates and interest rates: a monetary policy reaction function, with the interest rate as the instrument, and an interest parity equation. The important
identifying assumption is that the currency risk premium depends on the
level of interest rates. The effects of interest rates on exchange rates are ambiguous because increases in interest rates can increase a risk premium.

Cho and West estimate a special case of the model using weekly data from
1997 and 1998 for Korea, the Philippines, and Thailand. Their results suggest that increases in interest rates following crises led to exchange rate ap-


Introduction

3

preciation in Korea and the Philippines but to depreciation in Thailand.
Confidence intervals around point estimates are very large, however, and
they cannot rule out the possibility that the sign of the actual effect is the
opposite of the one estimated.
Alan Drazen’s chapter, “Interest Rate Defense Against Speculative Attack as a Signal: A Primer,” also deals with an interest rate defense against
a speculative attack. He argues that high interest rates per se are unlikely to
deter speculators when a discreet devaluation is likely. However, an interest
rate defense might nevertheless succeed if high interest rates are a signal of
the government’s willingness or ability to defend the exchange rate. Drazen
explores a class of models in which an interest rate defense alters the speculators’ views of the type of government they face. In other words, this
model allows for building credibility. The interest rate increase allows the
government to distinguish itself from other governments that would not defend. This model presumes that the only available strategy for supporting a
peg is an interest rate defense; if, instead, central banks can also run down
or borrow reserves, the high interest rate defense may signal low reserves
and hence encourage speculation. Drazen argues that empirical work supports both possibilities.
In “Does It Pay to Defend Against a Speculative Attack?” Barry Eichengreen and Andrew K. Rose compare the behavior of failed and successful
defenses of currency pegs. They show that the costs of unsuccessfully defending against an attack are large. They are equivalent to approximately
one year of economic growth: 3 percentage points of GNP in the year immediately following a crisis and roughly half that amount in the succeeding year. These losses are only evident for short periods. This finding helps
to account for a number of observations about the behavior of open
economies and their policy makers. Authorities have good reasons for defending currency pegs. International organizations tend to provide generous financial assistance to countries seeking to defend their currencies
against attack. Finally, it appears that the V-shaped pattern of recovery
from the Asian crisis is quite general—it is the prototypical response of output to a successful attack. These results are robust to the following sensitivity checks: (a) how tranquil versus crisis periods are defined; (b) inclusion

of capital control variables; (c) addition of financial variables, or external
sustainability variables (like foreign exchange reserves to debt, etc.); (d) exclusion of high inflation countries; and (e) exclusion of OECD countries.
The Program
In “The International Lender of Last Resort: How Large is Large
Enough?” Olivier Jeanne and Charles Wyplosz explore the idea that an international lender of last resort would be a useful addition to the international financial architecture. Could an international lender of last resort


4

Michael P. Dooley and Jeffrey A. Frankel

(ILOLR) function effectively as a fund with limited and predetermined resources? If so, how much resources would it need? Using a model of an
emerging economy that is vulnerable to international liquidity crises, the
authors find that the required size of the ILOLR depends on how its resources are used by the domestic authorities. If the ILOLR resources are
used to finance foreign exchange intervention by the domestic central bank,
the bad equilibrium is not removed, even by an arbitrarily large LOLR. If,
in contrast, the LOLR backs a guarantee of the foreign currency liabilities
of domestic banks, its resources do not need to be larger than the liquidity
gap in the domestic banking sector.
In “Rescue Packages and Output Losses Following Crises,” Michael P.
Dooley and Sujata Verma take on several issues. The first is analyzing the
role of the IMF in a game theoretic context. The key assumption is that
creditors cannot distinguish between nonpayment for liquidity reasons (liquidity defaults) and strategic defaults. In this environment, it may be optimal for creditors to precommit to imposing losses on the debtors by deliberately making the contracts difficult to renegotiate (this entails “excess
sanctions” from a first best perspective). In this framework the IMF can
have a role by facilitating negotiations so that the proceeds from the assets
can still be shared following default. The IMF can also serve a welfareimproving role if it possesses more information than the creditor does about
the state of nature facing the debtor.
A second major issue that is explored is why there are large output losses
postcrisis. Most first-generation models of currency crises do not predict
output losses. Second-generation (multiple-equilibrium) models might predict large output losses; and, in most such models, adding liquidity (increasing the size of the rescue packages) will reduce the output losses associated with crises. The explanation forwarded is an extension of Dooley’s

“insurance model.” Capital inflows are “insured” by governments. The extent of the inflow is a function of the amount of insurance available—reserves, liquid assets of the government, credit lines from other governments
and international institutions. Hence, in this framework, a crisis is the exchange of assets between the government and private investors. It is differentiated from a default by the fact that, in an uncertain world, guesses about
the extent of insurance may be too high. In this case the country must default, and real resources will have to be transferred. A corollary of this is
that the default durations will be linked to the size of the rescue packages.
The authors provide some empirical evidence suggesting that output losses
(a proxy for default durations) are indeed correlated with ex post rescue
packages.
In “Financial Restructuring in Banking and Corporate-Sector Crises:
What Policies to Pursue?” Stijn Claessens, Daniela Klingebiel, and Luc
Laeven examine a micro dataset for 700 companies in nine crisis countries
with the objective of identifying what policies are important in minimizing


Introduction

5

the costs of the crises. They find that liquidity support early in the crisis and
the use of a government-run asset management corporation (AMC) can
mitigate the severity of a financial crisis. On the other hand, government
guarantees of the banking system’s financial liabilities do not appear to be
helpful. Finally, the extent and quality of the legal framework are critical
factors in determining whether the financial system’s recovery from a financial shock is sustained and durable.
In “On the Fiscal Implications of Twin Crises,” A. Craig Burnside, Martin Eichenbaum, and Sergio Rebelo explore the implications of different
strategies for financing the fiscal costs of twin crises for rates of inflation and
currency depreciation. They use a first-generation-type model of speculative attacks that has four key features: (a) the crisis is triggered by prospective deficits; (b) there exists outstanding nonindexed government debt issued prior to the crises; (c) a portion of the government’s liabilities is not
indexed to inflation; and (d) there are nontradable goods and costs of distributing tradable goods, so that purchasing power parity does not hold.
The model can account for the high rates of devaluation and moderate rates
of inflation often observed in the wake of currency crises. Their analysis
suggests that the Mexican government is likely to pay for the bulk of the fiscal costs of its crisis through seigniorage revenues. In contrast, the Korean

government is likely to rely more on a combination of implicit and explicit
fiscal reforms.
In “An Evaluation of Proposals to Reform the International Financial
Architecture,” Morris Goldstein provides an assessment of some of the
leading reform proposals. He uses lending policies and practices of the IMF
as an organizing device for discussing selected issues in the reform debate,
namely, interest rate increases and reduction of IMF loan maturity, the size
of IMF packages, and issues of conditionality. The paper emphasizes the
importance of currency mismatches and argues that most of the antidotes
for currency mismatching problems proposed so far appear to be either too
costly or too drastic. Instead of such antidotes, the paper favors a combination of managed floating and active development of hedging mechanisms. Furthermore, it suggests that every request for an IMF program
should contain data on existing currency mismatching by the banking and
corporate sectors, analysis of the sustainability of these mismatches, and explicit conditions for reducing the mismatch.
The Impact
In “Recovery and Sustainability in East Asia,” Yung Chul Park and JongWha Lee analyze macroeconomic adjustment following the crisis in East
Asia from a broad international perspective. The stylized pattern that
emerges from the previous 160 currency crisis episodes shows a V-type adjustment of real gross domestic product (GDP) growth in the years prior to


6

Michael P. Dooley and Jeffrey A. Frankel

and following a crisis. The adjustment shows a much sharper V-type adjustment in the crisis episodes with an IMF program, compared to those
without. Cross-country regressions show that depreciation of real exchange
rate, expansionary macroeconomic policies, and favorable global environments are critical for the speedy postcrisis recovery. In this sense, the East
Asian process of adjustment is not much different from the previous currency crisis episodes.
However, the degree of initial contraction and following recovery has
been far greater in East Asia than what the cross-country evidence predicts.
This paper attributes the sharper adjustment pattern in East Asia to the severe liquidity crisis that was triggered by investors’ panic and then amplified by the weak corporate and bank balance sheets. They find no evidence

for a direct impact of currency crises on long-run growth.
In “A Cure Worse Than The Disease? Currency Crises and the Output
Costs of IMF-Supported Stabilization Programs,” Michael M. Hutchison
concludes that participation in an IMF program is associated with a 0.75
percentage point reduction in GDP growth. He notes, however, that the
growth slowdown usually precedes participation in an IMF program, suggesting that the relationship might not be causal. On the one hand, participation in an IMF-supported program following a balance-of-payments or
currency crisis does not appear to mitigate the output loss associated with
such events. On the other hand, Malaysia—the one crisis country in the
East Asian episode that did not have an IMF program—suffered more than
those countries with programs. Countries participating in IMF programs
significantly reduce domestic credit growth, while no effect is found on
budget policy. Applying this model to the collapse of output in East Asia
following the 1997 crisis, the author finds that the unexpected (forecast error) collapse of output in Malaysia—where an IMF program was not followed—was somewhat larger on average than in those countries adopting
IMF programs (Indonesia, Korea, the Philippines, and Thailand).
In “IMF and World Bank Structural Adjustment Programs and Poverty,” William Easterly argues that structural adjustment, as measured
by the number of adjustment loans from the IMF and World Bank, reduces
the sensitivity of poverty reduction to the rate of growth. Growth does reduce poverty, but he finds no evidence for a direct effect of structural adjustment on the average rate of growth. Instead, the poor benefit less from
output expansion in countries with many adjustment loans than in countries with few. By the same token, the poor suffer less from an output contraction in countries with many adjustment loans than in countries with few
adjustment loans. Why would this be? One hypothesis is that adjustment
lending is countercyclical in ways that smooth consumption for the poor.
There is evidence that some policy variables under adjustment lending are
countercyclical, but there is no evidence that the cyclical component of
those policy variables affects poverty. He speculates that the poor may be ill


Introduction

7

placed to take advantage of new opportunities created by structural adjustment reforms, just as they may suffer less from the loss of old opportunities

in sectors that were artificially protected prior to reforms.
In “Impacts of the Indonesian Economic Crisis: Price Changes and the
Poor,” James Levinsohn, Steven Berry, and Jed Friedman provide early estimates of the impact of the July 1997 Indonesian economic crisis on Indonesia’s poor. They find that price increases have affected the cost of living of poor households disproportionally. Just how hard the poor have been
hit, however, depends on where the household lives, on whether the household is in an urban or rural area, and on just how the cost of living is computed. What is clear is that the notion that the very poor are so poor as to
be insulated from international shocks is simply wrong. Rather, in the Indonesian case, the poor appear the most vulnerable.



I

The Defense



1
Interest Rates and Exchange Rates
in the Korean, Philippine, and Thai
Exchange Rate Crises
Dongchul Cho and Kenneth D. West

1.1 Introduction
A standard policy prescription in exchange rate crises is to tighten monetary policy, at least until the exchange rate has stabilized. Indeed, in the
East Asian countries whose currencies collapsed in 1997, interest rates were
raised, usually quite dramatically. For example, short-term rates rose from
12 to 30 percent in the space of a month in December 1997 in South Korea.
The successful recovery from the crisis may seem to vindicate this policy.
However, that is not clear. High interest rates weaken the financial position of debtors, perhaps inducing bankruptcies in firms that are debt constrained only because of informational imperfections. The countries might
have recovered, perhaps with less transitional difficulty, had an alternative,
less restrictive, policy been followed. This has been argued forcefully by, for
example, Furman and Stiglitz (1998) and Radelet and Sachs (1998).

There is mixed empirical evidence on the relationship between interest
and exchange rates, even for developed countries (Eichenbaum and Evans
1995; Grilli and Roubini 1996). For countries that have undergone currency
crises, Goldfajn and Gupta (1999) found that, on average, dramatic increases in interest rates have been associated with currency appreciations.
However, there was no clear association for a subsample of countries that
have undergone a banking crisis along with a currency crisis. This subsample includes the East Asian countries.
Dongchul Cho is a research fellow at the Korea Development Institute. Kenneth D. West is
professor of economics at the University of Wisconsin and a research associate of the National
Bureau of Economic Research.
The authors thank Akito Matsumoto, Mukunda Sharma, and Sungchul Hong for research
assistance, and Robert Dekle, Gabriel Di Bella, and conference participants for helpful comments. West thanks the National Science Foundation for financial support.

11


12

Dongchul Cho and Kenneth D. West

Papers that focus on the 1997 currency crises in East Asia also produce
mixed results. Representative results from papers using weekly or daily data
are as follows. Goldfajn and Baig (1998) decided that the evidence is mixed
but on balance favor the view that higher interest rates were associated with
appreciations in Indonesia, Korea, Malaysia, the Philippines, and Thailand. Cho and West (2000) concluded that interest rate increases led to exchange rate appreciation in Korea during the crisis. Dekle, Hsiao, and
Wang (2001) found sharp evidence that interest rate changes are reducedform predictors of subsequent exchange rate appreciations in Korea,
Malaysia, and Thailand, though with long and variable lags. Finally, Gould
and Kamin (2000) were unable to find a reliable relationship between interest rates and exchange rates in the five countries.
This paper conducts an empirical study of the relationship between exchange rates and interest rates during the 1997–98 exchange rate crises in
Korea, the Philippines, and Thailand. Our central question is: in these
economies, did exogenous monetary-policy-induced increases in the interest rate cause exchange rate depreciation or appreciation? Our central contribution is to propose a model that identifies a monetary policy rule, in a

framework general enough to allow either answer to our central question.
Our starting point is the observation that the sign of the correlation between exchange and interest rates—used in many previous studies to decide
whether an increase in interest rates causes an exchange rate appreciation—
will be sufficient to answer our question only if monetary policy shocks are
the dominant source of movements in exchange and interest rates. Since
shocks to perceived exchange rate risk are also arguably an important
source of variability during an exchange rate crisis, one must specify a
model that allows one to distinguish the effects of the two types of shocks.
We do so with a model that has two equations and is linear. One equation
is interest parity, with a time-varying risk premium. Importantly, we allow
the risk premium to depend on the level of the interest rate. The second
equation is a monetary policy rule, with the interest rate as the instrument.
The two variables in the model are the exchange rate and domestic interest
rate. These two variables are driven by two exogenous shocks, a monetary
policy shock and a shock to the component of the exchange rate risk premium not dependent on the level of the interest rate. The model has two key
parameters. One parameter (a) indexes how strongly the monetary authority leans against incipient exchange rate movements. The other parameter
(d ) indexes the sensitivity of exchange rate risk premiums to the level of interest rates.
Whether interest rates should be increased or decreased to stabilize a depreciating exchange rate depends on how sensitive risk premiums are to interest rates. Interest rates should be increased unless risk premiums are
strongly increasing with the level of the interest rate. This is the orthodox
policy. Interest rates should be lowered if risk premiums are strongly posi-