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Economics 216:
The Macroeconomics of Development
Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.)
Kwoh-Ting Li Professor of Economic Development
Department of Economics
Stanford University
Stanford, CA 94305-6072, U.S.A.
Spring 2000-2001
Email: [email protected]; WebPages: http://www.stanford.edu/~ljlau
Lecture 10
Stabilization in
Closed and Open Economies
Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.)
Kwoh-Ting Li Professor of Economic Development
Department of Economics
Stanford University
Stanford, CA 94305-6072, U.S.A.
Spring 2000-2001
Email: [email protected]; WebPages: http://www.stanford.edu/~ljlau
Macroeconomic Stabilization
in Closed Economies
Over- and under-utilization of capacity
Unemployment
Inflation
Hyper-inflation
Lawrence J. Lau, Stanford University
3
Instruments--Monetary
Money supply
Currency in circulation
Reserve ratio
Discount rate/Rediscount Rate
Open market operations (a well developed bond market is required)
The rate of interest--maintaining a positive real rate of interest
The role of expectations
The credibility of commitment (self-fulfilling rational expectations)
Inflation rate targeting
Lawrence J. Lau, Stanford University
4
Instruments-Fiscal
Revenue (revenue net of the costs of collection, including
enforcement)
Individual taxation
Income
Capital gains
Business taxation
Income or value added
Turnover tax
Treatment of depreciation
Investment tax credit
Expenditure
Current expenditure
Government services, including education and health
Transfer payments
Subsidies
Capital expenditure
Changes in the government
budget surplus (deficit) change the
Lawrence J. Lau, Stanford University
aggregate demand
5
Institutional and Other Constraints
Flexibility of prices and wages
Are prices downward flexible in nominal terms?
Are prices downward flexible in real terms?
Are wage rates downward flexible in nominal terms?
Are wage rates downward flexible in real terms?
It all depends on the industrial organization, strength of the labor unions
(including unions of government employees), if any, and how close the real
wage rate is to the subsistence level
The outstanding stock of public debt relative to government revenue
and GDP
The credibility of the financial institutions
The “surplus” of output over consumption
The degree of “leverage” in the economy
Lawrence J. Lau, Stanford University
6
Macroeconomic Stabilization
in Open Economies
The degree of openness
Goods
Services
Current accounts
Capital accounts
Convertibility
Lawrence J. Lau, Stanford University
7
Macroeconomic Stabilization
in Open Economies
Over- and under-utilization of capacity
Unemployment
Inflation
Hyper-inflation
Disequilibrium in the current accounts
Over- or under-valuation of the currency
Lawrence J. Lau, Stanford University
8
Additional Constraints
The level of foreign exchange reserves relative to imports
The outstanding stock of short-term and long-term foreign debt
relative to the value of exports and foreign exchange reserves
The outstanding stock of foreign portfolio investment relative to the
value of foreign exchange reserves
The net foreign asset position
The credit rating of the country
The “surplus” of exports over imports
Lawrence J. Lau, Stanford University
9
Fiscal Policy
Counter-cyclical public investment
Limitations on its effectiveness
Revenue collection capability
Bond issuance capacity
Lawrence J. Lau, Stanford University
10
Monetary Policy
Currency substitution
Dollarization
Credible commitment: The concept of a currency board
Credible commitment: Inflation rate targeting (The Taylor Rule)
Lawrence J. Lau, Stanford University
11
Interest Rate Policy
Forward interest arbitrage condition
id = if + E((r - r-1)/r-1), where id is the domestic rate of interest, if is
the foreign rate of interest, and r is the exchange rate in terms of
units of the domestic currency per unit of foreign currency
Lawrence J. Lau, Stanford University
12
Exchange Rate Policy
Fixed exchange rate (with respect to a single currency or a fixed
basket of currencies)
Floating exchange rate
“Dirty” float (managed float)
“Purchasing-power-parity (PPP)” exchange rate
Level form: Pd = Pf . r, where r is the exchange rate in terms of units of the
domestic currency per unit of foreign currency
First difference form: Rate of change of the exchange rate is the difference
between the rate of change of the domestic prices and the rate of change of the
foreign prices
Lawrence J. Lau, Stanford University
13
Foreign Capital
Foreign direct investment
A stable political as well as economic environment is required
National treatment
Investment protection
Foreign portfolio investment
Foreign debt
The rate of interest--fixed or floating
The currency
The maturity
Lawrence J. Lau, Stanford University
14
The East Asian Currency Crisis (1997-1998)
The Basic Questions
What were the causes of the crisis?
Is the recovery real?
What lessons can be drawn?
Lawrence J. Lau, Stanford University
15
A Brief History of the East Asian Currency
Crisis
The East Asian currency crisis began in Thailand in late June of 1997
and essentially stabilized in the last quarter of 1998
With the exception of two currencies, the Chinese Yuan and the
Hong Kong Dollar, all other East Asian currencies lost significant
value vis-à-vis the U.S. Dollar, albeit by varying degrees, and did not
recover to pre-crisis levels
Once the exchange rates stabilized at their new (lower) levels, the
rates of interest began to fall to more reasonable levels that permit
normal real economic activities to resume
While the declines in real GDP were exceptionally sharp in the
affected East Asian economies, the recoveries were also very rapid-by mid-1999 the real GDPs of all of the affected economies began to
show positive rates of growth
Lawrence J. Lau, Stanford University
16
The Recovery from the Crisis
For most of the East Asian economies, the bottom has been reached
(0% rate of growth of real GDP) in 2Q/1999 with the recovery most
tentative in Indonesia and Philippines with their political problems
In terms of quantity, exports as well as imports have been growing
very rapidly
The current accounts have turned positive and foreign exchange
reserves have been largely replenished
Inflation caused by the devaluation has largely subsided
The stock markets have rebounded from their troughs but not all of
them have fully recovered to their pre-crisis levels
While the simultaneous downturns in the East Asian economies
exacerbated the problems of one another, the simultaneous upturns
have allowed the recovery to be extraordinarily and unexpectedly
rapid, with the rising import demands of each economy feeding into
rising export demands of its trading partners
Lawrence J. Lau, Stanford University
17
The Recovery Followed the Stabilization of the
External Environment
Since 3Q/1998, there have not been any speculative attacks on the
Thai Baht or any other East Asian currency.
The hedge funds had a “credit crunch” due to losses, net redemption
and curtailment of available credit lines in the aftermath of the
collapse of the Russian ruble and the “Long-Term Capital
Management” crisis.
The U.S. economy has been exceptionally strong throughout period
of the East Asian currency crisis (until 4Q/2000), providing a market
for East Asian exports and compensating for the very slow recovery
of the Japanese economy.
Lawrence J. Lau, Stanford University
18
Domestic Political Instability Has Affected the
Economic Recovery
Continuing as well as more recent domestic political instability has
affected the exchange rates as well as the economies of Indonesia
and Philippines and to a lesser extent Taiwan and Thailand
Indonesia: President Abdurrahman Wahid is in a struggle with the National
Assembly with regard to alleged financial improprieties; potential successor
Vice President Megawati Sukarnoputri also has weaknesses
Philippines: President Gloria Macapagal Arroyo took over from President
Estrada on Jan. 20, 2001 but there may be potentially be a legal and
constitutional contest from Estrada
Taiwan: Taiwan suffered from a crisis of public confidence in the ability of the
new government to govern effectively
Thailand: The new Prime Minister, Thaksin Shinawatra, has yet to be cleared
of charges of less than full financial disclosure
A code of ethics for political leaders in East Asia?
All assets of self and spouse and minor dependent children placed in blind trust
Lawrence J. Lau, Stanford University
19
Indexes of East Asian Exchange Rates:
Local Currency per US$ (January 2, 1997=100)
Indices of East Asian Exchange Rates
(Local Currency per U.S. Dollar, 1/2/97=100)
700
650
600
C. Yuan
HK$
I. Rupiah
K. Won
RM
P. Peso
S$
NT$
550
T. Baht
Japan Yen
500
Indian Rupee
Brazilian Real
1/2/97=100
450
400
350
300
250
200
150
100
50
1/2/97
8/12/97
3/20/98
10/28/98
6/7/99
Lawrence J. Lau, Stanford University
1/13/00
8/23/00
4/2/01
20
Indexes of East Asian Exchange Rates:
Local Currency per US$ (March 31, 1995=100)
Indexes of Selected East Asian Exchange Rates (March 31, 1995 = 1.0)
2.6
2.4
Chinese Yuan
2.2
Japanese Yen
2
South Korean Won
1.8
Thai Baht
1.6
1.4
1.2
1
0.8
3/31/95
10/16/95
4/30/96
11/15/96
6/5/97
12/24/97
7/15/98
2/8/99
Lawrence J. Lau, Stanford University
8/20/99
3/3/00
9/13/00
3/27/01
21
Early Warning Signals (1)
L. J. Lau and and J. S. Park, “Is There a Next Mexico in East Asia?,”
Project LINK World Meeting, Pretoria, South Africa, Sept., 1995;
Lau and Park, “Is There a Next Mexico in East Asia?,” Beijing,
China, 1996
Thailand and Philippines were identified as the most likely candidates as the
next Mexico, followed by S. Korea and Indonesia
China, Hong Kong, Singapore and Taiwan were identified as the least likely
candidates as the next Mexico
Indicators of potential vulnerability, e.g.
Stock of potential short-term foreign-currency liabilities (including portfolio
investment and bank loans) relative to foreign exchange reserves
Interest rate differential between domestic and foreign currency-denominated
loans
Real exchange rate appreciation (loss of competitiveness)
Lawrence J. Lau, Stanford University
22
Early Warning Signals (2)
Indicators of economic performance, e.g.
Level and rate of change of the marginal efficiency of real capital (rate of
return)
Rates of return on the domestic stock market relative to the rates of return on
the world stock markets
Lawrence J. Lau, Stanford University
23
Fundamental Macroeconomic Causes
of the East Asian Currency Crisis
Savings-investment imbalance--also reflected as current account imbalance
Dependence on short-term foreign capital (portfolio investment--both equity and
debt instruments--and loans) by private investors
Equity is better than debt
Direct investment is better than portfolio investment
Insolvency caused by the revaluation of foreign-currency denominated debts
and the rise in the rate of interest
Domino effects of insolvency and bankruptcy
Problems magnified by high leverage (high debt to equity ratio)
Inadequacy of foreign exchange reserves (working capital of a country) for
supporting imports, debt service, and (potential) net short-term capital outflows
Real exchange rate appreciation (loss of competitiveness) due to a domestic rate of
inflation higher than the U.S. rate of inflation
Lawrence J. Lau, Stanford University
24
Dependence on Potentially Short-Term Foreign
Capital
Dependence on foreign capital per se is not necessarily risky, but
dependence on potentially short-term foreign capital, such as foreign
portfolio investment and short-term bank loans, that can be
withdrawn on short notice (and usually at the first sign of real or
perceived trouble), can be risky. Both the foreign portfolio investors
and lenders need to be paid, directly or indirectly, in terms of foreign
exchange, thus potentially putting tremendous pressure on the
exchange rate to devalue, especially if the domestic borrowers do not
have matching sources of foreign-currency revenue.
Lawrence J. Lau, Stanford University
25
Savings Rates as a Percent of GDP
of Selected East Asian Economies
T h e S av in g s R a te a s a P e r ce n t o f G D P
50
40
P e rc e n t
30
20
10
C h in a
H ong K on g
In d o n e sia
Ko re a , R e p u b lic o f
M a la ysia
P h ilip p in e s
S in g a p o r e
T a iw a n
T h a ila n d
M e xic o
In d ia
0
196 5
196 7
196 9
197 1
197 3
197 5
197 7
197 9
198 1
198 3
198 5
198 7
198 9
199 1
199 3
199 5
199 7
199 9
-1 0
Lawrence J. Lau, Stanford University
26
The Savings-Investment Gap
Selected East Asian Economies
T h e S a v in g s -In v e s tm e n t G a p a s a P e r ce n t o f G D P
30
C h in a
I n d o n esi a
M a la y si a
S in g a p o r e
T h a ila n d
In d i a
25
20
Hon g K on g
K o re a , R e p u b lic o f
P h i lip p in e s
T a iw a n
M e x ic o
P e rc e n t
15
10
5
0
198 6
198 7
198 8
198 9
199 0
199 1
199 2
199 3
199 4
199 5
199 6
199 7
199 8
199 9
-5
-1 0
-1 5
Lawrence J. Lau, Stanford University
27
Current Account Surplus (Deficit)
as a Percent of GDP
The Current Account Surplus (Deficit) as a Percent of GDP
30
24
China
Hong Kong
Indonesia
Korea, Rep. of
Malaysia
Philippines
Singapore
Taiwan
Thailand
Mexico
India
18
Percent
12
6
0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
-6
-12
Lawrence J. Lau, Stanford University
28
Composition of Foreign Investment:
Mexico (Quarterly Data)
Composition of Foreign Investment: Mexico
12000
10000
8000
Foreign Portfolio Investment
Foreign Direct Investment
Million US$
6000
4000
Foreign Portfolio Investment
2000
Foreign Direct Investment
0
1986 Q1 1987 Q1 1988 Q1 1989 Q1 1990 Q1 1991 Q1 1992 Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1
-2000
-4000
-6000
Lawrence J. Lau, Stanford University
29
Composition of Foreign Investment:
Thailand (Quarterly Data)
Composition of Foreign Investment: Thailand
4200
Foreign Portfolio Investment
Foreign Direct Investment
2200
1200
Foreign Portfolio Investment
200
-800
2000 Q1
1999 Q3
1999 Q1
1998 Q3
1998 Q1
1997 Q3
1997 Q1
1996 Q3
1996 Q1
Lawrence J. Lau, Stanford University
1995 Q3
1995 Q1
1994 Q3
1994 Q1
1993 Q3
1993 Q1
1992 Q3
1992 Q1
1991 Q3
1991 Q1
1990 Q3
1990 Q1
1989 Q3
1989 Q1
1988 Q3
1988 Q1
1987 Q3
1987 Q1
1986 Q3
Foreign Direct Investment
1986 Q1
Million US$
3200
30
Composition of External Debt
Thailand
S to c k o f E x te rn a l D e b t: T h a ila n d
12 0
10 0
80
S h o rt-t e rm
60
40
Lawrence J. Lau, Stanford University
199 9
199 8
199 7
199 6
199 5
199 4
199 3
199 2
199 1
199 0
198 9
198 8
198 7
198 6
198 5
198 4
198 3
198 2
0
198 1
20
198 0
B il li o n U .S . $
L o n g -t e rm
31
External Debt and Foreign Exchange Reserves
Thailand
T h a ila n d ' s E x te r n a l D e b t v s . F o re ig n E x c h a n g e R e s e r v e s
12 0
10 0
T o ta l e x te rn a l d e b t
F o re ig n e x c h a n g e r e se rv e s
B il li o n U S $
80
60
40
20
0
198 0
198 2
198 4
198 6
198 8
199 0
199 2
Lawrence J. Lau, Stanford University
199 4
199 6
199 8
200 0
32
Composition of Foreign Investment:
South Korea (Quarterly Data)
C o m p o s i tio n o f F o re ig n In v e s tm e n t: R e p u b lic o f K o r e a
1 0 0 00
F o r e ign P o r tf ol io In v e stm e n t
F o r e ign D ir e c t In v e stm e n t
8 0 00
M i ll ion U S $
6 0 00
4 0 00
2 0 00
F or e ig n P or tfo lio I n ve s tm e n t
0
1 9 86 Q 1 1 9 87 Q 1 1 9 88 Q 1
F o re i g n D i re c t I n ve s tm e n t
1 9 89 Q 1 1 9 90 Q 1 1 9 91 Q 1 1 9 92 Q 1
1 9 93 Q 1 1 9 94 Q 1 1 9 95 Q 1 1 9 96 Q 1
1 9 97 Q 1 1 9 98 Q 1 1 9 99 Q 1
-2 0 00
Lawrence J. Lau, Stanford University
33
Composition of External Debt
South Korea
S to c k o f E x te rn a l D e b t: K o re a
18 0
16 0
14 0
L o n g -t e rm
S h o rt-t e rm
10 0
80
60
40
Lawrence J. Lau, Stanford University
199 9
199 8
199 7
199 6
199 5
199 4
199 3
199 2
199 1
199 0
198 9
198 8
198 7
198 6
198 5
198 4
198 3
198 2
0
198 1
20
198 0
B i ll io n U .S .$
12 0
34
External Debt and Foreign Exchange Reserves
South Korea
K o re a ' s E x te r n a l D e b t v s . F o re ig n E x c h a n g e R e s e r v e s
18 0
16 0
14 0
T o ta l e x te rn a l d e b t
F o re ig n e x c h a n g e r e se rv e s
B il li o n U S $
12 0
10 0
80
60
40
20
0
198 0
198 2
198 4
198 6
198 8
199 0
199 2
Lawrence J. Lau, Stanford University
199 4
199 6
199 8
200 0
35
Composition of Foreign Investment:
China (Annual Data)
Composition of Foreign Investment, China
60
50
Foreign Portfolio Investment
Foreign Direct Investment
30
20
10
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
0
1980
Billion US$
40
Year
Lawrence J. Lau, Stanford University
36
Composition of External Debt
China
Stock of External Debt: China
Bank for International Settlements Data
160
140
Long-term
Short-term
120
80
60
40
20
Lawrence J. Lau, Stanford University
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
0
1980
Billion US$
100
37
Composition of External Debt
China
S to c k o f E x te r n a l D e b t: C h i n a
O ffi c ia l C h in e s e D a ta
B illion U S $
16 0
L o n g -t e r m
S h o r t -t e r m
14 0
12 0
10 0
80
60
40
20
0
1990
1991
1992
1993
1994
1995
1996
1997
Lawrence J. Lau, Stanford University
1998
1999
2000
38
External Debt and Foreign Exchange Reserves
China
China's External Debt vs. Foreign Exchange Reserves
(International Financial Statistics Data)
180
160
Total external debt
140
Foreign exchange reserves
100
80
60
40
20
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
0
1980
Billion US$
120
Year
Lawrence J. Lau, Stanford University
39
External Debt and Foreign Exchange Reserves
China
C h in a 's E x te r n a l D e b t v s . F o re ig n E x c h n a g e R e s e rv e s :
O ffic ia l C h in e s e D a ta
18 0
T o ta l e x te rn a l d e b t
16 0
F o re ig n e x c h a n g e r e se rv e s
14 0
B il li o n U S $
12 0
10 0
80
60
40
20
0
199 0
199 1
199 2
199 3
199 4
199 5
199 6
Lawrence J. Lau, Stanford University
199 7
199 8
199 9
200 0
40
Composition of Foreign Investment:
Indonesia (Quarterly Data)
C o m p o s it io n o f F o re i g n In v e s tm e n t: In d o n e s ia
4 0 00
3 0 00
2 0 00
F o r e ign P o r tf ol io In v e stm e n t
1 0 00
M i ll ion U S $
F o r e ign D ir e c t In v e stm e n t
0
1 98 6 Q 1 1 98 7 Q 1 1 98 8 Q 1 1 98 9 Q 1 1 99 0 Q 1 1 99 1 Q 1 1 99 2 Q 1 1 99 3 Q 1 1 99 4 Q 1 1 99 5 Q 1 1 99 6 Q 1 1 99 7 Q 1 1 99 8 Q 1 1 99 9 Q 1 2 00 0 Q 1
-1 0 00
-2 0 00
-3 0 00
-4 0 00
F o r e ign D ir e c t In v e stm e n t
F o r e ign P o r tf ol io In v e stm e n t
-5 0 00
-6 0 00
Lawrence J. Lau, Stanford University
41
Composition of External Debt
Indonesia
S to c k o f E x te rn a l D eb t: In d o n e s ia
14 0
12 0
L o n g -t e rm
S h o rt -t e rm
80
60
40
Lawrence J. Lau, Stanford University
199 9
199 8
199 7
199 6
199 5
199 4
199 3
199 2
199 1
199 0
198 9
198 8
198 7
198 6
198 5
198 4
198 3
198 2
0
198 1
20
198 0
B i ll io n U .S .$
10 0
42
External Debt and Foreign Exchange Reserves
Indonesia
In d o n e s ia ' s E x te r n a l D e b t v s . F o re ig n E x c h a n g e R e s e r v e s
16 0
14 0
T o ta l e x te rn a l d e b t
12 0
F o re ig n e x c h a n g e r e se rv e s
B il li o n U S $
10 0
80
60
40
20
0
198 0
198 2
198 4
198 6
198 8
199 0
199 2
Lawrence J. Lau, Stanford University
199 4
199 6
199 8
200 0
43
Composition of Foreign Investment:
Japan (Quarterly Data)
Composition of Foreign Investment:Japan
70
Foreign Portfolio Investment
Foreign Direct Investment
Billion US$
50
30
10
1986 Q1 1987 Q1 1988 Q1 1989 Q1 1990 Q1 1991 Q1 1992 Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1
-10
Lawrence J. Lau, Stanford University
-30
44
Comparison between Thailand and South Korea
and China
The contrast between, for example, Thailand and South Korea on the
one hand, and China on the other, immediately prior to mid-1997, is
striking. Both Thailand and South Korea had a large proportion of
foreign investment in the form of portfolio investment, and a large
proportion of foreign debt in the form of short-term (less than one
year maturity) loans, and low foreign exchange reserves relative to
the potential foreign exchange liabilities--hence they were both
vulnerable to speculative attacks.
Lawrence J. Lau, Stanford University
45
Ratio of Short-Term Foreign-Currency
Liabilities to Foreign Exchange Reserves
The potential short-term foreign exchange liabilities, that is, the
foreign exchange that can be withdrawn with little or no prior notice,
consists of the stock of foreign portfolio investment and short-term
foreign loans
The stock of foreign portfolio investment can be estimated by
cumulating past foreign portfolio investments; however, the existing
stock may be under- or over-estimated by this procedure because of
the possibilities of gains and losses from these investments
To these may be added the current account deficit of the current
period
If foreign exchange reserves are low relative to these potential
demands on foreign exchange, the currency may be vulnerable to a
run
Lawrence J. Lau, Stanford University
46
Ratio of Short-Term Foreign-Currency
Liabilities to Foreign Exchange Reserves
Ratio of Short-Term Foreign Currency Liabilities to
Foreign Exchange Reserves
%
2000
1500
CHINA
HONG KONG
INDIA
INDONESIA
KOREA
MALAYSIA
MEXICO
PHILIPPINES
SINGAPORE
THAILAND
TAIWAN
1000
500
1999
1998
1997
1996
Year
1995
1994
1993
1992
1991
Lawrence J. Lau, Stanford University
1990
1989
1988
1987
1986
1985
0
47
Ratio of Short-Term Liabilities, Including
Current Account Balance, to Reserves
Ratio of Short-Term Foreign Currency Liabilities, Including Current Account
Balance, to Foreign Exchange Reserves
%
2500
2000
CHINA
HONG KONG
INDIA
INDONESIA
KOREA
MALAYSIA
MEXICO
PHILIPPINES
SINGAPORE
THAILAND
1500
TAIWAN
1000
500
1999
1998
1997
1996
1994
1993
1992
1991
Lawrence J. Lau, Stanford University
1990
1989
1988
1987
1986
1985
0
1995
Year
48
Ratio of Short-Term Liabilities, Including
Current Account Balance, to Reserves
%
Ratio of Short-Term Foreign Currency Liabilities, Including Current Account
Balance, to Foreign Exchange Reserves
800
CHINA
HONG KONG
700
INDONESIA
600
KOREA
MALAYSIA
500
PHILIPPINES
SINGAPORE
400
THAILAND
TAIWAN
300
200
100
-100
1999
Lawrence J. Lau, Stanford University
1998
1997
1996
1995
0
Year
49
Ratio of Short-Term Foreign-Currency
Liabilities to Foreign Exchange Reserves
Ratio of Short-Term Foreign Currency Liabilities to
Foreign Exchange Reserves
%
800
CHINA
HONG KONG
INDIA
INDONESIA
KOREA
MALAYSIA
PHILIPPINES
SINGAPORE
THAILAND
TAIWAN
700
600
500
400
300
200
100
Lawrence J. Lau, Stanford University
0
1995Q1
1996Q1
1997Q1
1998Q1
1999Q1
50
2000Q1
Quarter
Ratio of Short-Term Liabilities, Including
Current Account Balance, to Reserves
%
Ratio of Short-Term Foreign Currency Liabilities, Including Current Account
Balance, to Foreign Exchange Reserves
800
CHINA
HONG KONG
INDIA
INDONESIA
KOREA
MALAYSIA
PHILIPPINES
SINGAPORE
THAILAND
TAIWAN
700
600
500
400
300
200
100
Lawrence J. Lau, Stanford University
0
1995Q1
1996Q1
1997Q1
1998Q1
1999Q1
51
2000Q1
Year
Real Exchange Rate Appreciation
By mid-1997, many of the East Asian currencies, with the exceptions
of the Chinese Yuan, the Indonesian Rupiah and the Malaysian
Ringgit, have appreciated, in real purchasing power terms, 20-50%
relative to the U.S.$ compared to 1986.
This implies a loss of competitiveness vis-a-vis the U.S., and an
adjustment is potentially warranted.
However, by 1999, sufficient adjustments have occurred in the East
Asian currencies so that, with the exception of Hong Kong and
Singapore, they have effectively devalued, in real terms, relative to
their 1990 values
Lawrence J. Lau, Stanford University
52
Rates of Inflation Relative to the United States
Rates of Inflation Relative to the United States (percent p.a.)
90
80
70
China
Hong Kong
Indonesia
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
60
Percent p.a.
50
40
30
20
10
0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
-10
-20
Lawrence J. Lau, Stanford University
53
Rates of Inflation Relative to the United States
(without Indonesia)
Rates of Inflation Relative to the United States (percent p.a.)
(without Indonesia)
20
15
Percent p.a.
10
5
0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
-5
-10
-15
China
Hong Kong
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
Lawrence J. Lau, Stanford University
54
Real Exchange Rate Movements
Indexes of East Asian Real Exchange Rates
(Local Currency per U.S.$, 1986=100)
250
225
China
Hong Kong
Indonesia
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
200
Percent
175
150
125
100
75
50
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
Lawrence J. Lau, Stanford University
1996
1997
1998
1999
2000
55
Real Exchange Rate Movements
(without Indonesia)
Indexes of East Asian Real Exchange Rates (without Indonesia)
(Local Currency per U.S.$, 1986=100)
175
150
China
Hong Kong
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
Percent
125
100
75
50
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
Lawrence J. Lau, Stanford University
1996
1997
1998
1999
2000
56
Real Exchange Rate Movements
(1990=100)
In d e x es o f E a s t A s ia n R e a l E x c h a n g e R a te s
(L o c a l C u r re n c y p e r U .S .$ , 1 99 0 = 1 0 0 )
22 0
20 0
18 0
C h in a
Hon g K on g
I n d o n esi a
Ko re a
M a la y si a
P h i lip p in e s
S in g a p o r e
T a iw a n
T h a ila n d
16 0
14 0
12 0
10 0
80
60
40
20
197 8
198 0
198 2
198 4
198 6
198 8
199 0
199 2
Lawrence J. Lau, Stanford University
199 4
199 6
199 8
200 0
57
Official Foreign Exchange Reserves
O ffic ia l F o re ig n E x ch a n g e R e se r v e s
18 0
16 0
C h in a
I n d o n esi a
M a la y si a
S in g a p o r e
T h a ila n d
In d i a
14 0
B i ll io n U S $
12 0
Hon g K on g
K o re a , R e p . o f
P h i lip p in e s
T a iw a n
M e x ic o
10 0
80
60
40
20
0
196 1
196 4
196 7
197 0
197 3
197 6
197 9
198 2
198 5
Lawrence J. Lau, Stanford University
198 8
199 1
199 4
199 7
200 0
58
Foreign Exchange Reserves
as a Percent of Annual Imports
F o r ei g n E x c h a n g e R e s e rv e s as a P er c e n t o f A n n u a l Im p o rts
20 0
C h in a
Hon g K on g
I n d o n esi a
K o re a , R e p . o f
M a la y si a
P h i lip p in e s
S in g a p o r e
T a iw a n
T h a ila n d
M e x ic o
In d i a
P e rc e n t
15 0
10 0
50
0
198 6
198 7
198 8
198 9
199 0
199 1
199 2
199 3
199 4
199 5
Lawrence J. Lau, Stanford University
199 6
199 7
199 8
199 9
200 0
59
Inadequacy of Foreign Exchange Reserves
Traditional yardstick of a level of foreign exchange reserves equal to
3-6 months of imports no longer adequate for some countries
because of the magnitudes of potential movements in the capital
accounts (foreign direct and portfolio investment, short- and longterm bank loans and deposits) relative to the current accounts.
The International Monetary Fund’s pre-crisis standard of 13 weeks
of imports was established in an era in which trade flows dominate
capital flows (late 1950s and early 1960s). The cross-border flow of
short-term capital, if any, at the time was primarily related to the
financing of trade. The old standard is totally inadequate in today’s
world in which the magnitudes of the potential capital flows dwarf
those of the trade flows
Lawrence J. Lau, Stanford University
60
Inadequacy of Foreign Exchange Reserves
A higher level of foreign exchange reserves is therefore necessary to support not
only imports, but also debt service (including both principal and interest), and
potential net short-term capital outflows resulting from the withdrawal of foreign
portfolio investors and lenders
Moreover, if the level of foreign exchange reserves is allowed to fall to a level
perceived to be inadequate, a crisis will likely ensue
Simulations by Lau, Li and Qian (1999) suggest that foreign exchange reserves can
be considered adequate (in the absence of capital controls) only if it is
approximately equal to 10 months of imports
Potential disruptions in the foreign exchange and capital markets can be caused by
the quick inflows and outflows of large pools of hot money, which can in turn
affect adversely trade flows, real fixed investment and real output in the absence of
a high level of foreign exchange reserves as a buffer
Lawrence J. Lau, Stanford University
61
Fundamental Microeconomic Causes:Borrowing
Too Much, Short-Term and in Wrong Currency
Maturity mismatch--borrowing short and investing (lending) long
Currency mismatch--revenue and cost (liability) in different
currencies
Vulnerability magnified by high debt to equity ratio
Insolvency caused directly or indirectly (through domino effects of bankruptcy
and high nominal rates of interest) by declines in the exchange rates
Oversold currencies create unnecessary bankruptcies and discourage recapitalization and re-structuring
Moral hazard on the parts of both lenders and borrowers
Past bailouts (Latin American loans, Mexican loans) of developed country
lenders encourage moral hazard on the part of lenders
Implicit guarantee of banks and enterprises “too big to fail” by governments
encourage moral hazard on the part of borrowers
Lawrence J. Lau, Stanford University
62
Fundamental Microeconomic Causes:
Excessive Leverage and Herd Mentality
Excessive Leverage
Excessive leverage of enterprises magnifies the negative effects of a sharp
devaluation on foreign-currency denominated debt as well as the resulting rise
in both the domestic and the foreign rates of interest
Excessive leverage encourages moral hazard (recklessness) on the part of the
borrowers
Excessive leverage magnifies the domino effect of insolvency and bankruptcy
on the entire financial system
Excessive leverage also enables the hedge funds to engage in predatory
speculation on a large scale
“Herd mentality”--too much money chasing too few good projects
leading to mis-pricing by developed country investors and lenders (it
is better to make the same mistake as everyone else)--the making of
an East Asian “bubble”
Lawrence J. Lau, Stanford University
63
What is New?
(1) New Channels for Contagion!
The speculative attacks on the New Taiwan Dollar (10/17/97) and the
Hong Kong Dollar (10/23/97) show that even ECONOMIES WITH
SOUND FUNDAMENTALS ARE NOT IMMUNE!
Spread to South Korea, Latin America, and Russia
Traditional Channels for Contagion (through trade)
Competitive devaluation
Nervous domestic traders and investors (Prof. Jeffrey Sachs’s “rational panic”)
New Channels for Contagion (through short-term capital flows)
Predatory speculation by hedge funds
Domino effect of cross-country lending and re-lending (e.g., by Korean banks
and chaebols)
The confidence factor--withdrawals by indiscriminate investors of developing
(emerging) countries equity and debt; reduction of outstanding credit by
multinational banks
Lawrence J. Lau, Stanford University
64
Predatory Speculation (1)
Large pools of hot money (3,000-4,000 hedge funds with aggregate
capital of US$300 billion+) that can move (small) markets
Formulae for almost risk-free profits, especially in economies that
are expected to defend their exchange rates (transactions must be
large enough to be a credible threat to the exchange rates)
(Short) Sales of large quantities of local currency induce purchases
by local central bank or monetary authority
Such purchases by the central bank or monetary authority cause the
local money supply to contract and liquidity to tighten, sending the
short-term rate of interest up
The local central bank or monetary authority may also raise the rate
of interest directly to discourage the conversion of local currencydenominated assets into foreign currency-denominated assets
Lawrence J. Lau, Stanford University
65
Predatory Speculation (2)
For example:
Simultaneous shorting of currency and going long on interest rate futures
(Attack on the British Pound, 1992)
Simultaneous shorting of currency and stock (or stock index futures), in either
spot or forward markets or both (Attacks on Hong Kong)
Shorting the stock market and then selling the domestic currency proceeds for
U.S. dollars
Simultaneous longing of currency and stock or stock market index
Predatory speculation can occur and succeed independently of the
economic fundamentals if the resources of the speculators are
sufficiently large relative to the size of the market
Short sales of forward contracts in the local currency will have the
same effect through arbitrage (Buyers of forward contracts will sell
short in the spot market)
Lawrence
Stanford
66
Predatory speculation has
theJ. Lau,
effect
ofUniversity
depressing the exchange rate
and increasing its volatility and hence the interest rate risk premium
An Example:
Hong Kong
Relationship between Exchange Rate, Stock Market Index and Interest Rate,
Hong Kong
160
45
Exchange Rate Index, 1/2/97=100
40
Stock Market Index, 1/2/97=100
140
Interest Rate (right scale)
35
120
30
100
25
80
20
60
15
40
10
20
5
0
1/2/97
0
7/15/97
1/23/98
8/5/98
2/15/99
8/26/99
Lawrence J. Lau, Stanford University
3/8/00
9/18/00
3/29/01
67
What is New? (2) Contagion Leading to
Synchronization of Down Turns
Over the last decade, the proportions of East Asian exports to other
East Asian economies have been increasing rapidly
By the late 1990s, approximately 50% of the exports of the East
Asian economies are destined for other East Asian economies
All East Asian economies, with the exception of China and Taiwan,
experienced rises in the rate of interest and downturns in economic
activities at the same time, which in turn caused significant
reductions in the demands for one another’s exports, further
exacerbating their recessions
Lawrence J. Lau, Stanford University
68
Was “Crony Capitalism” or the Primitive
Financial System the Culprit?
The real mistake was to borrow too much short-term and in the
wrong currency
Even a perfectly efficient enterprise cannot withstand the increase in
debt servicing required due to the massive exchange rate devaluation
Japan, despite its massive devaluation between 1995 and mid-1998,
has been able to muddle through because its firms have little net
foreign debt
Hong Kong, Singapore and Taiwan have also escaped relatively
unscathed because they did not and do not have significant net
foreign debt, especially short-term debt, relative to their foreign
exchange reserves
China has not been significantly affected because it retains capital
control and its foreign debt is mostly medium to long-term
Lawrence J. Lau, Stanford University
69
Was “Crony Capitalism” or the Primitive
Financial System the Culprit?
The financial systems collapsed in the affected countries because of
the currency crisis. Many of the firms became insolvent because of
illiquidity. Whatever weaknesses they might have had were not the
direct causes of the crisis.
Lawrence J. Lau, Stanford University
70
Indexes of East Asian Stock Market Indexes:
Local Currency (January 2, 1997=100)
Indexes of East Asian Stock Exchange Indexes
(Local Currency, 1/2/97=100)
270
China
Hong Kong
Indonesia
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
Japan
India
1/2/97=100
220
170
120
70
20
1/1/97
8/11/97
3/19/98
10/27/98
6/4/99
Lawrence J. Lau, Stanford University
1/12/00
8/22/00
3/30/01
71
Short-Term Rates of Interest
Short-Term Rates of Interest, Selected East Asian Countries
(percent p.a.)
70
60
Percent per annum
50
40
CHINA
HONG KONG
INDONESIA
KOREA
MALAYSIA
PHILIPPINES
SINGAPORE
TAIWAN
THAILAND
JAPAN
INDIA
30
20
10
0
1/1/97
8/11/97
3/19/98
10/27/98
6/4/99
Lawrence J. Lau, Stanford University
01/12/00
08/22/00
03/30/01
72
Leading Indicators of Recovery
Stabilization of the exchange rate
Capital controls have been instituted in Malaysia
Hedge funds are no longer active
Decline in the rate of interest
Rise in the stock market
Improvement in the balance of payments
Rise in the official foreign exchange reserves
Deceleration in the rate of decline of real GDP
Leveling of the unemployment rate
Narrowing of yield spread on U.S. dollar-denominated sovereign
debt relative to U.S. Treasury securities
Upgrading of credit ratings by rating agencies such as Moody’s,
Standard & Poor and Fitch IBCA
Lawrence J. Lau, Stanford University
73
The Recovery
For most of the East Asian economies, the bottom has been reached
(0% rate of growth) in 2Q/1999
The recovery is most tentative in Indonesia, with its political
problems
In quantity terms, exports have been growing very rapidly
Foreign exchange reserves have been largely replenished
Inflation caused by the devaluation has largely subsided
The stock markets have recovered
The recovery has been much stronger than expected because of
synchronization across the East Asian economies
Lawrence J. Lau, Stanford University
74
The Rates of Growth of Real GDP Have All
Turned Significantly Positive and Remained So
Q u a rt e rl y R a t es o f G ro w th o f R e a l G D P , Y e a r -o v e r-Y e a r, S e le c ted E a st A si a n E co n o m i e s
2 0 .0
A n n u a li zed R a te s in P e r c e n t
1 5 .0
1 0 .0
2 00 0 Q 3
2 00 0 Q 1
1 99 9 Q 3
1 99 9 Q 1
1 99 8 Q 3
1 99 8 Q 1
1 99 7 Q 3
1 99 7 Q 1
1 99 6 Q 3
0 .0
1 99 6 Q 1
5 .0
-5 .0
-1 0 .0
C hin a
H on g K on g
In d on e si a
K or e a
M a la ysi a
P h il ip pin e s
S in ga p or e
T aiwa n
T h a ila n d
Ja p a n
In d i a
-1 5 .0
Q u a r te r
Lawrence J. Lau, Stanford University
75
Quarterly Rates of Growth of Exports
40.0 0
Y e a r-o v e r-Y e a r Q u a rte rly R a te s o f G ro w th o f E x p o rts in U .S . D o lla rs
(P e rc e n t)
30.0 0
C h in a
Hon g K on g
I n d o n esi a
S o u th Ko re a
M a la y si a
S in g a p o r e
P h i lip p in e s
T a iw a n
T h a ila n d
J apa n
In d i a
P e rc e n t p . a .
20.0 0
10.0 0
0.0 0
Q1 97
Q2 97
Q3 97
Q4 97
Q1 98
Q2 98
Q3 98
Q4 98
Q1 99
Q2 99
Q3 99
Q4 99
Q1 00
Q2 00
Q3 00
Q4 00
-10.0 0
-20.0 0
Lawrence J. Lau, Stanford University
76
Quarterly Rates of Growth of Imports
Y e a r-o v e r-Y e a r Q u a rte rly R a te s o f G ro w th o f Im p o rts in U .S . D o lla rs
(P e rc e n t)
60.0 0
50.0 0
40.0 0
P e rc e n t p . a .
30.0 0
C h in a
Hon g K on g
I n d o n esi a
S o u th Ko re a
M a la y si a
P h i lip p in e s
S in g a p o r e
T a iw a n
T h a ila n d
J apa n
In d i a
20.0 0
10.0 0
0.0 0
Q1 97
Q2 97
Q3 97
Q4 97
Q1 98
Q2 98
Q3 98
Q4 98
Q1 99
Q2 99
Q3 99
Q4 99
Q1 00
Q2 00
Q3 00
Q4 00
-10.0 0
-20.0 0
-30.0 0
-40.0 0
-50.0 0
Lawrence J. Lau, Stanford University
77
The Current Account Balance
The Current Account Balance, Billion US$
50
40
30
China
Hong Kong
Indonesia
Korea, Rep. of
Malaysia
Philippines
Singapore
Taiwan
Thailand
Mexico
India
Billion US$
20
10
0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
-10
-20
-30
-40
Lawrence J. Lau, Stanford University
78
The Current Account Balance as a Percent of
GDP
T h e C u rr e n t A c c o u n t S u rp lu s (D e fic it) a s a P e r ce n t o f G D P
30
24
C h in a
Hon g K on g
I n d o n esi a
K o re a , R e p . o f
M a la y si a
P h i lip p in e s
S in g a p o r e
T a iw a n
T h a ila n d
M e x ic o
In d i a
P e rc e n t
18
12
6
0
198 6
198 7
198 8
198 9
199 0
199 1
199 2
199 3
199 4
199 5
199 6
199 7
199 8
199 9
200 0
-6
-1 2
Lawrence J. Lau, Stanford University
79
Rate of Inflation
(Consumer Price Index)
Rate of Change of the Consumer Price Index (Year-over-Year)
80
CHINA
INDONESIA
KOREA
PHILIPPINES
TAIWAN
INDIA
70
60
Percent per annum
50
HONG KONG
JAPAN
MALAYSIA
SINGAPORE
THAILAND
40
30
20
10
0
1990Q1
1991Q2
1992Q3
1993Q4
1995Q1
1996Q2
1997Q3
1998Q4
2000Q1
-10
Lawrence J. Lau, Stanford University
80
Rate of Inflation (Consumer Price Index)-without Indonesia
Rate of Change of the Consumer Price Index (Year-over-Year)
30
CHINA
JAPAN
MALAYSIA
SINGAPORE
THAILAND
25
Percent per annum
20
HONG KONG
KOREA
PHILIPPINES
TAIWAN
INDIA
15
10
5
0
1990Q1
1991Q2
1992Q3
1993Q4
1995Q1
1996Q2
1997Q3
1998Q4
2000Q1
-5
-10
Lawrence J. Lau, Stanford University
81
Lessons:
A Currency Crisis Inducing a Financial Crisis
The problem stemmed from insufficient liquidity in terms of foreign
exchange
Unexpected outflow of short-term capital caused the exchange rate to
plunge
A “bank run” on foreign exchange ensued
Financial insolvency caused by the resulting revaluation of the
foreign-currency denominated debt and the rise in the rate of interest
(due to expected further devaluation and increased volatility of the
exchange rate)
Domino effects of insolvency and bankruptcy, magnified by high
leverage (that is, debt to equity ratio), leading to systemic failure
Lawrence J. Lau, Stanford University
82
Lessons:
The Hazards of Short-Term Foreign Capital
There is good theoretical justification for the desirability of free trade
and free international flows of direct investment; there is no similar
justification for free international flows of short-term capital
Over-dependence on foreign capital, especially short-term foreign
capital, makes an economy and its exchange rate vulnerable
Foreign direct investment is better than foreign portfolio investment
or loans because it is less mobile
Long-term loans is better than short-term loans because they are not
subject to immediate withdrawal
Short-term foreign-currency denominated loans should be carefully
monitored and controlled in order to avoid the compounding of
currency mismatch by maturity mismatch
Short-term foreign funds are inherently different from short-term
domestic funds because
the former is much more likely to leave at
Lawrence J. Lau, Stanford University
83
the first sign of real or imagined trouble
Reducing Dependence on Short-Term Foreign
Capital
Lengthening maturities of foreign-currency denominated loans
through the imposition of a fee by the central bank, say, of 25 basis
points, each time such a loan is made or renewed. This fee implies
the recognition by the central bank of such a loan, which should be
comforting to the foreign lenders. However, it also has the effect of
forcing the foreign lenders and the domestic borrowers to rethink
whether a foreign-currency loan is in their best interests and if so
whether a longer-term loan, with floating rates of interest, may fit
their interests better, reducing the potential fees payable to the central
bank
Larger reserve requirements can also be imposed on non-resident
domestic currency deposits on the grounds that they are likely to be
more mobile than resident domestic currency deposits
Lawrence J. Lau, Stanford University
84
Reducing Dependence on Short-Term Foreign
Capital
Foreign portfolio investment can be channel into closed-end mutual
funds and/or foreign depository receipts, greatly reducing the
potential impact of a massive sell-off by foreign portfolio investors
on the exchange rate
Foreign direct investment should be promoted as a substitute to
foreign portfolio investment (Many East Asian countries, such as
South Korea and Thailand, used to discourage foreign direct
investment, especially in some selected industries.)
Lawrence J. Lau, Stanford University
85
Reducing Vulnerability to Speculation: An
Adequate Level of Foreign Exchange Reserves
An adequate level of foreign exchange reserves should be
maintained, taking into account not only trade flows but also shortterm and long-term capital flows. A conservative estimate of
foreign-currency needs would be three months of imports plus the
stock of foreign portfolio investment plus the stock of short-term
foreign-currency denominated bank loans plus debt service on longterm foreign-currency denominated debt. If foreign exchange
reserves, plus available lines from international organizations and
other counties, are perceived to be less than the estimated foreign
currency needs, a run on foreign currency may ensue.
Lawrence J. Lau, Stanford University
86
Lessons:
Avoiding Real Exchange Rate Appreciation
Maintaining a stable real exchange rate--a fixed exchange rate and
chronically higher relative inflation cannot be compatible in the long
run
A country must choose between having a fixed exchange rate and
hence low or zero inflation relative to the U.S. and having a high
relative inflation and continual devaluation
Lawrence J. Lau, Stanford University
87
Lessons: Excessive Leverage Should be
Discouraged/Prevented
Highly leveraged firms are more likely to fail than firms with low
leverage
Excessive leverage encourages moral hazard (recklessness) on the
part of the borrowers (risking “other people’s money”)
Excessive leverage also increases the odds of systemic failure
because of domino and spillover effects
A lower debt/equity ratio reduces the domino effect of insolvency
and bankruptcy--no borrower will become too big to fail
Excessive leverage of enterprises magnifies the effects of a sharp
devaluation even in the absence of foreign-currency denominated
liabilities because of the resulting rise in the rate of interest
The excessive leverage also enables the hedge funds to engage in
predatory speculation on a large scale
Lawrence J. Lau, Stanford University
88
Lessons: Excessive Leverage Should be
Discouraged/Prevented
Excessive leverage can be discouraged by the central bank charging
a commercial bank a deposit insurance premium that is calibrated to
the debt/equity ratio of the borrowers of the bank. This gives the
banks the incentive to lend to borrowers with lower debt/equity
ratios.
Lawrence J. Lau, Stanford University
89
Excessive Leverage Should be
Discouraged/Prevented
Globalization of accounting standards and disclosure (transparency)
requirements
Insistence of financially responsible auditors by lenders
Global credit reporting system for large borrowers (say over $500
million in aggregate debt) (e.g., LTCM, Daewoo)
Voluntary reporting by lenders of large credit transactions of large borrowers
(say, transactions exceeding $500 million each) to a central bureau operated by
a consortium of global lenders
Inquiry by lenders of total cumulative debt to-date (as opposed to debts to
individual lenders, thus preserving confidentiality and privacy) prior to
extension of additional credit
It is in the self-interest of each lender to cooperate and to report to such a
system
Regulatory agencies may require that a lender must have knowledge of the
total outstanding indebtedness of its large borrowers prior to extension of
Lawrence J. Lau, Stanford University
90
additional credit
Reduction of Moral hazard on the Parts of Both
Lenders and Borrowers
Past bailouts (Latin American loans, Mexican loans) of developed
country lenders encourage moral hazard on the part of lenders
Implicit guarantee of banks and enterprises “too big to fail” by
governments encourage moral hazard on the part of borrowers
Lawrence J. Lau, Stanford University
91
Lessons:
Containing Contagion
Predatory speculation by hedge funds should be monitored and
controlled --through mandatory disclosure of large positions (similar
to what New York Stock Exchange requires of individual stock
holdings) and imposition of margin requirements on purely
speculative (non-current account-related) spot, forward or future
currency transactions thereby reducing the degree of leverage and
hence potential profitability of such transactions
Worldwide or region-wide currency stabilization facility
Lawrence J. Lau, Stanford University
92
Lessons:
Post-Crisis Options for Exchange Rate Regimes
The impossible trinity--countries cannot simultaneously all three of
the following:
Large and deep individual markets--United States, Japan
Capital mobility
Independent monetary policy
Fixed exchange rate
Stabilization of a freely-floating currency is difficult unless it has a large and
deep market relative to the short-term capital flows
Currency areas
The Euro--even before the Euro there was the EMS “snake” pegged to the DM
(German Mark)--evidence that small and shallow markets for individual
currencies can be too volatile even for developed economies such as Austria,
Belgium and the Netherlands
World monetary union—A “group of three” monetary union advocated by
Robert Mundell, Nobel Laureate in Economics
Lawrence J. Lau, Stanford University
93
Lessons:
Post-Crisis Options for Exchange Rate Regimes
Capital control--Japan before 1980, China, Malaysia
Current account convertibility, long-term capital convertibility, limited shortterm capital convertibility
Some forms of capital control, especially on short-term flows, may make sense
to prevent exchange rates from being moved around excessively by short-term
capital flows as opposed to by real factors of competitiveness
For small economies, it is not possible to have a stable floating exchange rate
without some kind of control over short-term capital flows--this is because the
potential short-term capital flows can overwhelm the flows generated by
exports and imports of goods and services and long-term capital flows in the
determination of the exchange rate
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Post-Crisis Options for Exchange Rate
Regimes: Dollarization
True dollarization (Panama) and quasi-dollarization (Hong Kong,
Argentina) through a currency-board arrangement
True dollarization implies that the U.S. dollar will be legal tender for all
obligations and contracts can be denominated in U.S. dollars
Hong Kong and Argentina with a fixed U.S.$ peg are not quite truly dollarized
but is very close to being so
Benefits:
Insulation from exchange rate volatility
Promotes long-term FDI as well as foreign portfolio investment
The rate of interest and the rate of inflation will be at U.S. levels if credible
Facilitates foreign trade
Costs:
No more monetary policy (neither money supply nor interest rate can be
independently controlled)
Fiscal policy constrained by the ability to issue US$ denominated government
notes and bonds
Loss of seigniorage from currency issuance
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Dollarization
Conditions for an effective currency board system
Outstanding issues
A sufficient initial supply of foreign exchange reserves
Low, preferably zero, relative actual and targeted rates of inflation
A low level of short-term foreign capital (including debt) relative to official
foreign exchange reserves
Fiscal conservatism—a low level of net public debt over the economic cycle
Is there a lender of last resort (to domestic financial institutions)?
Can the seigniorage be shared under true dollarization?
Coordination, if any, of monetary policy with the U.S. (e.g., monetary union)?
The U.S. benefits from seigniorage, both direct and indirect
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A Multilateral Currency Swap Framework with
Bilateral Agreements
The ASEAN (Brunei, Indonesia, Malaysia, Myanmar, Khmer
Republic, Laos, Philippines, Singapore, Thailand and Vietnam) + 3
(China, Japan, Korea) have approved, in principle, bilateral standby
swap arrangements for the support of the exchange rate
It is also possible to have bilateral agreements on settlement of
transactions in the currencies of the countries instead of the U.S.
dollar, thus conserving foreign exchange reserves and freeing them
up for potential use in emergencies
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A Rule-Based Lender of Last Resort: The IMF
Contingent Credit Line (CCL) Facility
The facility offers countries with sound economic policies a one-year
(renewable) precautionary line of credit to defend against potential
balance of payments problems that may arise from financial
contagion
The distinction is between temporary illiquidity, which the IMF is
prepared to relieve with financial resources provided under the credit
line, and insolvency, for which more structural readjustment and
reform will be required
No country has applied as yet—signaling effect, insufficient
automaticity, surcharge and commitment fee (eliminated in
November 2000)
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A Rule-Based Lender of Last Resort: A
Cooperative Asian Currency Stabilization Fund
A multi-country cooperative currency stabilization fund may have a
useful role to play by augmenting the potential foreign exchange
reserves perceived to be available for the defense of any single
currency. (Timely intervention in the currency markets of certain
countries, such as Indonesia, would have helped to reduce the misery
significantly.)
In order to avoid moral hazard, countries must meet certain
prescribed rules of solvency and liquidity in order to avail
themselves of the facility
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Problems of Exchange Rate Stabilization
for a Small Economy
A thin market--total volume small relative to the size of hedge funds
and other pools of hot money (estimated to total 100s of billions of
US$)
E.g. the average daily net turnover of foreign exchange trading in April 1995 in
Hong Kong was US$90 billion compared to US$1,460 billion for the world as
a whole
At the time Hong Kong had foreign exchange reserves of US$ 55 billion
Shorting the Hong Kong $ for 6 months require only a 4% premium
Possibility of market manipulation due to lack of regulation and
transparency
Central bank/monetary authority has to assume the role of marketmaker
A credibly adequate level of foreign reserves (and/or standby
commitment from an international or regional stabilization facility) is
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required
The Importance of Expectations in
Exchange Rate Stabilization
Sudden increase in variance (riskiness) encourages flight to safety
Confidence of domestic citizens most critical
Successful stabilization requires “decisive and overwhelming force”
Perceived commitment is more important than
the actual value of the exchange rate (the Hong Kong (1983) and Chinese
(1993) examples) or
the actual amount of foreign exchange available (the Mexican example)
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The Size of the Global Foreign Exchange
Market
According to the Bank for International Settlements data, London is the largest
foreign exchange market in the world with average daily turnover of
approximately $650 billion in 1998
London is larger than the New York and Tokyo markets combined
Total worldwide average daily turnover is probably on the order of US$2 trillion,
approximately two-thirds of the trade are conducted through the interbank market
Private capital flows to developing countries increased from US$40 billion in 1990
to US$290 billion in 1997
There are between 3,000 and 4,000 hedge funds, at a conservative estimate of
US$100 million of equity capital each, with an estimate of aggregate capital of
between US$300-400 billion
Large and well known funds such as Quantum Fund (Soros) and Tiger Fund had
approximately US$20 billion worth of capital
With leverage, the hedge funds can collectively undertake transactions as high as
US$10 trillion (Total U.S. stock market capitalization is US$12.5 trillion)
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Is Another Crisis Likely?
Based on the early warning economic indicators, the East Asian
economies are unlikely to have another crisis in the foreseeable
future
The savings rates have remained high while the savings-investment gaps--also
reflected as the current account gaps--have largely disappeared
The dependence on short-term foreign capital (portfolio investment--both
equity and debt instruments--and loans) has been significantly reduced
Foreign investment now consists mostly of direct rather than portfolio investment
Both total and short-term external debts have declined
The ratio of short-term to total external debts has also declined
Foreign exchange reserves have risen both absolutely and as a percentage of
annual imports
Real exchange rates have depreciated significantly from their peaks in most of
the affected economies
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