Top PDF Expectations and information in second generation currency crises models

In a recent paper, Morris and Shin (1998) started a promising line of analysis by developing an SGM with incomplete information. They considered speculators having a uniform prior probability distribution over the state of fundamentals that is updated according to the observation of a private signal. Their model, as well as the earlier complete information models, does not allow one to examine the role of the distribution of agents’ beliefs about the fundamentals. This issue has been neglected in the literature, presumably because one could think that only the mean of speculators’ probability assessment of the fundamentals matters in an incomplete information framework. Hence, one could imagine that the equilibrium (or the equilibria) of the game depends on the region where the mean of the probability distribution falls. In such hypothetical case, the incomplete information framework would not enrich the benchmark analysis and would not modify the structure of the equilibria. Nevertheless, agents’ beliefs have often been used to explain actual currency crises. For instance, after the Russian crisis many commentators pointed to an increase in agents’ uncertainty as a possible explanation for the transmission of speculative pressures to other countries (especially in Latin America) that had very limited trade linkages with Russia [see BIS (1999) and IMF (1999)]. Yet, typical SGMs do not explain why uncertainty should in À uence speculative attacks.

Keywords: expectations; informational advantage; asymmetric information; local investors; managers; financial crises; exchange rate; prediction; survey; currency forecast.. + We thank I[r]

The effective exchange rate index (measuring the overvaluation of the euro at the national level) has the largest standardized impact on ADR returns. This suggests that ADR investors perceive a considerable misalignment of the euro exchange rate for some vulnerable member countries. Introduction of a new, devalued national currency in order to promote export growth appears to be the most significant argument in favor of withdrawing from the EMU. The impact of the banking and sovereign debt crisis risk variables on ADR returns is similar. 96 ADR investors seem to believe that the risk of withdrawal is driven equally by possible banking and sovereign debt crises. This finding seems reasonable as a considerable part of (implicit) public debt creation of some vulnerable EMU member countries (such as Ireland) can be attributed to the financing of bank bailouts, thereby linking the rise in sovereign debt crisis risk with the severity of the banking crisis. An interesting finding is that the CDS-based vulnerability measures have a larger standardized impact on ADR returns than the non-CDS-based vulnerability measures, i.e., bank stock returns for banking crisis risk and sovereign bond yield spreads for sovereign debt crisis risk. ADR investors seem to prefer CDS-based measures to derive crisis expectations since the primary purpose of CDS is to hedge against the risk of bank or sovereign defaults. The alternative measures reflect default risk-related information less precisely, making them less effective in assessing the risk of withdrawal.

episodes (both outliers and structural breaks) are accommodated in the analysis. We identified several currency episodes of the past two decades are responsible for the breakdown of PPP in the region. Although China, India and Pakistan did not experience the same crisis episodes as the other Asian countries, these countries were severely affected by local shocks from their own crises. This also explains why a continuous assessment of the parity condition is necessary as it is affected by the economic and financial environments. Using more recent data, we find that our results collaborate with those reported earlier in Nusair (2001), Hooi and Smyth (2007) and Zurbruegg and Allsopp (2004); they found PPP holds for most of the Asian countries when breaks are adequately accounted for the country they studied. We confirmed that the time series properties of RER during the post-crisis periods are not significantly different from those in the pre-crisis periods – they exhibit I(0) process. Therefore, we find no notable differences between the two crises in the recent decades. The crises cannot be predicted based on the fundamental based exchange rate model. Several scholars have emphasised currency crises – exchange rate depreciating substantially during a short period of time – can occur even if no secular trend or movements in economic fundamentals (e.g., fiscal deficits and monetary growth) can be identified. This also explains why early warning models were unsuccessful in forecasting future crises.

Financial crises are usually described as failures of financial institutions or sharp falls in asset prices. Currency crises played a large role in recent economic turmoil and since the late 1970s have been a major subject of academic study. In this review financial crisis models are categorized as first, second, third and fourth-generation models. First-generation models of currency crises are based on macroeconomic fundamentals and speculations. They focus on long run, unique equilibrium, fiscal deficits and monetary policies. The models were developed in response to the sovereign debt crisis of Latin America in 1980s. The models explain currency crises by poor domestic macroeconomic conditions such as budget deficit, hyperinflation, and current account deficit (Agenor et al., 1991; Blackburn and Sola 1993). Also, they emphasize the relationship between speculation attack in foreign exchange market and macroeconomic variables. First-generation models begin with a fixed rate regime but external macroeconomic conditions can set the stage for a crisis as in Dooley (1997). These models showed how fundamentally inconsistent domestic policies lead an economy inevitably toward a currency crisis. The models did not focus on predicting whether or not the currency will collapse but rather on the timing of a speculative attack on the currency. From the literature of first generation models it is difficult to understand why governments keep exchange rates fixed and retain a policy the government knows will ultimately lead to a currency crisis.

Most economists think about currency crises using one of two standard models of speculative attacks. The “first generation” models of, e.g., Krugman (1979) direct attention to inconsistencies between an exchange rate commitment and domestic economic fundamentals such as an underlying excess creation of domestic credit, typically prompted by a fiscal imbalance. The “second generation” model of, e.g., Obstfeld (1986) views currency crises as shifts between different monetary policy equilibria in response to self-fulfilling speculative attacks. There are many variants of both models, and a number of empirical issues associated with both classes of models, as discussed in Eichengreen, Rose and Wyplosz (1995). What is common to both classes of models is their emphasis on macroeconomic and financial

The theory leaves still many questions open to mention only three. One of the most important from theoretical and practical point is possible consequence of currency crisis for economy that implies introduction of appropriate stabilization programs. The striking contrast between the first- and the second-generation models were revealed in the consequences of the crises. Countries experiencing second-generation crises recovered faster than the first-generation crises ones. This argument can work in favor of more speculative than fundamental reasons of the second-generation crises. However, the short-history of recovery after the third-generation model of the Asian crisis presents a mixed picture. And performance of the Asian countries significantly differs, as purely economic fundamentals seem to be very different in individual countries. The second broadly discussed problem is liberalization of financial markets and capital flows. There is one fundamental problem with the advocates of restrictions on capital mobility. They were usually in favor of free capital movement (heavily) relying on financial markets as long as it paid off and as they provided financing to doubtful political decisions from economic perspective. The third open question is the role of international financial organizations and private sector in prevention of crises’ contagion and spillover and/or financing rehabilitation programs.

Following the literature on early warnings, this paper will classify currency crises using information on a variety of indicators. These indicators are described in Table 1. Indicators are grouped according to the symptoms on which the various generation models focus on. The first- generation models of currency crises highlight the inconsistency of expansionary macroeconomic policies with the stability of a fixed exchange rate regime. Fiscal deficits and easy monetary policy are at the core of these models. I capture the spirit of these models with two indicators: fiscal deficit/GDP and excess M1 real balances. 12 The second- generation models focus on countercyclical government policies. The essence of these models is centered on problems in the current account, with real appreciations fueling losses in competitiveness and recessions. I capture the focus of these models with five indicators: Exports, imports, real exchange rate (deviations from equilibrium 13 ), terms of trade, output, and real interest rates. The third- generation models focus on financial excesses. To capture the spirit of these models, I use six indicators: domestic credit/GDP ratio, M2/reserves, deposits, M2 multiplier, stock prices, and an index of banking crises. The literature on sovereign crises has focused mainly on too much debt and even debt concentrated at short maturities. To examine this variety of crises, I use two indicators: Foreign debt/exports, and short-term debt/foreign exchange reserves. Finally, the sudden-stop approach focuses on international capital flow reversals, which I will try to capture with fluctuations in both the world real interest rate and foreign exchange reserves of central banks. There are a total of eighteen indicators. The Appendix describes the data in detail.

First, we show that a broad class of currency crisis theories with a unique equilibrium — ranging from …rst-generation models with public information (such as those pioneered by Krugman, 1979, and Flood and Garber, 1984) to global games with public and private information (see Morris and Shin, 1998, and Hellwig, 2002) — predicts that the e¤ect of uncertainty on exchange rate pressures is non-monotone and varies with expected funda- mentals. 1 Speci…cally, these models predict that, when expected fundamentals are “good,” a reduction in information precision (i.e. an increase in uncertainty) raises the share of specula- tors attacking the currency, whereas a reduction in information precision with “bad” expected fundamentals has the opposite e¤ect. This broad-based prediction — which previous studies have overlooked — has a very intuitive interpretation: as information about fundamentals becomes less precise, speculators rely less on it in order to decide whether to attack the cur- rency. Thus, as information about bad fundamentals becomes less reliable, speculators lose con…dence in the success of a speculative attack and diminish exchange rate pressures. By the same token, as information about good fundamentals becomes less reliable, speculators lose con…dence in the good state of the economy and augment exchange rate pressures. 2

In second generation models of currency crises, best represented by Obstfeld (1986, 1994), policymakers weigh the cost and benefits of defending the currency and are willing to give up an exchange rate target if the costs of doing so exceed the benefits. In these models doubts about whether the government is willing to maintain its exchange rate target can lead to the existence of multiple equilibria, and a speculative currency attack can take place and succeed even though current policy is not inconsistent with the exchange rate commitment. This is because the policies implemented to defend a particular exchange rate level, such as raising domestic interest rates, may also raise the costs of defense by dampening economic activity and/or raising bank funding costs. The private sector understands the dilemma facing the government, and may question the commitment to fixed exchange rate when other

public debt might trigger a self-fulfilling attack if the speculators anticipate the weakness of the financial sector and believe that the government will not consider increasing the interest rate under such fragile circumstances. I believe that the weakness of the financial sector should be examined within the context of third generation models, since it brings about problems such as maturity mismatches which will be examined later. Another important point which can be drawn from Table 4 is the high growth rates following the crisis year. Ozatay (2003) defines the subsequent high growth rates as an implication of second- generation type crisis since the third-generation type crisis typically causes low growth rates due to the difficult recovery of corporate or financial sectors. However, the sound post-crisis growth performance can easily be attributed to the “baseline effect” and does not imply the type of the crisis per se.

The theoretical literature on currency crises is centered on the paradigm of the three generations of currency crises models. The first generation, owed to Krugman (1979) and Flood & Garber (1984), described currency crises as speculative attacks which re- sult from monetary or fiscal policies that were not in line with a fixed exchange rate tar- get. The run on foreign currency reserves occurred because market participants could foresee the depreciation and tried to avoid losses. The models described the currency crises of the 1970s and 1980s in Latin America. The second generation, based on Obstfeld (1986), stresses the trade-off between the central banks intentions to target a fixed exchange rate and to follow other policy targets, e.g. to achieve low levels of un- employment. If speculators assume that the policy response could be devaluation, the event may become self-fulfilling without (in contrast to first generation models) worsen- ing economic fundamentals. The models addressed, for example, the EMS crises in Europe. Third generation models stress the connection between banking and currency crises, and address problems such as contagion of crises and herd effects. These models were developed in response to the Asian crises of 1997/1998.

ning the ERM crises in 1992-1993 and Mexico crisis in 1994. New models were created, in particular by Obstfeld (1994, 1997) so-called second generation models, where a crisis can be triggered without ex ante significant deterioration of macroeconomic fundamentals. Therefore, even if economic policies are consistent with the fixed exchange regime, a speculative attack may occur when a shift realizes in the operators’ expectations whose herd behaviour leads to a currency crisis. Unlike the first generation models that describe a simple and mechanical behaviour of policymakers against a speculative attack, the optimizing behaviour of the latter is central to the process of crisis in the second generation models. Because, in these models economic policies are not predetermined, but respond to the problems of the economy that operators are aware of. So we are in a configuration of multiple equilibria in which the agents’ expectations are not related to the macroeconomic fundamentals observed in period (t), but to the expected continuity of the government's policies in terms of the sustainability of the situation in (t+1) and of the loss function of government. Expectations are therefore based on the future direction of economic policy that is not predetermined but responds to the loss function of the government and to the future development of the economy. This circularity creates multiple equilibria which lead to the manifestation of self-fulfilling crises. In these models the exact timing of the crisis is unpredictable comparing to the first generation models. But even here we can identify if a country is in a zone of vulnerability, called later as “crisis zone” by Jeanne (1997), where some fundamentals are sufficiently weak that a shift in operators’ expectations – generally triggered by sunspot dynamics – could bring a crisis.

Second, the club is exclusively defined by the politicians. It is they who determine which countries weigh heavily in their resolve to maintain the peg and which do not. Yet many emerging countries do not get to choose which club they belong to. Korean politicians in 1997 thought they were joining the club known as the OECD; financial markets became convinced

Financial crises are usually described as failures of financial institutions or sharp falls in asset prices. Since long, there is an active debate about the origins and nature of such crises. For example, one view holds that they are the expression of an occasional inherent malfunctioning of financial institutions or markets, e.g. related to self-fulfilling events and sunspots. Another view rather sees crises as caused by bad outcomes in underlying economic variables (fundamentals). The primary concern with financial crises is that they can reach a large breadth, in the sense that banks fail or markets crash together. The reason for this concern is that these widespread (or systemic) crises have the strongest real effects, in that aggregate consumption, investment and growth are adversely affected. A recent literature on financial contagion and systemic risk has therefore started to pay attention to the breadth of crises. The present paper provides a new perspective on this issue. By combining exchange rate theory with multivariate extreme value analysis, we derive conditions under which widespread currency market crises occur systematically.

Indicators that have proven to be particularly useful in anticipating crises include the behavior of international reserves, the real exchange rate, domestic credit, credit to the public[r]

The model is then used to devise monetary policy rules for crises. It shows that a monetary authority which seeks price and output stability is most likely to tighten policy in response to a currency crisis when the crisis has not disrupted the domestic financial system. In the event of twin banking and currency crises, the monetary authority might have to ease policy, unless there is substantial import price inflation. The optimal policy is subject to developments in the banking system because a twin crisis will tend to produce a much larger rise in the domestic interest rate than would a simple increase in the world interest rate. In these circumstances, the dampening effects of the higher interest rates on activity can overwhelm the stimulus from a depreciated exchange rate.

The purpose of this paper is to study whether the small group of macroeconomic variables that we identified in our previous work is also useful in explaining the presence of exchange rate crises in Central American (CA) countries. There are several reasons to be interested in studying the determinants of currency crises in this group of countries. First, CA countries are poorer relative to the sample in our previous work. Thus, results based in our expanded sample may therefore shed light on the validity of extrapolating our previous conclusions to other economies. Second, CA countries belong to a single geographical region and they tend to have strong commercial relationships. In fact, these countries have a trade agreement that goes back to the 1960s (the Central American Common Market). This characteristic allows us to test again for the existence of a regional contagion effect.

The third version of the third generation models stresses the balance-sheet implications of currency depreciation. These models attempt to combine moral hazard driven bubble with a balance sheet driven crisis when the bubble burst. The deterioration of balance sheets played key role in the Asian crisis. The explosion in the domestic currency value of balance sheets is having a disastrous effect on firms. The prospects for recovery are generally very difficult because of the weak financial condition of firms. Their capital is wiped out by the combination of declining sales, high interest rates, and a depreciated currency. These balance sheet problems are in turn a cause of the problem of non-performing loans at the banks, they are not a banking problem per se, and even a recapitalization of the banks would still leave the problem of financially weakened companies untouched.

currency crisis in 1991-93. Finland had pursued export -led growth strategy not unlike the Asian countries. The exporting …rms had high leverage and had invested heavily throughout the 1980’s. Moreover, the capital markets had recently been liberalized, and as a result …rms had increased their foreign borrowing. The chosen strategy of high leverage and excessive investments would have been risky at best of times, but Finland su¤ered two major external shocks: the German uni…cation and the collapse of the Soviet Union. The German uni…cation resulted in higher real interest rates and appreciating Deutsche mark to which the Finnish markka was pegged to through the ECU and the collapse of Soviet Union meant that Finland lost a major export market. The only way of making further investments feasible was to reduce costs, including the debt level, relative to the future cash ‡ows. This was achieved by currency devaluation. The markka was devalued by 12% in November 1991 and then in the following year the government was forced to let the markka ‡oat resulting in even a bigger depreciation than the year before. For futher analysis of the Finnish crisis, see Honkapohja and Koskela (1999), especially for the role that …nancial liberalization played in the onset of the Finnish crisis.