CRISES IN EMERGING MARKETS L21: Speculative Attack Models

CRISES IN EMERGING MARKETS L21: Speculative Attack Models

CRISES IN EMERGING MARKETS L21: Speculative Attack Models Generation I Generation II Generation III Breaching the central banks defenses. L22: Sudden Stops Boom & bust in EMs Contagion Currency crashes Early Warning Indicators API-120 - Prof.J.Frankel LECTURE 21: Speculative Attacks Breaching the central banks defenses. Traditional pattern: Reserves gradually run down to zero, at which point CB is forced to devalue. API-120 - Prof.J.Frankel

In 1990s episodes, reserves seem to fall off a cliff See graph for Mexico, 1994. An irrational stampede? Not necessarily. Rational expectations theory says S cant jump unless there is news; this turns out to imply that Res must jump instead. API-120 - Prof.J.Frankel Reserves fell abruptly in December 1994 API-120 - Prof.J.Frankel Models of Speculative Attacks First Generation Episodes that inspired model Bretton Woods crises 1969-73; 1980s debt crisis

"Whose fault is it?" and why Seminal authors Macro policies: Krugman (1979); excessive credit Flood & Garber (1984) expansion API-120 - Prof.J.Frankel Models of Speculative Attacks, continued Second Generation Episode inspiring model ERM crises 1992-93: Sweden, France "Whose

fault is it?" International financial markets: multiple equilibria Seminal authors 1. Speculators game Obstfeld (1994); 2. Endogenous monetary policy Obstfeld (1996), Jeanne (1997) 3. Bank runs Diamond-Dybvyg (1983), Chang-Velasco (2000) 4. With uncertainty Morris & Shin (1998) API-120 - Prof.J.Frankel Models of Speculative Attacks, concluded

Third Generation Episode inspiring model "Whose fault is it?" Structural Emerging fundamentals: market crises moral hazard of 1997-2001 (crony capitalism) Seminal authors Dooley (2000) insurance model; Diaz-Alejandro (1985); McKinnon & Pill (1996); Krugman (1998); Corsetti, Pesenti & Roubini (1999); Burnside, Eichenbaum & Rebelo (2001) API-120 - Prof.J.Frankel 1st-generation model of speculative attack:

Krugman-Flood-Garber version uses the flexible-price monetary model of exchange rate determination. m p y i Start with Cagan money demand function: Add uncovered interest parity: i i * s e } } m p y (i * s e ) Assume flexible prices, implying PPP: and output at potential => s p p* m s y s e (We have normalized p*-i*i*i* = 0; foreign monetary conditions are exogenous.)

API-120 - Prof.J.Frankel Consider a transition in regimes from fixed to floating rates. Under fixed rates, move s to the RHS to get an equation of determination of the money supply: m s y s e (Recall M NDA+R, where R forex reserves expressed in terms of domestic currency.) Or under floating, move m to the RHS to get an equation ~ s m y s e . of exchange rate determination: Krugman experiment: Central bank undertakes a fixed rate of growth of domestic credit d ( NDA) d (nda ) / NDA => dt dt As long as s is fixed, at ,

ndat . nda0 t dR d ( NDA) dt dt API-120 - Prof.J.Frankel Flood-Garber shadow floating exchange rate: ~ Define shadow price st ndat y nda0 t y (After all reserves are lost, m will consist only of nda.) When does the speculative attack occur, defined as t=T ? Rational expectations precludes jumps. Therefore it happens when ~ st s

nda0 T y => s nda0 y T While rate is still fixed: s m y * 0 m y log( NDA R ) y => log( NDA0 R0 ) nda0 T Lessons: (1) If initial R0 is high, T is far off. (2) If is high, T is soon. API-120 - Prof.J.Frankel Krugman-Flood-Garber Model of Speculative Attack Made Easy NDA

(JF ) S 7 1 5 S 2 10 t t T MB R 6

3 } 8 } T t T API-120 - Prof.J.Frankel 9 4 t 1.

Assume the exchange rate is pegged at . 2. Assume NDA grows exogenously at rate , to finance BD. 3. Reserves, R, flow out through the balance of payments, so MB does not grow beyond the level of money demand (in accordance with the MABP). With complete offset, every $1 of NDA creation causes $1 of reserve loss. 4. We want to find T, date of speculative attack. Will speculators wait until R hits 0? No: By then there would not be enough foreign reserves to go around. 5. If speculators waited until R ran down to 0, disequilibrium between demand & supply of money would require a discontinuous jump in S -- predictable ahead of time, a violation of rational expectations. => The attack must come sooner. 6. Does the attack come as soon as the trend of expansion in domestic credit (NDA) is set? No: Before T arrives, there is no reason for money demand to fall, because inflation and depreciation have not yet risen. and so M demand does not change during initial period. (Remember, this model assumes flexible prices, PPP, and Y = .) 7.

Assume new regime will be a pure float. => S & P will also increase at rate in the post-attack regime. 8. When T arrives, people switch discretely out of domestic money into foreign. bThe magnitude of the shift is , where is the semi-elasticity of money demand with respect to the rate of inflation. 9.This can only happen if at time T, R = -. On one day, speculators acquire the central banks entire remaining stock of R. T is determined by the date when R has fallen to . This is the central result. 10. The attack occurs when Flood-Garber shadow floating rate the s that would occur at any time t if the currency were to float, determined by the level of NDA at t crosses the peg level . Only in this way is a jump in S precluded at the time of the transition from one regime to another -- the no-jump condition required by rational expectations. API-120 - Prof.J.Frankel Krugman-Flood-Garber Model of Speculative Attack Made Easy NDA (JF )

S 7 1 5 S 2 10 | t t T MB R 6

3 } T| } 8 T| t API-120 - Prof.J.Frankel 9 4 t 2nd-generation model of

speculative attack: Obstfeld version (a) Strong fundamentals (b) Weak fundamentals (c) Intermediate fundamentals API-120 - Prof.J.Frankel Obstfeld (1986). Assume: * If the central banks reserves are exhausted, it has to devalue, by 50%. * Each traders holdings of domestic currency = 6. * Transaction cost = 1 (e.g., foregone interest when holding forex). (a) If fundamentals are strong (high R), neither speculator sells the currency <= Each realizes if he were to sell, the central bank could withstand the attack. => Equilibrium: no attack. (b) If fundamentals are weak (low R), speculators sell the currency. Each realizes that even if he does not sell, the other will; the central bank exhausts its reserves & is forced to devalue, earning profit for seller (50%*6-1) = 2 if one

sells; (50%*(6/2) -1) = if both sell. There are not enough reserves to go around. => Equilibrium: successful speculative attack. (c) If fundamentals are in between (R is intermediate), outcome is indeterminate. Each speculator will attack iff he thinks the other will attack. If either sells alone, the central bank can defend, and the seller loses. But if both sell, the central bank exhausts its reserves and devalues, leaving a profit for each (50%*(10/2)-1 = 1 ). => There are two Nash equilibria: either nobody attacks or both do. API-120 - Prof.J.Frankel 3rd-generation model of speculative attack Moral hazard: crony capitalists borrow to undertake dubious projects, knowing the government will bail them out if the projects go bad. Dooleys insurance model The crisis occurs at T, when stock of liabilities that have a claim on being bailed out equals pot of Reserves to bail them out with. API-120 - Prof.J.Frankel Appendix: Definitions of external financing crises

Current Account Reversal disappearance of a previously substantial CA deficit Sudden Stop sharp disappearance of private capital inflows, reflected (esp. at 1st) as fall in reserves & (soon) in disappearance of a previous CA deficit. Often associated with recession. Speculative attack sudden fall in demand for domestic assets, in anticipation of abandonment of peg. Reflected in combination of s -i* res & i >> 0. (Interest rate defense against speculative attack might be successful.) Currency crisis Exchange Market Pressure s -i* res >> 0. Currency crash s >> 0, e.g., >25%. But falls in securities prices & GDP are increasingly relevant.

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