Macroeconomic dynamics of currency crises

In a next step we complement the static approach of section 3.4.1 with a dynamic analysis. We estimate a univariate panel autoregressive model in x applying the methodology used in Cerra and Saxena (2008), Bussière et al. (2010) and Kappler et al. (2011), and simulate impulse responses of several macroeconomic variables for the three different types of currency crises. This way we are able to analyze how the macroeconomic adjustments differ between the three types of currency crises.

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Chapter 3 To Intervene, or Not to Intervene: Monetary Policy & Currency Crises Our benchmark model is given by:

x_it =α_i+ω_t+

wherex_it denotes the macroeconomic variable of interest in countryiin yeart. Since the dependent variable xit is either defined as a growth rate or a ratio (e. g., output growth, inflation, current account over GDP or private capital inflows over GDP), the model specification accounts for the non-stationarity ofxin levels²⁰and for serial correlation of x. The dummy variable D_kit−s takes on the value one if a k type currency crisis occurs in country i in year t−s. We additionally control for time (ωt) and country specific effects (αi). The i. i. d. error term is denoted by it. The lag length is set to three, as we do not find any significant coefficients beyond the third lag for most indicators.²¹ Furthermore, heteroscedasticity consistent standard errors are computed. In order to avoid potential endogeneity problems we estimate a dynamic model for each variable that only captures the lagged effects of a currency crisis. To examine the crisis dynamics, namely the deviation from the no-crisis trend behavior, we simulate impulse response functions of several macroeconomic variables to shocks of the different types of crises.²²

20Test statistics show that all underlying variables are integrated of order 1.

21We use a common lag length for all model specifications in order to ensure a direct comparison of impulse response functions of the different macroeconomic indicators (see Kappler et al., 2011, pp. 13).

22To ensure that the impulse response functions are not driven by overlapping currency crises we apply a time window, which determines the singular event status of a currency crisis, and consider only crisis events without overlapping time windows (see also section3.2). Precisely, currency crises have to be two years apart to be kept in our analysis. We also applied different lengths of this time window (from 0 to 3 years) and have found our results to be robust (results are available upon request).

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3.4 Empirical analysis

The upper part of figure 3.4 shows that the output effects of a currency crisis substantially differ between the three types of crises.²³ For immediate depreciations and unsuccessful interventions the impulse response functions show a V-shaped drop and recovery of output growth. Moreover, the decline in output growth in case of unsuccessful interventions is about threefold the drop in case of immediate depreci-ations. Successful defenses do not show any significant output effect. In addition, the results imply a highly persistent impact on the output level in the aftermath of an unsuccessful defense. In particular, the accumulated output loss is more than 5 percentage points after 5 years (see table 3.7).

Likewise inflation is characterized by distinct differences between the three types of crises in the post-crisis period. Both immediate depreciations and unsuccessful interventions appear to be associated with higher inflation during the post-crisis period. While immediate depreciations vaguely show a prolonged period of higher inflation rates up to 9 percentage points above trend, unsuccessful defenses seem to be followed by a strong one time inflation peak of about 11 percentage points. Again, no significant effects are found in the case of successful interventions.

Concerning current account effects, we find a particularly strong response in the case of unsuccessful interventions (see figure 3.5). The current account improves persistently and shows the largest effect of about 4 percentage points three years after the crisis, thereby mitigating the decline in output. Immediate depreciations are associated with a small improvement in the current account, whereas no change is apparent in the case of successful interventions.

In the case of private capital inflows, post-crisis the three types of crises are associ-ated with diverging developments. While capital inflows show no significant response

23As recommended bySims and Zha(1999), the interpretation of the impulse response functions presented in this paper is based on error bands with coverage .68 instead of conventional significance levels.

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Chapter 3 To Intervene, or Not to Intervene: Monetary Policy & Currency Crises

Immediate depreciation Successful defense Unsuccessful defense

Immediate depreciation Successful defense Unsuccessful defense

Output growth

Infl ation

Figure 3.4:Impulse responses of output growth and inflation

in the case of successful interventions, they overshoot in the following period in the case of immediate depreciations. In contrast, they strongly decline in case of un-successful interventions and only recover slowly which might be related to increased uncertainty concerning the future economic development, further suggesting a loss of confidence among investors (see, e. g., Radelet and Sachs, 1998).²⁴

Taken together the findings from the impulse response functions indicate that depreciation events – immediate depreciation and unsuccessful defense – are

associ-24From a first insight, the impulse response functions seem to show a somewhat different behavior compared to the test statistics of table3.1. However, these differences are not surprising as table3.1 only reports simple mean values, while the underlying regressions of the impulse response functions also consider important time series effects. The impulse response functions therefore indicate the details of the post-crisis dynamics, which are not captured by the simple comparison of the pre- and post-crisis mean values of table3.1.

50

3.4 Empirical analysis

Immediate depreciation Successful defense Unsuccessful defense

Immediate depreciation Successful defense Unsuccessful defense

Current account

Private capital infl ows

Figure 3.5: Impulse responses of current account and private capital inflows

ated with lower output growth and higher inflation during the post-crisis period.²⁵ Particularly, in case of an unsuccessful defense the output loss seems to be highly persistent. The empirical results provide further evidence on the risk associated with defending the domestic currency. On the one hand, if the central bank decides to let the currency depreciate without trying to defend it, the country is likely to face a mild recession. On the other hand, if she decides to intervene, she is either suc-cessful and avoids negative output effects or she abandons the exchange rate and most likely suffers high economic costs in terms of output loss. Monetary authorities that pursue an apparently consistent policy, i. e. either successfully defending the do-mestic currency or immediately giving in to a speculative attack, seem to fare best.

25Table 3.7 in the appendix provides an additional overview of the results obtained from the impulse response functions presented in this section.

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Chapter 3 To Intervene, or Not to Intervene: Monetary Policy & Currency Crises

In the inconsistent case of an unsuccessful defense, i. e. defending the exchange rate and later giving in to the speculative attack, negative expectational effects associated with the loss of the nominal exchange rate anchor are likely to lead to high economic cost in terms of output (see alsoEichengreen and Rose,2003). From this perspective, the case of an unsuccessful intervention seems to combine the worst of both worlds, namely the negative expectational and reputational effects due to the depreciation and the temporarily restrictive monetary policy in the futile attempt to defend the domestic currency.