Matthieu Bussière

External Vulnerability in Emerging Market Economies; How High Liquidity Can Offset Weak Fundamentals and the Effects of Contagion

This paper investigates the factors behind the 1994 and 1997 crises and whether these can explain the 1998 crisis. The study reveals that: (i) variables used in an Early Warning System model developed by IMF staff scored well in predicting the 1998 crisis out-of-sample; (ii) all three crisis episodes can be well explained by a parsimonious set of core fundamentals and liquidity related variables; and (iii) the presence of an IMF-supported program significantly reduced the depth of crises.

Exchange Rate Pass‐Through to Trade Prices: The Role of Nonlinearities and Asymmetries

A standard assumption in the empirical literature is that exchange rate pass-through is both linear and symmetric, implying that (a) large and small exchange rate changes and (b) appreciations and depreciations have an effect of the same magnitude, proportionally. This paper tests these assumptions for export and import prices in the G7 economies. It focuses on non-linearities in the reaction of profit margins to exchange rate movements, which may arise from the presence of price rigidities and switching costs. To this end, nonlinearities are characterised by augmenting a standard linear model with polynomial functions of the exchange rate and with interactive dummy variables. The presence of such non-linearities is confirmed by formal statistical tests. Overall, the results suggest that non-linearities and asymmetries in the exchange rate pass-through cannot be ignored, especially on the export side, although their magnitude varies noticeably across countries. JEL Classification: C22, C51, F14, F31

Financial Openness and Growth: Short-Run Gain, Long-Run Pain?

No empirical evidence has yet emerged for the existence of a robust positive relationship between financial openness and economic growth. This paper argues that a key reason for the elusive evidence is the presence of a time-varying relationship between openness and growth over time: countries tend to gain in the short-term, immediately following capital account liberalisation, but may not grow faster or even experience temporary growth reversals in the medium- to long-term. The paper finds substantial empirical evidence for the existence of such an intertemporal trade-off for 45 industrialised and emerging market economies. The acceleration of growth immediately after liberalisation is found to be often driven by an investment boom and a surge in portfolio and debt inflows. By contrast, the quality of domestic institutions, the size of FDI inflows and the sequencing of the liberalisation process are found to be important driving forces for growth in the medium to longer term. JEL Classification: F33, F34, F36, F43

A Framework for Assessing Global Imbalances

In this paper, we take a systematic look at global imbalances. First, we provide a definition of the phenomenon, and relate global imbalances to widening external positions of systemically important economies that reflect distortions or entail risks for the global economy. Second, we provide an operational content to this definition by measuring trends in external imbalances over the past decade and putting these in a historical perspective. We argue that three main features set today’s situation apart from past episodes of growing external imbalances - (i) the emergence of new players, in particular emerging market economies such as China and India, which are quickly catching up with the advanced economies; (ii) an unprecedented wave of financial globalisation, with more integrated global financial markets and increasing opportunities for international portfolio diversification, also characterised by considerable asymmetries in the level of market completeness across countries; and (iii) the favourable global macroeconomic and financial environment, with record high global growth rates in recent years, low financial market volatility and easy global financing conditions over a long time period of time, running at least until the summer of 2007. Finally, we provide an analytical overview of the fundamental causes and drivers of global imbalances. The central argument is that the increase in imbalances has been driven by a unique combination of structural and cyclical determinants. JEL Classification: F2, F32, F33, F41.

Protectionist Responses to the Crisis - Global Trends and Implications

In this paper we take a systematic look at recent trends in global protectionism and at the potential implications of a protectionist backlash for economic growth, using results from the recent economic literature and new model simulations. We find that there has so far been a moderate increase in actual protectionist measures to restrict trade through tariff and non-tariff barriers. At the same time, evidence from surveys shows that public pressure for more economic protection has been mounting since the mid-2000s, and has possibly intensified since the start of the financial crisis. However, no World Trade Organization (WTO) member has retreated into widespread trade restrictions or protectionism to date. Our model-based simulations suggest that the impairment of the global flow of trade would hamper the recovery from the crisis, as well as the long-term growth of the global economy. At the same time, it is unlikely that protectionism would help to correct existing current account imbalances. Moreover, the countries implementing protectionist measures should expect a deterioration of their international competitiveness, which would further affect the potential for longer-term real GDP growth.

Political instability and economic vulnerability

This paper analyzes and tests the influence of political instability on economic vulnerability in the context of the 1994 and 1997 crisis episodes. It constructs four political variables that aim at quantifying political instability. The paper finds that, for countries with weak economic fundamentals and low reserves, political instability has a strong impact on economic vulnerability. The estimation results suggest that including political variables in economic models does improve their power to explain and predict economic crises. The paper concludes that countries are more economically vulnerable during, and especially following, election periods, and when election results are less stable than at other times. Copyright @ 2000 by John Wiley & Sons, Ltd. All rights reserved.

Balance of Payment Crises in Emerging Markets: How Early Were the 'Early' Warning Signals?

Although many papers have already proposed empirical models of currency crises, the timing of such crises has received relatively little attention so far. Most papers use indeed a static specification and impose the same lag structure across all explanatory variables. This, by construction, prevents from specifically timing the crisis signals sent by the leading indicators. The objective here is to fill this gap by considering a set of dynamic discrete choice models. The first contribution is to identify how early in advance each explanatory variable sends a warning signal. Some indicators are found to signal a crisis in the very short run while others signal a crisis at more distant horizons. The second contribution is to show that state dependence matters, albeit mostly in the short run. The results have important implications for crisis prevention in terms of the timeliness and usefulness of the envisaged policy response.

Commonality in Hedge Fund Returns: Driving Factors and Implications

We measure the commonality in hedge fund returns, identify its main driving factor and analyze its implications for financial stability. We find that hedge funds’ commonality increased significantly from 2003 until 2006. We attribute this rise mainly to the increase in hedge funds’ exposure to emerging market equities, which we identify as a common factor in hedge fund returns over this period. Our results show that funds with a high commonality were affected disproportionately by illiquidity and exhibited negative returns during the subsequent financial crisis, thereby providing little diversification benefits to the financial system and to investors.

Trade integration of the new EU member states and selected South-East European countries: lessons from a gravity model

The rapid integration of the transition countries of Central and South Eastern Europe with the euro area is one of the most striking developments that affected trade flows in Europe over the past decade. The aim of this paper is to analyse the factors behind this quick integration and to gauge whether this pattern is likely to continue or to slow down in the coming years. For that purpose, we estimate a large gravity model. Furthermore, the issues related to the interpretation of fixed effects are discussed. Overall, the gravity model successfully explains the trade patterns observed in the past ten years. Although our results require a cautious interpretation, they suggest that trade integration between the largest Central and Eastern European countries and the euro area is already relatively advanced, while these countries still have scope to strengthen their trade links with countries in many other parts of the world. Thus, we conclude that market shares of these countries in the euro area are likely to stabilise soon. For the South Eastern European countries, by contrast, there is still ample scope to integrate more into the world economy. * We have benefited from comments by Stelios Makrydakis and Doris Ritzberger-Grünwald. The views expressed in this contribution are those of the authors and do not necessarily represent the position of the European Central Bank or the Oesterreichische Nationalbank. a European Central Bank.

In Defense of Early Warning Signals

The 2008 financial crisis has rekindled interest in the issue of early warning signals (EWS) of financial distress. It has also triggered renewed interest in the literature on currency crises, with many countries, especially among emerging market economies, experiencing severe exchange market pressure. While several policy institutions are in the process of developing new early warning systems, there is a lot of skepticism on the ability to predict currency crises or, more generally, any type of financial crises. This skepticism stems from the alleged poor out-of-sample performance of leading models, but also from a more fundamental objection, according to which it is by definition impossible to predict crises – what can be referred to as a new “impossibility theorem”. Moreover, another criticism of early warning systems is that they may contribute to the phenomenon they are supposed to fight (the self-fulfilling prophecies view). The objective of this paper is to challenge this skeptical view. To this aim, the paper discusses the general conditions under which the “impossibility theorem” may fail and self-fulfilling prophecies can be avoided, stemming e.g. from political economy arguments. The ability of a simple currency crisis model to provide useful information on economic vulnerabilities is illustrated by testing its out-of-sample performance in a panel of emerging market economies following the collapse of Lehman Brothers.