Vulnerability Among Emerging Markets

Among Emerging Markets
Jeffrey Frankel
Harpel Professor of Capital Formation and Growth
Harvard University
SSgA Institute Conference
Harvard Faculty Club
October 9, 2014, 10:30
Outline: Vulnerability Among Emerging Markets
• Boom & bust in EM capital flows
– despite differences across countries.
– The Joseph cycle.
• External shocks (push factors)
• Which countries withstand shocks well (pull factors)?
– The statistical record of Early Warning Indicators:
• In currency crises of the 1980s & 90s;
• in GFC of 2008-09;
• in 2013 “taper tantrum”.
• Appendices:
• EM complaint: Currency wars
• The choice of monetary regimes.
3 waves of capital flows to Emerging Markets:
• late 1970s, ended in the intl. debt crisis of 1982-89;
• 1990-97, ended in East Asia crisis of 1997-98;
• and 2003-2008, ended … when?
The Joseph cycle
Joseph prophesied 7 years of plenty,
with abundant harvests from a full Nile
-- followed by 7 lean years of drought & famine.
The Pharaoh empowered his technocratic official (Joseph)
to save grain in the 7 years of plenty,
building up stockpiles to save the Egyptian people
from starvation during the bad years.
-- a valuable lesson for today’s public officials
in advanced & developing countries alike.
Biblical cycle, cont.
For emerging markets,
the first phase of 7 years
of plentiful capital flows occurred in 1975-1981,
recycling petrodollars as loans to developing countries.
The international debt crisis that began in Mexico
in 1982 was the catalyst for the 7 lean years,
known in Latin America as the “lost decade.”
The turnaround year, 1989, saw the 1st Brady bond issue.
Biblical cycle, cont
The second cycle of 7 fat years was
the period of record capital flows
to emerging markets in 1990-96.
The 1997 “sudden stop” in East Asia
was then followed by 7 years of capital drought.
The third cycle of inflows, often identified
with BRICs & carry trade came in 2004-2008
and persisted even through the Global Financial Crisis.
Is it time for another sudden stop
of capital flows to emerging markets?
The role of US monetary policy
• Low US real interest rates contributed to EM flows
in late 1970s, early 1990s, and early 2000s.
• The Volcker tightening of 1980-82 precipitated
the international debt crisis of 1982.
• The Fed tightening of 1994 helped precipitate
the Mexican peso crisis of that year.
– as predicted by Calvo, Leiderman & Reinhart (1993).
But the relationship between the Fed’s interest rate
and EM capital flows does not always hold.
Kristin Forbes, 2014
Notes: Data on private capital flows and policy rates from IMF's IFS database, Dec. 2013 version. Capital flows are private financial
flows to emerging markets and developing economies. Policy rates measured at end of period. Data for 2013 are estimates.
Stronger relationship:
When implicit volatility is high (↓ in graph),
capital flows to EMs fall: “Risk off”
Kristin Forbes, 2014
Notes: Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets
and developing economies. Volatility index measured by the Chicago Board's VIX or VXO at end of period. 2013 data are estimates.
See K.Forbes & F.Warnock (2012), “Capital Flow Waves: Surges, Stops, Flight and Retrenchment”, J. Int.Ec.
After Fed “taper talk” in May 2013, capital
flows to Emerging Markets reversed again.
Jay Powell, 2013, “Advanced Economy Monetary Policy and Emerging Market Economies.”
Speech at the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Nov.
Taper talk was followed by greater depreciation
among a group of fragile EMs than others.
Aizenman, Binici & Hutchison,
”The Transmission of Federal Reserve
Tapering News to Emerging Financial Markets,”
March 2014
“We group emerging markets
into those with ‘robust’
fundamentals (current
account surpluses, high
international reserves and low
external debt) and those with
‘fragile’ fundamentals
and, intriguingly, find that the stronger group was
more adversely exposed to tapering news than the
weaker group. News of tapering coming from
Chairman Bernanke is associated with much larger
exchange rate depreciation, drops in the stock
market, and increases in sovereign CDS spreads of
the robust group compared with the fragile group.
A possible interpretation is that
tapering news had less impact on
countries that received fewer inflows
of funds in the first instance.”
EM stocks fell on fears of higher US interest rates
in both May-June 2013 & January 2014
Source: FT
Which EMs are hit the hardest in crises?
• In past studies of past crises, incl. 1982, 1994, & 1997-98,
• Early Warning Indicators that worked well include:
– Foreign exchange reserves
• especially relative to short-term debt;
– Currency overvaluation (i.e., real appreciation);
– Current account deficits.
– Composition of capital inflows.
Sachs, Tornell, & Velasco (1996) ”Financial crises in emerging markets: the lessons from 1995,” BPEA.
Frankel & Rose (1996) "Currency Crashes in Emerging Markets," JIE.
Kaminsky, Lizondo, & Reinhart (1998) “Leading Indicators of Currency Crises," IMF Staff Papers.
Kaminsky & Reinhart (1999) "The twin crises," AER.
The variables that showed up as significant predictors
most often in pre-2008 country crises:
(i) reserves and (ii) currency overvaluation
Real Exchange Rate
Current Account
Money Supply
Budget Balance
Exports or Imports
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Capital Account
External Debt
% of studies where leading indicator was found to be
statistically signficant
(total studies = 83, covering 1950s-2009)
Source: Frankel & Saravelos (2012)
Many EM countries -- excl. CEE -- learned lessons
from the crises of the 1990s,
which better prepared them to withstand the 2008-09 GFC.
• More flexible exchange rates
• Higher reserve holdings
• Less fx-denominated debt
• More local-currency debt
• More equity & FDI
• Fewer Current Account deficits
• Less pro-cyclical fiscal policy.
• Stronger government budgets in 2003-08 boom.
China & other EM countries
built up foreign exchange reserves
Aizenman, Cheung & Ito (2014)
-----------------------------“International Reserves Before and After the Global Crisis: Is There No End to Hoarding?” NBER WP 20386, Aug.
EM borrowers moved from fx-denominated debt
to local-currency debt over the last 10 years.
Share of External Debt in LC (Mean of 14 sample countries)
Wenxin Du & Jesse Schreger, Harvard U., Sept. 2014,
“Sovereign Risk, Currency Risk, & Corporate Balance Sheets,” Fig.2, p.19 .
Best and Worst Performing Countries
in Global Financial Crisis of 2008-09-- F&S (2012),
Appendix 4
GDP Change, Q2 2008 to Q2 2009
Macao, China
Russian Federation
Bo tto m 10
Sri Lanka
To p 10
Egypt, Arab Rep.
64 countries in sample
Foreign exchange reserves are useful
• One purpose is dampening appreciation in the boom,
– thus limiting current account deficits.
• Another is the precautionary motive:
Reserves were the best predictor of who
got hit in the 2008 Global Financial Crisis.
• Dominguez, Hashimoto & Ito (2012)
• Frankel & Saravelos (2012)
”International Reserves and the Global Financial Crisis,” JIE.
, “Are Leading Indicators Useful for Assessing Country Vulnerability?” JIE.
– This was the same Warning Indicator that also
had worked in the most studies of earlier crises.
Other predictors (besides fx reserves)
of who got into trouble† in 2008-09 GFC
• Current Account
• National Savings
• Bank credit growth, vs. bank reserves
• Short-term debt / exports
† Criteria for “trouble”: loss of GDP, loss of IP, currency market,
equity market & need to go to the IMF.
Source: Frankel & Saravelos (2012), “Are Leading Indicators Useful for Assessing
Country Vulnerability? Evidence from the 2008-09 Global Financial Crisis,” J.Int.Ec.
The next clean experiment:
Which EM countries were hit the hardest
by the “taper tantrum” of May-June 2013?
• Those with big current account deficits,
• or with inflation/exchange rate overvaluation.
• Less evidence that reserves helped this time.
• Very recent studies:
– Eichengreen & Gupta (2014), Tapering Talk: The Impact of Expectations of Reduced
Federal Reserve Security Purchases on Emerging Markets.,” UCB & World Bank, Jan.
– Hill (2014), “Exploring Early Warning Indicators for Financial Crises in 2013 & 2014,” HKS, April.
– Mishra, Moriyama, N’Diaye & Nguyen (2014), “Impact of Fed Tapering
Announcements on Emerging Markets,” IMF, June.
– Aizenman, Cheung, & Ito (2014), “International Reserves Before and After the Global
Crisis: Is There No End to Hoarding?” NBER WP 20386, Aug.
Countries with current account deficits
were hit in the spring of 2013.
Kristin Forbes, 2014
Countries with worse current accounts were hit
by greater currency depreciation after May 2013.
Mishra, Moriyama, N’Diaye & Nguyen,
“Impact of Fed Tapering Announcements on Emerging Markets,”
IMF WP 14/109 June 2014
Inflation had also risen in Brazil & Turkey.
Gerald D. Cohen | Jan. 2014, Brookings
Countries with higher inflation rates were hit
by greater currency depreciation after May 2013.
Mishra, Moriyama, N’Diaye & Nguyen,
“Impact of Fed Tapering Announcements on Emerging Markets,”
IMF WP 14/109 June 2014
Countries with high inflation rates suffered
depreciation & bond yield increases, in the year starting May 2013.
A.Klemm, A.Meier
& S.Sosa, IMF,
May 2014
Taper Tantrum or Tedium:
How U.S. Interest Rates
Affect Financial Markets
in Emerging Economies
Countries hit in April-July, 2013, had experienced
real appreciation
big capital inflows.
B. Eichengreen & P. Gupta (2013) Tapering Talk: The Impact of Expectations of Reduced Federal
Reserve Security Purchases on Emerging Markets,” Working Paper.
Countries that held excess fx reserves in 2012 suffered
smaller depreciations in 2013, the taper tantrum year.
Joshua Aizenman, Yin-Wong Cheung & Hiro Ito, 2014,
“International Reserves Before and After the Global Crisis:
Is There No End to Hoarding?” NBER WP 20386, Aug.
(%, vs. $)
in 2013
Reserves in excess of what is predicted
by some determinants, estimated for 2010-12.
Warning sign: Currency composition,
has continued to shift from fx-denomination
to local currency in the case of public debt,
but has reversed in the case of corporate debt, in some EMs.
Wenxin Du & Jesse Schreger, Harvard U., Sept.17, 2014,
“Sovereign Risk, Currency Risk, & Corporate Balance Sheets” p.18
• Many EMs learned lessons from the 1980s & 1990s,
and by 2008 were in a stronger position to withstand shocks:
More flexible exchange rates
More fx reserves
Less fx-denominated public debt
Stronger budget positions
Stronger current account positions.
• Some backsliding since 2009:
Weaker budgets
Current account deficits
The return of fx-denominated private debt.
Appendix 1: Currency wars
Brazil’s Finance Minister Guido Mantega
complained in 2010 about Fed easing.
India’s Central Bank Governor Raghuram Rajan
complained in 2014 about Fed tightening.
Origin of phrase “Currency Wars”
• Warning from Mantega:
“We’re in the midst of
an international currency war,
a general weakening of currency. This threatens us
because it takes away our competitiveness” (9/27/2010).
• I.e., countries everywhere are trying
to push down the value of their currencies,
to gain exports & employment,
– a goal that is not globally consistent.
“Currency wars”
must be another way of saying “competitive devaluation”
– a kind of beggar-thy-neighbor policy
• to use language of the 1930s,
• one motive at Bretton Woods
for fixed exchange rates;
– or “manipulating exchange rates…to gain an unfair
competitive advantage over other members…”
• to quote from
IMF Article IV(1)iii.
• If US unemployment is high & inflation low,
the Fed will naturally choose
an easy monetary policy (low i).
• If the macroeconomic situation
is the reverse in Brazil, its central bank
will naturally choose a tight monetary policy (high i).
• Also naturally, capital will flow from the US
to Brazil and will in turn appreciate the Real.
• But that is the beauty of floating rates.
Rajan complains about Fed tightening.
• “International monetary cooperation has broken down…
The U.S. should worry about the effects of
its policies on the rest of the world,” 1/30/14.
• “Central banks should assess spillover
effects from their own actions…
• For example, this would mean that while exiting
from unconventional policies, central banks would
pay attention to conditions in emerging markets…
• [T]he Fed policy statement in January 2014, with no mention
of concern about the emerging market situation, and with
no indication Fed policy would be sensitive to conditions
in those markets sent the probably unintended message
that those markets were on their own.” 4/10/2014 (Brookings)
US Congressional failure to approve IMF reform
• In one respect, at least, China, India & Brazil are right
to complain: the lack of proportionate
representation in international agencies.
• Congress refuses to pass the bill updating the
allocations of IMF quotas among member countries.
Quotas allocations in the IMF determine both monetary contributions of the member states and their voting power.
• The agreement among the IMF members had been
to allocate greater shares to big EM countries,
– coming primarily at the expense of European countries.
Appendix 2:
The Choice of Monetary Regimes
for Emerging Markets
How are EMs structurally different
from Advanced Economies?
Choice of exchange rate regime
III. Alternative anchors for monetary policy
I. How are EMs different
from Advanced Economies?
1. Monetary policy-maker has more need of credibility
a) due to high-inflation histories,
b) absence of credible institutions,
c) or political pressure to monetize big budget deficits.
2. Economy is more exposed to supply shocks
a) such as natural disasters,
b) other weather events,
c) strikes and social unrest,
d) productivity shocks.
3. More exposed to terms of trade shocks
because country tends to be price-taker
Volatility in price of export commodity on world markets
Volatility in price of imports like oil on world markets.
Trade & Supply Shocks are More Common
in Emerging Markets & Low-Income Countries
IMF SPRD & World Bank PREM, 2011, “Managing Volatility in Low-Income Countries:
The Role and Potential for Contingent Financial Instruments,” approved by R.Moghadam & O.Canuto
II. What is the desirable exchange rate regime?
 Very small, very open, economies will continue to
want to fix their exchange rates, in most cases.
 Most countries are in between,
 particularly middle-sized middle-income countries.
• Most of these countries should have intermediate
exchange rate regimes,
– neither firm fixing nor free floating.
– They include band & basket arrangements.
Distribution of EM exchange rate regimes
The big rise is in the “managed float” category
Distribution of
Exchange Rate
Regimes in Emerging
Markets, 1980-2011
(percent of total)
Atish Ghosh, Jonathan
Ostry & Mahvash
Qureshi, 2013, “Exchange
Rate Management and Crisis
Susceptibility: A Reassessment,”
IMF ARC , Nov..
So I reject the Corners Hypothesis.
 But Stan Fischer has a good point: giving speculators
a target to shoot at is often a losing proposition (“disastrous”),
• such as the boundary of a declared band.
• A particular intermediate regime could be useful,
a systematic sort of managed floating:
• A rule could say that for every 1% of Exchange Market Pressure,
the central bank takes x % as an appreciation of the currency
and (1-x) % as an increase in reserves (relative to the monetary base).
– This arrangement, tho rather obvious, has seldom been formalized.
– The parameter x calibrates exchange rate flexibility,
• and can range from 0 (fixing) to close to 1 (full flexibility).
– Thus one can have ½ monetary independence
+ ½ exchange rate stability.
Systematic managed floating
• refutes the corners hypothesis,
– but without capital controls,
– without violating the Impossible Trinity,
– and even without giving speculators
a line to shoot at.
 ≈ what some central banks do anyway.
 Attempts at econometric estimation:
 Adler & Tovar, 2011, “Foreign Exchange Intervention:
A Shield Against Appreciation Winds?” IMF WP 11/165.
 Frankel & Xie, 2010, “Estimation of De Facto Flexibility Parameter and
Basket Weights in Evolving Exchange Rate Regimes,” AER.
Systematic managed float (“leaning against the wind”):
Turkey’s central bank buys lira when it depreciates,
and sells when it is appreciates.
Kaushik Basu & Aristomene Varoudakis, Policy RWP 6469, World Bank, 2013,
“How to Move the Exchange Rate If You Must: The Diverse Practice of Foreign Exchange Intervention by Central Banks and a Proposal for Doing it Better” May, p. 14
Example: Renewed capital inflows to Asia in 2010
Korea & Singapore took them mostly in the form of reserves,
while India & Malaysia took them mostly
in the form of currency appreciation.
more-managed floating
= 1/x
less-managed floating
GS Global ECS Research
Renewed inflows to Latin America in 2010
were reflected mostly as reserve accumulation in Peru,
but as appreciation in Chile & Colombia.
more-managed floating
= 1/x
less-managed floating
Source: GS Global ECS Research
III: If the exchange rate is not to be
the anchor for monetary policy, what is?
• The need for an alternative anchor led many EMs to IT,
– after the currency crises of the late 1990s
pushed them off exchange rate targets.
• IT (Inflation Targeting) was in many ways successful.
• Two problems with IT:
– Neglect of asset bubbles
– Neglect of exogenous supply & trade shocks.
• Remember the textbook maxim: the exchange rate
should accommodate terms of trade shocks.
• If IT targets the CPI, it doesn’t allow the exchange rate
to rise & fall with the terms of trade.
• When the world price of imported oil rises, a literal CPI target says
to tighten monetary policy enough to appreciate the currency,
– the opposite of accommodating the adverse trade shock.
Nominal GDP Targeting
• NGDPT is more robust with respect to
supply shocks & terms of trade shocks,
– compared to the alternative of IT.
• The logic holds whether the immediate aim is
– Disinflation (as in 1980s, and today among some EMs);
– monetary stimulus (as among big ACs recently);
– or just staying the course.
Figure 2: When a Nominal GDP Target
Delivers a Better Outcome than IT
Supply shock is split between output & inflation objectives
rather than falling exclusively on output as under IT (at B).
• The proponents of Nominal GDP Targets
have focused on the biggest countries.
• But middle-size, middle-income countries
are better candidates.
• Why? They suffer bigger supply shocks
& trade shocks.
• Some evidence suggests the AS curve is indeed steep
enough so that NGDPT minimizes quadratic loss function:
– “Nominal GDP Targeting for Middle-Income Countries,”
Central Bank Review (CBRT), Sept. 2014.
• Conclusion: EMs should consider NGDPT
as a serious alternative to IT & exchange rate targeting.
Appendix 3: More indications
of strengthened EM policies after 2001
• Less pro-cyclical fiscal policy
• Current account surpluses
• Higher reserve holdings
• Ability to predict who got hit
– in 2008-09.
Correlations between Gov.t Spending & GDP
Adapted from Kaminsky, Reinhart & Vegh (2004)
Pro-cyclical spending
G always used to be pro-cyclical
for most developing countries.
Correlations between Government spending & GDP
Frankel, Vegh & Vuletin (JDE, 2013)
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
Developing Countries Used Capital Inflows
to finance CA deficits in 1976-1982 & 1990-97;
1st boom
but not 2003-08.
3rd boom
(carry trade & BRICs)
debt crisis)
2nd boom
(emerging markets)
EM countries
countries used
used post-2003
post-2003 inflows
Chairman Ben S. Bernanke, 6th ECB Central Banking Conference,
Frankfurt, Nov.19, 2010,” Rebalancing the Global Recovery”
M. Dooley, D. Folkerts-Landau & P. Garber,
“The Revived Bretton Woods System’s First Decade,”
NBER WP 20454, Sept. 2014
Actual versus Predicted Incidence of 2008-09 Crisis
Frankel & Saravelos (JIE, 2012)
Appendix 4: EM conditions in 2014
From IMF WEO: Legacies, Clouds,
Uncertainties, October 2014.
EMs have had to pay higher interest rates
since the taper tantrum of 2013,
but conditions eased a bit after April 2014.
From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.
Asia is still doing pretty well.
From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.
Capital flows recovered after the taper tantrum.
From IMF WEO: Legacies, Clouds, Uncertainties, Oct. 2014.
Oct. 2014.
GDP growth rates
IMF WEO, Oct. 2014.

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