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...involved Brazil, Argentina, and many other developing countries. The second wave began in 1990 and included Japan, Sweden, and several other Nordic countries. The third wave began in 1997 and involved Thailand and its neighbors in South Asia, as well as Russia in August 1998. The combined loan losses of the banks in some of these countries ranged from 30 to 40 percent of their governments' annual budgets. The range of movement in the foreign exchange value of national currencies has been larger than at any previous time. Moreover, the deviations of market exchange rates from real exchange rates--the extent of "overshooting" and "undershooting"--have been greater than in any previous period. Since the late 1990s the inflation rates in the United States and in the countries that share the euro have been similar and low, and yet the price of the euro in terms of the U.S. dollar has varied by nearly 50 percent. The deviations of market exchange rates from real exchange rates for many of the emerging market countries have been much larger than when these countries' currencies were pegged.
There have been more asset price bubbles (1) than in any previous period. The bubble in real estate and in stocks in Japan in the 1980s was the "mother of all asset price bubbles" as measured by both the increase in the ratio of household wealth to GDP and the increase in the value of Tobin's Q. The bubbles in real estate and in stocks in Finland, Norway, and Sweden in the second half of the 1980s were much larger than these countries had ever experienced before. There were bubbles in real estate and in stocks in Thailand, Indonesia, Malaysia, and several nearby countries in the first half of the 1990s. The United States experienced a bubble in stock prices that began a year or two before Chairman Greenspan's remark about "irrational exuberance" and continued until 2000; the increase in the Q ratio for U.S. stocks in the 1990s was much greater than in the 1920s.
The collapses of national banking systems, the asset price bubbles, and the scope of overshooting and undershooting of currencies in the foreign exchange market were systematically related. The extensive range of movement in the values of national currencies in the foreign exchange market and the scope of overshooting and undershooting resulted from the large variability in cross-border flows of money and the sudden reversal in the direction of these flows. The bubbles in real estate and in stocks in Tokyo in the second half of the 1980s were a unique Japanese event (although the United States encouraged the financial liberalization that contributed significantly to the bubbles). The other asset price bubbles were systematically related to the bubbles in Japan in two ways. The bubbles in the Nordic countries resulted from the coincidence of the liberalization of financial regulations in Tokyo that permitted Japanese banks to rapidly expand the number of their foreign branches at a time when Finland, Norway, and Sweden were liberalizing the regulations that had limited the ability of their domestic banks to borrow abroad. The bubbles in Thailand and the other Asian countries in the mid-1990s followed from the implosion of the bubbles in Japan and from the monies that sloshed to these countries from Tokyo, while the bubble in U.S. stocks in the second half of the 1990s gathered momentum from the inflow of funds from the Asian countries that followed the implosion of their bubbles.
The failure of the banks and other financial institutions resulted from large losses that were incurred by the borrowers in individual countries both when the asset price bubbles imploded and when their national currencies depreciated sharply in the foreign exchange market. In the preshock years, these countries had experienced sustained inflows of savings that led to both the real appreciation of their currencies and the increase in the prices of securities traded in the country.
The booms that resulted from the inflow of money from abroad may have clouded recognition that the magnitude of these inflows was not sustainable. As long as the inflow of foreign funds increased, the scope of overshooting increased, and the countries developed increasingly large trade deficits. The inference from the national income accounting identity is that their domestic economies adjusted to the increases in the inflows of funds by some combination of increased domestic investment, increased domestic consumption (which meant that domestic savings rates declined), and governments' increased fiscal deficits. Most countries experienced economic booms when the inflow of foreign saving was increasing, and usually the governments' fiscal deficits declined (unless the inflow of money from abroad was a direct response to increases in government borrowing). The primary adjustment to the increase in the inflow of funds was greater household consumption; this mechanism--increases in asset prices leading to increases in household wealth--continued until the decline in domestic savings matched the increase in the inflow of funds. The economic booms resulted primarily from the increase in consumption spending in response to the increase in household wealth and secondarily from the increase in investment spending.
The cross-border cash flows had a "good news"/"bad news" flavor. The cash inflows in the "good-news period" were not sustainable; some of the borrowers obtained all of the cash needed to pay the interest on outstanding loans from new loans. An adjustment was necessary to reduce the growth rate of indebtedness relative to the growth rate of GDP. A decline in the inflow of funds to a country would result in a decline in the value of its currency in the foreign exchange market, which triggered the realization that the borrower's indebtedness was too large.
The reversal of the pattern of cross-border flows and the depreciation of the currency in the "bad-news period" often led the currency to undershoot its long-run equilibrium value as the structures of imports and of exports adjusted to the change in the relationship between domestic and foreign prices. The large depreciation of the currencies was the trigger for massive revaluation losses on loans denominated in foreign currencies.
This paper seeks to explain why the past 35 years have been so tumultuous. One of the major questions is why the cross-border capital flows that led to the deviations of the prices of currencies and of securities from their long-run equilibrium values persisted for such extended periods. Were the shocks in the past 35 years larger than the shocks in previous periods, or did the shocks of a given magnitude have a greater impact on prices of securities because the adjustment process when currencies are not pegged differs from the process when currencies are pegged?
This paper summarizes six national episodes that led to large changes in prices of currencies and of assets and large loan losses for different groups of investors and lenders. It also reviews the operation of the transfer problem in response to shocks both when currencies are pegged and when they are floating.
I. Six Traumatic Financial Episodes
The six countries reviewed in this section experienced economic booms; five of the six countries received increasingly large flows of funds from abroad. (The sixth country is Japan; its current account surplus declined as its economic boom gathered momentum.) One of the major questions is whether the booms in these countries were like magnets that attracted funds from abroad, or whether the inflows of funds were an autonomous factor that contributed significantly to the economic booms. An explanation is needed for the mechanism that linked the increase in the inflow of funds to the booms.
The first episode reviewed is the surge in loans from major international banks to governments and to government-owned firms in Mexico and other developing countries that began in 1972. For the next 10 years, bank loans to these borrowers increased at an average annual rate of 30 percent; the indebtedness of the borrowers increased at an annual rate of 20 percent. These countries developed increasingly large current account deficits, and the ratios of their current account deficits to their GDPs increased.
In 1982 the price of the U.S. dollar increased by 60 to 70 percent in terms of the Mexico peso, the Brazilian cruzeiro, the Argentine peso, and the currencies of 15 other developing countries.
In terms of the stylized textbook model that distinguishes between countries as young debtors and mature debtors and young creditors and mature creditors, these developing countries were young debtors with trade deficits and current account deficits; they obtained the funds to pay the interest on their external indebtedness from their foreign creditors. (An analogy can be made between the external accounts of these countries and the fiscal balance of a government; a government with a...
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Mundell's International Economics: adaptations and debates., January 01, 2005
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