financial crisis jeffrey frankel harpel professor of capital formation & growth cutting edge of...

Financial CrisisFinancial Crisis

Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

Cutting Edge of Development Cutting Edge of Development ThinkingThinking

Harvard University, May 12, 2010Harvard University, May 12, 2010

2

OutlineOutlineEmerging Markets & Developing Emerging Markets & Developing

CountriesCountriesin the Global Financial Crisisin the Global Financial Crisis

The 3The 3rdrd capital inflow boom 2003-2008: capital inflow boom 2003-2008: Was it different?”Was it different?”

Lessons of 1994-2002 on avoiding crises: Lessons of 1994-2002 on avoiding crises: Did they hold up in 2008?Did they hold up in 2008?

Big emerging markets come of age in Big emerging markets come of age in 20092009 Macroeconomics: decouplingMacroeconomics: decoupling Global governance: the G-20 replaces the G-7Global governance: the G-20 replaces the G-7 The case of the RMB: sterilized intervention of The case of the RMB: sterilized intervention of

inflowsinflows AddendaAddenda

Global current account imbalancesGlobal current account imbalances Countercyclical fiscal policyCountercyclical fiscal policy

3

Cycle in capital flows to Cycle in capital flows to emerging marketsemerging markets

11stst developing country lending boom developing country lending boom (“recycling petro dollars”): 1975-1981(“recycling petro dollars”): 1975-1981 Ended in international debt crisis 1982Ended in international debt crisis 1982 Lean years (“Lost Decade”): 1982-1989Lean years (“Lost Decade”): 1982-1989

22ndnd lending boom (“emerging markets”): 1990-96 lending boom (“emerging markets”): 1990-96 Ended in East Asia crisis 1997Ended in East Asia crisis 1997 Lean years: 1997-2003Lean years: 1997-2003

33rdrd boom (incl. China & India this time): 2003-boom (incl. China & India this time): 2003-20082008 Global financial crisis of 2008-09Global financial crisis of 2008-09

4

This time, many countries used the This time, many countries used the inflowsinflows

to build upto build up forex reservesforex reserves, , rather rather thanthan

to finance to finance Current AccountCurrent Account deficits deficits

Net Capital Flow

Change in Reserves

Current Account Balance

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

% o

f G

DP

in % of GDP(Low- and

middle-income countries)

2003-07

boom1991-97

boom

5

Source: Benn Steil, Lessons of the Financial Crisis, CFR, March 2009

The financial crisis was abruptly transmitted to emerging markets in September 2008.

6

What characteristics have What characteristics have helped emerging markets helped emerging markets

resist financial contagion in resist financial contagion in the past?the past?

High FX reserves and/or floating currencyHigh FX reserves and/or floating currency Low foreign-denominated debt Low foreign-denominated debt (currency (currency

mismatch)mismatch) Low short-term debt Low short-term debt (maturity mis-match)(maturity mis-match) High Foreign Direct InvestmentHigh Foreign Direct Investment Strong initial budget, allowing room to Strong initial budget, allowing room to

ease.ease. High export/GDP ratio,High export/GDP ratio,

Sachs Sachs (1985);(1985); Eaton & Gersovitz Eaton & Gersovitz (1981),(1981), Rose Rose (2002); (2002);

Calvo, Izquierdo & Talvi Calvo, Izquierdo & Talvi (2003);(2003); Edwards ( Edwards (AER,AER, 2004); 2004); Cavallo & Frankel Cavallo & Frankel ((JIMFJIMF, 2008)., 2008).

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Are big current account deficits dangerous?Neoclassical theory – if a country has a low capital/labor ratio or transitory negative shock, a large CAD can be optimal.

In practice – Developing countries with big CADs often get into trouble.Traditional rule of thumb: “CAD > approx. 4% GDP” is a danger signal.

“Lawson Fallacy” – CAD not dangerous if government budget is balanced, so borrowing goes to finance private sector, rather than BD.

Amendment after 1994 Mexico crisis – CAD not dangerous if BD=0 and S is high, so the borrowing goes to finance private I, rather than BD or C.

Amendment after 1997 East Asia crisis –CAD not dangerous if BD=0, S is high, and I is well-allocated, so the borrowing goes to finance high-return I, rather than BD or C or empty beach-front condos (Thailand) & unneeded steel companies (Korea).

Amendment after 2008 financial crisis – yes, all CADs are dangerous.

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Lessons of the 1994-2002 Lessons of the 1994-2002 crisescrises

Many emerging markets after the 1990s Many emerging markets after the 1990s learned tolearned to (1) float or hold large reserves (1) float or hold large reserves or bothor both (2) use capital inflows to finance reserve (2) use capital inflows to finance reserve

accumulation accumulation (“self-insurance”),(“self-insurance”), rather than current account deficits rather than current account deficits

(3) take capital inflows more in the form of FDI (3) take capital inflows more in the form of FDI or local-currency-denominated debt flows; or local-currency-denominated debt flows;

avoiding the currency mismatch of $ liabilities avoiding the currency mismatch of $ liabilities and avoiding short-term bank loans.and avoiding short-term bank loans.

The ratio of reserves to short-term debt is the The ratio of reserves to short-term debt is the most robust predictor of crisis likelihood & most robust predictor of crisis likelihood & severity. severity. e.g. the Guidotti Rule: Keep ratio >1e.g. the Guidotti Rule: Keep ratio >1

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Early Warning Indicators: Early Warning Indicators: Some references on statistical Some references on statistical

predictors of crises among developing predictors of crises among developing countriescountries

• Jeffrey Sachs, Aaron Tornell & Andres Velasco, “Financial Crises in Emerging Markets: The Lessons from 1995” (1996):

Combination of weak fundamentals (changes RER or credit/GDP) and low reserves (relative to M2) made countries vulnerable to tequila contagion.

• J. Frankel & Andrew Rose, "Currency Crashes in Emerging Markets" (1996): Composition of capital inflow matters (more than the total): short-term bank debt raises the probability of crash; FDI & reserves lower the probability.

•Graciela Kaminsky, Saul Lizondo & Carmen Reinhart, “Leading Indicators of Currency Crises” (1998).

Best predictors: Real ex. rate, M2/Res, GDP, equity prices.

•A.Berg, E. Borensztein, G.M.Milesi-Ferretti, & C.Pattillo, “Anticipating Balance of Payments Crises: The Role of Early Warning Systems,” IMF (1999).

The early warning indicators don’t hold up as well out-of-sample.

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Did those who obeyed the lessons of Did those who obeyed the lessons of 1994-2002 done better in response 1994-2002 done better in response

to the 2008-09 shock?to the 2008-09 shock? Some who had large current account deficits & Some who had large current account deficits &

foreign-currency debts did have the most foreign-currency debts did have the most trouble,trouble, particularly in Central & E.Europe: particularly in Central & E.Europe:

Hungary, Ukraine, Latvia… Hungary, Ukraine, Latvia… Despite views of some economists that emerging Despite views of some economists that emerging

market countries had been holding too many market countries had been holding too many reserves, reserves, they appear to have turned out the ultimate they appear to have turned out the ultimate insurance.insurance. Aizenman (Aizenman (2009):2009): “ “The deleveraging triggered by the crisis The deleveraging triggered by the crisis

implies that countries that hoarded reserves have been implies that countries that hoarded reserves have been reaping the benefits.”reaping the benefits.”

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Systematic studies are only Systematic studies are only starting.starting.

Obstfeld, Shambaugh & Taylor (2009a, b):Obstfeld, Shambaugh & Taylor (2009a, b): Finding: A particular measure of countries’ reserve Finding: A particular measure of countries’ reserve

holdings just before the current crisis, holdings just before the current crisis, relative to relative to requirements (M2),requirements (M2), predicts 2008 depreciation. predicts 2008 depreciation.

Current account balances & short-term debt levels are Current account balances & short-term debt levels are notnot statistically significant predictors, once reserve statistically significant predictors, once reserve levels are taken into account. levels are taken into account.

Rose & Spiegel (2009a, b) and Blanchard Rose & Spiegel (2009a, b) and Blanchard (2009) found no role for reserves in (2009) found no role for reserves in predicting who got into trouble.predicting who got into trouble.

Frankel & Saravelos (May 2010): Frankel & Saravelos (May 2010): We get stronger results, because we We get stronger results, because we consider crisis period to have gone thru consider crisis period to have gone thru March 2009.March 2009.

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Table 1

Leading Indicator1 KLR

(1998) 2

Hawkins & Klau (2001)3

Abiad (2003)4,6

Others5,

6 Total

Reserves a 14 18 13 5 50

Real Exch.Rate b 12 22 11 3 48

GDP c 6 15 1 3 25

Credit d 5 8 6 3 22

Current Acct. e 4 10 6 2 22

Money Supply f 2 16 1 0 19

Exports or Imports 1a, g 2 9 4 2 17

Inflation 5 7 1 2 15

Top 8 categories of Leading Indicators in pre-2008-crisis literatureFrankel & Saravelos (2010)Frankel & Saravelos (2010)

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Table 1, continued

Leading Indicator1 KLR

(1998) 2

Hawkins & Klau (2001)3

Abiad (2003)4,6 Others5,6 Total

Next 9 categories of Leading Indicators in pre-2008-crisis literature

Frankel & Saravelos (2010)Frankel & Saravelos (2010)

Equity Returns 1 8 3 1 13

Real Interest Rateh 2 8 2 1 13

Debt Compositn1b, i 4 4 2 0 10

Budget Balance 3 5 1 0 9

Terms of Trade 2 6 1 0 9

Contagionj 1 5 0 0 6

Political/Legal 3 2 1 0 6

Capital Flows1c, k 3 0 0 0 3

External Debtl 0 1 1 1 3

Number of Studies 28 28 20 7 83

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NotesFrankel & Saravelos Frankel & Saravelos (2010)(2010)

1, 1a, 1b, 1c Leading indicator categories as in Hawkins & Klau (2000), with exception of 1aincludes imports, 1bdebt composition rather than debt to international banks, 1ccapital flows rather than capital account.2As reported in Hawkins & Klau (2000), but M2/reserves added to reserves, interest differential added to real interest rate. 3S&P, JP Morgan, IMF Indices, IMF Weo, IMF ICM, IMF EWS studies have been excluded due to lack of verifiability of results. The following adjustments have been made to the authors’ checklist: significant credit variables reduced from 10 to 8 as Kaminsky (1999) considers level rather than growth rate of credit; significant capital account variables reduced from 1 to 0 as Honohan (1997) variable not in line with definition used here; Kaminsky (1999) significant variables for external debt reclassified to debt composition as these variables relate to short-term debt.410 out of 30 studies excluded from analysis. 7 included in Hawkins & Klau (2000) and 3 due to absence of formal testing of variables.5Includes Berg, Borenzstein and Pattillo (2004), Manasse and Roubini (2005), Shimpalee and Breuer (2006), Davis and Karim (2008), Bergmen et.al. (2009), Obstfeld, Shambaugh and Taylor (2009), Rose and Speigel (2009a).6See App. 1 for criteria defining statistical significance in Abiad (2003) and Others studies. For rest see KLR (1998), Hawkins & Klau (2001)

Variables included in the leading indicator categories:aReserves: relative to GDP, M2, short-term debt, 12m change hReal Interest Rate: domestic or differential

bReal Exchange Rate: change, over/under valuation iDebt Composition: commercial/concess./variable-rate/debt to internat. banks/short-term/multilat./official relative to total external debt. Short-term debt relative to reserves (rather than relative to total external debt) is in the reserves category

cGDP: growth, level, output gap

dCredit: nominal or real growth

eCurrent Account: CA/GDP, Trade Balance/GDP jContagion: dummies for crisis elsewhere

fMoney Supply: growth rate, excess M1 balances kCapital Flows: FDI, short-term capital flows

gExports or Imports: relative to GDP, growth lExternal Debt: relative to GDP

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Equity prices suggest that the global Equity prices suggest that the global financial crisis did not begin in financial crisis did not begin in

earnest until Sept. 2008, earnest until Sept. 2008, nor end until March 2009 --nor end until March 2009 --

whereas Rose & Spiegel, Obstfeld et al, look whereas Rose & Spiegel, Obstfeld et al, look simply at 2008simply at 2008

0

200

400

600

800

1000

1200

1400

1600

1800

Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09

80

85

90

95

100

105

110

115

120

MSCI EM (lhs)MSCI World (lhs)Fed Broad Trade Weighted Dollar (rhs, inverted)

Sep 15th, 2008 Mar 5th, 2009

16

Best and Worst Performing CountriesBest and Worst Performing Countries -- -- F&S (2010), Appendix 4F&S (2010), 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

17


Industrial Production Change, Q2 2008 to Q2 2009

-40% -30% -20% -10% 0% 10% 20%

China

India

J ordan

Kazakhstan

Ireland

Indonesia

Switzerland

Korea, Rep.

Nicaragua

Mauritius

Hungary

Slovak Republic

Finland

Slovenia

Italy

Sweden

J apan

Ukraine

Estonia

Luxembourg

Top 10

Bottom 10


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Change in Local Currency vs USD, 15 Sep 08 to 5 Mar09

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

Syrian Arab Republic

J apan

Azerbaijan

Lao PDR

Haiti

Macao, China

Hong Kong, China

Bolivia

Honduras

China

Russian Federation

Serbia

Congo, Dem. Rep.

Turkey

Hungary

Mexico

Zambia

Poland

Ukraine

Seychelles

Top 10

Bottom 10


19


-5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0

Ecuador

China

Venezuela, RB

Bangladesh

Colombia

Morocco

Brazil

Chile

Botswana

Tunisia

Oman

Slovenia

Serbia

Estonia

Latvia

Bahrain

Italy

Lithuania

Croatia

Bulgaria

Annualized Returns/Standard Deviation of Benchmark Stock Index,

15 Sep 08 to 5 Mar09

Top 10

Bottom 10


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Table Appendix 6

Coefficients of Bivariate Regressions of Crisis Indicators on Each Independent Variable* (t-stat in parentheses)bolded number indicates statistical signficance at 10% level or lower, darker color shading equivalent to higher statistical significance

Currency Market

Equity Market

Recourse to IMF

Industrial Production

GDPSignificant and

Consistent Sign?^

Independent Variable

Reserves (% GDP)0.082 (2.52)

0.850 (1.6)

-1.020 (-1.92)

0.155 (2.22)

0.008 (0.27)

Yes

Reserves (% external debt)-0.000 (-1.42)

0.000 (2.11)

-0.010 (-3.42)

0.000 (3.62)

0.000 (3.07)

Yes

Reserves (in months of imports)0.002 (1.58)

0.103 (4.71)

-0.089 (-3.31)

0.006 (1.48)

0.001 (0.75)

Yes

M2 to Reserves0.000 (0.14)

-0.026 (-3.81)

-0.067 (-1)

-0.001 (-2.46)

0.000 (1.44)

Yes

Short-term Debt (% of reserves)-0.000 (-2.6)

-0.007 (-4.45)

0.000 (1.18)

-0.000 (-1.7)

-0.000 (-2.93)

Yes

REER (5-yr % rise)-0.293 (-5.4)

-0.303 (-0.32)

0.889 (0.99)

-0.000 (-0.01)

-0.029 (-0.85)

REER (Dev. from 10-yr av)-0.292 (-2.93)

-0.920 (-0.81)

0.671 (0.58)

-0.000 (-0.01)

-0.041 (-0.91)

GDP growth (2007, %)0.003 (1.7)

0.078 (1.58)

0.039 (1.63)

0.010 (2.59)

-0.002 (-1.21)

Yes

GDP Growth (last 5 yrs)0.002 (1.08)

0.118 (2.14)

0.052 (1.68)

0.009 (2.14)

-0.003 (-1.21)


0.087 (1.06)

0.042 (1.2)

0.016 (2.63)

-0.004 (-0.76)

GDP per capita (2007, constant 2000$)-0.003 (-0.7)

-0.296 (-4.69)

-0.221 (-3.23)

-0.027 (-2.48)

-0.010 (-1.74)

Change in Credit (5-yr rise, % GDP)-0.029 (-0.83)

-1.979 (-5.42)

0.139 (0.37)

-0.092 (-1.67)

-0.065 (-2.34)

Yes


-0.904 (-3.9)

-0.011 (-0.08)

-0.046 (-1.58)

-0.019 (-1.13)

Yes

Credit Depth of Information Index (higher=more)-0.005 (-1.34)

-0.115 (-1.72)

0.009 (0.19)

0.006 (0.57)

-0.003 (-0.47)

Bank liquid reserves to bank assets ratio (%)0.000 (1.52)

0.022 (1.51)

-0.000 (-13.97)

0.002 (2.34)

0.001 (2.58)

Yes

Current Account (% GDP)0.001 (1.57)

0.032 (2.18)

-0.032 (-3.46)

0.000 (0.42)

0.000 (0.78)

Yes

Current Account, 5-yr Average (% GDP)0.001 (1.31)

0.030 (1.66)

-0.032 (-2.76)

0.000 (0.53)

0.000 (0.42)


0.034 (1.46)

-0.038 (-2.63)

0.000 (0.15)

0.001 (1.59)

Net National Savings (% GNI)0.000 (0.9)

0.048 (4.5)

-0.020 (-1.88)

0.003 (2.42)

0.002 (2.92)

Yes

Gross National Savings (% GDP)0.000 (0.76)

0.047 (3.9)

-0.028 (-2.51)

0.003 (1.99)

0.002 (2.52)

Yes

Change in M3 (5-yr rise, % GDP)0.000 (0.16)

-0.018 (-1.41)

-0.001 (-0.14)

-0.002 (-1.49)

-0.001 (-1.05)


-0.023 (-1.5)

0.007 (0.63)

-0.002 (-1.14)

-0.001 (-0.91)

Trade Balance (% GDP)0.000 (0.44)

0.013 (1.2)

-0.018 (-2.38)

-0.000 (-0.78)

0.000 (0.01)

Exports (% GDP)0.000 (0.2)

-0.004 (-1.42)

-0.004 (-1.08)

-0.000 (-1.21)

-0.000 (-1.42)

Imports (% GDP)-0.000 (-0.04)

-0.007 (-1.67)

0.003 (1.01)

-0.000 (-1.18)

-0.000 (-1.46)

Inflation (average, last 5 yrs)0.000 (0.36)

0.080 (3.33)

-0.000 (-2.91)

0.003 (1)

-0.000 (-0.23)

Yes

Inflation (average, last 10 yrs)-0.000 (-1.25)

0.038 (1.81)

-0.000 (-0.92)

0.000 (0.03)

0.000 (0.31)

Stock Market (5 yr % change)-0.004 (-1.05)

0.022 (0.99)

0.046 (1.04)

0.001 (0.37)

-0.000 (-0.14)

Stock Market (5 yr return/st. dev.)-0.012 (-0.59)

-0.166 (-0.74)

0.436 (1.47)

-0.005 (-0.22)

-0.004 (-0.2)

Real Interest Rate-0.000 (-0.46)

0.036 (3.18)

0.006 (0.36)

0.001 (0.87)

0.004 (2.07)

Yes

Deposit Interest Rate-0.005 (-2.08)

0.107 (2.84)

0.001 (0.18)

0.002 (0.99)

-0.000 (-0.49)

Short-term Debt (% of exports)-0.000 (-0.88)

-0.023 (-3.66)

0.000 (0.09)

-0.000 (-2.03)

-0.001 (-3.99)

Yes

Short-term Debt (% of external debt)-0.001 (-1.41)

-0.014 (-0.64)

0.001 (0.18)

-0.000 (-0.2)

-0.000 (-0.26)

Public Debt Service (% of exports)0.001 (3.3)

0.022 (0.85)

-0.004 (-0.44)

-0.001 (-0.76)

0.003 (1.41)

Public Debt Service (% GNI)0.001 (3.02)

-0.010 (-0.33)

-0.031 (-0.83)

-0.005 (-0.68)

0.008 (1.1)

Multilateral Debt Service (% Public Debt Service)0.000 (1.41)

-0.001 (-0.2)

0.004 (1)

0.000 (0.97)

0.000 (0.65)

Aid (% of GNI)0.000 (2.67)

-0.019 (-0.93)

0.001 (0.18)

0.002 (1.09)

-0.001 (-0.09)

Financing via Int. Cap. Markets (gross, % GDP)0.000 (0.79)

-0.026 (-1.1)

-0.003 (-0.45)

0.001 (0.39)

-0.008 (-2.61)

Legal Rights Index (higher=more rights)-0.009 (-2.71)

-0.125 (-2.58)

-0.040 (-0.91)

-0.006 (-1.45)

-0.005 (-1.8)

Yes

Business Extent of Disclosure Index (higher=more disclosure)

-0.005 (-1.61)

-0.009 (-0.18)

-0.023 (-0.62)

0.006 (1.38)

0.002 (1.15)

Portfolio Flows (% GDP)-0.499 (-2.92)

0.344 (0.11)

1.433 (0.55)

0.726 (1.38)

-0.474 (-0.57)

FDI net inflows (% GDP)-0.000 (-0.67)

-0.003 (-3.73)

0.000 (0.2)

-0.000 (-15.13)

-0.000 (-1.52)

Yes

FDI net outflows (% GDP)0.000 (0.24)

0.002 (5.59)

0.001 (0.61)

0.000 (13.09)

0.000 (1.31)

Yes

Net FDI (% GDP)-0.000 (-0.05)

0.004 (0.97)

0.004 (0.43)

0.001 (7.06)

-0.000 (-0.05)

External Debt Service (% GNI)0.000 (0.76)

-0.058 (-2.39)

-0.007 (-0.65)

-0.001 (-0.74)

-0.005 (-6.32)

Yes

Present Value of External Debt (% exports)0.000 (0.31)

-0.007 (-3.99)

-0.000 (-0.08)

-0.000 (-1.67)

-0.000 (-2.77)

Yes

Present Value of External Debt (% GNI)0.000 (0.11)

-0.014 (-3.7)

-0.000 (-0.61)

-0.000 (-1.29)

-0.000 (-4.77)

Yes

Peg (1 = peg)0.057 (3.41)

-0.577 (-2.47)

-0.363 (-1.48)

-0.053 (-2.17)

-0.021 (-1.55)

Financial Openness (0=open)0.023 (1.34)

0.899 (4.56)

0.230 (1.03)

0.085 (1.6)

0.020 (0.63)

M3 (% GDP)0.000 (4.76)

-0.001 (-0.57)

-0.020 (-4.06)

0.000 (0.81)

0.000 (1.52)

Yes

M2 (% GDP)0.000 (4.21)

-0.001 (-0.59)

-0.019 (-3.88)

0.000 (0.63)

0.000 (1.43)

Yes

Domestic Credit (% GDP)0.012 (0.84)

-0.626 (-4.24)

-0.881 (-4.2)

-0.016 (-0.86)

0.004 (0.45)

Domestic Credit Provided by Banks (% GDP)0.000 (1.09)

-0.005 (-3.59)

-0.009 (-4.44)

-0.000 (-1.14)

0.000 (0.51)

Domestic Credit to Priv. Sector (% GDP)0.000 (0.58)

-0.006 (-4.92)

-0.014 (-4.19)

-0.000 (-1.03)

-0.000 (-0.32)

Market Cap of Listed Companies (% GDP)0.000 (1.86)

0.000 (0.28)

-0.010 (-1.91)

0.000 (0.45)

0.000 (1.66)

Yes

Euro Area-0.009 (-1.06)

-0.901 (-4.9)

--0.055 (-2.29)

-0.006 (-0.68)

Yes

Low Income Country0.021 (1.16)

0.729 (2.45)

0.376 (1.54)

- -

Middle Income-0.025 (-1.58)

0.821 (3.7)

0.398 (1.85)

0.067 (3.19)

0.017 (1.17)

Upper Income0.013 (0.86)

-0.982 (-4.83)

-1.079 (-3.27)

-0.067 (-3.19)

-0.017 (-1.17)

OECD-0.042 (-2.29)

-0.709 (-3.69)

-0.478 (-1.27)

-0.051 (-2.39)

-0.005 (-0.47)

Yes

South Asia0.063 (3.63)

0.799 (2.71)

0.185 (0.4)

0.195 (17.65)

0.015 (0.37)

Yes

Europe & Central Asia-0.078 (-4.9)

-1.038 (-5.13)

0.306 (1.34)

-0.071 (-3.45)

-0.052 (-4.29)

Yes

Middle East & North Africa0.074 (4.18)

0.092 (0.31)

-0.673 (-1.39)

0.058 (2.03)

0.074 (5.63)

Yes

East Asia & Pacific0.017 (0.8)

0.494 (1.75)

-0.953 (-2.12)

0.056 (1.55)

0.038 (2.64)

Yes

Sub-Saharan Africa-0.049 (-2.12)

0.549 (2.79)

0.513 (2.17)

0.068 (5.93)

0.017 (2.47)

Latin America & Carribean0.024 (0.94)

-0.634 (-1.53)

-0.320 (-0.81)

-0.018 (-0.73)

-0.046 (-1.82)

North America0.016 (0.26)

-1.003 (-5.2)

--0.027 (-2.25)

0.006 (0.91)

Yes

*OLS with heteroscedaticity robust standard errors performed for four continuous variables; probit for IMF recourse variable^At least two statistically signficant coefficients, of which all must have consistent sign (consistent = same sign, with exception of coefficient on IMF recourse variable, which should have opposite sign)

CAPITAL

FLOWS

EXT DEBT

INCOME

REGI

ON

FINANCIAL MKT

DEVELOPMENT

RESERVES

REER

GDP

CURRENT

ACCOUNT

TRADE

INFL.

DEBT COMPOSITI

ON

INT

RATE

CREDIT

STOCK

MKT

MONEY

F & Saravelos (2010): Bivariate

21

Exchange Market

Pressure

Currency % Changes

(H208-H109

Recourse to IMF

(SBA only)

Equity %Chng (Sep08-Mar09)

Equity % Chng

(H208-H109)

Significant and

Consistent Sign?^

Independent Variable

Reserves (% GDP)0.164 (3.63)

0.087 (2.98)

-1.069 (-1.66)

0.011 (0.12)

0.010 (0.14)

Yes

Reserves (% external debt)0.000 (1.06)

0.000 (1.1)

-0.006 (-2.29)

0.000 (1.81)

0.000 (2.65)

Yes

Reserves (in months of imports)0.004 (2.25)

0.003 (1.95)

-0.119 (-3.01)

0.006 (1.32)

0.009 (2.32)

Yes

M2 to Reserves0.000 (0.27)

0.000 (0.76)

-0.044 (-0.91)

0.000 (0.02)

-0.000 (-0.09)

Short-term Debt (% of reserves)-0.000 (-1.97)

-0.000 (-4.22)

0.000 (2.13)

-0.001 (-2.89)

-0.001 (-3.11)

Yes

REER (5-yr % rise)-0.440 (-5.55)

-0.210 (-3.19)

1.728 (2.15)

-0.182 (-1.24)

-0.185 (-1.61)

Yes

REER (Dev. from 10-yr av)-0.475 (-3.96)

-0.230 (-2.47)

2.654 (2.56)

-0.316 (-1.71)

-0.316 (-2.1)

Yes

GDP growth (2007, %)-0.000 (-0.2)

0.001 (0.94)

0.070 (2.58)

-0.001 (-0.1)

-0.007 (-0.71)

GDP Growth (last 5 yrs)-0.003 (-0.81)

0.000 (0.26)

0.084 (2.4)

-0.003 (-0.26)

-0.014 (-1.15)


0.001 (0.43)

0.064 (1.66)

-0.012 (-0.67)

-0.020 (-1.12)


-0.035 (-0.98)

0.552 (1.02)

-0.274 (-2.97)

-0.248 (-4.13)

Yes


-0.011 (-1.05)

0.210 (1.03)

-0.089 (-1.65)

-0.089 (-2.35)

Credit Depth of Information Index (higher=more)-0.008 (-1.06)

0.000 (0.05)

0.224 (2.4)

-0.006 (-0.37)

-0.018 (-1.33)

Bank liquid reserves to bank assets ratio (%)0.000 (3.84)

0.000 (0.5)

-0.000 (-11.44)

-0.002 (-0.54)

-0.002 (-0.79)

Yes

Current Account (% GDP)0.001 (1.48)

0.002 (2.7)

-0.023 (-2.09)

0.009 (3.84)

0.007 (3.95)

Yes


0.001 (1.82)

-0.025 (-1.72)

0.007 (2.4)

0.006 (2.74)

Yes


0.002 (1.39)

-0.035 (-2.11)

0.008 (2.21)

0.007 (2.44)

Yes

Net National Savings (% GNI)0.002 (1.6)

0.001 (2.33)

-0.013 (-1.22)

0.006 (2.92)

0.004 (2.28)

Yes

Gross National Savings (% GDP)0.003 (2.01)

0.001 (2.53)

-0.015 (-1.36)

0.008 (3.42)

0.006 (3.03)

Yes


-0.000 (-0.16)

-0.000 (-0.08)

-0.004 (-1.08)

-0.004 (-2.79)


-0.000 (-0.29)

0.006 (0.51)

-0.005 (-1.25)

-0.006 (-2.86)

Trade Balance (% GDP)0.001 (1.73)

0.001 (1.78)

-0.014 (-1.51)

0.006 (2.72)

0.003 (1.97)

Yes

Exports (% GDP)0.000 (0.93)

0.000 (1.97)

-0.002 (-0.53)

0.000 (0.02)

-0.000 (-0.83)

Imports (% GDP)-0.000 (-0.15)

0.000 (0.57)

0.002 (0.79)

-0.000 (-0.73)

-0.000 (-1.36)


-0.001 (-0.75)

0.094 (3.4)

0.000 (0.01)

0.002 (0.26)

Yes


-0.001 (-1.54)

0.017 (2.04)

-0.000 (-0.16)

0.000 (0.18)

Yes

Stock Market (5 yr % change)-0.006 (-0.86)

-0.006 (-1.34)

0.035 (0.74)

-0.016 (-3.72)

-0.018 (-5.59)

Yes

Stock Market (5 yr return/st.dev.)0.010 (0.31)

-0.024 (-1.02)

-0.394 (-1.17)

-0.097 (-1.92)

-0.042 (-0.93)

Real Interest Rate-0.001 (-0.79)

-0.000 (-0.42)

-0.022 (-1.05)

0.005 (1.81)

0.004 (1.85)

Yes

Deposit Interest Rate-0.014 (-4.43)

-0.003 (-1.72)

0.058 (1.78)

0.019 (3.33)

0.009 (1.39)

Short-term Debt (% of exports)-0.000 (-0.04)

-0.000 (-1.43)

0.000 (0.36)

-0.004 (-3.28)

-0.003 (-2.82)

Yes

Short-term Debt (% of external debt)-0.001 (-1.41)

-0.001 (-2.1)

0.009 (1.17)

-0.001 (-0.34)

-0.000 (-0.03)

Public Debt Service (% of exports)0.002 (3.04)

0.000 (1.18)

-0.036 (-1.14)

0.008 (1.22)

0.005 (0.98)

Public Debt Service (% GNI)0.001 (2.37)

0.000 (0.97)

-0.050 (-0.71)

0.003 (0.33)

0.002 (0.3)

Multilateral Debt Service (% Public Debt Service)0.001 (1.77)

0.000 (0.52)

0.001 (0.17)

-0.001 (-1.05)

0.000 (0.01)

Aid (% of GNI)0.002 (2.81)

0.000 (1.22)

-0.141 (-3.23)

-0.007 (-0.77)

-0.001 (-0.15)

Yes

Financing via Int. Cap. Markets (gross, % GDP)-0.000

(0)-0.000 (-0.48)

-0.011 (-0.57)

-0.012 (-2.14)

-0.005 (-1)

Legal Rights Index (higher=more rights)-0.009 (-1.49)

-0.006 (-1.46)

0.008 (0.15)

-0.017 (-1.52)

-0.015 (-1.78)

Business Extent of Disclosure Index (higher=more disclosure)

-0.002 (-0.39)

-0.001 (-0.32)

-0.024 (-0.52)

-0.001 (-0.13)

-0.000 (-0.1)

Portfolio Flows (% GDP)-0.616 (-2.88)

-0.435 (-3.33)

2.090 (0.74)

-0.979 (-0.77)

-0.889 (-0.77)

Yes

FDI net inflows (% GDP)-0.000 (-2.05)

-0.000 (-0.87)

-0.000 (-0.04)

-0.000 (-2.57)

-0.000 (-2.05)

Yes

FDI net outflows (% GDP)0.000 (1.8)

0.000 (0.81)

-0.000 (-0.45)

0.000 (3.38)

0.000 (2.84)

Yes

Net FDI (% GDP)0.001 (1.15)

0.000 (0.44)

-0.002 (-0.27)

-0.000 (-0.13)

-0.000 (-0.27)

External Debt Service (% GNI)0.000 (0.91)

0.000 (0.05)

-0.000 (-0.04)

-0.016 (-5.11)

-0.013 (-4.87)

Yes

Present Value of External Debt (% exports)0.000 (0.08)

-0.000 (-0.38)

-0.000 (-0.06)

-0.001 (-3.55)

-0.001 (-3.92)

Yes

Present Value of External Debt (% GNI)0.000 (0.16)

-0.000 (-0.82)

0.000 (0.38)

-0.003 (-4.39)

-0.002 (-3.8)

Yes

Peg (1 = peg)0.100 (3.89)

0.055 (3.34)

-0.577 (-1.89)

-0.075 (-1.67)

-0.041 (-1.04)

Yes

Financial Openness (0=open)0.083 (2.76)

0.023 (1.16)

-0.587 (-1.72)

0.059 (0.68)

0.003 (0.05)

Yes

M3 (% GDP)0.001 (4.12)

0.000 (4.47)

-0.020 (-3.45)

0.000 (0.31)

-0.000 (-0.22)

Yes

M2 (% GDP)0.001 (4.24)

0.000 (4.78)

-0.022 (-3.43)

0.000 (0.4)

-0.000 (-0.03)

Yes

Domestic Credit (% GDP)0.040 (1.53)

0.009 (0.61)

-0.593 (-2.66)

-0.010 (-0.22)

-0.027 (-0.62)

Domestic Credit Provided by Banks (% GDP)0.000 (1.81)

0.000 (1.52)

-0.006 (-3.17)

-0.000 (-0.21)

-0.000 (-0.55)

Yes

Domestic Credit to Priv. Sector (% GDP)0.000 (1.87)

0.000 (1.51)

-0.012 (-3.13)

-0.000 (-0.5)

-0.000 (-0.87)

Yes

Market Cap of Listed Companies (% GDP)0.000 (1.65)

0.000 (2.01)

-0.006 (-1.41)

0.000 (1.35)

0.000 (1.47)

South Asia0.045 (0.81)

0.045 (2.12)

0.476 (0.99)

0.158 (1.81)

0.033 (0.54)

Yes

Europe & Central Asia-0.150 (-4.43)

-0.095 (-5.61)

0.636 (2.09)

-0.202 (-4.43)

-0.167 (-4.64)

Yes

Middle East & North Africa0.080 (2.7)

0.061 (2.86)

-0.003 (0.05)

0.049 (0.84)

Yes

East Asia & Pacific0.071 (2.71)

0.034 (1.58)

-0.629 (-1.34)

0.135 (2.63)

0.054 (1.08)

Yes

Sub-Saharan Africa-0.006 (-0.14)

-0.024 (-0.83)

-0.424 (-0.98)

-0.068 (-0.89)

0.047 (0.72)

Latin America & Carribean-0.014 (-0.23)

-0.013 (-0.39)

0.205 (0.47)

-0.049 (-0.84)

-0.048 (-0.93)

North America0.061 (0.92)

0.041 (0.91)

-0.030 (1.1)

0.024 (0.95)

*OLS with heteroscedasticity robust standard errors performed for four continuous variables; probit for IMF recourse variable^At least two statistically signficant coefficients, of which all must have consistent sign (consistent = same sign, with exception of coefficient on IMF recourse variable, which should have opposite sign)

RESERVES

REER

GDP

CURRENT

ACCOUNT

CREDIT

MONEY

STOCK

MKT

TRADE

INFL.

DEBT COMPOSITI

ON

INT

RATE

CAPITAL

FLOWS

EXT DEBT

REGI

ON

FINANCIAL MKT

DEVELOPMENT

F & Saravelos (2010): Multivariate

Table Appendix 7

Coefficients of Regressions of Crisis Indicators on Each Independent Variable and GDP per Capita* (t-stat in parentheses)bolded number indicates statistical signficance at 10% level or lower

22

Actual versus Predicted Incidence of Actual versus Predicted Incidence of 2008-09 Crisis2008-09 Crisis

Frankel & Saravelos (2010)Frankel & Saravelos (2010)

AlgeriaAustralia

BoliviaBulgaria

Burundi

CanadaChile

China

Colombia

Costa Rica

Croatia

Czech Rep.

Denmark

Dom. Republic

Finland

France

Gabon

Gambia

Georgia

Germany Greece

Guyana

HungaryIceland

IrelandIsrael Italy

Japan

Luxembourg

Malawi

Malaysia

Morocco

Netherlands

New Zealand

Nicar

Nigeria

Norway

Pakistan

Paraguay

Philippines

Poland

Portugal

RomaniaRussia

Saudi ArabiaSingapore

Slovakia

S. Africa

St. Lucia

Sweden

Switzerland

UK

US

UruguayVenezuela

Predicted Resilience to Crisis

Act

ua

l Re

sili

en

ce t

o C

risi

s

lessresilient

more resilient

more resilient

23

Conclusions fromConclusions fromFrankel & Saravelos Frankel & Saravelos (May 2010)(May 2010)

Early Warning Indicators Early Warning Indicators werewere useful in useful in predicting which countries were hit by the predicting which countries were hit by the 2008-09 global financial shock,2008-09 global financial shock,

especially the most tried-and-trued EWIs:especially the most tried-and-trued EWIs: Reserves Reserves

(e.g., as a ratio to short-term debt),(e.g., as a ratio to short-term debt), Preceding real exchange rate Preceding real exchange rate

appreciationappreciation(relative to a long-run average RER).(relative to a long-run average RER).

Among others that do the best: CA & Natl. Among others that do the best: CA & Natl. SavingSaving

24

Big emerging marketsBig emerging markets

25

Big emerging markets Big emerging markets came of age in 2009came of age in 2009

Macroeconomics: Macroeconomics: decouplingdecoupling

Global governance: Global governance: the G-20 replaces the G-7the G-20 replaces the G-7

The RMB issueThe RMB issue

26

De-coupling turned out to be De-coupling turned out to be real after allreal after all

at least with respect to East Asia, at least with respect to East Asia, which has rebounded very strongly over the last which has rebounded very strongly over the last year,year, after a sharp loss of exports over the preceding year,after a sharp loss of exports over the preceding year,

from 2008 QI to 2009 Q I.from 2008 QI to 2009 Q I.

China’s growthChina’s growth has not only returned to its blistering pace of 10%has not only returned to its blistering pace of 10% but by now is a source of but by now is a source of globalglobal growth growth

because China is now a much larger share because China is now a much larger share of the world economy than in the 1980s or 90s.of the world economy than in the 1980s or 90s.

India, Indonesia, & other Asian countries also India, Indonesia, & other Asian countries also weathered the global recession well, and are weathered the global recession well, and are growing strongly.growing strongly.

27

Asian exports were especially Asian exports were especially hard-hithard-hit

via RGE Monitor 2009 Global Outlook

28

Emerging & Devel- 6.1 2.4 6.3 6.5 5.2 6.3 7.3oping Economies

Central & E.Europe 3.0 –3.7 2.8 3.4 1.9 1.3 4.1Russia 5.6 –7.9 4.0 3.3 –3.8 1.7 4.2

Developing Asia 7.9 6.6 8.7 8.7 8.6 8.9 9.1China 9.6 8.7 10.0 9.9 10.7 9.4 10.1India 7.3 5.7 8.8 8.4 6.0 10.9 8.2ASEAN-5 4.7 1.7 5.4 5.6 5.0 4.2 6.2

Middle East & N.Africa 5.1 2.4 4.5 4.8 . . . . . . . . .Sub-Saharan Africa 5.5 2.1 4.7 5.9 . . . . . . . . .

Western Hemisphere 4.3 –1.8 4.0 4.0 . . . . . . . . .Brazil 5.1 –0.2 5.5 4.1 4.3 4.2 4.2Mexico 1.5 –6.5 4.2 4.5 –2.4 2.3 5.5

Year over Year Q4 over Q4 (2010-2011 are projections)

2008 2009 2010 2011 2009 2010 2011

WEO forecasts,April 2010

2929

The G-20 in 2010The G-20 in 2010

Canada & Korea will host the summit Canada & Korea will host the summit meetings meetings

in June & November, respectively. in June & November, respectively.

3030

The true significance of the G-20 The true significance of the G-20 in 2009in 2009

The G-20 accounts for 85% of world GDPThe G-20 accounts for 85% of world GDP The developing countries are the ones with strong The developing countries are the ones with strong

fiscal positions!fiscal positions!

A turning point: The more inclusive group has A turning point: The more inclusive group has suddenly become central to global governance, suddenly become central to global governance, eclipsing the G-7, eclipsing the G-7, and thereby at last giving major and thereby at last giving major developing/emerging countries developing/emerging countries some representation,some representation,

after decades of fruitless talk after decades of fruitless talk about raising emerging-market about raising emerging-market representation in IMF & World Bank.representation in IMF & World Bank.

3131

Four possible G-20 agenda Four possible G-20 agenda items items for for 20102010

Financial regulatory reformFinancial regulatory reform Capital adequacy ratios should be higher, and less procyclicalCapital adequacy ratios should be higher, and less procyclical Surcharges on banks with large liabilities.Surcharges on banks with large liabilities. Most stays at the national level: mortgages, exec.compensation…Most stays at the national level: mortgages, exec.compensation…

Macroeconomic exit strategies Macroeconomic exit strategies

Global imbalances between Global imbalances between developing countries and industrializeddeveloping countries and industrialized US and China should both admit responsibilityUS and China should both admit responsibility

US: the budget deficit is too big. Needs to be fixed.US: the budget deficit is too big. Needs to be fixed. China: RMB is too low. Needs to be unfixed.China: RMB is too low. Needs to be unfixed.

Post-Copenhagen progress toward new Post-Copenhagen progress toward new agreement agreement on climate change, ideally to take effect 2012.on climate change, ideally to take effect 2012.

3232

1. It is inevitable that more power go 1. It is inevitable that more power go to large-GDP/creditor countries than smallto large-GDP/creditor countries than small..

This is why the IFIs work better than the UN .This is why the IFIs work better than the UN . The problem is that China, India, Korea, Brazil, etc.,The problem is that China, India, Korea, Brazil, etc.,

areare large enough to be included… Hence the G-20. large enough to be included… Hence the G-20.

Two principles of multilateral Two principles of multilateral institutionsinstitutions

2. Conversation is not 2. Conversation is not possible possible with more than 20 in the with more than 20 in the room.room.

3333

Worked well for years, Worked well for years, with small steering groups with small steering groups and few demands placed on developing and few demands placed on developing

countries.countries.

Failed when developing countries Failed when developing countries had become big enough to matter,had become big enough to matter,

but were not given enough role: but were not given enough role: Doha RoundDoha Round

Example: many rounds of tradenegotiations under the GATT.

3434

Conversation is not possible Conversation is not possible with more than 20 people in with more than 20 people in

the room.the room. Delegates just read their talking points.Delegates just read their talking points.

Latest evidence:Latest evidence: The Climate Change CoP in The Climate Change CoP in CopenhagenCopenhagen The UNFCCC proved an ineffectual vehicleThe UNFCCC proved an ineffectual vehicle

Incompetent management of logisticsIncompetent management of logistics Small countries repeatedly blocked progressSmall countries repeatedly blocked progress

Obama was able to make more progress Obama was able to make more progress at the end with a small group of big emitters.at the end with a small group of big emitters.

To be honest, the G-20 is too big (30).To be honest, the G-20 is too big (30). My recommendation: My recommendation: an informal steering group an informal steering group withinwithin

the G-20.the G-20.

The The Renminbi Renminbi

36

Attempts at sterilization where Attempts at sterilization where emerging markets have faced emerging markets have faced

large inflowslarge inflows

In early 1990s, Colombia, Korea, In early 1990s, Colombia, Korea, Indonesia and others tried for a year or Indonesia and others tried for a year or two and then gave it up.two and then gave it up.

In the past decade, China successfully In the past decade, China successfully sterilized for some years … until 2007-sterilized for some years … until 2007-0808.. Now it is trying again.Now it is trying again.

37

Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

Components of China’s rising balance of payments and the evolution of foreign exchange reserves

38

While reserves (NFA) rose rapidly, the growth of the monetary basewas kept to the growth of the real economy – even reduced in 2005-06.

Sterilization in China

39

But to sterilize, the PBoC had to But to sterilize, the PBoC had to raise the reserve ratios required raise the reserve ratios required

of banksof banksand to raise lending rates and to raise lending rates

while continuing to underpay depositorswhile continuing to underpay depositors

Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008

40

In 2007-08 China had more trouble In 2007-08 China had more trouble sterilizing the reserve inflow sterilizing the reserve inflow (as (as

predicted)predicted)

PBoC began to have to payPBoC began to have to payhigher domestic interest rates higher domestic interest rates and to receive lower interest rate on US T bills and to receive lower interest rate on US T bills => quasi-fiscal deficit.=> quasi-fiscal deficit.

Inflation became a serious problem in 2007-08.Inflation became a serious problem in 2007-08. True, global increases in food & energy pricesTrue, global increases in food & energy prices

were much of the explanation.were much of the explanation. ButBut

China’s overly rapid growth itself contributes.China’s overly rapid growth itself contributes. Appreciation is a good way to put immediate downward Appreciation is a good way to put immediate downward

pressure on local prices of agricultural & mineral pressure on local prices of agricultural & mineral commodities.commodities.

Price controls are inefficient and ultimately ineffective.Price controls are inefficient and ultimately ineffective.

41

Sterilization faltered in 2007 Sterilization faltered in 2007 & 2008& 2008

Growth of China’s monetary base, & its Growth of China’s monetary base, & its componentscomponents


42

China’s CPI accelerated in China’s CPI accelerated in 2007-08 2007-08

Inflation 2002 to 2008 Q1Inflation 2002 to 2008 Q1


43

Three reasons why China should Three reasons why China should move to a more flexible exchange move to a more flexible exchange rate regime, in its own interestrate regime, in its own interest

Excessive reserves ($2 ½ trillion Excessive reserves ($2 ½ trillion as of mid 2010as of mid 2010)) Though a useful shield against currency crises, by now Though a useful shield against currency crises, by now

China has enough reservesChina has enough reserves Harder to sterilize inflows over time, as it learned in Harder to sterilize inflows over time, as it learned in

2007-08.2007-08.

Attaining internal & external balance.Attaining internal & external balance. To attain both, need 2 policy instruments. To attain both, need 2 policy instruments. In a large country like China, the expenditure-In a large country like China, the expenditure-

switching policyswitching policyshould be the exchange rate.should be the exchange rate.

Along with expenditure-increasing policies (2009).Along with expenditure-increasing policies (2009). RMB undervalued, RMB undervalued, judged by Balassa-Samuelson judged by Balassa-Samuelson

relationship.relationship.

44

Longer-run perspective:Longer-run perspective:Balassa-Samuelson Balassa-Samuelson relationshiprelationship

For every 1% increase in real income/capita For every 1% increase in real income/capita (relative to US), prices increase .38% (relative)(relative to US), prices increase .38% (relative)

Prices of goods & services in China are lowPrices of goods & services in China are low not just low relative to the United States not just low relative to the United States (.23)(.23) but also low by standards of Balassa-Samuelson but also low by standards of Balassa-Samuelson

relationship estimated across countries (relationship estimated across countries (which which predicts .36predicts .36).).

before Dec. 2007 statistical revisions by IPC projectbefore Dec. 2007 statistical revisions by IPC project In this specific sense, the yuan was In this specific sense, the yuan was

undervalued undervalued by an estimated 35% in 2000by an estimated 35% in 2000 and is by at least as much today.and is by at least as much today. But doesn’t imply need for sudden change of this sizeBut doesn’t imply need for sudden change of this size

45

-1-.

50

.51

Lo

g o

f P

rice L

evel

-3 -2 -1 0 1 2Log of Real Per capita GDP (PPP)

coef = .23367193, (robust) se = .01978263, t = 11.81

Source: Arvind Subramanian, April 2010, “New PPP-Based Estimates of Renminbi Undervaluationand Policy Implications,” PB10-08, Peterson Institute for International Economics

Undervaluation of RMB in the regression estimated above = 26%.Estimated undervaluation averaging across four such estimates = 31%.

Compare to Frankel (2005) estimate for 2000 = 36%.

The Balassa-Samuelson Relationship2005

46

What about China’s currency What about China’s currency reform announced in July 2005?reform announced in July 2005?

China did not fully do what it implied, China did not fully do what it implied, i.e.,i.e., basket peg (with cumulatable +/- .3% band). basket peg (with cumulatable +/- .3% band). Frankel & WeiFrankel & Wei (2007)(2007) & Frankel & Frankel (2009)(2009) estimates: estimates:

De facto weight on $ still very high De facto weight on $ still very high in 2005-06in 2005-06.. Little appreciation against the implicit Little appreciation against the implicit basket,basket, but appreciation against $ in 2007, as the basket but appreciation against $ in 2007, as the basket

gave substantial weight to the € which appreciated gave substantial weight to the € which appreciated against $.against $.

Beijing responded to pressure on exporters in 2008Beijing responded to pressure on exporters in 2008 by switching back to a dollar peg. by switching back to a dollar peg.

Just in time to ride the $ up in its year of reverse-trend Just in time to ride the $ up in its year of reverse-trend appreciation !appreciation !

47

The Beijing-Washington The Beijing-Washington standoffstandoff

was deftly defused April 1-9.was deftly defused April 1-9.

The probable deal, saving face on both sidesThe probable deal, saving face on both sides US Treasury agreed to postpone report that was US Treasury agreed to postpone report that was

due due to Congress April 15, thus saving China face.to Congress April 15, thus saving China face.

I bet China announces a change in its currency I bet China announces a change in its currency regime, around June (SED & G-20 mtgs.), thus regime, around June (SED & G-20 mtgs.), thus saving US face.saving US face.

The coming currency reform won’t amount to The coming currency reform won’t amount to much more than the 2005 change.much more than the 2005 change.

49

AddendaAddenda

Current account imbalancesCurrent account imbalances

The problem of procyclical fiscal The problem of procyclical fiscal policypolicy

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The problem of global The problem of global current account imbalancescurrent account imbalances,,

especially the US CA deficit & China’s especially the US CA deficit & China’s surplus,surplus,

was the most salient global macroeconomic was the most salient global macroeconomic issue on the eve of the financial crisis.issue on the eve of the financial crisis.

Imbalances narrowed sharply in 2009;Imbalances narrowed sharply in 2009; the US deficit fell by almost ½ ;the US deficit fell by almost ½ ; China’s CA fell by almost ½.China’s CA fell by almost ½.

Its trade surplus actually dipped to 0 in March 2010.Its trade surplus actually dipped to 0 in March 2010.

Problem solved?Problem solved? The imbalances will now resume widening.The imbalances will now resume widening.

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Economists were (are) split Economists were (are) split betweenbetween

Ken Rogoff Ken Rogoff ** Maury ObstfeldMaury Obstfeld Larry SummersLarry Summers Martin FeldsteinMartin Feldstein Nouriel RoubiniNouriel Roubini Menzie ChinnMenzie Chinn MeMe Lots moreLots more

Ben BernankeBen Bernanke Ricardo Caballero Ricardo Caballero ** Richard CooperRichard Cooper Michael DooleyMichael Dooley Pierre-Olivier Pierre-Olivier

GourinchasGourinchas Alan GreenspanAlan Greenspan Ricardo HausmannRicardo Hausmann Lots moreLots more

those who saw the US those who saw the US deficit as unsustainable, deficit as unsustainable,

requiring a $ fall, requiring a $ fall,

and those who and those who saw saw

(see) no problem.(see) no problem.

* Some claim that the financial crisis of 2007-09 fits their theories.

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The events of 2007-09 struck The events of 2007-09 struck major blows against major blows against both both

interpretations of CA.interpretations of CA. Most of us in Most of us in the unsustainability campthe unsustainability camp would have would have

predicted that something like the US sub-prime predicted that something like the US sub-prime mortgage crisis would cause a big fall in the $.mortgage crisis would cause a big fall in the $. Instead , the $ strengthened.Instead , the $ strengthened.

Most of those in Most of those in the sustainability campthe sustainability camp had been had been arguing that the US has uniquely superior assets arguing that the US has uniquely superior assets (corporate governance, securities markets, bank (corporate governance, securities markets, bank regulation…)regulation…) Instead, the crisis showed the US system to suffer serious flawsInstead, the crisis showed the US system to suffer serious flaws

of crony capitalism like other countries of crony capitalism like other countries (Simon Johnson, Ragu Rajan)(Simon Johnson, Ragu Rajan) or – worse – excessive deregulation or – worse – excessive deregulation (Joe Stiglitz)(Joe Stiglitz)

The answer, for the moment: The $ and US Treasury The answer, for the moment: The $ and US Treasury bills still play unique roles in the world monetary bills still play unique roles in the world monetary system.system.

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When will the day of When will the day of reckoning come?reckoning come?

It didn’t come in 2008: It didn’t come in 2008: The financial crisis caused a flight to quality The financial crisis caused a flight to quality

which evidently still means a flight to US $. which evidently still means a flight to US $.

Nor in May 2010: The Greek debt crisis has Nor in May 2010: The Greek debt crisis has demonstrated demonstrated European policymakers still don’t have their European policymakers still don’t have their

act together,act together, And the $ remains the safe havenAnd the $ remains the safe haven

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2009: Chinese warnings 2009: Chinese warnings

Premier Wen worries US T bills may lose Premier Wen worries US T bills may lose value.value.Urges the US to keep its deficitUrges the US to keep its deficitat an “appropriate size” to ensure at an “appropriate size” to ensure the “basic stability” of the $the “basic stability” of the $ (again on 11/10/09).(again on 11/10/09).

PBoC Gov. Zhou, proposes PBoC Gov. Zhou, proposes replacing $ as international replacing $ as international currency, with the SDR currency, with the SDR (March 09).(March 09).

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In developing countries, In developing countries, unfortunately, fiscal policy has tended to be unfortunately, fiscal policy has tended to be proprocyclical: expanding in booms, contracting in cyclical: expanding in booms, contracting in recessions.recessions. Especially in LEspecially in Latinatin America & among commodity America & among commodity

producers.producers. The US made the same mistake 2003-07: The US made the same mistake 2003-07:

failed to take advantage of the expansion to cut structural failed to take advantage of the expansion to cut structural budget deficit.budget deficit.

References for procyclical fiscal policy: References for procyclical fiscal policy: Mendoza & Oviedo Mendoza & Oviedo (2006),(2006), Talvi & Vegh Talvi & Vegh (2005),(2005), Gavin & Perotti Gavin & Perotti (1997),(1997), Kaminsky, Reinhart & Vegh Kaminsky, Reinhart & Vegh (2004),(2004), Alesina & Tabellini (2005). Alesina & Tabellini (2005).

The problem of procyclical fiscal The problem of procyclical fiscal policypolicy

Correlations between government spending and GDP > 0 for most developing countries.Source: Reinhart

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As recently as June 2008, President As recently as June 2008, President Bachelet and Fin.Min. Velasco had Bachelet and Fin.Min. Velasco had the lowest popularity rating of any the lowest popularity rating of any ministers since the restoration of ministers since the restoration of

democracy to Chiledemocracy to Chile

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A year later, they had the A year later, they had the highest popularity rating of highest popularity rating of

any ministers Why?any ministers Why?

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Developing countries in 2009, for Developing countries in 2009, for the 1the 1stst time, were able to run time, were able to run countercyclical fiscal policies:countercyclical fiscal policies:

On a global scale, China’s fiscal expansion On a global scale, China’s fiscal expansion was the most important example.was the most important example.

Chile’s institutional reform could be a model for all: Chile’s institutional reform could be a model for all: Structural surplus of 1% of GDP Structural surplus of 1% of GDP (reduced to ½ %, then 0)(reduced to ½ %, then 0)

if economy is at full employment & if economy is at full employment & price of copper at its long-run level.price of copper at its long-run level.

Estimates of full employment & LR price of copper are made by Estimates of full employment & LR price of copper are made by commissions of experts, commissions of experts, notnot politicians. politicians.

those that had wisely saved during the those that had wisely saved during the boomboom Often in the form of ForEx reserves or a SWF.Often in the form of ForEx reserves or a SWF.

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Further thoughts on macro Further thoughts on macro policy policy

in mineral-exporting in mineral-exporting countriescountries ““The Natural Resource Curse: A SurveyThe Natural Resource Curse: A Survey

,” ,” forthcoming in forthcoming in Export PerilsExport Perils, edited by B. Shaffer , edited by B. Shaffer

(U.Penn. Press). (U.Penn. Press). March 2010March 2010. . A Comparison of Monetary Anchor OptiA Comparison of Monetary Anchor Opti

ons for Commodity-Exporters in Latin Aons for Commodity-Exporters in Latin America and the Caribbeanmerica and the Caribbean,” ,” Myths and Realities of Commodity Dependence: Myths and Realities of Commodity Dependence: Policy Challenges and Opportunities for Latin Policy Challenges and Opportunities for Latin America and the CaribbeanAmerica and the Caribbean, World Bank, Sept. 2009., World Bank, Sept. 2009.

“Peg the Export Price Index: A Proposed Monetary R“Peg the Export Price Index: A Proposed Monetary Regime for Small Countries,”egime for Small Countries,” Journal of Policy ModelingJournal of Policy Modeling, , June 2005 . June 2005 .

financial crisis jeffrey frankel harpel professor of capital formation & growth cutting edge of...

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