Comments: Can the Right Balance Be Achieved?
- Alexander Swoboda, and Peter Kenen
- Published Date:
- December 2000
My remarks fall into four parts: the general framework of financing versus adjustment as we have hitherto understood it; what instruments are to be employed to attain the adjustment targets; the actual pattern of adjustment that we have seen in recent crises; and whether and how the “financing-versus-adjustment” framework can still be viewed as relevant today after what we have learned.
The central question is: In the aftermath of an adverse real shock, e.g., a movement in the terms of trade, how much of the impact on the trade balance should be financed by borrowing from abroad and from capital inflows, and how much should be offset by adjustments to macroeconomic policies? The standard answer from economic theory is that if the shock is largely transitory, then it should be mostly financed. Given the growth and globalization of financial markets over the last 25 years, most of this financing should be from the private sector; but if sufficient private capital flows are not available, then official finance, particularly from the IMF, should supply the rest (on the condition, of course, that the country follows sound policies).
In practice, we have seen from the international crises of the 1980s and 1990s that private capital flows tend to exacerbate shocks rather than offset them—to be procyclical rather than countercyclical as they should be in theory. In the early 1980s, for example, a contraction in markets for many of the commodities produced by developing countries was followed by a reduction in capital flows, not an increase. Thus the share of the shock that is financed has turned out to be not just small but negative—perhaps worse than a negative 100 percent. In some cases, it appears that the entire shock was the withdrawal of capital. Sometimes it is possible to identify an initial real shock; in the case of the 1997 East Asia crisis it was the downturn in the world market for semiconductors and other manufacturers in 1996. But even in these cases, the loss in capital inflows is clearly the dominant change in the balance of payments, more than doubling any plausible measure of the initial loss in the trade balance. These are the sudden stops that Calvo and Reinhart discuss in their excellent paper. The recent reversal in capital inflows to Thailand—an outflow of 8 percent of GDP in 1997 from an inflow of 18 percent in 1996—is apparently the record holder. Even in more common cases, the swing is large. As a result, the affected countries have been forced to convert large trade deficits quickly into large trade surpluses.
Decidedly, the balance has indeed shifted away from financing, and perforce toward adjustment. Given the countercyclical nature of the capital flows, is the financing-versus-adjustment framework even relevant? Should we perhaps dispense with it altogether? We could interpret the initial shock as trade balance plus private capital account and interpret the financing response as solely official finance. Then the question would be: To what extent should the IMF and other public institutions step in to fill the gap? This is an extremely important question, involving key issues of moral hazard; of greater private sector involvement as a component in public rescue packages (bailing in rather than bailing out); and of political willingness in G-7 countries to provide resources on the unprecedented scale that would seem to be required. Although these issues are important, they generally are discussed under rubrics other than financing-versus-adjustment, and are discussed in other sessions of this conference. So I will retain the emphasis on private sector financing. But before I offer my interpretation of where the financing-adjustment framework can still be useful, I want to consider how adjustment is carried out, both in the traditional framework and in actual recent episodes.
In the traditional framework, there are two classes of policy instruments: expenditure-reducing policies, such as monetary contraction, and expenditure- switching policies, such as devaluation. The pair matches up nicely with two policy targets: internal balance and external balance. Consider a graphical representation, with the interest rate and exchange rate (price of foreign currency) on the axes. To satisfy external balance, there is an inverse trade-off between the two instruments. A devaluation and an increase in the interest rate are each ways of improving the trade balance—the latter by reducing expenditure—and so the more you have of one, the less you need of the other.1
To satisfy internal balance, the trade-off is traditionally considered to be upward sloping. An increase in the interest rate reduces the domestic demand for domestic goods, while a devaluation increases the net foreign demand for domestic goods; if you have more of one, you also need more of the other to prevent excess supply or excess demand. The existence of two independent instruments implies the possibility of attaining both targets simultaneously at the intersection of the internal and external balance schedule. In the aftermath of an adverse shock in the foreign sector, for example, the right combination of devaluation and monetary contraction will restore balance of payments equilibrium while maintaining real economic growth.
This is not the way things actually work.2 By now we have had enough experience with crises in emerging markets to know that the traditional framework needs to be modified. The simple generalization seems to be that all developing countries that are hit by financial crises go into recession. The reduction in income is the only way of quickly generating the improvement in the trade balance that is the necessary counterpart to the increased reluctance of international investors to lend. External balance is a jealous mistress that can only be satisfied if internal balance is left wanting.
Some critics of the IMF say that the recessions are the result of IMF policies, specifically the insistence on monetary contraction. They claim that the mix of a lower interest rate combined with a devaluation would successfully maintain internal balance. They often make the point that high interest rates are not, in practice, especially attractive to foreign investors when they carry increased probability of default (and associated recession). This is true, but in my view it is not the most important correction in the traditional framework. Even if interest rates do not have as big a positive effect on the capital account as our earlier models of high financial integration suggested, so that the graphical relationship may be flatter, I believe that the sign of the effect is still the same. One cannot normally attract many investors by lowering interest rates. Therefore, the external balance line still slopes downward. Claims that high rates are damaging to the real economy willfully ignore the lack of an alternative, if the external balance constraint is to be met.
Where the traditional framework needs most to be modified is in the relationship giving internal balance rather than external balance. By now, the evidence seems strong that devaluation is contractionary, at least in the first year, and perhaps in the second as well. We have long been aware of various potential contractionary effects of devaluation in developing countries. A total of 10 such effects are identified in textbooks, of which the difficulty of servicing dollar debts has turned out to be by far the most important in recent crises. But a mainstream view has been that any negative effects from a devaluation were eventually offset by the positive effect of stimulus to net exports; so that by the second year, when the latter had gathered strength, the overall effect on output had turned positive. Now, however, one must judge the negative effects stronger than we thought and the positive effects weaker. Calvo and Reinhart calculate that exports do not increase at all after a devaluation, but rather are down for the first eight months. The export side, at least, was supposed to be unambiguously positive. Apparently, production is derailed by corporate financial distress, absence of trade credit, and increased costs of imported inputs, even when the production is for the purpose of export. Imports fall sharply; indeed, crisis-hit countries have for this reason experienced sharp increases in their trade balances beginning as soon as two or three months after the crisis.3 But this is clearly a response to the unavailability of finance and the collapse of income and spending, not to relative prices. In other words, it is expenditure reduction, not expenditure switching.
If devaluation is contractionary, then the internal balance line slopes down, not up. Moreover, the slope is disturbingly similar to the slope of the external balance line. It is hard to see where the two intersect, if they intersect at all. This means that it is hard to see what combination of policy instruments, if any, can simultaneously satisfy both internal and external balance after an adverse shock has shifted the latter outward. The depressing conclusion is that there is no escape from recession. All policy instruments—devaluation, fiscal contraction, and monetary contraction—work via reduction in income in the short run. Even structural policy reform, such as insisting that bad banks go under, is likely to have a negative effect on economic activity in the short run (notwithstanding that I support the IMF’s new emphasis on the latter sort of conditionally in the East Asia packages).
Is the financing-versus-adjustment framework then no longer useful? I think that the framework may still be relevant during the (relatively brief) period after a terms-of-trade or other real shock arises, but before the financial or currency crisis hits. It is hard to identify and date the former, even with the benefit of hindsight. But I have in mind the interval of one to two years preceding July 1997 in East Asia, December 1994 in Mexico (where the shocks were political instability earlier in the year and increases in U.S. interest rates), and July 1982 in Latin America. In each case, policymakers responded to deterioration in their trade or capital accounts by running down foreign exchange reserves or shifting to short-term borrowing.4 They succeeded in this way in postponing macroeconomic adjustment and crisis. But when the crisis came, it was that much worse, requiring at that point the unfortunate pattern we have discussed—turning all dials to contractionary settings—as the only way of satisfying the constraints imposed by finicky international investors. It would have been better in these cases if the countries had spent these short intervals adjusting, rather than financing, at a time when there was still a meaningful tradeoff between the two, and the set of choices had not yet been narrowed in such an unattractively constrained manner. These considerations suggest that the G-7 and the IMF have been on the right track recently in emphasizing surveillance and in conditioning supranormal postcrisis finance on countries having followed appropriate policies immediately prior to the crisis—whether it is adjusting interest rates or exchange rates. The trick is in having the economic acumen and political will to recognize that an adverse shock has occurred and to enact prompt adjustment. This element is even more crucial than calculating the right amount of adjustment or choosing among the available instruments to carry it out.
CavesRichardJeffreyFrankel and RonaldJones1999World Trade and Payment 8th edition (Glenview, Illinois: Scott, Foresman) pp. 398–404.
CordenMax1993“Absorption, the Budget, and Debt: The Wonderland of Possibilities,” in Essays in Honor of Murray L. Kemped. byHorstHerberg and NgoVanLong (Ann Arbor: University of Michigan Press) pp. 379–91.
EdwardsSebastian1985“Are Devaluations Contractionary?”Review of Economics and StatisticsVol. 68 (August) pp. 501–08.
FrankelJeffrey and AndrewRose1996“Currency Crashes in Emerging Markets: An Empirical Treatment?”Journal of International EconomicsVol. 41 (November) pp. 351–x66.
KaminSteven1988“Devaluation External Balance and Macroeconomic Performance: A Look at the Numbers” Princeton Studies in International FinanceNo. 62.
KaminskyGracielaSaulLizondo and CarmenReinhart1998“Lending Indicators of Currency Crises,”Staff Papers International Monetary FundVol. 45 (March) pp. 1–48.
At the time this comment was presented, the author was New Century Chair, the Brookings Institution, and had recently departed the position of member of the Council of Economic Advisors.
If external balance is defined as equilibrium in the overall balance of payments, including the capital account along with the trade balance, the relationship is still downward sloping, since a devaluation and an increase in the interest rate are both ways of making domestic assets more attractive to global investors.
The pattern of adjustment in Thailand and Korea in 1998 looks very similar to Mexico in 1995.
Or by shifting to floating rate borrowing. Studies of leading indicators of currency crises, even before the East Asia episodes, showed that the magnitude of current account deficits was less important than the composition of the financing, with heavy reliance on short-term (and floating-rate) bank flows or the running down of foreign exchange reserves, strongly raising the probability of crisis. See Frankel and Rose (1996); and Kaminsky, Lizondo, and Reinhart (1998).