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Contractionary Currency Crashes in Developing Countries

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Jeffrey A. Frankel

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Abstract

To update a famous old statistic: a political leader in a developing country is almost twice as likely to lose office in the 6 months following a currency crash as otherwise. This difference, which is highly significant statistically, holds regardless whether the devaluation takes place in the context of an IMF program. Why are devaluations so costly? Many of the currency crises of the last ten years have been associated with output loss. Is this, as alleged, because of excessive reliance on raising the interest rate as a policy response? More likely it is because of contractionary effects of devaluation. There are various possible contractionary effects of devaluation, but it is appropriate that the balance sheet effect receives the most emphasis. Passthrough from exchange rate changes to import prices in developing countries is not the problem: this coefficient fell in the 1990s, as a look at some narrowly defined products shows. Rather, balance sheets are the problem. How can countries mitigate the fall in output resulting from the balance sheet effect in crises? In the shorter term, adjusting promptly after inflows cease is better than procrastinating by shifting to short-term dollar debt, which raises the costliness of the devaluation when it finally comes. In the longer term, greater openness to trade reduces vulnerability to both sudden stops and currency crashes.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11508.

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Date of creation: Aug 2005
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Full references

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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. García-Fronti, Javier & Miller, Marcus & Zhang, Lei, 2006. "Supply Shocks and Currency Crises: The Policy Dilemma Reconsidered," CEPR Discussion Papers 5905, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  2. Ugo Panizza & Eduardo Borensztein, 2008. "The Costs of Sovereign Default," IMF Working Papers 08/238, International Monetary Fund. [Downloadable!]
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  12. Axel Dreher & Stefanie Walter, 2008. "Does the IMF Help or Hurt? The Effect of IMF programs on the likelihood and outcome of currency crises," KOF Working papers 08-186, KOF Swiss Economic Institute, ETH Zurich. [Downloadable!]
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