It is possible that a historical perspective will show that in 2004 the ...

Draft Chapter for:
Managing Volatility and Crises
A Practitioner's Guide
March 2004
Managing Macroeconomic Crises: Policy Lessons*
by
Jeffrey Frankel (Harvard University) and Shang-Jin Wei (IMF) Peer Reviewers: Barry Eichengreen (University of California at Berkeley)
and Robert P. Flood Jr. (IMF) Abstract
This study is an attempt to review broadly what the last decade reveals
about which policies for crisis prevention or crisis management seem to
work and which do not. The empirical investigation tries out a variety of
methodological approaches: reasoning from examples of prominent crises of
the last eight years, formal probit analysis, a regression tree analysis,
conventional regression analysis, and a look at the typical profile of
financing during the sudden stop preceding a crisis.
The authors seek to draw greater attention to policy decisions that are
made during the phase when capital inflows come to a sudden stop.
Procrastination---the period of financing a balance of payments deficit
rather than adjusting---had serious consequences in some cases. Crises
are more frequent and more severe when short-term borrowing and dollar
denomination external debt are high, and foreign direct investment (FDI)
and reserves are low, in large part because balance sheets are then very
sensitive to increases in exchange rates and short-term interest rates.
Our point is that these compositional measures are affected by decisions
made by policymakers in the period immediately after capital inflows have
begun to dry up but before the speculative attack itself has hit. If
countries that are faced with a fall in inflows adjusted more promptly,
rather than stalling for time by running down reserves or shifting to loans
that are shorter-termed and dollar-denominated, they might be able to
adjust on more attractive terms. * The authors wish to thank Harvard University students Yannis Itokatlidis,
Evren Pacalioglu, Li Zeng, and especially Dora Douglass for very capable
research assistance; and Joshua Aizenman and Brian Pinto (World Bank) for
useful comments. Shang-Jin Wei contributed to this chapter before joining
the staff of the International Monetary Fund (IMF). The views expressed do
not necessarily reflect the views or policies of the IMF.
In the last 30 years, emerging markets have experienced at least two
complete boom-bust cycles. The last cycle was marked by rapid capital
inflows from 1990 to 1996, followed by severe crises for some countries and
scarce capital for all from 1997 to 2003. This cycle bore similarities to
the preceding 14 years, as well: large loans to developing countries from
1975 to 1981, followed by the international debt crisis of 1982--89.
Despite this volatility, many developing countries---although certainly not
all---have ended this 30-year period with a far higher level of per capita
income than they began it.
Taking Stock of Recent History
It is a good time to take stock of what has been learned from recent
experience about the determinants of economic performance in emerging
market countries. Which policies seem to work and which do not? Scholarly
research has not neglected the topic. Indeed, it is striking how much
emphasis has shifted within the field of international macroeconomics to
the problems of developing countries. But most of the contributions to
the subject focus on one particular model, or one particular empirical
effect. While there are overviews of the late-1990s crises, there are
not many that attempt to summarize and integrate what we have learned from
the numbers. It would help if the lists of variables that are run through
statistical predictors of crisis probabilities were more visibly tied to
the various competing theoretical models of crises.
One lesson we are learning from the trend of recent research is that
policymakers making decisions in real time are far more constrained in
their options than we have pretended to believe. (The international
financial institutions are of course one step further removed from the
policy levers than the national authorities.) Committing to a non-
inflationary monetary policy with 100 percent credibility may simply not be
an option in light of past history and current political structures, no
matter how sincere the governor of the central bank. This is the case
even in a pro-reform political environment, such as prevailed in many
countries in the late 1980s and early 1990s, and even if an institutional
commitment such as a currency board does happen to be an option
politically. These policies can always be reversed later, as history has
shown. Similarly, a decision to remove capital controls may not put a
developing country in the same category of financial integration as an OECD
country, because of the risk that capital controls will be re-imposed in
the future. Moreover, measures of the composition of capital inflows,
such as the maturity structure or the share of foreign-denominated debt,
may not be amenable to policy choice in any given year. Accordingly, the
fourth section of this chapter will take a longer-run perspective. The
data set will be constructed from country-averages over the period 1990--
2002. The analysis focuses on whether countries that on average had a
particular degree of exchange rate flexibility or financial openness over
this period tended on average to have a high or low level of volatility
over the period. The study begins with a whirlwind summary of academic literature,
emphasizing what is recent and what seems capable of producing a bottom
line. Included are the theoretical models of speculative attacks, which
come in three "generations." In addition, each of the major policy
questions that a country must decide has produced its own body of
literature: the choice of exchange rate regime; the choice of capital
account regime; openness to trade; institutional issues such as the quality
of financial regulation; the composition of capital inflows; and the
management of "sudden stop" events once they occur.[i] Included in the
empirical section of the literature review are studies of leading
indicators or crisis warning signals, which seek to include many factors,
but which are not designed specifically to look at a variety of policy
variables. Given all the theories and claims that have been offered, this
study seeks to ask what combinations of policy variables seem empirically
to be the most important, and which policy choices seem to work. Methodologies The study tries out a number of different methodologies to discern
determinants of economic performance. An impressionistic consideration of
the most visible crises of the 1994--2002 period (Mexico, Thailand, Korea,
Indonesia, Malaysia, Russia, Brazil, Turkey, and Argentina) concludes that
there are more variables and hypotheses that need to be evaluated than
there are major-crisis data points. More systematic analysis requires
turning to a larger set of developing countries. The study approaches
this larger data set several ways.
First, a simple probit analysis looks to see which of the variables
that are suggested by the literature are capable of helping forecast the
increased likelihood of a currency crisis on an annual basis. Second, the
technique of regression tree analysis allows the data to choose freely
which variables seem to matter the most. The technique has been used in
macroeconomics much less often than factor analysis. But it has the
advantage that it does not impose a linear functional form on the
relationship. It is a flexible way to look for robust statistical
relationships including threshold and interactive effects. This will be
particularly important when we consider some of the hypotheses that are on
the research frontier. This includes the proposition that capital account
liberalization is not helpful for all countries, but is helpful for those
that have strong macroeconomic fundamentals, or those that have strong
structural fundamentals, or those that have attained a threshold stage of
financial or economic development. The study uses regression analysis on
a broad sample of countries from the 1970s to the present to offer
direction as to which directions our econometric energies may be best
spent.
Third, the study applies conventional regression analysis to a cross-
section of countries to explain performance during the most recent decade
(taken to be 1990--2002, which includes both the boom and bust phase).
Fourth, the analysis focuses on the timing of currency crises---in
particular, looking at a typical month-by-month profile for reserves
preceding crises---again to see which crisis management policies seem to
help and which do not.
We use as our main criteria of economic performance the probability of
having currency crises and the total output lost during crises. The
crisis prevention policies that we examine include: macroeconomic
discipline (as measured by inflation, debt, budget deficits, money
creation); institutional quality (corruption); financial integration
(freedom from capital controls); currency regime (hard pegs, intermediate,
and floating); openness (trade/GDP ratio); composition of inflows
(maturity, share of FDI, currency mismatch) and reserves. The crisis
management policies that we examine include: promptness versus delay of
adjustment (measured either as the length of the lag after reserves peak,
or the amount of reserve loss during this period); changes in composition
(again, maturity and currency); and the mix of policies during the
adjustment period (expenditure reduction versus devaluation).