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Output Recovery After Currency Crises

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Abstract

This study examines the shape and dynamics of output recovery following currency crises characterized by currency crashes or large reserve losses. Our estimation allows output to follow U, V and L-shaped paths following each type of currency crises. The results indicate that output recovery after currency crises is, on average, V-shaped. In addition, currency crashes initially lead to a decline in output, but the output fully recovers to its non-crisis level within three years. Currency crises characterized by large reserve losses lead to a smaller initial output cost, but a larger decline in output in the long run.

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Notes

  1. Argentina intervened in the foreign exchange market by selling approximately $2.3 billion of its foreign exchange reserves. However, on 23 January, the country eventually experienced the largest devaluation since the crisis of 2001 (Vuletin and Ruiz Pozuelo, 2014). Turkey and South Africa raised the short-term interest rate to defend their currencies.

  2. To our knowledge, Erler et al. (2014) is the only empirical paper that separately evaluates the output costs associated with currency crashes, successful defenses, and unsuccessful defenses. However, they focus on a sample of 32 emerging countries and use a different methodology. The main question of their paper is to identify the least costly strategy a central bank can take in face of a speculative attack.

  3. Central banks’ interventions in the foreign exchange market are often sterilized to avoid a decrease in the monetary base. But sterilized interventions do not eliminate the original cause of a speculative attack on the exchange rate. Therefore, without a reduction in the monetary base and an increase in domestic interest rates, sterilized interventions lead to further losses of foreign exchange reserves. Under severe speculative pressure, the only way to limit the capital flight is through unsterilized interventions, which are costly in terms of growth (Lahari and Vegh 2007).

  4. See Angkinand et al. (2006) for a survey on measures of currency crises.

  5. The threshold is usually the pooled (or country specific) mean of EMPI plus two (or three) standard deviations of EMPI.

  6. We exclude the interest rate component of EMPI due to lack of reliable interest rate data for a large part of our sample.

  7. They use the percentage change of end-of-period official nominal bilateral dollar exchange rate.

  8. It is possible that EMPI signals a crisis in case of a moderate depreciation and a small reserve loss. Therefore, in order to make this dummy variable more comparable with EVENT, we add another restriction: the depreciation must be at least 15%. The results are similar when we exclude this restriction.

  9. The CRISIS dummy variable is only equal to one if the depreciation component of EMPI is at least 75% of the index. If depreciation is large but not at least 75% of EMPI, then CRISIS dummy is equal to zero.

  10. In order to make sure these episodes are not episodes of large depreciations accompanied by reserve losses, we add another restriction to our identification of reserve crisis: the exchange rate depreciation in these episodes must also be less than 15%. The results are similar when we exclude this restriction or change the threshold to different levels (10% and 5%).

  11. Including a control group of countries that have never experienced a currency crisis does not change any of our results.

  12. Nickell (1981) points out that fixed effect estimation is biased when the lagged dependent variable is included in the model. However, the order of bias is reversely related to the time dimension (T), and thus not serious when T is large. In our case, similar to Cerra and Saxena (2008), T is large (53 years), and thus the bias is negligible. For example, for a panel of size N=100, T=30, and low persistence, Judson and Owen (1999) report that the bias of the least squares dummy variable (LSDV) estimator is approximately 2%–3% on the lagged dependent variable and less than 1% on other regressors.

  13. The results are not reported for brevity but are available in Table A1 in the Appendix.

    Table A1 Model estimates using CRISIS and controlling for other types of financial crises
    Full size table

  14. This is similar to Basistha and Teimouri (2015) who investigate the long-run cost associated with currency crashes. They find that currency crashes that are not accompanied by a banking crisis are expansionary in the long run.

  15. Higher interest rates increase the cost of borrowing and engaging in the currency carry-trade.

  16. We exclude all episodes of reserves crises that were accompanied or proceeded by a devaluation of 15% or larger. The results remain similar when we change the devaluation threshold to 10% or 5%.

  17. Teulings and Zabanov (2014) note that the analytical IRFs are especially sensitive to the number of lags of the dummy variable included in the ARDL model.

  18. Our estimation method follows Furceri and Zdzienicka (2012a, 2012b); however, we estimate the immediate response of output to a currency crisis as well.

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Authors and Affiliations

  1. Department of Economics, College of Business Administration, University of Wisconsin-La Crosse, 1725 State Street, La Crosse, 54601, WI, USA

    Sheida Teimouri & Taggert J Brooks

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  1. Sheida Teimouri
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  2. Taggert J Brooks
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Appendix

Appendix

SeeTables A1, A2, A3, A4.

Table A2 Model estimates using CRISISR2
Full size table
Table A3 Model estimates using event dummy and controlling for recessionary episodes
Full size table
Table A4 Model estimates using CRISISR dummy and controlling for recessionary episodes
Full size table

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Teimouri, S., Brooks, T. Output Recovery After Currency Crises. Comp Econ Stud 57, 75–102 (2015). https://doi.org/10.1057/ces.2014.45

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