N o . 51 Marek D¹browski (ed.) Currency Crises in Emerging-Market Economies: Causes, Consequences and Policy Lessons with contribution from Ma³gorzata Antczak, Rafa³ Antczak, Monika B³aszkiewicz, Georgy Ganev, Ma³gorzata Jakubiak, Ma³gorzata Markiewicz, Wojciech Paczyñski, Artur Radziwi³³, £ukasz Rawdanowicz, Marcin Sasin, Joanna Siwiñska, Mateusz Szczurek, and Magdalena Tomczyñska and editorial support of Wojciech Paczyñski W a r s a w , 20 0 2 Summary Report from the research project on "Analysis of Causes and Course of Currency Crises in Asian, Latin American and CEE Countries: Lessons for Poland and Other Transition Countries", grant No. 0144/H02/99/17 of the State Committee for Scientific Research (KBN). The publication was financed by Rabobank Polska S.A. Key words: currency crisis, financial crisis, contagion, emer- ging markets, transition economies, exchange rates, mone- tary policy, fiscal policy, balance of payments, debt, devalua- tion. DTP: CeDeWu Sp. z o.o. Graphic Design – Agnieszka Natalia Bury Warsaw 2002 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, without prior permission in writing from the author and the European Commission. ISSN 1506-1647 ISBN 83-7178-285-3 Publisher: CASE – Center for Social and Economic Research ul. Sienkiewicza 12, 00-944 Warsaw, Poland e-mail: [email protected] http://www.case.com.pl Currency Crises in Emerging-Market Economies ... Contents Abstract . .7 1. Introduction . .9 2. Definition of Currency Crisis and its Empirical Exemplification . .12 3. Theoretical Models of Currency Crises . .17 3.1. First-generation Models . .17 3.2. Modified First-generation Models . .18 3.3. Second-generation Models . .19 3.4. Third-generation Models . .20 4. Early Warning Signals . .21 5. Causes of Currency Crises . .25 5.1. Fiscal Imbalances . .25 5.2. Current Account Deficit . .27 5.2.1. Evolution of the Theoretical Views . .27 5.2.2. Results of Empirical Research . .28 5.3. Currency Overvaluation . .29 5.3.1. How to Measure a Real Exchange Rate Overvaluation? . .30 5.3.2. Results of Empirical Research . .30 5.4. The Role of Exchange Rate Regimes . .32 5.5. Structural Weaknesses of the Banking and Corporate Sectors . .33 5.5.1. Relationship Between Banking and Currency Crises . .33 5.5.2. The Most Frequent Weaknesses of the Banking Sector . .34 5.5.3. Review of Empirical Research . .34 5.6. Political Instability . .35 6. Crisis Management – How to Defend an Exchange Rate if at All? . .37 7. Contagion Effect . .39 7.1. Definition Problems . .39 7.2. The Channels of Crises Propagation . .39 7.3. Empirical Investigation of Contagion Effect in CIS Countries . .40 8. Economic and Social Consequences of Currency Crises . .43 9. Crisis Prevention . .48 9.1. The Role of International Liquidity in Preventing Currency Crises . .48 9.2 The Role of the IMF in Preventing Currency Crises . .50 10. Research Conclusions and Policy Recommendations . .54 References . .56 CASE Reports No. 51 3 M. D¹browski (ed.) List of figures Figure 2.1. Typology of financial crises . .12 Figure 2.2. Severity of the currency crises measured by reserve losses and nominal depreciation of the domestic currency . .14 Figure 2.3. Real interest rate differentials around crisis dates, monthly . .14 Figure 2.4. Nominal and real interest rates before and after the crisis . .15 Figure 2.5. Broad money monetization in the crisis countries, 1992–1998 . .16 Figure 4.1. Early warnings indicator (statistically significant) . .21 Figure 4.2. Behavior of selected warning indicators (stylized facts) . .22 Figure 4.3. Reserves over short-term debt . .23 Figure 4.4. Ratio of the official international reserves to reserve money . .23 Figure 4.5. Real effective exchange rates in crisis countries . .24 Figure 4.6. Real exchange rates in relation to US dollar, CPI based . .24 Figure 5.1. Links between fiscal variables and currency crisis – review of empirical research . .25 Figure 5.2. The value of fiscal indicators in predicting a crisis in selected FSU economies . .26 Figure 5.3. Summary of the empirical researches showing the role of a current account deficit in predicting currency crises . .29 Figure 5.4. Summary of the empirical researches showing the role of real exchange rate overvaluation in predicting currency crises . .31 Figure 5.5. Performance of bank crises as a signal of currency crises and vice versa . .35 Figure 6.1. Declared and actual changes in the exchange rate regime during the crisis . .38 Figure 7.1. Contagion crisis probability in transition countries basing on trade links – results of the probit model . .41 Figure 7.2. Trade matrix of the crisis-affected countries in 1997 (% of total exports) . .41 Figure 7.3. Contagion crisis probability in transition countries: comparison of results of the probit and balance of payments models . .42 Figure 8.1. Real GDP growth rate before and after the crisis (median) . .44 Figure 8.2. Costs of crises in terms of lost output relative to trend . .45 Figure 8.3. Net capital inflow before and after the crisis . .45 Figure 8.4. CPI, y-o-y percentage change before and after the crisis; monthly data (medians for subgroups) . .46 Figure 8.5. Unemployment rate before and after the crisis . .47 Figure 9.1. Evaluating optimal international liquidity – marginal cost and benefit . .49 Figure 9.2. Optimal liquidity holding versus cost of the crisis . .50 Figure 9.3. Crisis cost to the policy maker, as of end-99 . .50 Figure 9.4. Compliance with the IMF quantitative performance criteria . .51 Figure 9.5. Compliance with IMF structural conditionality . .52 4 CASE Reports No. 51 Currency Crises in Emerging-Market Economies ... Marek D¹browski Professor of Economics Chairman and one of the founders of the CASE – Center for Social and Economic Research in Warsaw From 1991 involved in policy advising for governments and central banks of Russia, Ukraine, Kyrgyzstan, Kazakhstan, Georgia, Uzbekistan, Mongolia, and Romania; 1989–1990 First Deputy Minister of Finance of Poland; 1991–1993 Member of the Sejm (lower house of the Polish Parliament); 1991–1996 Chairman of the Council of Ownership Changes, the advi- sory body to the Prime Minister of Poland; 1994–1995 visiting consultant of the World Bank, Policy Research Department; from 1998 Member of the Monetary Policy Council of the National Bank of Poland. Recently his area of research interest is concentrated on macroeconomic policy problems.