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How should Russia manage its oil wealth?

International Monetary Fund. External Relations Dept.
Published Date:
November 2004
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Apolitical leader in a developing country is twice as likely to lose office in the six months following a currency crash as otherwise, regardless of whether the devaluation takes place in the context of an IMF program. How is it that a strong ruler like Indonesia’s Suharto could easily weather 32 years of political, military, ethnic, and environmental challenges only to succumb to a currency crisis? Jeffrey Frankel tackled this question in this year’s Mundell-Fleming Lecture at the IMF’s Jacques Polak Fifth Annual Research Conference. His address, presented at a November 5 IMF Economic Forum, also explored whether currency devaluation necessarily means a loss of output and how policymakers can minimize vulnerability to devaluations and associated economic contractions.

Most developing countries that are hit by financial crises go into recession. The reduction in income is the only way of quickly generating the improvement in the trade balance that is the necessary counterpart to the increased reluctance of international investors to lend.

—Jeffrey Frankel

The most obvious interpretation of why devaluations carry high political costs is that they are accompanied by painful recessions. But why? After all, devaluations are supposed to boost competitiveness, increase production and exports of tradable goods, reduce imports, and thereby improve the trade balance, GDP, and employment.

One possible explanation, says Frankel, is that, even if there is no negative effect on GDP in the aggregate, the redistributional effects could be politically costly to leaders. For example, a devaluation in an African country may benefit small rural coffee and cocoa farmers because the price of their products is determined in foreign currency terms on world markets; but farmers tend to have less political power than urban residents, who may consume imported goods and thus be hurt by the devaluation. The problem with this theory, Frankel points out, is that there are so many examples that go the other way, where the producers of the tradable products (agricultural, mineral, or manufactured) tend to have more political power than the producers of nontraded goods.

One can argue that simultaneous monetary and fiscal austerity (or banking failures or the sudden stop in foreign lending itself) are the true causes of these declines in economic activity. But Frankel says this misses a key point. According to the standard textbook theories, when a country faces a sudden stop in capital flows, there exists some optimal combination of expenditure-reducing policies (monetary or fiscal contraction) and expenditure-switching policies (devaluation) that should achieve external balance without inducing a recession.

But reality is different. All the countries in the East Asia crisis of 1997-98, for example, suffered a sharp loss in output regardless of their mix of devaluation and expenditure reduction. The simple generalization seems to be that most developing countries that are hit by financial crises go into recession. The reduction in income is the only way of quickly generating the improvement in the trade balance that is the necessary counterpart to the increased reluctance of international investors to lend.

By now the evidence seems strong that devaluation is contractionary, at least in the first year, and perhaps in the second as well. Until the currency crashes of the 1990s, a mainstream view had been that any negative effects from a devaluation were relatively quickly offset by the stimulus to net exports, so that by the second year, when exports had gathered strength, the overall effect on output would turn positive. Now, however, the negative effects seem stronger than first thought, and the positive effects weaker. The depressing conclusion is that there is no escape from recession. All policy instruments that work to improve external balance do so by reducing income in the short run—devaluation, fiscal contraction, and monetary contraction. Even structural policy reform, such as insisting that nonviable banks close, may have a negative effect on economic activity in the short run.

Why is devaluation often contractionary?

Of the many possible contractionary effects of devaluation, which ones were, in fact, responsible for the recessionary currency crashes of the 1990s? Several of the most important contractionary effects of a devaluation are hypothesized to work through a corresponding increase in the domestic price of imports or of some larger set of goods. Indeed, rapid pass-through of exchange rate changes to the prices of traded goods is the defining assumption of the “small open economy model,” which was thought to apply fairly well to emerging market countries. The contractionary effect would then follow in any of several ways: the higher prices of traded goods would, for example, reduce real money balances or real wages of workers, or increase costs to producers in the nontraded goods sector. These mechanisms were not much in evidence in the currency crashes of the 1990s. In fact, the pass-through coefficient fell significantly in the course of the 1990s, and the speed of decline was twice as fast among developing countries.

What, then, is the explanation for the recessions that followed many of the 1990s devaluations? Researchers have paid a great deal of attention—and in Frankel’s mind appropriately so—to the balance sheet effect. This is a problem of “mismatch” between the currency in which a country’s debts are denominated and the currency in which its firms earn revenue. Domestic banks and firms had large debts denominated in foreign currencies, particularly in dollars, which they might have been able to service at the previous exchange rate, but which they had trouble servicing after the price of foreign exchange went up sharply. The results were layoffs and bankruptcies.

How to mitigate the contraction

How might debtors mitigate contractionary currency crashes? It is not enough to instruct firms to avoid dollar debts or to hedge them, because international investors are not very interested in lending to these countries in their own currencies anyway, for understandable reasons. The shortrun solution is for countries to adjust promptly, rather than procrastinate. When foreign investors lose their previous enthusiasm for financing a country’s current account deficit, the national policymakers must decide whether to adjust or to wait. Typically they wait. As a result, even countries that had previously managed to keep dollar-denominated debt relatively low tend to switch the composition of their debt toward that currency during the year or so preceding the ultimate currency crash.

Laura Wallace


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A prime example is Mexico during the course of 1994. International enthusiasm for investing in Mexico began to decline after the beginning of that year, but the authorities clung to the exchange rate target and delayed adjustment in hopes that conditions would improve. During much of the year they ran down reserves. An important second mechanism of delay was to placate nervous investors by offering them Tesobonos (short-term dollar-linked bonds) in place of the peso bonds (Cetes) that they had previously held. It seems likely that the magnitude of the Mexican recession in 1995 stemmed not just from the adverse balance sheet effects that have been so frequently noted, but particularly from the adverse shift in balance sheets that took place during the course of 1994. A third mechanism of delay was a shift toward shorter maturities. And the fourth was an explicit commitment to defend the peg.

These tactics are part of a strategy that is sometimes called “gambling for resurrection.” What they have in common, beyond achieving the desired delay, is helping deepen the crisis, if it comes. It is harder to restore confidence after a devaluation if reserves are near zero and the ministers have lost personal credibility. Further, if the composition of the debt has shifted toward the short term and toward the dollar, then restoring external balance is likely to wreak havoc with private balance sheets regardless of the combination of increases in interest rate and currency depreciation. The lesson, according to Frankel is to adjust sooner rather than later—but this is something, he admits, that is easier said than done.

Trade openness helps

One final question concerns the wisdom of pursuing trade integration. Broadly speaking, there are two opposing views. One holds that a highly integrated economy is more exposed to shocks coming from abroad. The other holds that countries that are open to international trade are less vulnerable because when the ratio of trade to GDP is high, it is easier to adjust to a cut-off in international financing.

Frankel subscribes to the second view. He points out that since the emerging market crises of 1994-98, economists have increasingly emphasized the contractionary balance sheet effect: if the country’s debts are denominated in foreign currency, the balance sheets of the indebted banks and corporations are hit in proportion to the devaluation. If the economy is starting from a high ratio of trade to GDP, the necessary devaluation need not be large, and therefore the adverse balance sheet effect can be correspondingly modest. But if the economy is not very open to trade to begin with, the necessary devaluation and the resulting balance sheet impact and recession will both be large. In Frankel’s view, trade protectionism does not “shield” countries from the volatility of world markets as its proponents might hope. On the contrary, less trade openness leads to greater vulnerability to sudden stops and currency crashes. Openness is the only variable that is virtually always statistically significant.

Lessons to take away

Many of the currency crises of the past 10 years have been associated with output loss stemming from the contractionary effects of a devaluation, the most problematic being the balance sheet effects. How can countries minimize vulnerability to sudden stops, devaluations, and associated economic contractions?

In the shorter term, countries must keep balance sheets strong by avoiding a shift to short-term dollar debt as a means of procrastinating. Adjusting promptly after inflows cease is better than procrastinating. And in the longer term, greater openness to trade reduces vulnerability to both sudden stops and currency crashes and may be the more robust option, politically as well as economically.

The full text of Jeffrey Frankel’s lecture is available on the IMF’s website at staffp/2004/00-00/arc.htm.

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