Dollar Bloc or Dollar Block: External Currency Pricing and the East Asian Crisis

Transcription

1 FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES Dollar Bloc or Dollar Block: Exernal Currency Pricing and he Eas Asian Crisis David Cook Hong Kong Universiy of Science and Technology and Michael B. Devereux Universiy of Briish Columbia May 23, 24 Working Paper hp:// This paper was presened a he conference on "Emerging Markes and Macroeconomic Volailiy: Lessons from a Decade of Financial Debacles" cosponsored by he Cener for Pacific Basin Sudies of he Federal Reserve Bank of San Francisco and he Cener for Inernaional Economics a he Universiy of Maryland and held a he FRBSF on June The views in his paper are solely he responsibiliy of he auhors and should no be inerpreed as reflecing he views of he Federal Reserve Bank of San Francisco or he Board of Governors of he Federal Reserve Sysem.

2 Dollar Bloc or Dollar Block: Exernal Currency Pricing and he Eas Asian Crisis * David Cook HKUST Michael B. Devereux UBC May 23, 24 Firs draf, very preliminary and incomplee Absrac This paper provides a quaniaive invesigaion of he Eas Asian crisis of The wo essenial feaures of he crisis ha we focus on are a) he crisis was a regional phenomenon; he deph and severiy of he crisis was exacerbaed by a large decline in regional demand, and b) he pracice of seing expor goods prices in dollars (which we documen empirically) led o a powerful inernal propagaion effec of he crisis wihin he region, conribuing grealy o he decline in regional rade flows. We consruc a model wih hese wo feaures, and show ha i can do a reasonable ob of accouning for he response of he main macroeconomic aggregaes in Korea, Malaysia, and Thailand during he crisis. * Prepared for San Francisco Federal Reserve Bank Conference Emerging Markes and Macroeconomic Volailiy, June Cook: [email protected], Devereux: [email protected]. Devereux hanks SSHRC, he Royal Bank of Canada, and he Bank of Canada for financial assisance. Cook hanks he Research Grans Council of Hong Kong for financial assisance. 1

3 The las decade has winessed a series of maor macroeconomic crises in emerging marke economies. Many of he characerisics of hese crises a sudden reversal of he curren accoun, a big drop in GDP, and a large real exchange rae depreciaion, are relaively uniform across crisis episodes. In combinaion wih he sheer size of he crises hemselves, his opens up he possibiliy of undersanding crises using he ools of quaniaive dynamic general equilibrium heory. A number of recen sudies have followed his direcion 1. Bu some feaures of crises have been hard o undersand in he conex of open economy general equilibrium heory. In paricular, he magniude and persisence of crises on oupu and absorpion have no been adequaely explained in he models o dae. One of he heoreical problems in providing a macroeconomic accoun of crises is o explain why very large real exchange rae devaluaions fail o have an expansionary impac on he economy hrough an expor boom. This is paricularly puzzling in he Eas Asian crisis of Despie real depreciaions of 6 percen or more, expor volumes eiher fell or sagnaed for a year or more in mos of he wors hi crises counries. The rapid urnaround in he ne exernal balance in hese counries was more han accouned for by a huge collapse in impors raher han a rise in expors. This paper develops a quaniaive dynamic general equilibrium model of he Eas Asian crisis. We focus on he experience of hree of he wors hi counries Korea, Malaysia, and Thailand. We firs provide a quaniaive descripion of he impac of he crisis on macroeconomic aggregaes, prices, and exchange raes for hese counries. We hen develop a simple dynamic muli-counry open economy model, which is subeced o `crises. We represen a crisis as a shock o he counry or regional risk-premiums on borrowing. Using a calibraed version of he model, we show ha he impac of a crisis shock quie closely resembles he observed effecs of he Eas Asian crisis on our sample of counries, boh qualiaively and quaniaively. A key aspec of our modeling sraegy he main elemen ha allows us o quaniaively accoun for he scale and persisence of he shock, is o view he Eas Asian crisis as no simply a capial marke shock ha his one counry in isolaion, bu as a widespread ump in he risk premium o a region in which counries are inerlinked hrough rade flows. We show ha he large and persisen negaive affecs of he Eas Asian crisis occurs as a resul of a precipious drop in rade wihin he Eas Asia region. Thus, he Eas 1 See for example, Arrelano and Mendoza (22), Neumeyer and Perri (21), Cook and Devereux (24), Mendoza (21), and Gerler, Gilchris, and Naallucci (23). 2

4 Asian crisis is seen as a combinaion of a large exernal shock, and a powerful propagaion mechanism, inernal o he region. Our approach o modeling he crisis is similar o a number of previous papers we make use of a sicky price open economy macroeconomic framework. Bu we add o his framework a very specific assumpion abou price seing of expor goods. In our model, all expor goods prices are quasi-fixed in erms of US dollars, even for rade wihin he region. Using deailed price daa from our sample of Eas Asian counries, we argue ha ha his pricing assumpion accuraely characerizes he response of prices following he crisis, as well as he average behavior of prices over a longer sample period. Previous commenaorse.g. McKinnon and Schnabl (23), have also emphasized his aspec abou Eas Asian expor pricing. The effec of his assumpion abou expor pricing is o reconcile he above menioned discrepancy beween he observed behavior of ne expors in Eas Asia and he predicions of an devaluaion-fueled expor boom ha underlies mos models. In our model, a devaluaion of a counry does no immediaely simulae ne expors hrough lower expor prices abroad, since expor prices are emporarily fixed in erms of US dollars. Bu a he same ime, an exchange rae devaluaion leads o a big fall in impor demand, due o he immediae pass-hrough of exchange rae changes ino impored goods. The key feaure of he model however, is ha a devaluaion of a neighboring counry will reduce is impor demand for counries wihin he Eas Asian region us as much as i affecs demand for counries in he res of he world, even if he counries wihin he region have hemselves devalued. Tha is, a devaluaion of a counry does no immediae make is expors more compeiive wihin Eas Asia, because hey are priced in US dollars, and a devaluaion of a regional rading parner leads o a big drop in demand for ha counry s expors, since i leads o an increase in he domesic price of he counry s expors. We refer o his aspec of Eas Asian expor pricing as `Dollar Currency Pricing. We calibrae our model and simulae is response o a crisis shock when his dollar currency pricing applies, and conras his wih he alernaive of `local currency pricing of expors. We find ha wih local currency pricing of expors, our calibraed model can reproduce he main qualiaive feaures of he Eas Asian crisis, bu no he quaniaive feaures. Bu wih dollar currency pricing, we can do a good ob in providing boh a qualiaive and a quaniaive accoun of he crisis. 3

5 I An Empirical Descripion of he Eas Asian Crisis We firs ouline he main macroeconomic paerns of he Asian crisis for hree counries; Korea, Malaysia and Thailand. These hree counries direcly experienced a currency and financial crisis wih a fairly common se of crisis characerisics as described in he inroducion. The large size of he crisis makes i relaively easy o be precise abou he iniial iming. Figure 1 illusraes he movemen of each economy beginning in he hird quarer of We repor resuls from seasonally adused quarerly naional income accouns. The real variables examined are GDP, consumpion, invesmen, expors, and impors. The nominal variables examined are he deflaors of domesic absorpion, expors, and impors. In addiion, we illusrae he pah of he nominal exchange rae, and he shor-erm nominal ineres rae. Since hese counries were growing quickly in he period before he crisis, i is imporan o accoun for he rend pahs of he macroeconomic aggregaes. We derend all variables excep he exchange and ineres raes wih a log linear-quadraic rend. We hen assume ha in he absence of he crisis, each variable would rever back o rend according o an AR(1) process. We esimae he AR(1) process for each de-rended variable on pre-crisis daa. Figure 1 shows he difference beween each series and heir oucomes if hey had revered geomerically back o rend afer he 3 rd quarer of Panels I and J show he response of he US dollar based nominal exchange rae, and nominal ineres raes. Boh variables are illusraed in he form of deviaions from he mean exchange rae in he firs half of In he hree crisis counries, each economy experienced a sharp nominal exchange rae depreciaion in mid-lae1997. The nominal depreciaion ranges from 4% for Malaysia, o over 6% for Thailand and Korea. The absorpion deflaor (Panel F) rises sharply in each case, bu by far less han he nominal depreciaion, so he nominal depreciaion leads o a persisen real depreciaion of around 3-4%. Moreover, he iniial burs of general inflaion quickly reverses in all hree crisis counries, and (relaive o rend) he move owards deflaion exacerbaes he persisence of real exchange rae depreciaion. In all counries, nominal ineres raes rise sharply following he crisis. Bu his is shor lived. By mid 1998, nominal ineres raes are below heir iniial rend, and remain persisenly low unil he end of he sample. Panels A-E illusrae he real effecs of he crisis. All counries experience a sharp conracion in GDP. In early 1998 GDP was beween 1% and 16% below rend for all 4

6 counries. The fall in GDP is associaed wih a 1-2% fall in consumpion, and a much larger fall in invesmen, combined wih a sharp improvemen in he rade balance. The fall in GDP is persisen for Korea, Malaysia, and especially Thailand. The fac ha GDP falls by much less han absorpion for all counries poins o a key aspec of he crisis in Eas Asia a maor improvemen in he rade balance occurs in all counries. Bu he rade balance improvemen is due much more o a subsanial fall in impors more han o a rise in expors. Impors fall by beween 2% and 4% and remained persisenly below rend unil 2. Expors, on he oher hand, responded in a mixed fashion. While i would be anicipaed ha a real devaluaion of he size experienced in Korea, Malaysia and Thailand would simulae a subsanial boom in expors, expors acually fall below rend in Malaysia and Thailand, and remained essenially unchanged in Korea. Abou a year afer he crisis, an expor boom sars up in all counries, and expors are subsanially above rend in lae Why do expors remain so depressed following a subsanial real devaluaion? Figure 2 gives some furher evidence by decomposing expors for all four counries ino expors specifically desined for he Eas Asia region, and expors o he res of he world (using he same de-rending echnique as above). Expors o he res of he world rises above rend in all counries, albei slowly. Expors o he Eas Asia region fall sharply and persisenly below rend. This is perhaps no surprising, bu i underscores he fac ha he Eas Asian crisis ook on he characer of a wide regional slump. In he model developed below, we argue ha his regional ineracion is criical in order o undersand he magniude and persisence of he crisis, and he inabiliy of even very large devaluaions o expand aggregae demand in hese economies. How imporan is inra-regional rade in Eas Asia? Table 1 shows he fracion of expors o Asia as a percenage of expors o Asia plus EU, Norh America, and Japan, where in addiion o our hree counries we include Singapore, Indonesia, he Philippines, and Taiwan. Wih he excepion of Indonesia, he share of regional expors was growing for all counries hrough he 199 s. In 1996, all counries excep he Philippines had an excess of 4 percen of expors going o he Asian region. This share had fallen quie sharply by 1998 (again wih he excepion of he Philippines), bu more recenly has grown srongly, and now exceeds he levels of he mid 199 s. These figures again sugges ha i may be imporan o allow for regional rade effecs when accouning for he Eas Asia crisis. While he region-wide recession represened one facor for he slow response of aggregae expors following he large devaluaion, he behavior of expor prices is anoher 5

7 imporan elemen. Figure 1 shows he effecs of he crisis on he expor and impor prices for Korea, Malaysia and Thailand, relaive o heir pre-crisis rend (panels G and H). In he wake of he sharp devaluaion, boh impor and expor price deflaors rise sharply. Hence, here is high exchange rae pass-hrough (as documened in Bursein e al 23) ino impor prices, bu also ino expor prices. Figure 3 shows he changes in impor and expor prices a he monhly frequency, from February 1997 o he end of 1998, for Korea and Thailand 2. There is a very close correspondence beween monhly changes in he US dollar exchange rae and prices of boh impors and expors. For comparison, Figure 3 also shows he same daa for Singapore. While he movemens in he exchange rae were significanly less, and here is a much weaker associaion beween he exchange rae and impor prices, here seems o be subsanial pass-hrough of exchange rae movemens ino expor prices. The behavior of expor and impor prices has an imporan implicaion for he way in which raded goods prices in Asia are se, and he effecs of exchange rae changes in our model. A cenral characerisic of our model is ha boh expor and impor good prices for each emerging economy are quasi-fixed in US dollars. We refer o his as `Dollar Currency Pricing. Tha he US dollar is he mos imporan currency for inernaional rade is widely acknowledged. In Asia paricularly, MacKinnon and Schnabl (23) emphasize he cenral role of he US dollar in boh goods and financial markes. Some evidence for dollar currency pricing is given in Table 2. This repors he currency of rade invoicing for expors and impors for Korea and Thailand. For Korea in he mid-199 s 8 percen of indusrial impors, and almos 9 percen of expors were invoiced in US dollars. In Thailand in 1997, US dollar invoicing covered 8 percen of impors and 92 percen of expors. Since he US share in oal expors for boh counries is only abou 22 percen, and he US impor share is lower, he US dollar clearly plays a disproporionae role in rade pricing. The sriking feaure of Table 2 is he fac ha he local currency has only a iny weigh in eiher impor or expor currency invoicing. In paricular, for Thailand in 1997, only abou 2 percen of expors and impors were invoiced in Thai bah 3. Indirec evidence on he role of he US dollar as an expor currency is given in MacKinnon and Schnabl (23), and Ausralian Business Survey (1998). Over 7 percen of Japan s impors from Asia in he mid 199 s were US dollar invoiced, while less han 25 percen were invoiced in yen. Asian currency invoicing (besides yen) of Japanese impors from Asia is essenially non-exisen. Similarly, 2 To dae, we have no been able o obain monhly daa on impor and expor prices for Malaysia. 3 More deailed evidence for Thailand indicaes ha subsanial Bah expor invoicing is used only for smaller ASEAN counries, in paricular Laos, Cambodia, and Myanmar. 6

8 Ausralian impors in 1997 were denominaed overwhelmingly in US dollars, Ausralian dollars, or Japanese yen. Oher Asian currencies besides yen represened less han 2 percen of Ausralian impor currency invoicing. Invoicing daa alone do no esablish ha prices are sicky in he invoicing currency, since i is no auomaically rue ha he conracual price and he invoicing price of a raded good are in he same currency. For insance, a Korean car sold o he US could have is conracual price pre-se in Won, and is official US dollar invoicing price adused in response o changes in he exchange rae. Bu his seems inconsisen wih he evidence shown above ha local currency prices of impors and expors closely reflec movemens in he US dollar exchange rae. More suppor for he assumpion of dollar currency pricing may be gleaned from a deailed sudy of Korean expor and impor pricing. Figure 4 illusraes Korean aggregae expor prices separaely on a won basis, and a US dollar basis, as repored by he Bank of Korea. As shown above, expor prices in won umped dramaically afer he depreciaion in December 1997 and January By conras, prices on a US dollar basis changed hardly a all in he shor run. However, over he succeeding year, US dollar prices fell persisenly. This is in accord wih he pricing mechanism in our model. Exporers se prices in US dollars, and only gradually adus hem in responses o exchange rae changes. The model predics ha, following a crisis generaed by a rise in he world risk premium, US dollar prices will remain unchanged in he shor run, bu will gradually fall as exporers adus heir prices in response o lower real domesic marginal coss. This paern seems o occur in Figure 4. Table 3 furher breaks down he price adusmen of Korean expors by individual caegories of goods. The Table shows he percenage change in he average price, by caegory, beween he four monhs prior o November 1997, and he four monhs afer November Measured on a won basis, he price rise is very large for all goods excep oher meal producs. On a dollar basis, mos prices fall, bu by much less han he rise in he won price. Of course, during he crisis, Eas Asian exchange raes depreciaed no us agains he US dollar, bu agains all oher maor currencies. Hence, expor and impor prices are likely o be much more sable measured in any currency, relaive o he local currency. Bu in general, while domesic expor and impor prices in hese economies are very sensiive o he US dollar exchange rae, hey are less sensiive o movemens in oher bilaeral exchange raes. Table 4 shows he resuls of a regression of monhly changes in expor and impor 7

9 prices indices for Korea and Thailand on monhly changes in bilaeral exchange raes for he US dollar, he Japanese yen, he euro, and he pound serling 4. This can be inerpreed as a simple-minded `pass-hrough regression on impor and expor prices. The coefficien on he US dollar is large and highly significan for impor and expor prices in boh counries. In Korea, he yen is significan, bu wih much lower coefficien value, while he yen is marginally significan for impor prices bu no expor prices in Thailand, wih a very small coefficien. Noe in paricular ha he `pass-hrough of US dollar exchange rae changes o expor prices is higher han ha for impor prices, in boh counries. This provides some furher evidence of our dollar currency pricing hypohesis for Eas Asian expor goods. 4 For pre-1997 daa, we use he bilaeral d-mark exchange rae insead of he euro. 8

10 II The Model The model consiss of wo small open emerging marke economies, Korea and Thailand, which inerac wih a larger, developed world hrough rade in goods and a single risk-free bond 5. The currency of he developed world is called he dollar. In he baseline model, all inernaional ransacions are denominaed in dollars, even hose beween agens in Korea and Thailand. We will hen conras ha wih an alernaive `local currency pricing assumpion, where prices of expor goods are se in he currency of he imporing counry. The prices of goods produced in he developed world are exogenous he emerging marke economies. Wihin he wo emerging marke economies, households consume, work, and accumulae capial, firms produce a range of counry specific goods which are sold o domesic consumers, o he developed world, and o he oher emerging marke economy. Firms se prices in advance, and adus hem gradually. Finally, moneary auhoriies in each economy follow an ineres rae rule. A. The Developed World The developed world produces goods which are available in unlimied quaniies o Korea and Thailand a a dollar price P. The developed world has an iso-elasic demand for goods from Korea and Thailand given by: D γ φ EA, D D, P,$ P D = D,. D, EA EA, D D P P X s s A (.1) where A D is oal absorpion of he developed world, X D, is he expors of counry o he developed world, P,$ is he dollar price of he expors of counry, P represens he EA, D, dollar price of Eas Asian expors o he developed world, he parameers γ andφ are he 5 This srucure was developed in Corsei e al. (2) also. 9

11 elasiciies of demand for each individual Eas Asian counry good, and for Eas Asian expors in general, and finally, s D, and s D, EA represen share parameers. Inernaional financial markes provide funds o each counry a an exogenous ineres r EA, rae, 1+. Ineres raes may be counry-specific due o he fac ha here are counryspecific deb sensiive risk premia, which we define below. We also allow for an exogenous risk premium shock ha affecs r. EA, B.Households Each small economy, = {Korea, Thailand} is populaed wih a coninuum of worker-households ha accumulae capial and inernaional deb and own local firms. The EA, agen issues dollar denominaed deb, D, a a dollar ineres rae 1+ (aken as exogenous by he agen) and domesic currency deb, B, a nominal ineres rae1+. Capial r i K and labor H is rened o firms in compeiive markes a raes R and W respecively. The agen receives profis, Π, from monopolisically compeiive firms. Agens purchase final goods a price P and allocae goods o consumpion, C and invesmen, I. Lump-sum axes finance governmen spending, G. Define S as he spo exchange rae (he price of US dollars). The budge consrain is: SD + B EA 1 ( ) = (1 + r ) S D + (1 + i ) B + P C + I + G W H + R K +Π (.2) Capial accumulaion is deermined by he condiion: K = (1 δ ) K + I Φ I 1 I K I 1 where he household faces adusmen coss of changing capial ha depends on he rae of change of invesmen. 2 The infiniely lived households preferences maximize discouned uiliy, defined by: 1

12 { ln( ) 1 } = β Γ = E U E C hc H (.3) Households display `habi persisence wih respec o consumpion. B. Impors The final goods absorbed by he small economy, X are a CES funcion of goods produced wihin he Eas Asian region X and goods impored from he developed EA, economy (which is he res of he world): φ φ EA D φ + + = = +, 1 1 φ φ, { } (1 ) { } C I G X a X a IM (.4) Goods absorbed from Eas Asia are hemselves a CES funcion of goods produced in each counry: γ EA, γ KR, TH, γ = γ γ { } (1 ) { } X b X b X where KR and TH sand for Korea and Thailand, respecively.. (.5) C. Producion The economy produces value added using capial and labor wih a Cobb-Douglas echnology. θ { } { } 1 Y = K H (.6) Capial and labor are rened from households in compeiive markes. Producers sell heir oupu in a compeiive price o exporers and reailers a a price, deermined by he condiions: Y Y MCθ = R, MC (1 θ) = W. K H θ MC. Facor prices are D. Sicky Prices 11

13 Each of he hree caegories of demand for domesic goods, X, D, X, KR, X are Dixi- TH, Sigliz indices of goods provided by a uni range of domesic reailers or exporers indexed, by i. Define he index l = D,KR,TH. We define he quaniy aggregaor X l and prices P, l, as well as he demand curve for each individual reailer l, l, l, l, l, l, x p i i l l X P ξ ξ ξ ξ i, i, {, } {, } (.7),, X = x di P = p di = In he case of domesic demand (l = ), Reailer i buys maerials a he compeiive price MC and earns profis l, l, l, i, ( pi, MC ) xi, Π. Reailers receive an opporuniy o change ξ prices wih a fixed randomly disribued probabiliy ( κ ) 1 1 as in Calvo (1983) and Yun (1996). If hey do adus heir prices, hey mus se he price for period before he beginning of he period (as in Roemberg and Woodford, 1997). The domesic reailer maximizes he discouned sum of profis max E p Π = m κ, 1 (1 + i ) m, i n m= n= { } {, 1 }, {, max E P X p } { p, } MC p m ξ ξ ξ κ 1 (1 + in ) m m, i, i m n= n= (.8) The opimal price follows he dynamics: m l, ξ l, κ E 1 (1 + i ) { } n Pm Xm MCm l, * 1 m= n= p = l = m ξ l, ξ κ l, E 1 (1 + i ) { P } n m Xm m= n= (.9) Boh he exporers o he oher Asian economy ( = l) and he developed world are priced in dollars. Profis in erms of domesic currency for (l, l=d) are given by MC l, l, l, Π i, S p, i x, i S. The reailers selling o he exernal buyers maximize expeced profis as follows: 12

14 max E 1 + Sm Pm Xm pi, pi, p S n= n= m m {, }, 1 {, } {, l ξ l l ξ l ξ κ MCm (1 i ) } n (.1) p l, * m l, ξ l, κ E 1 (1 + i ) { } n Pm Xm MCm 1 m= n= = m ξ l, ξ κ l, E 1 (1 + i ) S { } n m Pm Xm m= n= (.11) In each case, aggregae prices follow he adusmen process: l, l, l, * { P } κ{ P 1 } ( 1 κ){ p } 1 ξ 1 ξ 1 ξ = + (.12) The consumer (or absorpion) price index in counry is hen defined as ( ( ) ( ) ) 1, 1 (1 ), 1 1 EA IM = φ + φ φ P a P a S P while he Eas Asian price index for counry is: E. Ineres Raes ( ( ) ( ) ) 1 1 (1 ) 1 1 EA, KR, TH, = γ + γ γ P b P a S P Dollar ineres raes in Asia are he sum of dollar ineres raes in he res of he world, r, a counry premium, cp, and an exogenous regional premium, rp. 1 ( ) 1 υ EA r = r + cp cp = cp + D D + rp 1 υ (.13) The regional premium follows an AR(1) process. rp = ρrp + ε (.14) 1 Domesic ineres raes are sen according o an inflaion-argeing ineres rae rule, wih some weigh given o exchange rae sabiliy: λ p S 1 S 1 P 1+ i = 1+ i P λ s (.15) 13

15 This rule represens a reasonable descripion of moneary policy in he pos-crisis Eas Asia period. In he crisis counries, he previous exchange rae pegs had been abandoned. Wha followed he pegs evolved ino he curren pracice of inflaion argeing in Korea and Thailand. Bu, as shown in Figure 1, nominal ineres raes rose sharply in he pos-crisis period, probably reflecing some concern wih limiing he exen of exchange rae depreciaion. Hence boh inflaion sabiliy and exchange rae sabiliy seem o be separae concerns of he moneary auhoriies. F. Equilibrium Define Ξ as he hisory of he economy up o ime. An equilibrium is a se of policy funcions of he represenaive agens, manufacurers and price seers: C (Ξ ), I (Ξ ),), X(Ξ ), X T (Ξ ), X N (Ξ ), X Td (Ξ ), EX(Ξ ), IM(Ξ ), Y T (Ξ ), Y N (Ξ ), M(Ξ ), H(Ξ ), H T (Ξ ), H N (Ξ ), D(Ξ ), K T (Ξ ), K N (Ξ ), w T (Ξ ), w N (Ξ ), p T (Ξ ), p N (Ξ ), p $T (Ξ ); and price funcions: P(Ξ ), P T (Ξ ), W(Ξ ), R T (Ξ ), R N (Ξ ), PPI T (Ξ ), PPI N (Ξ ), S(Ξ ), i(ξ ); which solve he firs-order condiions of he agens opimizaions problems and labor and goods markes clear ROW,, l, i, i, i, x di + x di + x di = Y = TH, KR (.16) 14

16 III Calibraion A log-linear version of he model is solved using he algorihm in King and Wason (21). Some parameers are fairly sandard from he open-economy macro lieraure. The depreciaion rae is se a δ=.25 and he discoun rae is calibraed as in Backus Kydland and Kehoe, β=.99. We esimae he elasiciy of subsiuion beween goods equal o φ = ψ = γ = 2 3 based on some esimaes for Eas Asia by Reinhar (1995). Cook and Devereux (24) calculae some of he grea raios for Korea and Thailand. We calibrae our symmeric model using averages of he parameers for hose wo counries. We se he raio of expors in GDP a.31. Governmen as a share of GDP is.16. We se he raio of seady-sae exernal deb o (annualized) annualized GDP and.275. The capial inensiy parameer is θ =.36. We se he Benchmark moneary policy a λ 1 = 1.2 and λ 2 =.3, so much of he weigh is on he absorpion deflaor raher han exchange raes. Cook and Devereux (24) show ha his rule does a reasonable ob capuring he response of domesic ineres raes in a dynamic general equilibrium model of he Eas Asian crisis. We se he dynamics of he model o mos closely mach he dynamic response which feaures a persisen and hump-shaped decline in producion, consumpion and invesmen. We assume ha prices change on average every six quarers κ =.84. The consumpion habi formaion parameer is se a h =.5. The invesmen adusmen cos is se a Φ K =.75. During he Eas Asian crisis, we observe indices for bond yields in Korea and Thailand consruced by HSBC. Counry premiums over 3 monh US Treasuries reach a peak of approximaely 7 annualized basis poins. Premiums on some long-erm bonds rise by similar levels indicaing a persisen shock. We calibrae he size of he shock equal o 1.7% (i.e. 7% annualized) wih a persisence equal o ρ=

17 IV Resuls In his secion, we describe he resuls of a `crisis shock in he form of an increase in he exernal risk premium on he wo emerging marke economies. We wish o examine how closely our model can accoun for he acual macroeconomic experience of he Eas Asian crisis as described in Figure 1. We also examine he symmeric model under he assumpion of local currency pricing (blue lines). We can firs describe he qualiaive effecs of a rise in he exogenous world risk premium. We discuss he impac on one economy, e.g. Korea. The effecs on he oher small economy are analogous. The rise in he world cos of borrowing leads o a fall in domesic invesmen and consumpion. Consumpion falls, due o boh subsiuion and wealh effecs, because he economy is a ne debor. The fall in domesic absorpion will lead o a decline in domesic aggregae demand and in GDP. The behavior of impors and expors depends on he paricular pricing assumpions made. Firs assume ha expor prices wihin he region are se in erms of local currencies. Tha is, expor prices from Korea o Thailand are se in erms of Thai bah, and expors o he Unied Saes are se in dollars. In ha case, he nominal price of expors facing US consumers does no change, and demand is unaffeced. In he same way, Thai consumers see no effec on heir impor prices. Bu expors o Thailand will fall anyway, because of he fall in Thai absorpion. On he oher hand, here is immediae and full pass-hrough of he nominal depreciaion ino impor prices of Korea. Thus, impor prices rise, and impors fall. This generaes a compensaing rise in demand for domesic goods, bu he overall effec is small, since impored goods and home produced goods are relaively poor subsiues according o he calibraion. If, on he oher hand, all expor prices wihin he region are se in US dollars, hen he regional shock has a much greaer impac on aggregae demand for Korea. The reason is ha 16

18 Thailand s devaluaion will lead o a fall in demand for Korean goods, as heir price rises by us as much as he price of goods from he res of he world. Korean expors o Thailand fall precipiously, and his cases a much bigger negaive impac on Korean GDP. Figure 5 describes he impulse response of he model o a persisen shock o he foreign risk premium, for he wo ypes of pricing mechanisms. Wih local currency pricing, GDP, invesmen, consumpion, and impors fall. Expors fall slighly on impac, as sales o he res of he world are unchanged, bu regional sales fall. Afer his, expors sar o grow and US dollar prices fall over ime, so ha expors o he res of he world increase. Impors immediaely fall, as impor prices rise. Qualiaively, Figure 5 resembles he main feaures of he response of our sample of economies o he Eas Asian crisis. Bu quaniaively, he overall effecs are smaller han in he daa. The fall in GDP is abou half of he observed fall in he hree wors hi Eas Asian economies (6 as opposed o 12 percen). This is mainly because consumpion falls by less (6 percen as opposed o percen in he daa), bu also expors fall by much less han hey did in Malaysia and Thailand. The crisis shock leads o an immediae large nominal depreciaion of 3 percen in he model. This is smaller han he approximaely 4 percen persisen depreciaion ha akes place in he daa. In he daa, he immediae impac of he crisis on exchange raes is also much higher abou 6 percen. Bu here is significan `overshooing of exchange raes in all economies, and afer a few monhs all he economies exchange raes converged o around a 4 percen depreciaion. Even in he case of local currency pricing, we find significan persisen in he real effecs of he crisis shock. This is due parly o he persisence in he risk premium shock iself, bu also o he elemens of propagaion buil ino he model, in paricular adusmen coss of invesmen, habi persisence, and gradual nominal price adusmen. 17

19 Figure 5 also illusraes he effec of he crisis shock under he assumpion of dollar currency pricing. In his case, he effecs of he shock are much greaer, and more persisen. This is due o he fac ha depreciaion of a rading parner s currency leads o a much larger drop in expors o he rading parner han akes place under local currency pricing. The depreciaion causes a large rise in he domesic currency price of regional rading parners expor goods. The resul is a very powerful propagaion effec of he shock, purely inernal o he region, as Korean impors from Thailand fall sharply, and Korean expors o Thailand fall in he same manner. Quaniaively, we find ha he dollar currency pricing mechanism leads o a much closer correspondence beween he model and he daa, in mos dimensions. The fall in GDP is much greaer han wih local currency pricing, as i now reflecs he precipious fall in inra-regional rade. GDP falls by abou 11 percen in he model, very close o ha in he daa for Malaysia, Korea and Thailand. Moreover, he persisence of GDP is much greaer han before. GDP does no reurn o rend unil abou 1 quarers. This maches quie well he persisence in he deviaion of he crisis counries GDP from rend we see from Figure 1 ha he hree crisis counries all reurn o rend in mid 2. The fall in consumpion is also much greaer han wih local currency pricing, and closer o ha in he daa. Impors fall now by us under 3 percen approximaely he same as in he daa. Expors fall by 1 percen close o ha seen in Malaysia and Thailand. Expors o he res of he world are unchanged on impac, while expors o Eas Asia fall by 25 percen. This is larger han ha experienced in Korea and Malaysia, bu close o he fall in regional expors experienced by Thailand. Invesmen falls by abou 5 percen again almos he same as ha experienced in Malaysia and Thailand. Finally, he nominal exchange rae depreciaes by more under dollar currency pricing. The persisen nominal 18

20 depreciaion of abou 33 percen is greaer han under local currency pricing, bu less han ha seen in he daa. Quaniaively, we herefore see ha he dollar currency pricing assumpion provides a fairly good descripion of he magniude and persisence of he main macroeconomic effecs of he Asian crisis. Given ha his pricing assumpion seems quie consisen wih he observed daa on rade prices and exchange raes, we sugges ha i aced as a cenral elemen in he propagaion mechanism of he crisis wihin he Eas Asian region. Since our model provides a reasonable accoun of he Eas Asian crisis under a given moneary policy rule, an imporan quesion o ask is how would he crisis have played ou under alernaive policy rules. In paricular, wha would be he consequence of puing more weigh on exchange rae sabiliy in he moneary rule described above? Figure 6 shows how his would affec he oucome of he crisis. In he Figure, he red line describes he benchmark case of dollar currency pricing from Figure 5. The blue line shows he impac on he counry ha follows a moneary policy puing more weigh on exchange rae sabiliy, while he green line describes he effec on he counry following he benchmark moneary policy rule. Under he exchange rae sabilizaion policy, we se λ 1 =.75 and λ 2 =.75, Clearly, a counry ha aemps o preven exchange rae adusmen incurs large immediae coss. Since real ineres raes mus rise a lo more, absorpion and GDP fall by considerably more for his counry. In paricular, GDP falls by abou 7 percen more han in he benchmark case, and he recession is much more prolonged. The effec on he counry ha follows he benchmark policy is more involved. In he Figure, we see ha his counry experiences a slighly greaer fall in GDP han i would if all counries followed he benchmark moneary policy rule. There are wo effecs a work. If all counries depreciae as in he benchmark model, here is a subsanial fall in regional impor demand due o dollar currency pricing, as described in Figure 5. On he oher hand, if one counry places more 19

21 weigh on exchange rae sabilizaion, hen is oal absorpion falls by a lo more, which reduces regional impor demand in iself. In he baseline calibraion, we find ha he second effec ends o be slighly greaer han he firs effec, so he counry following he benchmark moneary policy rule experiences a greaer recession when he oher counry ends o sabilize he exchange rae. I is possible o show, however, ha his ranking may be reversed. In paricular, if here is a higher elasiciy of subsiuion beween Eas Asian goods, hen in he benchmark moneary policy regime, he collapse in iner-regional rade will be much more. In his case, i is beer, in he sense of a higher level of GDP, for he counry following he benchmark rule for he oher counry o sabilize is exchange rae. V. Conclusions We have argued ha he collapse in inra-regional rade is an imporan facor in he quaniaive accouning for he Eas Asian crisis. Cenral o his is he role of he US dollar in pricing expors. In a sense, his represens anoher aspec of dollarizaion ha may be imporan in crises, quie disinc from `liabiliy dollarizaion which has been a maor par of he recen lieraure on undersanding crises (e.g. Aghion e al, 2, 21). 2

22 Bibliography Aghion, P., P. Bacchea, and A. Baneree, 2, ``A Simple Model of Moneary Policy and Currency Crises,'' European Economic Review 44, Aghion, P., P. Bacchea, and A. Baneree, 21, ``Currency Crises and Moneary Policy in an Economy wih Credi Consrains,'' European Economic Review 45, Arellano, C., and E.G. Mendoza, 22, Credi Fricions and 'Sudden Sops' in Small Open Economies: An Equilibrium Business Cycle Framework for Emerging Markes Crises, NBER Working Paper No.888. Backus, D.K., P.J. Kehoe, and F.E. Kydland, 1992, ``Inernaional Real Business Cycles.'' Journal of Poliical Economy 1, Baxer, M., and M. Crucini, 1993, ``Explaining Saving-Invesmen Correlaions'' American Economic Review 83, Bernanke, B., M. Gerler and S. Gilchris, 2, ``The Financial Acceleraor in a Quaniaive Business Cycle Framework,''\ in J. Taylor and M. Woodford, eds. Handbook of Macroeconomics, Norh-Holland Elsevier Press. Bes, C. and M.B. Devereux, 1996, The Exchange Rae in a Model of Pricing-o-Marke, European Economic Review 4, Bes, C. and M.B. Devereux, 2, Exchange Rae Dynamics in a Model of Pricing-o- Marke, Journal of Inernaional Economics 5, Burnside, C., M. Eichenbaum and S. Rebelo, 21a, ``Hedging and Financial Fragiliy in Fixed Exchange Rae Regimes.'' European Economic Review 45, Burnside, C., M. Eichenbaum and S. Rebelo, 21b, Prospecive Deficis and he Asian Currency Crisis, Journal of Poliical Economy Bursein, A. M.Eichenbaum, S.Rebelo, 22, Why Are Raes of Inflaion So Low Afer Large Devaluaions? NBER Working Paper No.w8748 Bursein, A. M. Eichenbaum, and S. Rebelo, 23 Large Devaluaions and he Real Exchange Rae, mimeo, Norhwesern Universiy Calvo, G.A., 1983, Saggered Prices in a Uiliy-Maximizing Framework. Journal of Moneary Economics 12 (3): Calvo, G.A. and E.G. Mendoza, 2, Raional Conagion and he Globalizaion of Securiies Markes, Journal of Inernaional Economics 51, Calvo, G.A. and C. Reinhar, 1999, When Capial Flows Come o a Sudden Sop: Consequences and Policy Opions, Mimeo. Universiy of Maryland. Chang, R. and A.Velasco, 1998, The Asian Liquidiy Crisis. NBER Working Paper

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24 Kollmann, Rober, 21, ``The exchange rae in a dynamic-opimizing business cycle model wih nominal rigidiies: a quaniaive invesigaion,'' Journal Of Inernaional Economics 55, Krugman, P Wha Happened o Asia. Massachuses Insiue of Technology. Mimeo. Krugman, P., 1998, Wha Happened o Asia, Mimeo. MIT. Lane, P.R. and G. Milesi-Ferrei, 21, ``The Exernal Wealh of Naions: Measures of Foreign Asses and Liabiliies for Indusrial and Developing Counries,''\ Journal of Inernaional Economics 55, McKinnon, R. and E. Schnabl (23) ``The Eas Asian Dollar Sandard, mimeo, Sanford Universiy. Mendoza, E., 21, `` Credi, Prices and Crashes: Business Cycles wih a Sudden Sop,''\ NBER Working Paper No.w8338. McKibbin, W.J., 1998, The Crisis in Asia: An Empirical Assessmen, Brookings Discussion Papers in Inernaional Economics 136. Neumayer, P.A. and F. Perri, 21, Business Cycles in Emerging Economies: The Role of Ineres Raes, Mimeo. Obsfeld, M,, and K.Rogoff The Ineremporal Approach o he Curren Accoun. Vol. 3, Handbook of Inernaional Economics, edied by Gene M. Grossman and Kenneh Rogoff. Amserdam, New York; Oxford: Elsevier, Norh-Holland. Osry, J.D. and C.M. Reinhar, 1992, Privae Saving and Terms of Trade Shocks, IMF Saff Papers 39, Reinhar, C. M., 1995, ``Devaluaion, Relaive Prices, and Inernaional Trade: Evidence from Developing Counries,''\ Inernaional Moneary Fund Saff Papers 42, Roemberg, J. J. and M. Woodford, 1996, Imperfec Compeiion and he Effecs of Energy Price Increases on Economic Aciviy, Journal of Money, Credi, and Banking 28, Roemberg, J. J.; and M. Woodford, 1997,. An Opimizaion-Based Economeric Framework for he Evaluaion of Moneary Policy B.S. Bernanke and J.J. Roemberg, eds., NBER macroeconomics annual Cambridge and London: MIT Press Sachs, J. D. and F. Larrain, 1993, Macroeconomics in he Global Economy Prenice Hall. New Jersey. Sarel, M., 1997, Growh and Produciviy in Asean Counries, IMF Working Paper. Suherland, A., 1996, Financial Marke Inegraion and Macroeconomic Volailiy, Scandinavian Journal of Economics 98 (4): 23

25 Taylor, J.B., 1996, ``Discreion vs. Policy Rules in Pracice,'' Carnegie-Rocheser Series on Public Policy 39, Yun, T, 1996, Nominal Price Rigidiy, Money Supply Endogeneiy, and Business Cycles, Journal of Moneary Economics 37,

26 Figure 1a Korea (A) GDP (B) Invesmen (C) Consumpion (D) Expors (E) Impors (F) Absorpion Deflaor (G) Expors Deflaor (H) Impor Prices (I) Nominal Exchange Rae (J) Nominal Ineres Rae

27 Figure 1b Malaysia (A) GDP (B) Invesmen (C) Consumpion (D) Expors (E) Impors (F) Absorpion Deflaor (G) Expor Deflaor (H) Impor Deflaor (I) Nominal Exchange Rae (J) Nominal Ineres Rae

28 Figure 1c Thailand (A) GDP (B) Invesmen (C) Consumpion (D) Expors (E) Impors (F) Absorpion Deflaor (G) Expor Deflaor (H) Impor Deflaor (I) Nominal Exchange Rae (J) Nominal Ineres Rae

29 Figure 2 Real Expors by Region.3 Korea.3 Malaysia :1 98:3 99:1 99:3 :1 :3 1:1 1: :1 98:3 99:1 99:3 :1 :3 1:1 1:3.12 Singapore.2 Thailand :1 98:3 99:1 99:3 :1 :3 1:1 1: :1 98:3 99:1 99:3 :1 :3 1:1 1:3 o Eas Asia o Developed World 28

30 Table 1. Expors o Asia as a percenage of expors o Asia plus expors o Anipodes, NAFTA, EU, and Japan on a 2-year average basis Indonesia 74.76% 71.4% 67.3% 63.84% 61.76% 58.95% 59.37% 57.3% Korea 14.21% 18.5% 24.25% 36.76% 41.53% 48.16% 42.52% 42.56% 48.22% Malaysia 45.99% 44.74% 46.25% 46.7% 46.13% 48.62% 44.% 45.99% 5.7% Philippines 22.18% 19.62% 2.21% 18.57% 24.85% 26.4% 3.75% 34.16% 41.43% Taiwan 19.68% 25.46% 32.71% 39.8% 43.79% 42.16% 42.58% 48.12% Thailand 3.2% 26.75% 24.87% 28.93% 36.78% 39.39% 35.31% 37.82% 41.5% 29

31 Table 2 Thailand: Srucure of Impor Paymens (Percen Share) Currency US dollar bah Japanese yen Deusche mark Pound serling Euro Singapore dollar Ohers Toal Thailand: Srucure of Expor Receips (Percen share) Currencies US dollar bah Japanese yen Deusche mark Pound serling Euro Singapore dollar Ohers Toal Korea: Expor Receips Currencies US dollar Japanese Yen Deusche Mark Pound Serling Oher Korea: Impor Paymens Currencies US dollar Japanese Yen Deusche Mark Pound Serling Oher Source: Bank of Thailand, McKinnon and Schnabl (23) 3

32 TABLE 3 4 Monh Expor Price Change Dec97-Mar98 from Sep97-Nov98 Won dollar Agriculural Producs Marine Producs Processed Marine Producs Oher Processed Beverages and Foods Processed Yarns & Threads Texile Fabrics Oher Texile Producs Texile Apparel Leaher Clohes.5259 Apparel Accessory Leaher Producs Foowear Paper & Paper Producs Refined Crude Peroleum Producs Elemenary Chemical Producs Synheic Rubber & Plasic Maerials Oher Chemical Producs Rubber Producs Plasic Producs Nonmeallic Mineral Producs Seel Rolling Mill Producs Galvanized Shees Oher Basic Iron & Seel Producs Basic Nonferrous Meal Producs Hand Tools & General Hardware Screws & Wire Producs Oher Meal Producs General Purpose Machinery Special Purpose Machinery Elecric Apparaus For Household Office, Accouning and Compuing Machine Elecrical Machinery & Apparaus Semiconducor Devices Oher Elecronic Tube & Elecronic Compo Communicaion Equipmen Apparaus Sound & Image Equipmen Apparaus Precision Insrumens Transporaion Equipmen Oher Manufacuring Indusry Producs

33 Korea: Monhly Changes 199/1-23/12 Table 4: Trade Prices and Exchange Raes Dependen Variable Expor Price Impor Price US dollar.69*** (1.99).44*** (6.57) Jap Yen.17*** (3.72).28*** (5.73) Euro (-.35) -.3 (-.34) UK Pound.1 (.1).3 (.3) R Thailand: Monhly Changes 1996/1-21/8 Dependen Variable Expor Price Impor Price US dollar.76*** (9.45).72*** (9.1) Jap Yen.2 (.34).13* (1.9) Euro 1.12 (1.56).7 (.88) UK Pound. (.17) -.5 (-1.8) R D-mark subsiued for euro before *** Significan a 1% level * Significan a 1% level 32

34 Figure 3a Korea Feb Apr-97 Jun-97 Aug-97 Oc-97 Dec-97 Feb-98 Apr-98 Jun-98 Aug-98 Oc-98 Dec-98 Figure 3b Thailand Exchange Rae Expor Price Impor Price Feb Apr-97 Jun-97 Aug-97 Oc-97 Dec-97 Feb-98 Apr-98 Jun-98 Aug-98 Oc-98 Dec-98 Exchange Rae Expor Price Impor Price 33

35 Figure 3c Singapore Feb-97 Apr-97 Jun-97 Aug-97 Oc-97 Dec-97 Feb-98 Apr-98 Jun-98 Aug-98 Oc-98 Dec-98 Exchange Rae Expor Price Impor Price Figure 4 Korea Expor Price Feb Apr-97 Jun-97 Aug-97 Oc-97 Dec-97 Feb-98 Apr-98 Jun-98 Aug-98 Oc-98 Dec-98 Won Price Dollar Price 34

36 Figure 5 LCP versus Dollar Currency Pricing (A) GDP (B) Invesmen (C) Consumpion n o i D evia % (D) Impors 5 (E) Expors 1 (F) Expors o ROW -5 8 n o i D evia % (G) Expors o Eas Asia 2 (H) CPI 35 (I) Exchange Rae -5 3 n o i D evia % Dollar Currency Pricing x Local Currency Pricing 35

37 Figure 6: Targeing he Exchange Rae (A) GDP (B) Invesmen (C) Consumpion io n D evia % (D) Impors 5 (E) Expors 1 (F) Expors o ROW -5-1 n o i D evia % (G) Expors o Eas Asia 2 (H) CPI 35 (I) Exchange Rae io n D evia % Benchmark Counry w ih Benchmark Moneary Policy Counry ha Sabilizes he Exchange Rae 36