Crisis Talk - The World Bank Group

The Double-Edged Sword of Emerging Market Growth

The Economist has two interesting articles this week about capital flows in India. The Indian government is currently confronted with the a challenge of nurturing the growth of India's financial markets and multinationals, while mitigating the risks of excessive "hot money" flowing into the economy.

Proponents of capital controls point to India's success in avoiding the worst of the Asian financial crisis in the late 1990s and the current crisis, which was in part achieved by limiting the amount of money flowing in and out of the economy (for example, foreigners are limited in the amount of local bonds they can purchase).

Yet, India remains a sponge for foreign capital. The Economist notes that foreigners have invested $13.8 bn in India’s stockmarkets since April, having withdrawn $8.6 billion over the same period last year. The Sensex, India’s most widely watched stockmarket index, has surged by almost 100% since its March lows.

Advocates of a stricter capital controls are facing a strong resistance from the market...

What's New in Decoupling?

I recently wondered what the relationship between developed and emerging economies would look like during the recovery phase of the crisis:

Will a robust emerging market rebound boost OECD growth? Or, are we due to see a multi-speed global recovery?

John Authers points out that, thus far, the recovery has been quite heterogeneous:

The grand theory was that decoupling by emerging markets would be good for everyone- they would grow even if consumers in the developed world caught a cold, and help everyone through. The latest data suggest a decoupled world, but that does not seem so positive.

Authers highlights the Reserve Bank of India's recent decision to raise rates and the "stunning" recovery in South Korea. Meanwhile, consumer confidence in the US is awful. He concludes:

Asian economies are already at the point where overheating is the main danger, while US consumers, for all the money thrown at them, are still not feeling any better. This is not encouraging.

Meanwhile, equity indices are down and the dollar is up. Perhaps investors were a bit too sanguine, and are now sobering up?

Weekend Reading

"Good news for investors who like to lose all their money". LTCM 3.0 is here.

The dangers of ultra cheap money.

Is US Government debt actually "risk-free"?

Historically, a weak dollar has been deflationary.

Great charts from Calculated Risk and Barry Ritholtz.

The average unemployment period in the US is at an all-time high.

Another take on why bankers make so much money.

Is Paul Krugman Panda-bashing?

"If you are going to be doing business in a foreign country, particularly China, it pays to do so legally and it pays to have the right visa."

South-South Trade Tensions

John Authers argues that the newsworthy economic story of late isn't dollar weakness; rather, it is the weak renminbi:

Many, if not most, hopes for global recovery are pinned on China buying goods from countries such as Brazil. Commodity prices, a key driver of equities and forex rates, also move in response to the new orders received by China's manufacturers.

This currency regime makes it far harder for such countries to sell to China. So it is no wonder that currencies are back at the top of the agenda.

China's currency is 15 percent cheaper against the dollar than it was in 1993. Meanwhile, many emerging market currencies are returning to their pre-crisis exchange rates.

China has been building stronger trade relations with the Global South for quite some time. It is now South Africa's top export destination. But many of these partnerships are built around China purchasing commodities, and selling manufactured goods. With a weakening currency, China is likely to purchase fewer non-commidty goods from its trading partners. This may lead to growing trade tensions, particluarly with countries who are not endowed with commodities.

East Asian Production Networks: Beggar Thy Neighbor?

There is an interesting article in Econbrowser by Willem Thorbecke of the Asian Development Bank, which looks at East Asian Production Networks, Global Imbalances, and Exchange Rate Coordination.

Thorbecke highlights the important relationship between exchange rates and production chains in East Asia, arguing for increased policy coordination between the two. The paper presents both good news and bad news regarding East Asia's crisis recovery. First, the good news:

Signs are emerging that East Asian production networks are reviving. Imports for processing and processed exports both collapsed earlier this year. Since then, however, imports for processing have recovered 85 percent of their losses and processed exports 75 percent. Thus trade within East Asian production networks is recovering.

Rising Reserves

One sign of crisis abatement is the downward slide of the US dollar. As the market rediscovers its appetite for risk, the dollar's appeal as a safe haven currency diminishes. Indeed, the dollar has become the de facto carry trade currency. 

The market has renewed its faith in emerging markets, and the US has more tools to repair its trade balance and begin a phase of export-led growth? Is this a win-win situation? Not quite.

Although the dollar may be weakening, this weakening hasn't stopped central banks from accumulating more dollar reserves. In fact, dollar weakness may be accelerating accumulation.

Last week, several emerging market countries intervened in currency markets in order to prop up the dollar (or, rather, to push down their own currencies).  This involves buying dollars: Russia recently picked up $1.4bn in a single day, and $4bn in the same week.  

What are central banks doing with these dollars? Most of them are tucking them away for a rainy day, having seen the benefits of such accumulation during the crisis.

Crisis Roundup

European exports declined by 5.8 percent last month, the biggest drop since last January.

Understanding the European Central Bank means looking at its individual members.

The economic blogosphere really is a remarkable resource.

Bloggers at the IMF's ask, Did Islamic Banks in the Gulf Do Better Than Conventional Ones in the Crisis?

Did economic theory actually do a good job of predicting the crisis?

Greg Mankiw ♥ VAT.

Thoughts on exit strategies from one of China's prominent market economists.

Does China have a dollar problem?

Still confused about the dollar? Why do many of Asia's currency remain weak? Why are the euro and yen so strong, when their respective economies look weak? Bilal Hafeez, global head of foreign exchange research at Deutsche Bank is fielding questions from readers, which he will answer on Monday October 19.

Exchange Rate Movements in the Crisis and Beyond

Editor's note: Sebastian Weber and Charles Wyplosz are from the Graduate Institute in Geneva. They are the authors of a World Bank working paper on Exchange Rates during the Crisis.

A key leitmotiv as the financial crisis unfolded was to avoid a repeat of the policy mistakes of the Great Depression, including the beggar-thy-neighbour competitive devaluations which have had devastating effects causing rising protectionism and a collapse of international trade (Kindleberger, 1973).

Unlike in the 30s, only some 42% of countries are officially pegging their exchange rate today, implying that movements in the exchange rate do not necessarily reflect official decisions, but are rather market-driven. Furthermore, governments today have many more policy tools at hand, ranging from fiscal policy over labour markets to monetary policy measures, making them less reliant on measures that are perceived as beggar-thy-neighbour.

While exchange rates have moved a lot since the onset of the crisis, these movements have mostly been interpreted as a byproduct of expansionary policies and the move to ‘quality’. Sharp depreciations in countries like the UK or South Korea have not been welcomed by the authorities, at least not officially. Intentions, of course, are hard to detect and no one will argue that expansionary policies were not needed.

 

Local Bond Markets: From Strength to Strength

Most emerging markets are having a better crisis than their G7 counterparts. One sign of robustness in emerging markets is the growing importance of their local bond markets. A new paper from Vox by Ismali Dalla and Heiko Hesse (of the IMF) takes a look at how local-currency bond markets are becoming a viable funding alternative for many emerging market issuers.

Not surprisingly, many of the countries that have succeeded in weathering the worst of the crisis (China, India, Brazil, Poland) also have substantial local bond markets:

 

Global Monetary Architecture Matters

Editor's Note: Nadia Piffaretti is an assistant to the Chief Economist at the World Bank Group and a Special Assistant to the Senior Vice President. She is the author of an upcoming paper on Reshaping the International Monetary Architecture.

The crisis has taught us that economists ought to believe their own warnings about systemic vulnerability. If analysis points out that a system can fail, it probably will at some point. Knowing what we know today, having experienced – in a sort of “real-life economic laboratory” – how systemic vulnerabilities can transmit and amplify shocks, we cannot avoid turning a worried eye to the largely imbalanced growth of the global economy.

Before this crisis, many economists had warned about another crisis – a disorderly unwinding of global imbalances. It didn’t happen. It still may.

While most recently global imbalances have been narrowing, due to short term factors (like oil prices), the IMF is forecasting a widening again starting in 2010. At the same time, conditions do not seem to be reunited for a clear shift of growth engines at both sides of the global imbalances, especially at a juncture when governments attempt to calibrate exit-strategies from fiscal stimuli, walking the fine line between possible fiscal unsustainability, and the risk of too early withdrawal of stimulus.

It is against this backdrop, and the realization that the international monetary architecture looks vulnerable indeed, that I reminded myself of the almost forgotten “1941 Keynes’ Plan” which the “Master” had elaborated in view of the Bretton Woods negotiations.

The plan stemmed from the idea that monetary architecture matters.

Weekend Reading

Real Time Economics interviews: Hernando de Soto talks about the effects of the crisis on the world's poorest, while our Chief Economist Justin Lin discusses China, the IMF, and stimulus packages.

Paul Kedrosky praises venture capitalists.

One quarter of US jobs are offshorable. It might not matter.

Unemployment is high on Europe's frontiers.

In other unemployment news, Ryan Avent thinks that the stimulus is needed to fight joblessness. Tyler Cowen doesn't.

The US trade gap narrowed last month. It is down almost 50 percent from a year ago. Could it have anything to do with the dollar?

Larry Summers dismisses the idea of a low-growth America.

Our East Asia blog looks at 60 years of China's development, and asks, "Are China's banks having a good crisis?"

Emerging Market Merry-go-Rounds

Paul Kedrosky writes about one of my favorite topics, emerging market decoupling. He cites a new report by HSBC which discusses a "global monetary merry-go-round":

Our optimistic views on the emerging world are also based on what we call the monetary merry-go-round. Low US interest rates typically encourage capital to flow into the emerging world. Attempts by emerging nations to limit the resulting exchange rate appreciation lead to offsetting capital outflows in the form of rising foreign exchange reserves which are often invested in US Treasuries. Higher demand for Treasuries keeps yields low and, hence, leaves US interest rates low, thereby allowing the merry-go-round to repeat, seemingly ad infinitum.

Pity the Pound

A few weeks ago I wondered if Britain was back. According to the Bank of England, it's not.

The Times reports:

In its Quarterly Bulletin, the Bank tried to explain the reasons for the collapse in value of sterling since the final quarter of last year. It said: "It is possible that sterling's depreciation may be part of a more prolonged process of rebalancing of the UK economy, generating a fall in the long-run sustainable real exchange rate."

Weekend Reading

The European Central Bank's crisis efforts are laudable. The current account surplus is back in the black, and the euro is hitting one-year highs against the dollar.

Meanwhile, sterling continues to suffer.

An explanation of the new dollar carry trade.

The American manufacturing sector is rebounding.

The jobless recovery has been kind to those with jobs. Wages are up.

California is investigating the ratings agencies.

Speaking of California and the ratings agencies, Moody's forecasts that California's real estate sector won't return to normal until 2030.

Finally, where is Paul Volcker?

Plus: In case you get lost in the thicket of financial jargon, the Devil's Dictionary is here to help. A taste:

STRESS TEST, n. 1. A measure of arterial blood flow to the head. 2. Alchemic process by which struggling, undercapitalized banks are transformed into paragons of modern finance. (See BANKS, GOOD.) Also known as the "Timothy F. Geithner Seal of Approval," which some bankers insist is good until it isn't anymore. (See BANKS, BAD.)

One Year On

On the one-year anniversary of the Lehman Crisis, the biggest names in financial punditry have been voicing their thoughts and concerns on the most important issues facing the world economy.  Let's take a look:

Martin Wolf, who spent most of the crisis bringing attention to global imbalances, has become a China bull:

China has emerged as the most significant winner from the global financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?

Crisis Roundup: Anniversary Edition

Is another boom around the corner?

Or has the real pain only begun?

Fedex can't find any green shoots in the US...

...and American consumers can't find any more credit.

Is the end near for the dollar? Probably not.

Hank Paulson doesn't use email. Can he be trusted?

The upside to rising foreclosures.

Declining Consumer Credit + Weaker Dollar = Time to Export

There are two noteworthy stories in the economic blogosphere, aside from the exciting news coming out of the World Bank.

The first has to do with the sharp decline in consumer credit in the United States. Buttonwood reports:

While governments round the world clock up more debts, American consumers are finally cutting back. The volume of consumer credit fell by $21.6 billion in July, the sixth monthly decline in a row. According to Lombard Street Research, this was the second largest percentage decline since World War Two. The 3-month annualised rate of decline is now running at 7%.

It appears that the recession has actually succeeded in frightening the American consumer into saving. This is not an insignificant feat.

Sovereign Wealth Funds: A Stabilizing Force?

I attended a discussion at the IMF today on the effects of sovereign wealth funds (SWFs) on financial market stability, particularly during the crisis*. It was hosted by two resident economists, Tao Sun and Heiko Hesse, who presented the results from their paper on Sovereign Wealth Funds and Financial Stability. The study analyzes whether or not the introduction of the massive financial resources behind sovereign wealth funds destabilizes capital and equity markets. 

The answer, for now, appears to be no. 

The US Dollar: The worst choice (except for every other option)

Barry Eichengreen has written a piece in this month's Foreign Affairs outlining the difficulties of replacing the dollar with an alternative reserve currency (subscription required).

Professor Eichengreen sets the stage with the usual talking points over the dollar's weaknesses:

• Confidence in the US-championed global financial system is waning
• The US government will continue to issue staggering amounts of debt
• In order for central banks to acquire dollars, the US must run a current-account deficit, which aggravates global imbalances and puts further downward pressure on the dollar
• The political logic for supporting the dollar has weakened, as the US is no longer seen as the military protector of Europe and Asia

In spite of this cocktail of structural weaknesses, there is an "inconvenient truth" to the dollar: its global importance hasn't changed as a result of the crisis. Based on the Federal Reserve's holdings of US Treasuries on behalf of its foreign counterparts, "foreign authorities have continued to accumulate dollars, and even accelerated their purchases in the first half of the 2009."

What gives? Why stick to a currency that is so clearly flawed? Why buy into a system that many respected economists warn is destined to fail?

Bernanke's Challenges: Look North

Now that we are due for at least four more years of a Bernanke Fed, what will Act Two look like? The New York Times invited several economists to forecast the challenges lying ahead for Mr Bernanke.

Chief among these challenges is unwinding the massive stimuli and support mechanisms that the Fed introduced in order to "prevent another Great Depression" (in the words of Barack Obama). This will involve a deceleration of monetary easing as the Fed balances growth and recovery with inflation and the credibility of the dollar.

Iceland may be an interesting case study of what's ahead. Just as Iceland was a precursor to the severity of the credit crunch, it may be the first to feel the withdrawal symptoms of diminishing government stimulus policies. Robert Wade argues:

Europe's Recovery: Half full or half empty?

A few weeks ago I pondered if Europe was the biggest loser in the crisis. In light of today's upbeat economic news coming out of France and Germany, was I being too harsh? 

Alas, Europe is not a homogeneous body, and this certainly holds true for its economies. The eurozone's northern members are doing better than those on the Med. Growth within the Europe is uneven and often unrelated. For example, Germany seems to be growing in spite of Europe, tying its export-led fortunes to the winds of Asia.

Furthermore, while good news tends to stay within national borders, bad news can spill over. Stronger exports in Germany cannot fix Spain's unemployment woes, and effective consumer stimulus efforts in France will not cure Ireland's Celtic Tiger hangover. Yet, a currency peg collapse in the Baltics, or a Hungarian debt crisis, can spread damage to Scandinavian and Austrian banks, and beyond. 

Fear and the Dollar: A New Relationship?

There is growing speculation that we have reached the end of an era for the US dollar. Out with the dollar as an instrument of market safety in tough times; in with the dollar as a pulse of the strength (or weakness) of the American economy. 

That's right, Bloomberg and the FT both ran stories yesterday which argue that the relationship between the dollar and the euro is beginning to be based more on economic fundamentals, and less on risk appetite. 

Previously, when bullish investors looked for higher yields, hot money would flow into emerging markets. This flow resulted in a weakening of the dollar, often at the expense of the euro (and GBP and CHF).

These patterns may have been fundamentally altered by the crisis.

Is Britain Back?

Paul Krugman and The Economist's Free Exchange blogger are beginning to think so. As is Daragh Maher, FX strategist at Calyon, who believes that sterling has become "the recovery currency":

Policy stimulus is helping drive a recovery in the UK. The catalyst for a re-think on sterling is already evident with early signs of improvement in the economic cycle and the financial sector.

The latest signs of health are coming from the services sector, which is growing at its fastest pace in over a year. Markets have been rapidly buying up Sterling, which has reached a 9-month high:

China: Bubble on the Horizon?

A new paper has been released by former Morgan Stanley Analyst Andy Xie that is garnering much chatter in the blogosphere. It addresses two of my favorite issues, China and the dollar. Surprisingly, the author is bearish on the former and bullish on the latter. 

The paper, via Big Picture, is well worth reading in its entirely. Xie's assertions are quite harsh:

Chinese asset markets have become a giant Ponzi scheme. The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn’t enough liquidity to feed the beast

Walking the (Crisis) Talk

By now it's no secret that Simeon Djankov, chief economist of the Financial and Private Sector Development Vice Presidency of the World Bank Group and regular contributor to Crisis Talk, has been appointed as Bulgaria's finance minister. (You can read about Simeon's appointment at Reuters, Forbes, and SETimes.) He will have his work cut out for him. The impact of the financial crisis on the real sector has meant that Bulgaria has seen declining budget revenues. Never one to rest on his laurels, Simeon has already set out an impressive goal for Bulgaria: adoption of the Euro by 2012 or 2013.

Update: In a more recent article in Forbes than the one I linked to above, Simeon explains the difficult task he faces:

'The situation we have inherited is much worse than what the previous government has said,' he said. 'It is necessary to fill a gap of 2.5 billion levs ($1.81 billion) so that we can achieve a balanced budget'.

This Week in China

In honor of this week's US-China Strategic and Economic Dialog, today's Crisis Talk is dedicated to the latest discussions on Sino-American economic relations.

To start, Brad Setser has three excellent articles on Chinese-American monetary relations:

• The first article points out that the PBoC's balance sheet totals 70% of GDP, compared to the Fed's, which recently hit 15% (and was 6% before the crisis).
• The second asks, "Doesn’t a smaller (external) deficit mean less dependence on (external) creditors, including China?" Setser thinks so, and I agree.
• Third, for all its concerns about a weak dollar, China has been allowing its own currency to depreciate lately. 

Simon Johnson analyzes Tim Geithner's China strategy:

Any country that runs such a current account surplus is implicitly taking a great deal of currency risk – China was in effect deciding to take the biggest ever official long-dollar position.  The idea that the US government should spend time reassuring them is somewhere between quaint and not good strategy.

Today's FT has two commentaries on China and the dollar. The titles speak for themselves:

• Washington risks taking China too seriously
• Chatter about a new global currency is overblown

Finally, China Law Blog gives advice on how to avoid getting kidnapped in China.  The solution: "Plan in advance or go home."

Currency Swaps: Fed=>Brazilian Central Bank=>Real Sector

Last week, the IMF held a discussion entitled "From Lombard Street to Avenida Pauista: Foreign Exchange Liquidity Easing in Brazil in Response to the Global Shock of 2008-09". The presentation highlighted the Brazilian Central Bank’s FX swap agreements with the Fed in the aftermath of the Lehman Brothers collapse.

These swaps had several unusual features.

Dollar Devaluation: The Fed's Secret Weapon?

Continuing our discussion on the contradictory nature of the US dollar, Seeking Alpha has an article by Prieur du Plessis asking, "Is the U.S. Dollar the Fed's Next Weapon?" Du Plessis argues that the Fed's responses to the crisis, from eliminating interest rates to expanding its balance sheet by over 100 percent, have failed to bring about positive growth and curb unemployment, which leaves it with few remaining options beyond devaluation. He quotes a recent report from David Rosenberg, chief economist at Gluskin Sheff:

(Dollar devaluation) is the only policy tool that has not budged one iota since the crisis erupted two years ago. But we are sure that as the unemployment rate makes new highs and increasingly poses a political hurdle in a mid-term election year, it would make perfect sense for a country that always operates in its best interest - even if it may not be in everyone’s best interest - to sanction a U.S. dollar devaluation as a means to stimulate the domestic economy.

Note to Central Banks: Get More Dollars

That is what Terrence Keeley, head of sovereign client services at UBS, prescribes in today's FT: 

In an extreme crisis, there is no alternative to the US dollar. Indeed, far from needing a new “super-sovereign currency” most central banks need more US dollars. Moreover, those dollars need to be invested in the safest instruments possible, namely US Treasury bills, notes and bonds. All other assets in a crisis are ineffective.

Over the past eight years, central banks have over-invested in illiquid assets, such as credit and equity instruments, which created the need emergency currency swap lines with the Federal Reserve once the crisis hit:

Deficits and the Dollar, Mutually Exclusive?

There has been a lot of chatter among policymakers about the future of the dollar. In particular, the BRIC countries have opined on the need for a new, global reserve currency to replace the greenback's predominance. (Last week, India chimed in).

At the same time, many emerging market countries, including the BRICs, continue to increase their dollar holdings. I recently posted on how foreign exchange reserves have been very useful in cushioning the adverse effects of the crisis. (Imagine how confidence in the Russian economy would differ if the central bank didn't hold over $400bn in reserves).

What do we make of all of this? How is it that the dollar's reserve status is being questioned, but simultaneously reinforced by the same countries who are doing the questioning? This paradoxical sentiment can probably be viewed as an expression of concern about the United States' deteriorating fiscal health.

Skidelsky, Wolf on Global Imbalances

The most recent issue of the New York Review of Books features an essay by Robert Skidelsky, biographer of Keynes, which discusses Martin Wolf's 2008 book, Fixing Global Finance (itself an excellent summary of global imbalances and the seeds of the crisis). Skidelsky elaborates on the role of the dollar as the world's premier reserve currency, arguing that the dollar's preeminence created a capital glut via the creation of the unofficial "Bretton Woods II" system of fixed exchange rates.

Under Bretton Woods II, many East Asian economies pegged their exchange rates to the dollar in order to build an arsenal of central bank reserves and retain export competitiveness. This buildup allowed the United States government to borrow cheaply and led American consumers to invest in asset-bubbles such as real estate and equities.

Crisis Roundup

Here's a roundup of some of the more interesting crisis-related discussions in the blogosphere:

1.  Simon Johnson, former Chief Economist of the IMF, summarizes his main points from last week's World Bank conference in Seoul, "Lessons from East Asia and the Global Financial Crisis":  

If the size, nature, and clout of finance is the problem, then the official view is nothing close to a solution. At best, pumping resources into the financial sector delays the day of reckoning and likely increases its costs. More likely, the Mother of All Bailouts is storing up serious problems for the near-term future

2.  Should we be promoting access to finance in the developing world, even in the midst of a financial crisis? CGAP Microfinance

3.  Is the next bubble in emerging markets? FT Alphaville

4.  Nouriel Roubini discusses China's waning dollar appetite...

Our creditors' nervousness about the eventual debasement of the US dollar has some increasing validity.

5.  ...while others are less convinced.

More on Emerging Market Corporate Debt

Yesterday, I discussed a new World Bank report that highlights the effects of the financial crisis on the corporate debt market: "The impact of the current crisis in developing countries has been transmitted primarily through the corporate sector." 

There are three core concerns about the strength of the corporate debt market:

1. Short-term FX liabilities, which are difficult to meet as the value of local currencies dwindle;
2. Huge corporate losses in derivatives; and,
3. Mercurial attitudes of foreign investors in local bond markets, which leave corporations vulnerable to investor whims.

FX Reserves as Insurance Policy

Editor's Note: Brian Hoyt is a consultant in the Financial and Private Sector Development Vice Presidency of the World Bank Group.

A new report from Deutsche Bank on emerging market economies' anti-crisis measures highlights the benefits of FX accumulation. The top performers as identified by the report share one obvious commonality: massive dollar reserves. Nearly every country that has successfully weathered the crisis is either a petrostate and/or has a significant sovereign wealth fund. Not only have FX reserves been key in facilitating an economic stimulus, they have also have provided significant currency stability:

The amount of FX reserves in relation to external financing requirements is still crucial to the assessment of countries’ resilience to external shocks. From a policy perspective, accumulating FX reserves still seems to be pretty good insurance.

This observation seems to contradict concerns that central banks will be hesitant to accumulate further dollar reserves. The question remains as to how central banks' desire to purchase this kind of insurance can be squared with the need to resolve global macroeconomic imbalances.

A Brave IMF

In a supposedly-leaked report, the IMF has said the best strategy for Eastern Europe in fighting the current crisis is to adopt the euro fast (see the FT article). This is an obvious point and one that some Baltic countries and Bulgaria have made for months. To the consternation of the European Central Bank (ECB), which takes the view that proper procedure should be followed and conversion to the euro shouldn't be rushed. It could in fact be delayed.
 
This is a case of bravery on the side of the IMF - and a second big hit for the institution in a week (also see this). And a case of constipated thinking on the part of ECB. The cost of early euro entry is surely a lot smaller for Europe than the eventual cost of bailouts and macro instability that is otherwise likely in Eastern Europe. So why does the ECB push this line (for now)?

How Fast Do Currency Boards Adjust?

Editor's Note: Georgi Angelov is a senior macroeconomics researcher at the Open Society Institute in Sofia, Bulgaria.

It is an old debate. Some believe that currency boards – because of their fixed exchange rate – bring about adjustment of external imbalances very slowly. Currency boards cannot and do not depreciate the currency, and that is perceived as a problem.

Is this true? We can check fresh data. Because of the financial crisis in the post-Lehman world, East European countries cannot attract as much capital inflow as before – so their current account deficits should decrease quickly.

In the case of Bulgaria, the trade deficit started decreasing rapidly after October. Within three months the deficit decreased by two thirds. The decrease of the trade deficit year on year is 45% in January 2009 – and the current account deficit is also down by 45% year on year in January. Quite a substantial adjustment within just a few months. With this speed, the big current account deficit will be history very soon.

Will the Currency Board Survive in Bulgaria?

Yes, we can. But since this is a lively topic in Bulgaria these days, it is useful to go through the reasons. A new Citibank report entitled CBA likely to ride out financial turmoil does just that.
 
Before going into the report, let me just say why the alternatives are bad. During crises, the common argument for devaluation is that your exports become more competitive. Italy has used devaluations successfully now and then, and more recently Russia, Belarus, Ukraine and Kazakhstan have all devalued their currencies. Other currencies like the Mexican peso, the Czech krony, the Polish zloty and the Korean won have depreciated by 30% or so too. It is not clear, however, that this has helped their exports. The December export numbers show a universal decline of 25-30%. The collapse in demand in many sectors is so great that depreciations are just not cutting it. In addition, for a country like Bulgaria where banks have borrowed in euros or dollars or Swiss francs and have given some credit in lev, a depreciation would be bad news. In sum, exiting the currency board arrangement won't pay off.

Revising the Balance of Consumption

Marinus Verhoeven, a lead economist in public sector governance at the World Bank, raised an interesting question to my earlier post, Living in a Madoff World:

I am not sure excess provides a good framework for thinking about the crisis...It may have had something to do with inadequate control of the money supply, misguided legislation, and an unequal distribution of wealth, but excess consumption--no, I don't think so...The second issue is more controversial...is there a moral dimension here?.

This got me thinking.  So, here's my response. I was using excess as metaphor for bubbles we have had in real estate, in consumer spending, in leveraging, and so on...and excess consumption too.
 
Like most economists, who first look for a phenomenon and then go find a theory to fit it, let me try the same here…
 
Over the last decade, many countries became frugal, some by their demographics such as Japan, others by choice like the middle income countries (MICs), which, afraid of exchange-rate volatility, ran precautionary current account surpluses and accumulated large stocks of foreign reserves. And yet others like China where a combination of demographics, exporting more and spending less, induced large savings.

Competitive Devaluations?

Kazakhstan’s central bank devalued the tenge by 18 percent yesterday. The central bank is letting the tenge weaken for the first time since it started managing the currency in 2007. Kazakshstan joins Russia, Ukraine, and Belarus in abandoning attempts to prop up exchange rates as currency reserves dwindle and economies stagger. A number of other resource-rich countries have also seen their currencies fall substantially against the dollar over the last few months, including Brazil, Mexico, and South Africa. 

Maintaining a currency’s value under pressure is costly. Kazakhstan spent $3.5 billion, or 16 percent, of its foreign-exchange reserves supporting the tenge. Russia spent between $7 and $8 billion in one day last month defending the already weakened ruble. And the longer the process lasts, the more money that goes down the drain. Argentina’s net reserves fell by $20 billion in 2001 before the currency board eventually collapsed the following year. 

Some countries attempt to maintain currencies because of a history of inflation. Sudden and large depreciations can be destabilizing, leading to inflation and higher interest rates. Depreciations also increase the cost of foreign currency debt. But depreciation is not necessarily bad for growth. Depreciation mimics an export subsidy and import tax, boosting exports and consumption of domestic goods. This can help countries to grow when domestic demand is weak or declining. 

But what happens if many currencies collapse simultaneously? This puts downward pressure on import prices, fueling deflation in foreign markets. Kindleberger has argued that such competitive devaluations are part of what led to the Great Depression. 
 
Volatile currency movements are already aggravating uncertainties in global financial markets. But at least so far, most of the these currency declines are understandable. Sharp declines in commodity prices have worsenened the terms of trade of the resource exporters at the same time as western capital has dried up. If depreciations spread to the large manufacturing countries then there could be real trouble.

A Virtual Iron Curtain

Editor's Note: Nadiya Pustovoytova is Acting HR administrator in the IFC Ukraine country office and a Program Assistant for the corporate governance business line in the Eastern Europe and Central Asia region. Nadiya will be adding a new angle to coverage of the financial crisis in the Crisis Talk blog with a "view from the field." Welcome!

Financial issues that were quite abstract and distant at the beginning have now become quite concrete for an ordinary person in Ukraine.

The US dollar is over 1.6 times more expensive today than it was in the summer (UAH 7.38 compared to 4.54), and this last week the exchange rate has deteriorated 0.1-0.15 every day. Besides, it’s close to impossible to purchase dollars. There are many currency exchange booths in the streets, but since the beginning of November it’s hard to find dollars or Euros. If you’re lucky you can find dollars in the banks, but you’ll have to pay a commission of up to 7 percent of the amount exchanged.

Currency Depreciation - Reaching the Asian Crisis Levels

The currencies of Malaysia, Philippines, and Thailand depreciated between 40% and 53% during the Asian crisis (a 6-7 month period between mid-1997 and January 1998). Indonesia's currency was the outlier, with a depreciation of 84% in the 12 months from July 1997 to July 1998.

How do these numbers compare with the current crisis? The worst performer since July 2008 has been Iceland--its currency depreciated 51% in less than 4 months (more than Malaysia or the Philippines during the Asian crisis). But other currencies also look bad: South Africa depreciated 38% in less than 4 months; currencies from Hungary, Brazil, Poland, and Turkey have depreciated more than 30% since July; those of Ukraine, Czech Republic, Colombia, Chile, and Mexico have already depreciated almost 30% in the same time period. The pressure on emerging market currencies has been extremely strong in the last few months, in particular since September. If this trend continues, we are likely to see many more countries, across all regions, reaching levels similar to those observed during the Asian crisis.