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Article Excerpt
"That this region [East Asia] might become embroiled in one of the worst financial crises in the postwar period was hardly ever considered--within or outside the region--a realistic possibility. What went wrong? Part of the answer seems to be that these countries became victims of their own success. This success had led domestic and foreign investors to underestimate the countries' economic weaknesses. It had also, partly because of the large scale financial inflows that it encouraged, increased the demands on policies and institutions, especially but not only in the financial sector; and policies and institutions had not kept pace. The fundamental policy shortcomings and their ramifications were fully revealed only as the crisis deepened" (International Monetary Fund World Economic Outlook, May 1998).
THE EXPERIENCE OF the last decade suggests that emerging capital markets are vulnerable to significant shifts in investors' confidence in both upward and downward directions. Downward shifts in confidence and financial market collapses are abrupt and often take place unexpectedly after a large boom. Table 1 documents the magnitude of these booms for several precrisis episodes: Argentina and Mexico in 1994, Korea in 1997, and Turkey in 2000. Taking Turkey as an example, the year before its financial crisis in 2001, the country boasted an average quarterly current account-to-GDP ratio of -5.1%, consumption growth of 4.5%, an increase in equity prices of 57%, and GDP growth of 3%. (1)
It is widely agreed that overconfidence and informational problems are at least partially responsible for recent crisis episodes, as the above opening quote by International Monetary Fund (IMF) on the Asian crisis suggests. Whether these frictions in international capital markets can be large enough to explain precrisis periods of bonanza and the depth of the crises remains an open question.
In this paper, we aim to answer this question by studying the quantitative predictions of a model in which optimism, due to investors' underestimation of the weaknesses of emerging economies, acts as the driving force behind both the precrisis booms and the vulnerability that paves the way to financial turmoil and deep recessions. In the model, the precrisis bonanza is driven by a sequence of positive signals that investors interpret as an improvement in the true fundamentals of the economy. The crisis occurs as a sudden downward adjustment in investors' expectations of the true fundamentals is triggered and their optimism suddenly fades. The magnitude of this downward adjustment increases with the level of optimism attained prior to the crisis.
The informational frictions that are the key ingredient of the model are likely to be prevalent in emerging markets for several reasons. One is the lack of transparency in policymaking and data reporting, which manifests itself in the form of inaccurate or misleading data. (2)
A second reason informational frictions pose particular challenges for emerging economies is the existence of high fixed costs associated with obtaining country-specific information and keeping up with the developments in emerging economies, as suggested by Calvo (1999). Such costs could arise due to idiosyncrasies affecting financial markets in these countries, for example, each country's unique institutions, policies, political environment, and legal structure. From international investors' perspective, it might be optimal not to "buy" this information. Calvo and Mendoza (2000) provide two arguments for why this can be the case. First, if short-selling positions are limited, the benefit of paying for costly information declines as the number of emerging economies in which to invest becomes sufficiently large. Second, if punishment for poor performance is high, managers of investment funds may choose to mimic each other's behavior instead of paying for costly information.
The model in this paper features two types of investors, domestic and foreign, both of whom trade a single emerging market asset. Domestic investors are consumer-investors who maximize the expected present discounted value of their lifetime utility. Foreign investors specialize in trading the emerging market asset, face trading costs, and maximize the expected present discounted value of profits from investing. We model the informational frictions as follows. Both sets of investors are imperfectly informed about the true state of current productivity, which contains information relevant for predicting future returns on the emerging market asset. They can only partially infer the true state of productivity by "learning" from publicly observed dividends (or signals), and they share the same information set. The dividends consist of two parts: a persistent component, which we interpret as "true productivity," and a transitory component, which is a noise term that controls the accuracy of the signals. Modeled in this way, dividends serve an informational role since a dividend payment is a noisy signal that contains information about current and future realizations of productivity. Every period, foreign and domestic investors observe dividends, solve a signal extraction problem, and learn about productivity by updating their expectations or "beliefs" regarding true productivity.
When investors turn pessimistic (optimistic), asset prices are driven below (above) the "fundamentals price," which is defined as the expected present discounted value of dividends conditional on full information. In these periods, asset prices and domestic investors' consumption display swings that are not associated with changes in true productivity. We find that a sequence of positive signals can cause a boom in both the asset market and consumption, and can be a source of economic vulnerability if true productivity is in fact low. If a negative signal is realized at the peak of a boom of this nature and, as a result, "challenges" current prevailing beliefs, an abrupt and large downward adjustment in asset prices and consumption takes place. If, however, the same signal "confirms" prevailing beliefs, its impact is smaller. (3)
Foreign and domestic investors trade due to differences in their objective functions, particularly their risk aversions, but not for speculation (given that they have the same beliefs). From the domestic investors' perspective, dividend shocks are important for two reasons. First, in order to intertemporally smooth consumption domestic investors would like to increase (decrease) their asset position in response to positive (negative) dividend shocks. Second, they play a critical informational role. In response to a negative dividend shock, changes in expectations due to the new information compound the first effect, and as a result, domestic investors reduce their demand for the emerging market asset. Foreign investors also reduce their demand for the asset in response to this shock since they receive a negative signal regarding future productivity. In equilibrium, we find that domestic investors' demand decreases by more than that of their foreign counterparts; therefore, domestic investors become net sellers in response to a negative dividend shock. This result leads to a procyclical current account on average. However, we also find that for a given dividend shock, the higher the expectations about future productivity, the lower are the domestic investors' asset holdings since higher expectations induce foreign investors to bid more aggressively, compared to their risk-averse domestic counterparts, for the same asset. Hence, the higher the investment optimism, the more the emerging economy can attract foreign investment, and therefore the more likely the country is to develop a potentially sizable current account deficit.
Given the inherent noisiness of signals obtained by calibrating the model to a typical emerging economy, we analyze the frequency, duration, and magnitude of booms and busts that are due to misperceptions of investors. (4) The model generates these booms (busts) with 8.79% (4.41%) probability and with duration of 2.75 (1.41) quarters on average. In addition, the model produces booms (busts) in asset prices and consumption of the size observed in the data in units of standard deviations with probabilities 2.88 (0) and 2.33 (2.60), respectively.
With the introduction of informational frictions, the variability of the emerging economy's consumption increases by 2 percentage points compared to the "full information" setup. Uncertainty about true current productivity leads to increased uncertainty regarding future asset returns and a more volatile consumption profile for the risk-averse domestic investors. Moreover, informational frictions produce persistence in response to transitory noise shocks. If investors turn pessimistic in response to a misleading signal, it takes several periods for them to correct their beliefs. The mechanism behind this result is the Bayesian learning process: the posteriors of one period are used in the calculation of the following period's priors.
This paper is at the crossroads of two main strands of literature. The first is the literature on sudden stops and financial crises in open economies, and the second is that on informational frictions in finance. Most existing models of financial crises and sudden stops focus on crash episodes but not on the booms preceding the crashes that might indeed contain the seeds of the financial crises. In contrast, the model proposed in this paper emphasizes more the dynamics of precrisis booms. Studies explaining sudden stops focus on financial frictions and often utilize collateral constraints (see, e.g., Caballero and Krishnamurthy 2001, Paasche 2001, Mendoza and Smith 2004). In this literature, recently, Boz, Daude, and Durdu (2008) also utilize a signal extraction framework. In that setting, agents decompose total TFP into trend and cycle, building on the work of Aguiar and Gopinath (2007).
In the international finance literature, shifts in investor sentiment have usually been analyzed within the context of currency crises. These studies often utilize sunspot models with multiple equilibria and therefore provide little guidance as to when and how the shifts in investor sentiment occur. In this paper, we take a different approach by considering a model with a unique equilibrium that can endogenously produce shifts in investors' confidence and switches between good states and bad ones, which allows us to predict when these shifts occur and how long it takes...
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