IMF conference paper links currency depreciation to post-crisis growth
A new paper presented at the IMF’s Annual Research Conference suggests that emerging markets should counter liquidity problems from capital outflows with currency depreciation and reserve sales. Read the full IMF report here.
Political risk can be a difficult concept to pin-point as the effects of a policy change might not have immediate effects but still greatly shape future outcomes. In looking at financial crises, the policy response – and thus political risk – affects the recovery of the country in question. At the 14th IMF Annual Research Conference, two researchers from MIT and Tufts looked at the major monetary policy actions taken after the 1997 financial crises and the most recent global recession. Both of these crises stemmed from liquidity shocks, spreading to the wider global financial system. There were sudden stops and reversals of capital flows around the world as markets clamped up and sought safer assets.
With the tapering of U.S. monetary policy still in question, emerging markets have seen volatile capital flows and have struggled to find the right policy mix to address this challenge. In their study, Ms. Forbes and Mr. Klein find that currency depreciation and major reserve sales impact GDP growth positively when responding to capital outflows. On the other hand, the imposition of capital controls and interest rates hikes led to sharp GDP contractions. Notably, they found that the standard policy response has shifted from 1997 to today. Following the East Asian financial crisis, the most frequent response to a halt in capital flows was a sharp increase in interest rates. Following the most recent recession, most countries turned to extensive currency depreciation.
As the global recovery still chugs along at a tepid pace, this study demonstrates how certain policy mixes can impact key economic variables like GDP, unemployment, or inflation. With positive growth still not guaranteed, the balance between strengthening economic fundamentals and preserving growth is delicate Forbes and Klein argue that there is no panacea which simultaneously boosts growth, lowers unemployment, and improves the inflation picture. Currency depreciation and reserve sales work with a lag, hitting GDP negatively in the first quarter or two but raising GDP significantly on the year to two-year horizon. There are some signs of positive unemployment gains from depreciation, however Forbes and Klein did not find this to be statistically significant.
Discussing their paper at the IMF, Jeffrey Sachs from Columbia University pointed out that their discovery showed the seemingly obvious but often ignored solution of treating a liquidity crisis with liquidity. Raising interest rates and controlling the flow of capital only further seizes up the financial machinery. Mr. Sachs got at the heart of a thorny problem associated with political risk. With the outcome of a crisis and its subsequent recovery tied so strongly to political decisions, the largest risk comes from misidentifying the crisis and mismatching the solution to the problem.
In the conference, the noted economist Stanley Fischer separately noted that policymakers and economist always prepare for the last crisis. While the U.S. and other advanced economies have strengthened financial regulations, their respective economies are only better equipped to handle risk in the areas previously stressed. Forbes and Klein show the most effective counter to crises that have already happened. Their prescriptions may not be ideal for what comes next, but the new emphasis on systemic risks and forward-looking macro-prudential tools is welcome for just this reason.