Subir Lall

Financial Stress, Downturns, and Recoveries

This paper examines why some financial stress episodes lead to economic downturns. The paper identifies episodes of financial turmoil using a financial stress index (FSI), and proposes an analytical framework to assess the impact of financial stress-in particular banking distress-on the real economy. It concludes that financial turmoil characterized by banking distress is more likely to be associated with severe and protracted downturns than stress mainly in securities or foreign exchange markets. Economies with more arms-length financial systems appear to be particularly vulnerable to sharp contractions, due to the greater procyclicality of leverage in their banking systems.

Speculative Attacks, Forward Market Intervention and the Classic Bear Squeeze

A typical strategy used by speculators to launch an attack on a fixed exchange regime is the use of forward markets. Central banks also intervene in forward markets to counter speculation. This paper addresses the question of how an attack is launched on the forward market, and what the optimal policy response to such speculation is in the forward and spot markets. The paper also demonstrates how central banks can impose a bear squeeze on speculators. Recent events in South East Asian currency markets are interpreted within the framework of the model’s predictions.

Rising Income Inequality: Technology, o+L3904r Trade and Financial Globalization?

We examine the relationship between trade and financial globalization and the rise in inequality in most countries in recent decades. We find technological progress as having a greater impact than globalization on inequality. The limited overall impact of globalization reflects two offsetting tendencies: whereas trade globalization is associated with a reduction in inequality, financial globalization-and foreign direct investment in particular-is associated with an increase. A key finding is that both globalization and technological changes increase the returns on human capital, underscoring the importance of education and training in both developed and developing countries in addressing rising inequality.

Managerial Incentives and Financial Contagion

This paper proposes a framework to examine the comovements of asset prices with seemingly unrelated fundamentals, as an outcome of the optimal portfolio strategies of large institutional fund managers. In emerging markets, the dominant presence of dedicated fund managers whose compensation is linked to the outperformance of their portfolio relative to a benchmark index, and of global fund managers whose compensation is linked to the absolute returns of their portfolios, leads to portfolio decisions that result in systematic interactions between asset prices even in the absence of asymmetric information. The model endogenously determines the optimal amount of cash holdings or leverage, the incidence of relative value versus macro hedge fund strategies, and how prices can systematically deviate from the long-term fundamental value for long periods of time, with limits to the arbitrage of this differential. Managerial compensation contracts, while optimal at a firm level, may lead to inefficiencies at the macroeconomic level. We identify conditions when a negative shock to one emerging market affects another market negatively.

Did Korean Monetary Policy Help Soften the Impact of the Global Financial Crisis of 2008-2009?

Korea was one of the Asian economies hardest hit by the global financial crisis. Anticipating the downturn that would follow the episode of extreme financial stress, the Bank of Korea (BOK) let the exchange rate depreciate as capital flowed out, and preemptively cut the policy rate by 325 basis points. But did it work? This paper seeks a quantitative answer to the following question: Were it not for an inflation targeting framework underpinned by a flexible exchange rate regime, how much deeper would the recession have been? Taking the most intense year of the crisis as our baseline (2008:Q4?2009:Q3), counterfactual simulations indicate that rather the actual outcome of a -2.1 percent contraction, the outturn would have been -2.9 percent if the BOK had not implemented countercyclical and discretionary interest rate cuts. Furthermore, had a fixed exchange rate regime been in place, simulations indicate that output would have contracted by -7.5 percent over the same four-quarter period. In other words, exchange rate flexibility and the interest rate cuts implemented by the BOK helped substantially soften the impact of the global financial crisis on the Korean economy. These counterfactual experiments are based on an estimated structural model, which, along with standard nominal and real rigidities, includes a financial accelerator mechanism in an open-economy framework.

An Assessment of Malaysian Monetary Policy During the Global Financial Crisis of 2008-09

Malaysia was hit hard by the global financial crisis of 2008-09. Anticipating the downturn that would follow the episode of extreme financial turbulence, Bank Negara Malaysia (BNM) let the exchange rate depreciate as capital flowed out, and preemptively cut the policy rate by 150 basis points. Against this backdrop, this paper tries to quantify how much deeper the recession would have been without the BNMs monetary policy response. Taking the most intense year of the crisis as our baseline (2008:Q4-2009:Q3), counterfactual simulations indicate that rather the actual outcome of a -2.9 percent contraction, growth would have been -3.4 percent if the BNM had not implemented countercyclical and discretionary interest rate cuts. Furthermore, had a fixed exchange rate regime been in place, simulations indicate that output would have contracted by -5.5 percent over the same four-quarter period. In other words, exchange rate flexibility and the interest rate cuts implemented by the BNM helped substantially soften the impact of the global financial crisis on the Malaysian economy. These counterfactual experiments are based on a structural model estimated using Malaysian data.

The Impact of the Global Financial Crisis on Emerging and Newly Industrialized Asia

The paper analyzes the impact of the global financial crisis on capital flows, financial markets and economic activity in Asia and attempts to explain why Asian markets were hit hard despite relatively strong fundamentals, and why the subsequent recovery was relatively quick. The openness of a country to trade and finance and the degree of integration into international financial markets are shown to be important determinants of the swings in economic activity and capital flows during both the reversal and recovery phases. It also discusses the role played by macroeconomic and financial policies in the recovery and concludes with some lessons from Asias experience.