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Economic Review 99-03 Depreciation and Recessions in East Asia The recent currency and financial crises in East Asia have sparked a new round of theoretical and empirical research on the causes of such crises, leading to significant advances in our understanding of these issues.1 However, there has Ramon Moreno been relatively little recent discussion of the aftermath of these crises. In particular, one of the striking characteris- tics of the recent currency crises in East Asia is the sharp reductions in output that followed depreciations. At first glance, this outcome seems counterintuitive, as deprecia- tions are generally expected to boost output. Recent explanations for closely timed depreciations and output contractions focus on the interaction between ex- ternal shocks and financial sector disruptions. In this view, Senior Economist, Federal Reserve Bank of San Francisco. low interest rates in industrial economies and sterilized in- The author thanks Mary Daly, Mark Spiegel, and partici- tervention policies that kept interest rates high in emerg- pants at a Federal Reserve Bank of San Francisco semi- ing markets contributed to a surge in capital flows to the nar for helpful comments, and Guillermo F. Pinczuk for emerging markets in the first half of the 1990s (Calvo, Lei- research assistance. derman, and Reinhart 1996). These capital flows supported credit growth and a boom in economic activity in East Asia that was associated with growing financial sector vulnera- bility. Financial liberalization also may have played a role in financial vulnerability (Diaz Alejandro 1985, Kaminsky and Reinhart 1999). According to these explanations, the One of the striking characteristics of the recent currency unprecedented contractions in output observed in East Asia crises in East Asia is the sharp reductions in output that following the currency depreciations of 1997 were the re- followed depreciations. This paper draws on an earlier lit- sult of financial crises. These in turn were caused either by erature on contractionary depreciations to motivate an em- panics in illiquid financial systems (Chang and Velasco pirical model of the relationship between exchange rate and 1998, Radelet and Sachs 1998) or by moral hazard that made output fluctuations in a panel of six East Asian economies. financial systems vulnerable to shocks because of exces- There is evidence of a negative relationship between eco- sively risky lending or unhedged foreign currency borrow- nomic activity and the real exchange rate in East Asia. In- ing (McKinnon and Pill 1998, Krugman 1998, Corsetti, formal examination of output fluctuations around episodes Pesenti, and Roubini, 1998). of sharp depreciation over the 1975–1996 period conveys While the relationship between financial crises and cur- the impression that such episodes are associated with mod- rency crises in East Asia in 1997 is very evident and is est expansion and contraction cycles, with output above broadly consistent with the experience in other emerging trend before a sharp depreciation episode and below trend markets (Kaminsky and Reinhart 1999), the characteristics after it. The cyclical pattern is accentuated when the sharp of past depreciations in East Asia—and their implications depreciation episode occurs during a banking crisis. The very steep output declines that followed the 1997 sharp de- preciation episodes appear to reflect a high concentration 1. For a recent overview of this literature of stylized facts around cur- of banking crises of unprecedented severity. However, ex- rency crises episodes, see IMF (1998). Glick and Moreno (1998) and Moreno (1999) discuss the predictive ability of alternative macroeco- plicitly accounting for sharp depreciation episodes or bank- nomic indicators on the eve of currency crises in East Asia. For discus- ing crises does not add to the explanatory power of the sions of the causes of these crises see also Corsetti, Pesenti, and Roubini benchmark model over the period 1975–1996. (1998), Radelet and Sachs (1998), and Chang and Velasco (1998). 28 FRBSF ECONOMIC REVIEW 1999, NUMBER 3 for output behavior—have not been so closely studied. In relationship between the real exchange rate and output. If particular, it is of interest to inquire whether depreciations the coefficient is negative, depreciations are contractionary. have been associated with output contraction in East Asia Using panel data from developing countries Edwards (1989) in the past, and whether currency and banking crises have and Agenor (1991) estimate equations similar to equation played a significant role in explaining output fluctuations. (1) and find evidence suggesting that depreciations are τ τ To address these questions, we draw on an earlier litera- contractionary. As we shall see, 2 and 3 also may be af- ture on contractionary depreciations2 to motivate an empiri- fected by contractionary depreciation effects. cal model of the relationship between exchange rate and As much of the discussion that follows will focus on the output fluctuations in a panel of six East Asian economies. derivation and interpretation of the first three coefficients This paper is organized as follows. Section I discusses of equation (1), it is worth discussing the external shocks τ alternative ways in which a reduced-form relationship be- briefly. The coefficient 4 reflects the impact of foreign eco- tween the real exchange rate and output may be derived and nomic activity on domestic output, and its sign is expected interpreted and conditions under which contractionary de- to be positive. τ preciation may occur. Section II estimates regression mod- The coefficient 5 reflects the impact on domestic output els of the relationship between exchange rate behavior and of global interest rate shocks, which may occur through in- output fluctuations. Section III highlights the behavior of ternational capital flows and which is likely to be negative. exchange rates and output around periods of sharp depre- A rise in world interest rates reduces capital inflows and ciation and banking crises and extends the model to control may adversely affect investment demand and output. Re- for episodes of currency crises and banking crises. Section search by Calvo, Leiderman, and Reinhart (1993, 1996) IV offers some conclusions. suggests that global interest rate shocks are important con- tributors to capital flows in developing countries. Agenor I. MODELS OF CONTRACTIONARY and Hoffmaister (1998) confirm that these results carry DEPRECIATION through in the East Asian context. Using VA R models, they find that world interest rates have a significant impact To motivate the analysis of contractionary depreciations, on capital flows and the real exchange rate in Korea, the consider the following reduced-form model of the relation- Philippines, and Thailand. Agenor (1998) develops an in- ship between the real exchange rate and output: tertemporal optimizing model that spells out the conditions that determine the impact of global interest rate shocks on (1) y – ¯y = τ (e – ¯e) + τ (m – m¯ ) + τ (g – g¯ ) 1 2 3 capital flows. τ τ ξ + 4(y* – ¯y*) + 5(r* – ¯r*) + , Before estimating equation (1), two questions are worth addressing. First, what explanations may be offered for where bar superscripts refer to expected or trend values and contractionary depreciation effects? Second, what type of y = output macroeconomic framework is consistent with the reduced- e = real exchange rate, measured so that an increase is form specification used in equation (1), and what do these a depreciation models say about the signs of the various coefficients? In m = money particular, to what extent can equation (1) be reconciled g = government spending with equilibrium optimizing behavior by rational agents? y* = foreign output In the discussion that follows, we will review how the r* = world interest rate, and literature has addressed these questions by focusing on two ξ = reduced-form residual. models. One model, by Agenor (1991) shows how contrac- Equation (1) is broadly consistent with empirical mod- tionary depreciation effects may reduce aggregate supply els of contractionary depreciation that have been estimated because of the use of imported inputs in production. An- in the literature, and it provides a reasonably complete de- other model, by Gavin (1992) shows how depreciation may scription of possible influences to economic activity, as it have a contractionary influence on demand if there is in- accounts for domestic monetary and fiscal conditions, as vestment spending on imported capital goods. Thus, the two well as external shocks. Researchers have been particularly models provide complementary interpretations of equa- interested in the coefficient τ , which measures the direct 1 tion (1). Agenor’s model will be discussed in some detail to provide a benchmark for alternative interpretations and 2. The traditional literature refers to contractionary devaluations rather to highlight the contributions and limitations of the litera- than depreciations, because the focus was on episodes in which single- currency pegged exchange rates were abandoned. In this sense, the ref- ture on contractionary depreciation. We also will briefly erence to depreciations is more general, referring to economies where discuss alternative explanations of contractionary depreci- exchange rates may be flexible to varying degrees. ation effects, the difficulties associated with incorporating MORENO / DEPRECIATION AND RECESSIONS IN EAST ASIA 29 contractionary depreciation effects in fully specified in- where w is the log nominal wage, pd is the log producer price α ρ tertemporal optimizing models, and the possible implica- for the domestic good, c1 = (Q¯ /N¯ ) is the share of imported α ρ tions of sharp depreciation episodes and banking crises. materials (0 < c1 < 1), c2 = (1 – )(Q¯ /V¯ ) is the share of do- mestic value added (0 < c2 < 1, c1 + c2 = 1), e = (s + pn – pd) Depreciation Effects with Imported Inputs is the log of the real exchange rate, and s is the log nominal exchange rate. Following Agenor (1991),3 consider a small open economy The derived demand for imported raw materials depends with a fixed exchange rate and a perfectly elastic supply on the same three variables: schedule for imports.
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