The anatomy of financial crises: Evidence from the emerging ADR market

We study the anatomy of recent financial crises in Mexico, East Asia, Russia, Brazil, Turkey, and Argentina by investigating the efficiency and pricing of the emerging American depositary receipt (ADR) market. We use a non-parametric technique to test for persistent regime shifts in two basic structural relationships for ADR returns in 20 emerging countries — identified via arbitrage and capital mobility considerations — that should always hold in efficient and integrated capital markets. We find that those “normal” market conditions were instead often violated in proximity of financial crises: The law of one price often weakened (by 54% on average) and domestic sources of risk became more important (often by more than 100%) for many emerging ADRs. We also find the likelihood of these regime shifts to be related to proxies for uncertainty among investors, exchange rate volatility, trade linkages, and liquidity (but not stock market trends, currency devaluations, capital flight, or capital controls).     

The anatomy of financial crises: Evidence from the emerging ADR market

We study the anatomy of recent financial crises in Mexico, East Asia, Russia, Brazil, Turkey, and Argentina by investigating the efficiency and pricing of the emerging American depositary receipt (ADR) market. We use a non-parametric technique to test for persistent regime shifts in two basic structural relationships for ADR returns in 20 emerging countries — identified via arbitrage and capital mobility considerations — that should always hold in efficient and integrated capital markets. We find that those “normal” market conditions were instead often violated in proximity of financial crises: The law of one price often weakened (by 54% on average) and domestic sources of risk became more important (often by more than 100%) for many emerging ADRs. We also find the likelihood of these regime shifts to be related to proxies for uncertainty among investors, exchange rate volatility, trade linkages, and liquidity (but not stock market trends, currency devaluations, capital flight, or capital controls).     

Currency risk in emerging equity markets

The paper develops an international capital asset-pricing model (ICAPM), which includes foreign currency risk, and examines the impact of capital market liberalisation on the pricing of risks. It applies the model to data from Pacific Basin financial markets and finds substantial evidence that not only currency risk is priced in both pre- and post-liberalisation periods, but the model is superior to one which does not include currency risk. This evidence suggests that an international capital asset-pricing model, which omits currency risk, will be misspecified. Furthermore, the results imply that since currency risk is priced and investors are compensated for bearing such risk they should not be discouraged by more flexible exchange rate regimes from investing in emerging markets.     

Market integration and contagion: Evidence from Asian emerging stock and foreign exchange markets

This paper examines whether Asian emerging stock markets (India, Korea, Malaysia, Philippines, Taiwan, and Thailand) have become integrated into world capital markets since their official liberalization dates by estimating and testing a dynamic integrated international capital asset pricing model (ICAPM) in the absence of purchasing power parity (PPP) using an asymmetric multivariate GARCH(1,1)-in-Mean approach. Also examined in this paper is whether there are pure contagion effects between stock and foreign exchange markets for each Asian country during the 1997 Asian crisis. The empirical results show that first, both currency and world market risks are priced and time-varying, suggesting that an international asset pricing model under PPP and constant price of risk might give rise to model misspecification. Second, the stock markets for India, Korea, Malaysia, Philippines, and Thailand were segmented from the world capital markets before their liberalization dates, but all six markets have become fully integrated since then. Third, the market liberalization has reduced the cost of capital and price volatility for most of the countries. Finally, as for the contagion effects, strong positive impact of return shocks originating from the domestic stock market to its foreign exchange market during the crisis is found. This dynamic relationship between stock market and foreign exchange market is consistent with stock-oriented exchange rate models.     

Export prices,selection into exporting and market size: Evidence from China and India

This paper empirically analyses the export pricing behaviour of Chinese and Indian exporters when there is selection into exporting. Previous exchange rate pass-through estimates that did not take selection into account could be biased if selection into exporting is correlated with pricing strategy. We use 6-digit product-level data across high- and low-income export destinations over the period 1994–2007 and assess a number of determinants of the degree of pass-through of exchange rates to export prices, such as the level of external demand, exporter’s wage cost, degree of competition in export markets, currency volatility and the direction of currency movements. We find systematic differences in the pricing strategies of Chinese and Indian exporters while uncovering a selection bias in exports to high-income markets, although the pricing of exports to low-income markets is independent of the decision to export. Export prices do not increase systematically with the destination market per capita income, and tend to be less sensitive in shipments to advanced nations. Export prices of India are sensitive to the volatility of the trade-weighted nominal effective exchange rate (NEER), indicating heterogeneity in prices to maintain competitiveness, but not in China as volatility is insignificant given a fixed currency system. It is also revealed that a country with a relatively flexible currency regime and arms-length trade such as India is more likely to exhibit incomplete pass-through, whereas a country with an inflexible currency system and involved in outward processing trade is more likely to have full pass-through as shown in the case of China.     

The Economics of Exchange‐Rate Regimes: A Review Essay

The exchange‐rate regime issue has taken centre‐stage in discussions of international economic policy. Much of the profession appears to have been converted to ‘the hypothesis of the vanishing middle regime’; for countries well‐integrated into world capital markets, there is little, if any, middle ground between floating exchange rates and monetary unification. This paper considers the exchange‐rate‐regime issue in the context of recent books on the subject by W. Max Corden and Morris Goldstein. Both authors prescribe managed floating exchange rates, supplemented with inflation targeting, for emerging‐market economies. Under managed floating, and with a credible monetary policy, the public finances in order, and strengthened debt management and prudential regulation, the exchange rate is free to act as a market gauge for assessing policies and as a mode of conflict resolution. Both authors also argue, however, that no exchange‐rate regime is a Holy Grail. Ultimately, a credible exchange‐rate regime depends upon the trust evoked by governments. There is no exchange‐rate regime, whether of the managed‐floating or hard‐fix variety, that can eradicate a history of failed stabilisation attempts.     

Sovereign credit ratings,capital flows and financial sector development in emerging markets

How does the sovereign credit ratings history provided by independent ratings agencies affect domestic financial sector development and international capital inflows to emerging countries? We address this question utilizing a comprehensive dataset of sovereign credit ratings from Standard and Poor's from 1995–2003 for a cross-section of 51 emerging markets. Within a panel data estimation framework, we examine financial sector development and the influence of sovereign credit ratings provision, controlling for various economic and corporate governance factors identified in the financial development literature. We find strong evidence that our sovereign credit rating measures do affect financial intermediary sector developments and capital flows. We find that i) long-term foreign currency sovereign credit ratings are important for encouraging financial intermediary development and for attracting capital flows. ii) Long-term local currency ratings stimulate domestic market growth but discourage international capital flows. iii) Short-term ratings (both foreign and local currency denominated) retard all forms of financial developments and capital flows. There are important implications in this research for policy makers to encourage the provision of longer-term credit ratings to promote financial development in emerging economies.     

Dove or Hawk? Characterizing monetary policy regime switches in India

The past two decades have witnessed a worldwide move by emerging markets to adopt explicit or implicit inflation targeting regimes. A notable and often discussed exception to this trend, of course, is China which follows a pegged exchange rate regime supported by capital controls. Another major exception is India. It is not clear how to characterize the monetary regime or identify the nominal monetary anchor in India. Is central bank policy in India following a predictable rule that is heavily influenced by a quasi inflation target? And how has the monetary regime been affected by the gradual process of financial liberalization in India? To address these points, we investigate monetary policy regime change in India using a Markov switching model to estimate a time-varying Taylor-type rule for the Reserve Bank of India. We find that the conduct of monetary policy over the last two decades can be characterized by two regimes, which we term ‘Hawk’ and ‘Dove.’ In the first of these two regimes, the central bank reveals a greater relative (though not absolute) weight on controlling inflation vis-à-vis narrowing the output gap. The central bank however was found to be in the “Dove” regime about half of our sample period, focusing more on the output gap and exchange rate targets to stimulate exports, rather than moderating inflation. India thus seems to be following its own direction in the conduct of monetary policy, seemingly not overly influenced by the emphasis on quasi-inflation targeting seen in many emerging markets.     

The Aftermath of a Currency Collapse: How Different are Emerging Markets?

In currency crises, unlike in orderly devaluations, the financial markets dominate events. Previous research has shown that the output effects of a crisis tend to be worse in emerging markets, and the current account adjustment greater. This paper examines the evolution of a wider range of macroeconomic variables from two years before a currency collapse to two years afterwards. On the basis of twelve recent episodes, it is shown that currency collapses (crises followed by depreciations) have had a much greater adverse impact in emerging markets (defined as relatively high‐income developing countries exposed to international capital markets) than in developed countries. There is greater nominal and real depreciation, a substantial inflation shock, a much bigger output effect, and far greater import compression, whilst inflows of portfolio capital virtually cease. These differences are statistically significant. Nevertheless there is wide variation n the post‐collapse experience of the six emerging markets studied (Mexico, Thailand, Korea, Indonesia, Russia and Brazil). Although all six experienced a sudden stop or even a reversal of capital flows and very sharp nominal depreciations, inflation remained low in Thailand, Korea and Brazil, and output losses were comparatively small in Russia and Brazil. Previous studies of individual crises suggest that important factors are the state of the banking system and its vulnerability to currency movements, the ability of the authorities to establish a credible macroeconomic policy after the collapse, and whether the crisis triggers significant political instability.     

Devaluation,Innovation, and Prices

We investigate the effects of exchange rate changes on innovation by a multinational corporation. The firm enjoys a monopoly in the home market but engages in Cournot competition with a domestic firm in the foreign market. Changes in currency values affect the multinational firm’s profits in domestic currency units, and thus influence the optimal level of process innovation as well as output and prices in the two markets. We find that a devaluation of the home currency will lead the home firm to increase its output in both the home and foreign markets, and increase its spending on R&D. We also find that currency devaluation in the home market leads to lower prices in both markets.     

Financial liberalization, structural change, and real exchange rate appreciations

The last twenty years have witnessed periods of sustained appreciations of the real exchange rate in emerging economies. The case of Mexico between 1988 and 2002 is representative of several episodes in Latin America and Central and Eastern Europe in which countries opening to capital flows experienced large appreciations accompanied by a significant reallocation of workers towards the non-tradable sector. We account for these facts using a two sector dynamic general equilibrium model of a small open economy with frictions to labor reallocation and two driving forces: (i) A decline in the cost of borrowing in foreign markets, and (ii) differential productivity growth across sectors. These two mechanisms account together for 60% of the decline in the domestic relative price of tradables in Mexico and for a large fraction of the observed reallocation of labor across sectors. The decline in the interest rate faced by Mexico in international markets is quantitatively the most important channel. Our results are robust to the inclusion of terms of trade into the model.     

Financial liberalization,structural change,and real exchange rate appreciations

The last twenty years have witnessed periods of sustained appreciations of the real exchange rate in emerging economies. The case of Mexico between 1988 and 2002 is representative of several episodes in Latin America and Central and Eastern Europe in which countries opening to capital flows experienced large appreciations accompanied by a significant reallocation of workers towards the non-tradable sector. We account for these facts using a two sector dynamic general equilibrium model of a small open economy with frictions to labor reallocation and two driving forces: (i) A decline in the cost of borrowing in foreign markets, and (ii) differential productivity growth across sectors. These two mechanisms account together for 60% of the decline in the domestic relative price of tradables in Mexico and for a large fraction of the observed reallocation of labor across sectors. The decline in the interest rate faced by Mexico in international markets is quantitatively the most important channel. Our results are robust to the inclusion of terms of trade into the model.     

A new world order: explaining the international diffusion of the gold standard, 1870-1913

The gold standard gradually became an international monetary regime after 1870. Similarly, some nations in the European Union are waiting to adopt the euro while others have joined immediately. What explains the timing of exchange rate regime adoption? To find out, the international diffusion of the gold standard is analyzed. Duration analysis shows that network externalities operating through trade channels, the desire to decrease borrowing costs on international capital markets, and the level of development matter. Some evidence shows that the level of exchange rate volatility or inflationist agricultural interests did not matter for the timing of adoption.     

Behavior of output during currency crises

This paper documents the behavior of output and its association with other macroeconomic variables in 195 episodes of currency crises in developing countries during 1970-2000. We find that about 60% of the crises are contractionary, while the rest are expansionary. Crises are one and a half times more likely to be contractionary in emerging markets than in other developing economies. The number of contractionary crises or their severity does not increase in the 1990s. Economies which experience capital inflows in the years prior to the crisis or an increase in external debt burden during the crisis are more likely to slow down during crises, while those with restrictions on capital flows prior to the crisis or are more open to international trade are less likely to do so. The results are robust to different ways of measuring changes in output during crises.     

Local currency systemic risk

Emerging country governments increasingly issue local currency denominated bonds and foreign investors have been increasing their holdings of these assets. By issuing debt denominated in local currency, emerging country governments eliminate exchange rate risk. The growing stock of local currency government debt in the financial portfolios of foreign investors increases their diversification and exposure to fast growing economies. In this paper, we highlight some of the risks associated to this recent trend. First, we adopt the CoV aR risk-measure to estimate the vulnerability of individual countries to systemic risk in the market for local currency government debt. Second, we show that our country-level estimates of vulnerability increase with the share of local currency debt held by foreign investors. A version of the old adage “When New York sneezes, London catches a cold,” used often to describe the relationship between the stock markets in these two cities, still applies between individual emerging countries and the aggregate market for local currency government debt.     

Corporate financial policies and the exchange rate regime: Evidence from Brazil

This paper analyzes the relationship between companies' financial policies and the exchange rate regime for a sample of non-financial Brazilian companies from 1996 to 2006. The adoption of a floating exchange rate regime is shown to improve the match between the currency composition of companies' assets and liabilities. The paper also shows that this reduction in companies' currency mismatches is more pronounced for companies in the highest quantile of foreign exposure; therefore the results confirm that the exchange rate regime plays an important role in the determination of companies' foreign vulnerability.     

Regional financial integration in the GCC

We investigate the extent of regional financial integration in the member countries of the Gulf Cooperation Council. Interest rate data show that convergence exists and that interest rate differentials are relatively short-lived—especially relative to other unified currency area and comparable to those of the Euro Area post 1999. Equity data using cross-listed stocks confirm that stock markets are fairly integrated compared to other emerging market regions, although price equalization is hampered by market illiquidity. The limited volume data available suggests that intra-GCC capital flows are sizeable.     

On the significance of the incremental returns from hedging international portfolios

This paper investigates whether hedging the currency risk associated with international portfolios diversified into established and emerging markets leads to significant incremental returns. From the empirical results, for the period August 1989 to December 1997, the ineffectiveness of hedging for generating superior returns could be explained by the low correlations among the observed markets and the presence of negative index/currency correlations in many assets. In the particular case of emerging markets, the predominance of positive index/currency correlations suggests that the currency risk could compound the risk posed by these markets beyond the power of a hedging strategy.