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Capital Account Liberalization and Currency Crisis – the Case of Central Eastern European Countries

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Capital Account Liberalization and Currency Crisis – the Case of Central Eastern European Countries Capital Account Liberalization and Currency Crisis – The Case of Central Eastern European Countries Malgorzata Sulimierska Economic Department, University of Sussex, Brighton BN1-9RH, England E-mail: [email protected] Abstract The dissertation investigates if Central and Eastern European countries with unregulated capital flows are more vulnerable to currency crises. In order to answer this question properly the paper considers two lines of analysis: single-country and multi-country. Single –country studies look into three cases: Russia, Poland and Latvia. The multi-country analysis is the simple adaptation of Glick, Guo and Hutchison’s probit panel model (2004). The results suggest that countries with liberalized capital accounts experience a lower likelihood of currency crises. Moreover, the information from case studies pointed that the speed and sequence of the CAL process needs to be adequate for the country development. Keywords currency crises, capital account liberalization, exchange rate CONTENTS INTRODUCTION.............................................................................................................. 3 CHAPTER I. The theoretical link between Capital Account Liberalization and 6 Currency Crisis episodes .……………………………………………….. 1.1. Capital Account Liberalization…………… ………………………………………... 6 1.1.1. Capital flows......................................................................................................... 6 1.1.2. Capital controls..................................................................................................... 8 1.1.3. The preconditions and sequencing of Capital Account Liberalization................. 12 1.1.4. CAL Measures...................................................................................................... 13 1.2. Currency Crisis Theory................................................................................................ 19 1.2.1. Definition of a Currency Crisis .................... .................... .................... ............... 20 1.2.2. Theoretical Currency Crisis models .................... .................... .................... ......... 24 1.3. The Link between the regulation of capital control and currency crisis events.......... 35 CHAPTER II. Overview of empirical literature ……………...…………………………. 41 2.1. Empirical literature – single country studies……… ………………………………. 42 2.2. Empirical literature –multi-country studies…............................................................. 54 CHAPTER III. The cross-country empirical model……………….…………………….. 63 3.1. Motivation for the cross-country analysis………….. ……………………………… 63 3.2. Methodology……………………………………………………………………….. 66 3.3. Data construction and descriptive statistics………………………………………… 68 3.3.1. Definition of Currency Crises………………………………………………….. 68 3.3.2. Measuring the liberalization of capital control regulations……………………. 70 3.3.3. Descriptive statistics on Currency Crises and CAL…………………………… 75 3.4. Empirical implementation and results: estimating propensity scores and currency crisis equations.......………………………………………………………………… 78 3.4.1. Propensity scores………………………….......................................................... 78 3.4.2. Currency crisis equations ………………………………………......................... 82 CONCLUSION………………………………………………………………………….. 86 BIBLIOGRAPHY............................................................................................................... 89 105 INDEXES……….……….................................................................................................. APPENDIXES..………….................................................................................................. 107 1 INTRODUCTION The topic of capital account liberalization (henceforth CAL) and currency crisis episodes is an important issue for today’s emerging market economies in the current era of multinational financial integration, the technology progress and development of international organizations such as the IMF, EU and OECD. Nevertheless, the CAL process is not a new issue; a similar situation occurred in the era of globalization from 1870-1914 when the capital flows were free of any restrictions. 1 However, at that time money could not be transferred with the press of a button from one part of world to another in one second. Today, the debate about the relationship between CAL and the currency crisis phenomena has become a heated one. This is due to the fact that in the last two decades, the increase of the intensity of the CAL process has been accompanied by an increase of currency and banking crises phenomenon, particularly in developing countries. 2 Many countries imposed or were tempted to impose controls on international capital movement in fear of the economic disruption that may accompany capital flows (e.g. Malaysia, Chile) 3. These capital controls have different forms, and their efficacy in promoting or deterring currency crisis episodes or economic growth is questionable and much debated. 4 Furthermore, at present, the macroeconomic empirical analysis and theoretical implications have not found conclusive evidence demonstrating that CAL increases the risk of a currency crisis. These ambiguous empirical results have moved the researchers’ attention towards investigating the different ways of measuring CAL and currency crisis events, as well as more complicated econometric techniques. 5 In this context, Central and Eastern European (henceforth CEE) countries 6 seem to be very interesting case studies for analyzing the connection between CAL and currency crisis events. Since Berlin Wall fell most of the CEE countries have transformed their economy from totally closed to an almost fully integrated economy with a global market (e.g. 1 See among others Bordo (2007), Henry (2006), Summer (2000) and Stiglitz and Charlton (2004). 2 Griffith-Jones, Gottschalk and Cirara (2000) found that three countries (Korea, Mexico and the Czech Rep.) from the six emerging countries that joined the OECD and liberalized their capital flows in the 1990s, had a large and costly crisis shortly after they joined. 3 See Kawai and Takagi (2003), Kapla and Rodrik (2001), Charlton and Stiglitz (2004), Cowan et al (2005). 4 See Le Fort and Lehman (2003), Glick, Reuven and Hutchison (2000), Eiteman, Stonehill and Moffett (2006). 5 See Jonhston and Ryan (1994), Quirk (1994), Kaminsky and Reinhart (1999), Kauffman (2000), Martin and Rey (2002), Williamon (2002), Tudela (2004), Rodrik (1998), Edwards (2001), Klein and Olivei (2000), Arteta, Eichengree and Wyplosz (2001), Gruszczynski (2001), Demirguc-Kunt and Detriagiache (1998), Eihengreen and Rose (1999), Calvo and Reinhart (2000), Licchenta (2006). 6 Russia and Ukraine were included to this analysis due to these countries are very interesting in the context of this subject. Both countries had currency crisis and similar communist history to other CEE’s countries. 2 participation in international organizations, liberalization of capital and trade regulations). 7 In addition, most of these countries have had constant speculative attacks on their currency over the last ten years 8, which has often forced them to seek helps in IMF or World Bank programs. 9 Sometimes this cooperation with international organizations has had a positive effect of CAL intensity (e.g. the Baltic countries or Czech Republic). On the other hand, the transition from communism to a market economy has been more complicated than simply an economic one. There has also been the transformation of social structures and political changes which are connected with additional costs for the economy such as additional early retirement or unemployment benefits 10 . In this situation, CEE countries experienced macroeconomic problems such as fiscal deficit, macroeconomic instability and high inflation. Therefore, all CEE countries’ experiences implied that the analysis might be very interesting. However, the simultaneous political-economic-social changes might provide an unambiguous answer to the questions about the CAL’s negative impact on the likelihood of a currency crisis. Maybe this is the reason why the impact of CAL on currency crisis episodes for CEE countries has not been documented yet. There are only a very few papers that seek to account for the impact of the CAL process on the structure of capital flows into Central Eastern Countries and EU/EMU accession problems, or which try to explain the reasons for the currency crisis episode in single countries (e.g. the Czech Republic crisis, the Bulgarian crisis). 11 All the points which are mentioned above suggest that there is room for another analysis which will assess the negative impact of capital liberalization on the risk of currency crisis in CEE countries over the last ten years. In order to explain that free movement of capital reduces a country‘s vulnerability to currency crisis, three aspects need to be considered. Firstly, how theoretical studies can explain the currency crisis and whether there is any theoretical background which supports the hypothesis that CAL has an impact on currency crisis episodes. Secondly, it is necessary to consider whether there is any empirical evidence from single-country studies that might maintain the negative correlation between 7 Since 2004, 8 CEE countries have accessed to EU and most of them were members of the IMF. 8 According to my own calculations for 12 countries from this region, there were between 77-99 speculative attacks episodes over the period 1995-2005 and 7-16 were successful
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