FRBSF Economic Letter
99-30; October 8, 1999
 Economic
Letter Index
Depreciations and Recessions
Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Monetary and Economic Studies within the FRBSF's
Economic Research Department.
Following the dramatic currency depreciations in many East Asian economies
in 1997, these countries suffered sharp and lingering recessions. This
outcome runs counter to the notion that depreciations ought to boost
output because they make domestically produced goods cheaper.
Economists offer at least three possible explanations for the close timing
of depreciations and recessions. First, depreciations reduce aggregate
demand or aggregate supply, thus reducing output. Second, depreciations
may reflect external shocks that have contractionary effects. Third, depreciations
may be associated with domestic conditions (such as a weak financial sector)
that make an economy vulnerable to adverse shocks. Under the first explanation,
depreciations cause recessions. Under the second and third explanations
the same factors that cause currencies to depreciate may cause output
to contract, but the depreciation may (or may not) be directly contractionary.
This Economic Letter briefly discusses the reasoning behind these
explanations and highlights some implications.
Contractionary devaluations
Depreciations can have expansionary and contractionary consequences
for economic activity. (See Agenor and Montiel 1996 for an overview of
the extensive literature on this subject.) To illustrate these effects,
consider a small open economy that produces a nontradable good (say cement)
that is consumed only in the domestic market because it is too expensive
to trade internationally, imports fuel for use in the production of cement
and also for consumption, and exports computer chips. The exchange rate
is fixed, but one day the currency is suddenly devalued, perhaps because
the government has run out of foreign reserves. This scenario has been
repeated many times in many countries, notably in Latin America.
A depreciation tends to raise the price of tradable goods in domestic
currency (both fuel and computer chips), increasing the demand for nontradable
goods and the supply of exports. The expansionary effects of a depreciation
can be understood by noting that a depreciation tends to increase the
overall price level, lowering the real wages of workers and encouraging
more hiring and increased production if there is unemployment. (Obstfeld
and Rogoff 1996, Chapter 10, provide a more subtle discussion of how the
output of nontradable goods will increase in response to the increased
demand for such goods if prices or wages are sticky.)
The contractionary consequences arise from a number of effects on aggregate
demand or supply. A depreciation can reduce demand by reducing real income,
reducing wealth, and raising real interest rates; it can reduce aggregate
supply by raising the cost of imported inputs, capital goods, or working
capital, or by interrupting the supply of credit.
To illustrate the effect on real income, assume that the economy exports
nothing, but only imports fuel. In this case a depreciation raises the
domestic currency price of imported fuel, reducing the net income of the
owners of the firms that use it as inputs in the production of cement.
Also, the higher price of fuel reduces the purchasing power of consumers
who use this product, with no offsetting increase in their incomes.
A depreciation also can reduce consumer demand by reducing real financial
wealth, as the resulting domestic price increase will tend to reduce real
money balances. If capital markets are not fully integrated with world
markets (so that domestic interest rates are not anchored by world interest
rates), the reduction in money balances will tend to create excess demand
in the loan market, raising domestic interest rates. This, in turn, will
depress investment demand and, as discussed below, also may adversely
affect supply.
A depreciation may reduce aggregate supply by increasing production costs.
In our example, a depreciation increases the price of tradable or imported
inputs (computer chips) used in production. If equipment also is imported,
a depreciation also may increase the cost of capital. As noted earlier,
domestic interest rates also may rise following a depreciation, which
may raise the cost of financing working capital.
External shocks
While the traditional literature focuses on the direct effects of depreciations
on output, more recent work highlights more general conditions under which
depreciations and output contractions may be closely timed. In particular,
this literature seeks to explain cycles in which periods of relative exchange
rate stability may be associated with surging foreign capital inflows
and economic booms, followed by capital flow reversals, currency depreciations,
and economic contraction. This research has emphasized (i) the contribution
of cycles in external shocks and (ii) domestic conditions that influence
the vulnerability of small open economies to shocks.
Well before the recent East Asian currency crises, Calvo, Leiderman,
and Reinhart (1996) noted that declining world interest rates played a
role in capital inflow surges in the first half of the 1990s in both Latin
America and East Asia, and that such external factors contain an "žimportant
cyclical component, which has given rise to repeated booms and busts in
capital inflows" (p. 124). Indeed, in the 1970s, low global real interest
rates were associated with large capital flows to developing countries
(in the form of bank lending) that were reversed in the early 1980s, in
the wake of steep increases in these interest rates. A wave of currency
and debt crises and economic contraction in developing countries followed.
The Mexican peso crisis of 1994, which was followed by a severe contraction
in output, also was preceded by an increase in U.S. interest rates, which,
along with political uncertainty in Mexico, made investing in the U.S.
market more attractive relative to emerging markets.
Other external shocks, such as unfavorable movements in the terms of
trade (the ratio of export to import prices) also have played a role.
For example, in Mexico, sharp increases in oil prices in the 1970s contributed
to an economic boom fueled by government spending and foreign borrowing.
The stagnation in oil prices in the early 1980s adversely affected Mexico's
export revenues and output performance, contributing to the debt crisis
Mexico experienced after 1982. Steep increases followed by sudden declines
in semiconductor prices contributed to similar economic cycles (booms
and slowdowns) in a number of East Asian economies prior to the currency
crises these countries experienced in 1997.
Vulnerable financial sectors
Global shocks do not have the same effects on all open economies, suggesting
that domestic conditions in these economies determine how they will be
affected. For example, adverse terms of trade shocks appear to have contributed
to slowing growth in a number of East Asian economies after 1995, eventually
leading to sharp currency depreciations in 1997. However, the impact on
Thailand was far more severe than the impact on Singapore. In Thailand,
GDP growth fell from 5.5% in 1996 to -9.4% in 1998, while in Singapore
GDP growth fell from 7.5% to 0.3% over the same period.
Recent explanations for differences in the severity of output contractions
focus on the vulnerability of the financial sector. However, there is
disagreement on the reasons for such vulnerability. Some authors stress
that economies that are open to foreign borrowing may become increasingly
illiquid. As is well known, the return on illiquid investments (such as
plant and equipment) in developing countries is typically higher than
the return on liquid investments (such as U.S. Treasury bills) in developed
markets. A model by Chang and Velasco (1998) shows that under these conditions,
residents in developing countries may find it advantageous to borrow as
much as possible from abroad (short-term) in order to invest in illiquid
assets at home. Over time, the short-term foreign currency liabilities
of domestic residents will exceed assets, making the economy vulnerable
to a sudden loss of confidence or panic. Such a loss of confidence can
mean interruptions in foreign financing that can trigger a financial crisis,
because banks would have to liquidate long-term investments at a loss
to pay off short-term foreign loans as they mature. As a result, one would
see a close timing of depreciation and output contraction.
Others focus on the role of government guarantees in encouraging risky
behavior (moral hazard), making the financial system vulnerable to shocks.
For example, Corsetti, Pesenti, and Roubini (CPR 1998) formulate a model
in which an "elite" in a developing country can borrow from abroad to
finance investment and expect the government to provide financial support
should investment projects fail. CPR show that this type of government
guarantee implies over-investment (in excess of the amount consistent
with profit maximization), which may be financed by foreign borrowing.
The guarantee also prompts borrowers to cover any losses or cash shortfalls
by increasing their foreign borrowing (this is known as "evergreening").
However, once the debt becomes too large (relative to foreign exchange
reserves), the government guarantee is no longer credible. Foreign creditors
then refuse to roll over the debt, triggering a financial crisis. In response,
the government incurs a budget deficit to make good on its guarantee and
cover the liabilities of domestic residents. As people expect the deficit
to be financed by money creation and higher inflation, the currency collapses.
Investment and output also decline as a result of the withdrawal of government
guarantees and the associated interruption in foreign credit. Similar
arguments are made by Burnside, Eichenbaum, and Rebelo (1999).
Recent discussions of financial sector vulnerability also point out that
depreciations may be contractionary by worsening the condition of the
financial sector. This may disrupt economic activity by interrupting the
supply of credit. For example, moral hazard also may encourage unhedged
foreign currency borrowing (McKinnon and Pill 1998, Burnside, Eichenbaum,
and Rebelo 1999), in which case a depreciation would reduce the availability
of credit by bankrupting borrowers and weakening the financial condition
of lenders. A depreciation also may reduce credit by reducing the value
of collateral that lenders may require to provide credit (Kasa 1998).
Conclusions
This brief overview has highlighted alternative scenarios under which
exchange rate depreciations may be associated with output contraction.
Future research could further explore which of the alternative explanations
for closely timed depreciations and output contraction are most consistent
with the empirical evidence and what policy approaches could reduce the
frequency, magnitude, or duration of such contractions.
Ramon Moreno
Senior Economist
References
Agenor, Pierre Richard, and Peter Montiel. 1996. Development Macroeconomics.
Princeton, NJ: Princeton University Press.
Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo. 1999. "Herding
and Financial Fragility in Fixed Exchange Rate Regimes." NBER Working
Paper 7143.
Calvo, Guillermo A., Leonardo Leiderman, and Carmen A. Reinhart. 1996.
"Inflows of Capital to Developing Countries in the 1990s." Journal
of Economic Perspectives 10(2) pp. 123-139.
Chang, Roberto, and Andres Velasco. 1998. "The Asian Liquidity Crisis."
NBER Working Paper No. W6796 (November).
Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. 1998. "Paper
Tigers? A Model of the Asian Crisis." NBER Working Paper No. W6783 (November).
Kasa, Kenneth. 1998. "Borrowing Constraints and Asset Market Dynamics:
Evidence from the Pacific Basin." Federal Reserve Bank of San Francisco
Economic Review
3, pp.17-28 (accessed September 28, 1999).
McKinnon, Ronald, and Huw Pill. 1998. "International Overborrowing: A
Decomposition of Credit and Currency Risks." World Development
26(7) pp. 1,267-1,282.
Obstfeld, Maurice, and Kenneth Rogoff. 1996. Foundations of International
Economics. Cambridge, MA: MIT Press.
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