Frankel Paper

IMF Staff Papers
Vol. 52, Number 2

2005 International Monetary Fund
Mundell-Fleming Lecture: Contractionary Currency

Crashes in Developing Countries
JEFFREY A. FRANKEL*
To update a famous old statistic: a political leader in a developing country is almost
twice as likely to lose office in the six months following a currency crash as otherwise. This difference, which is highly significant statistically, holds regardless of
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 10 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.
Pass-through 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. [JEL F32, F33, F34]
*The author is James W. Harpel Professor at Harvard Universitys John F. Kennedy School of
Government. This paper was presented as the Mundell-Fleming Lecture at the Fifth IMF Annual Research
Conference (ARC) in 2004. The author thanks Yun Jung Kim, Maral Shamloo, and Rodrigo Urcuyo for
capable research assistance; the Kuwait Fund and the Ash Institute for Democratic Governance and
Innovation, both of Harvards Kennedy School, for support; and Miguel Messmacher and participants at
the ARC, especially Robert Flood, for useful suggestions. Some results draw on joint work with Eduardo
Cavallo, David Parsley, and Shang-Jin Wei.
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Jeffrey A. Frankel
t is a great honor to give this fifth annual Mundell-Fleming lecture.

December 2004 is the tenth anniversary of the Mexican peso crisis of 1994. In
retrospect, this crisis ushered in an eight-year series of highly visible devaluations
in emerging markets, most of which proved highly costly to the countries involved.
These currency crashes are the theme of my lecture.
Accordingly, I will begin by invoking neither Mundell nor Fleming, but another
article from three decades ago: Richard Coopers Currency Devaluation in Developing Countries (Cooper, 1971). This was one of the few major papers from that
period to deal explicitly with the macroeconomics of developing countries. The
weight of our attention over the last decade or two has shifted increasingly away
from rich countries and toward developing countries, whether judged by the caseload of the staff at the International Monetary Fund or by working papers turned
out by scholars in the field of international finance and macroeconomics. In part
this reflects the extent to which lower- and middle-income countries have become
increasingly integrated into world financial markets. Twenty years ago, for example,
one would not have wanted to apply the Mundell-Fleming models insights regarding
international capital mobility to developing countries, because they didnt have much
capital mobility. Indeed, I dont think the phrase emerging markets even existed
then. But after the liberalizations and capital inflows of the early 1990sand the
crises of the late 1990swe are applying to developing countries a wide variety of
models and tools that were originally created with rich countries in mind. We have
also created some new models and tools to try to capture what is different about
developing countries.
I. Political Costs of Devaluation
I wish to start with a widely cited statistic from Cooper (1971, p. 28). He found
that, in the aftermath of devaluations, nearly 30 percent of governments fell within
12 months, as opposed to 14 percent in a contemporaneous control group. This is
an impressive fact, as demonstrated by the frequency with which other authors
still cite it 33 years later. A citation count reveals that: Coopers article has
received 84 citations, with no downward trend over timenot as high as the two
seminal papers that constituted the Mundell-Fleming model and thus gave this lecture its name, but still very healthy for a paper written so long ago.1 So I expect to
garner a lot of citations myself by updating Coopers calculation!
Updating a Statistic on Leaders Loss of Office
First we need to define a currency crash. Cooper counted anything more than
10 percent as a devaluation episode. But the world changed in the 1970s and 1980s,
and depreciations of that magnitude have become commonplace. For a high-inflation
1Mundell (1963) and Fleming (1962) received 319 and 257 citations, respectively, over the same
period, 19722003. This probably understates the contribution of the Mundell-Fleming model: many discussions of the model cite other works, or none at all.
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CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES
country, one would not want to say that a new currency crisis occurs every month.
So I use the following definition:2
The devaluation must be at least 25 percent, on a cumulative 12-month basis.
The devaluation must represent an acceleration of at least 10 percentage points,
relative to the rate of depreciation in the 12 months before that.
It must have been at least three years since the last currency crisis.
By these criteria, looking at a sample of 103 developing countries over the period
19712003, we found 188 currency crashes. In these countries, the person holding the
position of chief executive changed within 12 months of the devaluation 27 percent
of the time. The standard of comparison that we use normally is all other 12-month
periods: the leader changed 21 percent of the time normally. Thus, devaluation
increases by an estimated 32 percent the probability of the executive losing his
or her job. The difference is statistically significant only at the 13 percent level.3
However, it may be that countries that tend generally to instability are overrepresented in the crisis group, so that political turnover is more common in this group
and is not necessarily the result of currency crises. If we narrow the standard of nondevaluation comparison periods to the set of countries that have experienced a currency crash at some point during the sample period, on the grounds that these are
more comparable to the crisis episodes, we find that the increase in job loss among
devaluers now becomes almost statistically significant at the 1 percent level.4
We then narrowed the window to a half year. Now the chief executive lost
office 19.1 percent of the time, as opposed to 11.6 percent of the time otherwise. In
other words, a currency crash increases the probability of a change in the top leadership within the following six months by 1.7 times. This time the difference is statistically significant not only at the 10 percent or 1 percent levels, but at the 0.5
percent level as well, regardless of whether the entire set of countries is used as the
standard of comparison.
We also looked at whether the finance minister or central bank (CB) governor
whoever held the office of the countrys governor of the IMFlost his or her job.
Here, even using the longer 12-month window (and even with only five years of
data: 199599), the effect is statistically significant. In the year following a currency
crash, the holder of this position changed 58.3 percent of the time. In other years during this period the rate of turnover was 35.8 percent. By this measure the finance
minister or CB governor was 63 percent more likely to lose office. The difference is
highly significant statistically (at the 0.001 level).5
When we segregate countries according to three income levels, we find that the
phenomenon is chiefly one of middle-income countries. Within the class of poor
countries, the increase in turnover of the leader is not statistically significant, and
among rich countries there were no cases of a leader losing office within a year of
a devaluation.
2The
same as that in Frankel and Rose (1996).

1, Part A. The source for the identity of the president, prime minister, premier, or other
chief executive is http://rulers.org.
4See Appendix 1, Part B.
5See Appendix 1, Part C.
3See Appendix
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Jeffrey A. Frankel
We also tried segregating countries according to three kinds of political structure:

presidential democracy, parliamentary democracy, and nondemocracy. Our expectation was that we would find that the effect of devaluation on leadership turnover
would be greater among parliamentary democracies than among presidential democracies. The logic was that in any given year the latter might not have a scheduled election, or, if they did, a term limitation might prohibit the incumbent from running for
reelection. We found, instead, that the job-loss rate was much higher and more significant in the case of devaluations occurring in presidential democracies.6
We examined whether a loss of reserves equally as large results in job loss as
often as a devaluation. Such episodes also tend to be unpleasant (often implying
monetary contraction and recession; for example, Argentina in 1995 and 1999).
Apparently they do not carry the same political costs: however their effect on leaders job loss was not significant.
What is it about devaluation that carries such big political costs? How is it that
a strong ruler like Indonesias Suharto can easily weather 32 years of political, military, ethnic, and environmental challenges, only to succumb to a currency crisis?
Possible Sources of Political Costs of Devaluation
Currency crises are often accompanied by sharp recessions. Thus, an obvious interpretation, which we will consider further, is that leaders are punished by their constituents when the performance of the economy is poor. But before proceeding on
the assumption that the loss of ministerial jobs is a reflection of unemployment and
depressed activity throughout the economy, let us consider the possibility that the
costs of a devaluation may be more political than economic. First, there is the possibility that elections cause currency crashes, rather than the other way around.
Second, it could be that IMF programs or other austerity programs are unpopular
in general and that the devaluations are an incidental aspect of this. Third, it could
be that the leaders in question had made public promises in advance not to devalue
and that they were punished for breaking these promises, regardless of subsequent
economic performance.
What do I mean by the first possibilitythat elections cause devaluations,
rather than the other way around? It is striking in how many of the major crises of
the 1990s, even though trouble began during the run-up to a major regularly scheduled national election, the worst speculative attack and currency crash came soon
after the election. This describes Mexico in 1994, Korea in 1997, and Brazil in
199899. In an earlier era, one would have guessed that election-motivated macroeconomic expansionthe famous political business cycleexplained the need for
a subsequent devaluation. But that explanation does not fit the experience of the
1990s. Macroeconomic expansion in these election campaigns was limited.7
6The
breakdown by income and democratic structure is given in Parts D, E, and F of Appendix 1.

political business cycle literature observes that politicians are sometimes able to fool voters by
aggressive macroeconomic expansion preceding the election, with costs borne later. But Brender and
Drazen (2004) argue that this is primarily a phenomenon found in countries that have only recently made
the transition to democracy. Voters eventually learn.
7The
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A better explanation is that devaluation is politically costly to leaders, and so

in an election year they try to postpone ithoping to get reelected, that the crash
happens on their successors watch rather than theirs, or that something will turn up
in the meantime to improve the balance of payments.8 A related hypothesis is
that because a devaluation uses up scarce political capital, it is more likely to be
undertaken by a new leader with a strong mandate, especially in a visible crisis, and
especially if he can blame it on his predecessor. Edwards (1994, Table 5) reports that
devaluations occur disproportionately often during the first two years after a transfer of government: 77.3 percent of devaluations among presidential democracies
(that is, those with prescheduled elections) and 70.0 percent among parliamentary
democracies. This is a topic worth exploring, but not here: my calculations about
the frequency with which ministers lose their jobs in the year after a devaluation
were careful to start the clock the day after the devaluation, so that cases in which
the devaluation came soon after an electoral change are not included in the statistics.
The second possibility I mentioned is that devaluations are a proxy for unpopular IMF austerity programs or other broad reform packages. IMF-associated austerity programs have often resulted in popular unrest. For example, riots following
food-subsidy cutbacks contributed to the overthrow of President Nimeiri of Sudan
in 1985.9
One can test the proposition that devaluations are acting as a proxy for unpopular IMF austerity programs by conditioning our previous calculation on the adoption of IMF programs. We created a dummy variable to represent cases where an
IMF program was initiated within three months on either side of the devaluation.10
The IMF program variable does not seem to raise the frequency of leader job loss
relative to devaluations that did not involve an IMF program. Thus, it is not surprising that conditioning on the IMF dummy variable has no discernible effect on
the frequency of leader turnover: 21.05 percent of the time for the cases with an
IMF program; 21.92 percent of the time for the ones without. In both cases, it is
similar to the overall rate of job loss following devaluations (19.05 percent) in the
complete sample and is still almost double the 11.6 percent rate in normal times.
That leaves the third noneconomic explanation, that the ministers in question
have made public promises in advance not to devalue, and that they feel it necessary to resign or are punished for breaking these promises, regardless of subsequent
economic performance. In many cases the commitment to the peg is explicitly reaffirmed by top policymakers and political leaders in the months immediately prior
to the devaluation. Perhaps such ill-fated promises are made because the minister
8On governments incentives to postpone devaluations until after elections, see Stein and Streb (1998
and 1999).
9In a study that looks at the role of IMF presence along with various measures of political instability
in determining whether devaluations during the period 195071 were economically successful, Edwards
and Santaella (1993) report nine cases of postdevaluation coup attempts. Lora and Olivera (2004) find that
voters punish presidents for promarket policies and for increases in the rate of inflation, but not for
exchange rate policies per se. For an earlier summary of the political consequences of IMF-type austerity
programs, see Bienen and Gersovitz (1985).
10Whether Stand-By Arrangement, or other. See Appendix 2 for a list with dates. Part G of Appendix 1
reports the results.
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Jeffrey A. Frankel
is duplicitous or at least is ignorant of the speculative pressures he or she is up

against. More likely they are too attached to the peg psychologically to let go;
many of the currency crashes of the 1990s occurred in countries where governments had a lot invested in the peg, because exchange-rate-based stabilizations
earlier had been the successful and popular means of ending a 1980s cycle of high
inflation, even hyperinflation.
Perhaps it is even better to regard the public commitments as sincere expressions of a strong desire to maintain the peg. The ministers may realize that events
could force the abandonment of the exchange rate policy, if speculative pressures
accelerate and it develops that reserves are about to run out, leaving little other
option. And they may realize that making an explicit statement beforehand increases
the chances that they will have to resign if and when the peg is abandoned. But
making the promise is a way of buying a bit of credibility, and buying some
time. Specifically, it is a device for signaling that their determination to hold the
line on the currency is so strong that they are willing to risk sacrificing their
jobs.
We selected a subsample of 24 cases out of our total set of currency crashes.
We chose roughly equal numbers of cases with and without subsequent premier
changes.11 We searched local newspapers for the 30 days preceding the devaluation for statements by government officials that could be construed as commitments not to devalue. We included assurances even if the language did not read as
explicit or ironclad, because these are so often interpreted as promises.12
The sample size was small. But we found that when a member of the government (chief executive, finance minister, or central bank governor) gave assurances
that there would be no devaluation and yet a devaluation did subsequently occur,
the probability that the chief executive would lose his or her job within 12 months
was 2/3. When no such assurances were reported, the frequency of job loss was
only 7/18, despite the devaluation. In other words, whatever the credibility benefits of the promise ex ante, it almost doubles the likelihood that the leader loses
office ex post. If we use the six-month horizon, then the relative effect is even
stronger: the leader is more than twice as likely to be out on the street if the government had made a previous commitment than if it had remained quiet (0.50 versus 0.19). If we consider only cases where the chief executive is the one to have
given the assurances, then the job-loss rate becomes 100 percent. But there were
only 2 such cases, out of 24. Usually the dangerous task of making assurances
is delegated to a cabinet member. (Details are reported in Appendix 3 for the
12-month horizon and in Appendix 4 for the 6-month horizon.)
Despite this suggestive outcome, to the effect that the broken-promise factor
does indeed matter, it seems unlikely that the broken-promise effect is the sole rea-
11The other major criteria were that the country in question be represented by comprehensive
microfiche files in Harvards Widener Library of past newspapers and that the languages of those newspapers be either English, Spanish, Korean, or Arabic, the languages spoken by the research assistants
working on this project. Appendixes 3 and 4 offer details of these cases.
12In at least one case (Syrian Arab Republic), the newspapers appear to have been so lacking in candor regarding the relevant exchange rate that they did not even bring up the subject.
154
son for devaluations to result in turnover at the top. After all, even among those cases
where our newspaper search turned up no record of assurances in the month preceding the devaluationeither from the leader, finance minister, or central bank
governor22 percent of the leaders lost office within 6 months of the devaluation
anyway and 39 percent lost within 12 months. These percentages are well above the
11.6 percent and 20.5 percent rates, respectively, of job loss in normal times.
Evidently, the economic effects of devaluation also play an important role.
II. Does Devaluation Necessarily Mean Loss of Output?
As already noted, the most obvious interpretation of why devaluations are so often
associated with high political costs is that they are accompanied by painful recessions.13 But why? After all, devaluations are supposed to increase competitiveness, increase production and exports of tradable goods, and reduce imports, and
thereby boost the trade balance, GDP, and employmenthence the story of the
British Chancellor of the Exchequer singing in the bath after the 1992 devaluation of the pound. Apparently, developing countries are different, or at least
emerging market countries are. Figuring out why may amount to figuring out what
aspect of these countries most requires us to modify the macroeconomic models
generally applied to advanced economies.
One can argue that simultaneous monetary and fiscal austerity, banking failures,
or the sudden stop in foreign lending itself are the true causes of these declines in
economic activity. But this misses what, to me, is 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
accomplish adjustment to external balance (the new balance of payments constraint), without necessarily sacrificing internal balance (that is, without a recession).
Why did all the countries in the East Asia crisis of 199798 suffer a sharp loss in
output growth regardless of their mix of devaluation and expenditure reduction? The
expansionary effect of the devaluation is supposed to make up for whatever contraction comes from other sources.
Consider a graphical representation with the interest rate and exchange rate
(price of foreign currency) on the axes, as illustrated in Figure 1a. To satisfy external balance, there is an inverse trade-off between the two instruments. A devaluation and an increase in the interest rate are each ways of improving the trade
balancethe latter by reducing expenditureand so the more you have of one,
the less you need of the other. (If external balance is defined as equilibrium in the
13Another possibility is that, even if there is no negative effect on GDP in the aggregate, the redistributional effects could be politically costly to the leaders. For example, a devaluation in an African country may benefit small rural coffee and cocoa farmers because the price of their product is determined on
world markets, but they tend to have less political power than urban residents, who may be hurt by the
devaluation. The problem with this theory 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.
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Jeffrey A. Frankel
Figure 1a. Attaining Internal and External Balance: Traditional Version
Overheating
Internal
balance
E
(Price of
foreign
exchange)
Recession
or other
spendingswitching
policy
Surplus
New external
balance
Deficit
Original
external
balance
i (interest rate), or other expenditure-reducing policy

overall balance of payments, including the capital account along with the trade balance, the relationship is still downward-sloping, since a devaluation and an increase
in the interest rate are both ways of making domestic assets more attractive to global
investors.)
To satisfy internal balance, the trade-off is traditionally considered to be upwardsloping. An increase in the interest rate reduces the domestic demand for domestic
goods, while a devaluation increases the net foreign demand for domestic goods. If
you have more of one, you also need more of the other, to prevent excess supply or
demand.
The existence of two independent instruments implies the possibility of attaining both targets simultaneously, at the intersection of the internal and external balance
schedule. In the aftermath of an adverse shock in the foreign sector, the right combination of devaluation and monetary contraction will restore balance of payments
equilibrium while maintaining real economic growth.
This is not always the way things actually work.14 By now we have had enough
experience with crises in emerging markets to realize that the traditional framework
needs to be modified. The simple generalization seems to be that most developing
14Paul
156
Krugman, Latin Americas Swan Song, at http://web.mit.edu/krugman/www/swansong.html.
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. External balance is a jealous mistress that can be satisfied only if internal balance is left wanting.
Critics of the IMF say that the recessions are the result of Fund policies,
specifically, the insistence on austerity in country-rescue programs.15 Some can be
interpreted as arguing that there should have been more expenditure switching and
less expenditure reductionthat the mix of a lower interest rate combined with a
bigger devaluation would successfully maintain internal balance. But many of the
devaluations in East Asia and elsewhere were very large as it was.
The critics often make the point that high interest rates are not in practice as
attractive to foreign investors as the Mundell-Fleming model, for example, would
suggest, because they carry increased probability of default. This is true. But in my
view it is not the most important correction in the traditional framework. Even if
interest rates do not have as big a positive effect on the capital account as our earlier models of high financial integration suggested, so that the graphical relationship may be flatter, I believe that the sign of the effect is still the same. Even if
higher interest rates have no effect at all on capital inflows, their effect on the balance of payments still goes the same way, owing to the effect on spending. One
cannot normally attract many investors by lowering interest rates. Therefore, the
external balance line still slopes downward. Claims that high rates are damaging
to the real economy willfully ignore the lack of an alternative, if the external balance constraint is to be met.
Where the traditional framework needs most to be modified is the relationship
giving internal balance, not that giving external balance. By now the evidence
seems strong that devaluation is contractionary, at least in the first year and perhaps in the second as well. We have long been aware of various potential contractionary effects of devaluation in developing countries. The same 1971 Cooper
article that tallied job losses among ministers also listed six ways in which devaluation could be contractionary. By 1990, a total of 10 such effects had been identified in textbooks.16
Until the currency crashes of the 1990s, a mainstream view had been that any
negative effects from a devaluation were before long offset by the positive effect
of stimulus to net exports, so that by the second year, when the latter had gathered
strength, the overall effect on output had turned positive.17 Now, however, one
must judge the negative effects as stronger than first thought, and the positive
effects as weaker. Calvo and Reinhart (2000), for example, calculate that exports
do not increase at all after a devaluation but are down for the first eight months.
The export side, at least, was supposed to be unambiguously positive. Apparently,
production is sometimes derailed by corporate financial distress, absence of trade
15For
example, Radelet and Sachs (1998); and Furman and Stiglitz (1998).
example, the 5th through 9th editions of Ronald Caves, Jeffrey Frankel, and Ronald Jones, 2002,
World Trade and Payments.
17Edwards (1986); and Kamin (1988).
16For
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Jeffrey A. Frankel
credit, and increased costs of imported inputs, even when the production is for the
purpose of export. Imports fall sharply; indeed, crisis-impacted countries have for
this reason experienced sharp increases in their trade balances as early as two or
three months after the crisis. But this is clearly a response to the unavailability of
finance and collapse of income and spending, not to relative prices. In other
words, it is expenditure reduction, not expenditure switching.
If devaluation is contractionary, then the internal balance line slopes down,
not up (as illustrated in Figure 1b). Moreover, the slope may be disturbingly similar to the slope of the external balance line. It is hard to see where the two intersect, if they intersect at all. This means that it is hard to see what combination of
policy instruments, if any, can simultaneously satisfy both internal and external
balance, after an adverse shock has shifted the latter outward. The depressing conclusion is that there is no escape from recession. All policy instruments work via
reduction in income in the short rundevaluation, fiscal contraction, and monetary contraction. Even structural policy reform, such as insisting that bad banks go
under, may have a negative effect on economic activity in the short run.
Is the targets-and-instruments framework then no longer useful? I think the
framework is still relevant during the period after a terms-of-trade shock or reverFigure 1b. Attaining Internal and External Balance:
When Devaluation Is Contractionary
E
(price of
foreign
exchange)
or other
spendingswitching
policy
Recession
New
external
balance
Internal
balance
i (interest rate), or other expenditure-reducing policy

158
sal in capital flows (as reflected in a peaking of reserves) but before the speculative attack hits (as reflected in a very sharp devaluation, loss in reserves, or
increase in interest rates). It can be hard to identify such an interval, especially at
the time. But I have in mind the interval of a year or so preceding December 2001
in Argentina, July 1997 in East Asia, and December 1994 in Mexico. I call this
interval the period of procrastination, for reasons that will become clear below.
III. Why Is Devaluation Often Contractionary?
Of the many possible contractionary effects of devaluation that have been theorized,
which are in fact responsible for the recessionary currency crashes of the 1990s?
Several of the most important contractionary effects of an increase in the exchange
rate 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 has always been 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 workers18 or increase costs to producers in the nontraded goods sector.19
These mechanisms were not much in evidence in the currency crashes of the
1990s. The reason is that the devaluations were not passed through to higher prices
for imports, for domestic competing goods, or to the Consumer Price Index (CPI)
in the way that the small open economy model had led us to believe. The failure of
high inflation to materialize in East Asia after the 199798 devaluations, or even in
Argentina after the 2001 devaluation, was good newsa surprise that perhaps to
some extent compensated for the unexpectedly sharp recessions. But it calls for
some investigation.
The Decline in Exchange Rate Pass-Through in Developing Countries
Conventional wisdom has long been that pass-through is slower or less complete
in large industrialized countries than in small developing countries. A number of
authors have pointed out a further decline during the 1990s in the pass-through coefficient among industrialized countries. But most of the many econometric studies of
pass-through, even those that examine a recent decline in the pass-through coefficient, have focused on prices of imports into industrialized countries, rather than
into developing countries. Taylor (2000) proposed that a decline in pass-through of
exchange rate changes into the CPI in the 1990s was due to a lower inflationary
environment and looked at U.S. data. Gagnon and Ihrig (2004) extended this claim
18Diaz-Alejandro (1963) pointed to a transfer of income from (low-saving) urban workers who consume traded goods to (high-saving) rich owners of agricultural land.
19 Increased costs to producers of nontraded goods could come from either higher costs of imported
inputs, like oil, or higher labor costs if wages are indexed to the cost of living (see, for example, Corbo,
1985, for a discussion of Chile in 1981).
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Jeffrey A. Frankel
to a sample of 11 industrialized countries. Otani, Shiratsuka, and Shirota (2003)

found a similar decline in pass-through for imports into Japan. Campa and Goldberg
(2002) again found a decline in the coefficient in the 1990s but attributed it more to
changing commodity composition than to a less inflationary environment.20 Their
data set also consisted solely of industrialized countries.
Only a few studies include lower-income countries. Choudhri and Hakura
(2001) extend to a sample of 71 countries, including developing countries, the
finding that a low-inflation environment reduced pass-through to the CPI in the
1990s. Borensztein and De Gregorio (1999) and Goldfajn and Werlang (2000)
study the low pass-through of recent large devaluations in developing countries.21
But these are all studies of influences on aggregate price measures, the CPI in particular, not on import prices. Few studies concentrate on imports of specific goods
into developing countries. The difference is important because effects on price
indices versus prices of specific imports are really two distinct conceptions of the
word pass-through. It is even more important because, as in the rich-country context, some authors have claimed that what appears to be slow or incomplete passthrough in developing countries can really be attributed to changes in composition
with regard to product varieties.22
Table 1, taken from Frankel, Parsley, and Wei (2005), reports estimates for passthrough to prices of narrowly defined retail imports into 76 countries. Notice, first,
confirmation of the conventional wisdom that pass-through has historically been
higher in developing countries than in rich countries. As of the beginning of our
sample period, 1990, the coefficient was 0.3 for rich countries and 0.8 for developing countries, with the difference highly significant statistically. (Figure 2, which
illustrates the numbers on average during our sample period.) That these numbers
fall below 1.0 cannot be attributed to compositional effects, as the eight goods are
defined very narrowly: a roll of color film, a carton of Marlboro cigarettes, an issue
of Time magazine, a bottle of Cointreau, and so forth.
Theories of slow or incomplete pass-through can be divided according to what
sort of arbitrage barrier they posit as blocking the enforcement of the law of one
price: barriers to international trade such as tariffs and transportation costs, or local
costs of distribution and retail. The results in Frankel, Parsley, and Wei (2005) support both theories. Bilateral distance is a statistically significant determinant of the
Error Correction Mechanism (ECM) term; that is, higher transport costs lead to
slower pass-through to import prices. At the same time, a higher wagethe largest
component of local distribution and retail costsalso shows up as a significant negative determinant of the pass-through coefficient.23 Both determinants apply to rich
20 It has been pointed out at least since Knetter (1993) that differences in pass-through coefficients
could be attributable to differences in the composition of the price index, rather than to differences in passthrough that would show up for narrowly defined commodities.
21 References to some further studies are given in Frankel, Parsley, and Wei (2005).
22 Burstein, Eichenbaum, and Rebelo (2002) attribute the low observed pass-through in general price
indices to the disappearance from consumption of newly expensive import goods and their replacement in
the indices by inferior local substitutes.
23 Table 1 applies only to prices of retail imports. But results for prices at other stages, reported in
Frankel, Parsley, and Wei (2005), supply further evidence that both kinds of arbitrage barriers are opera-
160
Table 1. Determination of Pass-Through to Imported Goods Prices:

Developing Countries Relative to Rich Countries (76 countries, 19902001)
Estimated Coefficient on
Change in exchange rate
Change in exporters price
(Change in exchange rate) trend
Error correction term (ECM)
ECM trend
Number of observations
Adjusted R-squared
Rich
Dev.
0.310***
(0.075)
0.108***
(0.025)
0.025***
(0.009)
0.091***
(0.016)
0.000
(0.002)
5,677
0.324
0.496***
(0.101)
0.023
(0.042)
0.026**
(0.013)
0.105***
(0.025)
0.011***
(0.003)
Source: Frankel, Parsley, and Wei (2005).

Notes: Dependent variable: change in retail import prices of eight narrowly defined commodities. The eight import commodities (given with their country of origin) are: Marlboro cigarettes
(U.S.), Coca-Cola (U.S.), cognac (France), Gilbeys gin (U.S.), Time magazine (U.S.), Kodak color
film (U.S.), Cointreau liqueur (France), and Martini & Rossi vermouth (Italy). Levels of significance
are 5 percent (**) and 1 percent (***). For developing country coefficients, values in the Dev.
column can be added to those in the Rich column.
and poor countries alike. Size does not appear as a determinant in most of our
results: small countries do not experience more pass-through than do large ones, a
very surprising finding in light of pricing to market theories (that is, price discrimination by sellers).
For present purposes, the important points are that the pass-through coefficient
fell significantly in the 1990s and that the speed of decline was twice as fast among
developing countries as it was among rich ones (0.051 per year compared with
0.025).24 The speed of pass-through, which is estimated in the form of an ECM term,
also shows a significant downward trend for developing (not for rich) countries.
tive. On the one hand, pass-through is incomplete even for the prices of these imported commodities at
dockside, which suggests that local distribution costs cannot be the only barrier to arbitragetransport
costs, tariffs, and other trade barriers must matter as well. In support of this conclusion, distance has an
important effect, either reducing or slowing pass-through, at all four stagesdockside imports, retail,
competitors prices, and the CPI. On the other hand, pass-through behavior for retail imports is more like
behavior for local substitutes than it is like imports at the dock, which suggests that tariffs and transportation costs cannot be the only barrier to arbitragelocal distribution matters too. In support of this conclusion, higher wages have a strong negative effect on pass-through to the local competitors prices and
the CPI.
24 Taken literally, the estimated trend is strong enough to bring the pass-through coefficient to zero by
2006. This conclusion may to some extent be an artifact of the assumption of a linear trend that should not
be extrapolated. But when we try a different functional form that allows the effect of time to asymptote to
zero (the reciprocal of time), we get a similar result: the pass-through coefficient falls most of the way to
zero during the sample period.
161
Jeffrey A. Frankel
Figure 2. Pass-Through and Income, Average 19902001

(Country grouping based on World Bank classification)
Pass-through coefficient
0.7
0.6
12 countries
36 countries
0.5
0.4
0.3
0.2
28 countries
0.1
0
Low-income
Middle-income
High-income
Source: Frankel, Parsley, and Wei (2005)prices for 8 narrowly defined commodities imported into 76
countries; effect of exchange rate change within one year.
Note: Pass-through for less developed countries is greater than for rich countries, historically.
One might wonder if this estimated decline in the pass-through coefficient

during the 1990s is an indirect reflection of an asymmetry whereby pass-through
of depreciation is greater than pass-through of appreciation, or a threshold effect
whereby large devaluations result in proportionately less pass-through. We have
found in extensions that the answer is no; the trend remains even after controlling for the big devaluations.25
One would expect pass-through to prices of domestically produced goods or
the general CPI to be (even) lower than to prices of imports. Our paper also reports
results for other local price measures, and this is indeed the pattern they show
(Figure 3). Tariffs and distance both contribute significantly to low pass-through to
the CPI. But pass-through to prices of local substitutes and to the CPI both show
the same downward trends over the sample period as does pass-through to import
prices. The difference in coefficient trends between poor and rich countries is even
greater for pass-through to the CPI than it is for import prices. This is important, in
the present context, because most of the potential contractionary effects of devaluation require that pass-through extend beyond import prices alone, to include passthrough to locally produced goods or the CPI.
What can we say about the reasons for the decline in pass-through? As noted,
one hypothesis proposed by others is declining long-run inflation rates. This factor turns out to be particularly relevant in the case of explaining the downward
trend in pass-through to developing country CPIs.
25 The threshold effect, while significant, goes the wrong way: changes in the exchange rate above
25 percent are found to have proportionately larger pass-through effects, not smaller. We did find strong
evidence of asymmetry. In fact, we cannot reject the hypothesis that appreciation is not passed through
at all, suggesting downward price rigidity. This is an interesting finding. But the significant downward
trend in the pass-through coefficient remains.
162
Figure 3. Exchange Rate Pass-Through to Domestic Prices

Pass-through
coefficient
0.6
0.4
0.2
At the dock
Imported good
prices
Local
competitor
prices
Consumer price
index
Source: Frankel, Parsley, and Wei (2005)effect within one year, in 76 countries.
Note: Pass-through is greatest for prices of imports at dock, but less for retail and CPI.
Another possible explanation for the trend is rising labor costs in retail and distribution. We find that wages are a significant determinant of the pass-through coefficient. The wage hypothesis turns out to be particularly relevant in the case of
explaining the downward trends in pass-through either to the prices of local substitutes or to the CPI. Controlling for wages reverses an estimated tendency for passthrough to the CPI to decline as a countrys per capita income grows. A possible
interpretation is that the role of distribution and retail costs in pricing to market
becomes increasingly important as countries achieve higher incomes, owing to the
Balassa-Samuelson-Baumol effect.
In any case, most of the decline in pass-through remains unexplained, despite
the many contributing factors we estimated.26 The strongest conclusion is simply
that incomplete pass-through is another respect in which developing countries have
become a bit more like rich countries, for whatever reason.
The Balance Sheet Effect
If the contractionary effects that rely on pass-through to higher goods prices do not
explain the recessions that followed many of the 1990s devaluations, then what does?
On the list of contractionary channels, the balance sheet effect is the one that has
26 Another variable we looked at is long-run exchange rate variability. Here the influence could go
either way. On the one hand, if exchange rate variability is another sign of monetary instability, like the
inflation rate, it might be thought to contribute to faster pass-through; there is some support for this effect
in the case of import prices in developing countries. On the other hand, Froot and Klemperer (1989),
Krugman (1987), and Taylor (2000) have suggested that when exchange rate fluctuations are largely transitory, pass-through is lower, an effect supported in the case of pass-through to the CPI in developing countries. Indeed, an increase in exchange rate variability in the late 1990s can apparently explain fully the
significant downward trend in the speed of adjustment of the CPI.
163
Jeffrey A. Frankel
dominated in terms of attention from researchers, appropriately so. Domestic banks

and firms had large debts denominated in foreign currencies, particularly in dollars.
They might have been able to service their debt at the previous exchange rate, but
they had trouble servicing it after the price of foreign exchange had gone up sharply.
The results were layoffs and bankruptcies.27
There is plenty of evidence of the output cost associated with the balance sheet
effect. Looking at the experience of the 1990s, Cavallo and others (2002) show that
countries entering a crisis with high levels of foreign debt tend to experience large
real exchange rate overshooting (devaluation in addition to the long-run equilibrium
level) and large output contractions. Similarly, Guidotti, Sturzenegger, and Villar
(2004) find evidence that liability dollarization worsens output recovery after a sudden stop in capital inflows. Cspedes (2004) finds that the interaction of real devaluation and external debt has a significant negative effect on output.
It is easier to point out the problem of mismatchbetween the currency of
denomination of a countrys debts and the currency its firms earnthan it is to identify a cause, let alone a remedy. 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. The result of following a rule to avoid borrowing in foreign currency would thus be to borrow less in total (which, admittedly,
might not be such a bad outcome). Eichengreen and Hausmann (1999) have made
the inability to borrow in local currencies famous under the name original sin. The
phrase is meant to imply that the problem is not the fault of the countries themselves,
or at least not the fault of recent governments. But we need not accept that it is completely predetermined.28
IV. How Might Debtors Mitigate Contractionary Currency Crashes?
One need not dismiss the charge that international financial markets discriminate
against developing countries in a number of ways in order to discuss the respects
in which debtors have some responsibility for their own fate. Let us consider two.
One respect is short run, and one is long run.
27 The analytical literature on balance sheet effects and output contraction includes, but is not limited
to, Aghion, Bacchetta, and Banerjee (2000); Caballero and Krishnamurthy (2003); Cspedes, Chang, and
Velasco (2003 and 2004); Chang and Velasco (1999); Christiano, Gust, and Roldos (2004); Dornbusch
(2002); Jeanne and Zettelmeyer (2005); Kiyotaki and Moore (1997); Krugman (1999); Mendoza (2002);
and Schneider and Tornell (2001).
28 One school of thought is that the choice of an adjustable peg regime, or other intermediate exchange
rate regime, leads to dangerously high unhedged foreign currency borrowing. It is argued that a floating
regime would force borrowers to confront the existence of exchange rate risk and thereby reduce unhedged
foreign currency borrowing (see, for example, Eichengreen, 1999, p. 105). This sounds like an argument
in favor of governments introducing gratuitous volatility, because private financial agents underestimate
risk. But the models of Pathak and Tirole (2004); Jeanne (2005); Chamon and Hausmann (2005); and
Chang and Velasco (1999) do it with only fundamentals-generated uncertainty and rational expectations.
Hausmann and Panizza (2003) find empirical support only for an effect of country size on original sin, not
for an effect of income level or exchange rate regime. Goldstein and Turner (2004) point out things countries can do to reduce currency mismatch.
164
Shifts on the Balance Sheet During the Procrastination Phase

The short-run question over which countries have some control arises during the
interval I have called the period of procrastination. When foreign investors lose
their enthusiasm for financing a countrys current account deficit, the national policymakers must decide whether to adjust or to wait. Typically, they wait. Countries
that had managed to keep dollar-denominated debt relatively low tended to switch
the composition of their debt in that direction during the year or so preceding the
ultimate currency crash, to entice skeptical foreign investors to stay in.
A prime example is Mexico in 1994. International enthusiasm for investing in
Mexico began to decline after the beginning of the year. The authorities clung to the
exchange rate target and delayed adjustment, hoping circumstances would turn
around. Most obviously, during much of the year they ran down reserves, as shown
in Figure 4. But 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) they had previously held. Figure 5 shows the dramatic
increase in dollar-linked debt during the year leading up to the peso crisis of
December 1994. 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 in
1994. A third mechanism of delay was a shift toward shorter maturities, illustrated
in Figure 6.29 And the fourth has already been noted, an explicit commitment to
defend the peg.
These mechanisms are part of a strategy that is sometimes called gambling for
resurrection. What they have in common, beyond achieving the desired delay, is
helping to make the crisis worse when it does come, if it comes.30 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, in maturity, and toward the dollar, in denomination, then restoring
external balance is likely to wreak havoc with private balance sheets, regardless of
the combination of increases in interest rate versus increases in exchange rate.
The lesson? Adjust sooner rather than later (which is, admittedly, easier said
than done).
Openness to Trade Reduces Vulnerability to Currency Crises
One final question concerns an aspect of the structure of the economy that can be
influenced by policy, but only in the long run: the degree of integration with
respect to international trade. Broadly speaking, there are two opposing views on
29 See
Broner, Lorenzoni, and Schmukler (2004).

helps explain why the ratio of short-term foreign debt to reserves appears so often and so
robustly in the literature on early warning indicators for currency crashes. Examples include Frankel and
Rose (1996); Berg and others (1999); Goldstein, Kaminsky, and Reinhart (2000); Rodrik and Velasco
(2000); Mulder, Perrelli and Rocha (2002); Frankel and Wei (2005, Table 2); and many other references
given in those papers.
30 This
165
166
10
15
20
25
30
In billions of U.S. dollars
1994M4
1994M3
1994M1
1993M10
1993M9
1993M8
1993M7
1993M6
1993M5
1993M4
1993M3
1993M2
1993M1
1992M12
3-month moving average
1994M5
Level
1994M6
Source: IMF, International Financial Statistics.
Crisis
IMF Program
Figure 4. Evolution of Mexicos Reserves, from Sudden Stop to 1994 Currency Crash,
January 1992April 1995
Jeffrey A. Frankel
1995M4
1995M3
1995M2
1995M1
1994M12
1994M11
1994M10
1994M9
1994M8
1994M7
1994M2
1993M12
1993M11
Figure 5. Evolution of Mexican Debt According to Currency

Denomination, 199295
In percent
80
70
60
50
40
30
20
10
Tesobonos/(tesobonos + cetes)
Sep-95
Nov-95
Jul-95
Mar-95
May-95
Jan-95
Nov-94
Sep-94
Jul-94
May-94
Jan-94
Mar-94
Sep-93
Nov-93
Jul-93
Mar-93
May-93
Jan-93
Nov-92
Sep-92
Jul-92
May-92
Jan-92
Mar-92
Tesobonos/total domestic debt
Source: Mexican Ministry of Finance and Public Credit.
Figure 6. Evolution of Mexican Debt According to Maturity, 199295

In percent
days
Percent long term/(long + short) - left axis
Nov-95
Sep-95
Jul-95
May-95
Mar-95
Jan-95
Nov-94
Sep-94
Jul-94
May-94
Jan-94
Mar-94
Nov-93
Jul-93
90
Sep-93
100
May-93
92
Mar-93
200
Jan-93
94
Nov-92
300
Sep-92
96
Jul-92
400
May-92
98
Mar-92
500
Jan-92
100
Average maturity in days - right axis
Source: Mexican Ministry of Finance and Public Credit.
167
Jeffrey A. Frankel
the relationship between a countrys openness and whether it is prone to sudden

stops or currency crashes. The first view is that openness makes a country more vulnerable to sudden stops. A country highly integrated into world markets is more
exposed to shocks coming from abroad. The second view is that countries that are
open to international trade are less vulnerable to sudden stops. If the ratio of trade to
GDP is structurally high, it is easier to adjust to a cutoff in international financing of
a given magnitude. I will describe a new test of the relationship between trade openness and vulnerability to sudden stops to help choose between the two hypotheses.
Such tests have been done before, but usually without taking into account the possible endogeneity of trade. The incremental contribution here is to use the gravity
instrument for trade opennesswhich aggregates geographically determined
bilateral trade across a countrys partnersto correct for the possible endogeneity
of trade.
The view that trade openness makes countries more vulnerable to crises comes
in a number of forms. One variant is that a weakening in a countrys export markets is sometimes the trigger for a sudden stop in capital flows, so that a high-trade
country is more vulnerable. Another variant notes that sudden stops in finance
often extend to a loss in trade creditespecially for imports, but sometimes even
for exportsand that the resulting shrinkage in trade is more painful if trade was
a larger share of the economy to begin with. A third variant says that financial
openness raises vulnerability to sudden stops, and openness to trade in practice
goes hand in hand with openness to financial flows.31 In the limiting case, a country that is in autarky with respect to trade must have a net capital account of zero
owing to the balance of payments adding-up constraint. Regardless of the specific
reasoning, the notion that globalization leads to crises is a generalization that
appeals to many.
The view that openness to trade makes countries less vulnerable also comes
with a number of different specific mechanisms that have been proposed. Eaton
and Gersovitz (1981) and Rose (2002) argue that the threatened penalty of lost
trade is precisely the answer to the riddle, Why do countries so seldom default on
their international debts? Strong trade links are statistically correlated with low
default probabilities. International investors will be less likely to pull out of a country with a high trade-to-GDP ratio, because they know the country is less likely to
default. A higher ratio of trade is a form of giving hostages that makes a lending
cutoff less likely.
Another variant of the argument that openness reduces vulnerability takes as the
relevant penalty in a crisis the domestic cost of adjustment, that is, the difficulty of
eliminating a newly unfinanceable trade deficit. The argument goes back at least to
Sachs (1985, p. 548). He suggested that Asian countries were less vulnerable to dislocations than Latin American countries in the international debt crisis of the
1980sdespite similar debt-to-GDP ratiosbecause they had higher export-toGDP ratios. The relatively worse preformance observed in Latin America was due
31 For example, because much trade needs multinational corporations, which in turn need to be able to
move money across national borders, or because it is harder to enforce capital controls if trade is free.
Aizenman (2003); and Aizenman and Noy (2004).
168
to the lower availability of export revenue to service debt. More recently, Guidotti,
Sturzenegger, and Villar (2004) make a similar point by providing evidence that
economies that trade more recover fairly quickly from the output contraction that usually comes with the sudden stop, while countries that are more closed suffer sharper
output contraction and a slower recovery.
Consider first a country that faces a given cutoff in financing and must adjust
without nominal or real exchange rate flexibility. The adjustment must then come
through a reduction in spending. To achieve a $1 billion improvement in the trade
balance, the contraction has to be $ (1/m) billion, where m is defined as the marginal
propensity to import (in a Keynesian model) or the share of spending that falls on
tradable goods (in a tradable/nontradable model). The lower m is, the more painful
the adjustment. Whether output itself falls depends, of course, primarily on whether
wages and prices are flexible. But even in a full-employment world, sharp reductions in consumption are not enjoyable.
Consider, second, a country that does have the option of nominal and real
exchange rate flexibility. In traditional textbook models, if the adjustment is achieved
in part through nominal and real depreciation, rather than exclusively through expenditure reduction, the country can accommodate the tougher new financing constraint
without necessarily suffering a recession. This is true even if a relatively large devaluation is required to generate the necessary improvement in the trade balance. But
since the emerging market crises of 199498, as we have already noted, economists
have increasingly emphasized the contractionary balance sheet effect: if a countrys
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 need not be large. 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 be large. Again we arrive at the result that
whether the necessary adjustment will be large and painful depends inversely on
openness.
The balance sheet version of the openness story is modeled formally by Calvo,
Izquierdo, and Talvi (2003) and Cavallo (2004). Both have in mind the example of
Argentina, which has traditionally had a low ratio of trade to GDP and has suffered
some of the worst sudden stops.32 But the hypothesis that openness to trade reduces
a countrys vulnerability to sudden stops transcends any one formal model, causal
link, or country example. The same is true of the opposing hypothesis, that openness
raises a countrys vulnerability. It would be useful to be able to choose empirically
between the two competing hypotheses.
I will report new resultsfrom Cavallo and Frankel (2004)for two questions.
(1) What is the effect of openness on vulnerability to sudden stops implemented by
a probit model measuring the probability of a sudden reduction in the magnitude of
32 Others who have argued that Argentinas low trade-to-GDP ratio helps explain why it was such a
victim of the global sudden stop after 1999 include Calvo, Izquierdo, and Meja (2004); Calvo and Talvi
(2004); Desai and Mitra (2004); and Treasury Secretary Paul ONeill, who once reportedly said it was
unsurprising the Argentines had lost the confidence of investors, because they dont export anything.
169
Jeffrey A. Frankel
net capital inflows, following closely the definition of Calvo, Izquierdo, and Meja
(2004)?33 (2) What is the effect of openness on vulnerability to currency crises,
implemented by a probit model representing the probability of a sudden increase in
exchange market pressure, which is in turn defined as the percentage depreciation
plus percentage loss in foreign exchange reserves? In addition to analyzing the
probit model of this exchange market pressure definition of a currency crisis, as in
Frankel and Wei (2005), we also looked at the output loss subsequent to a crisis.
There is no reason, a priori, why something (openness) that makes the consequences of sudden stops better (less contractionary devaluations) should also necessarily make them less frequent, or that something that makes the consequences
worse should also make them more frequent. Indeed, some theories are based on
the notion that the worse the consequences, the less often it will happen. But in
our results the effects turn out to go the same way, regardless of which concept of
performance is used.
Calvo, Izquierdo, and Meja (2004) and Edwards (2004a and b) are among the
empirical papers that find that openness to trade is associated with fewer sudden
stops. On the other hand, Milesi-Ferretti and Razin (1998 and 2000) find that openness helps trigger crises and/or sharp reversals of the current account. Most of these
papers use the trade-to-GDP ratio as the measure for openness to trade.
A critic might argue that the trade-to-GDP ratio is endogenous. One way in
which trade openness could be endogenous is via income: countries tend to liberalize trade barriers as they grow richerin part because their mode of public finance
gradually shifts from tariff revenue to income taxes or Value Added Tax (VAT). A
second way is that trade liberalization could be part of a more general reform strategy driven by a proglobalization philosophy or Washington Consensus forces.
Other aspects of such a reform program, such as privatization, financial liberalization, or macroeconomic stabilization might affect the probability of crises, and yet
an Ordinary Least Squares regression analysis (OLS) might inappropriately attribute
the effect to trade. A third way that trade openness could be endogenous is that experience with crisesthe dependent variablemay itself cause liberalization, via an
IMF program. Or it might have the opposite effect, if a countrys response to a crash
is disenchantment with globalization and the Washington Consensus. A fourth way
in which trade openness could be endogenous is through the feedback between trade
and financial openness.
How can the endogeneity of trade be addressed? We use gravity estimates to
construct an instrumental variable for trade openness, a methodology developed
by Frankel and Romer (1999), in the context of the effect of trade on growth, and
updated in the Frankel and Rose (2002) data set.
The results reported in Table 2 show that openness reduces vulnerability to sudden stops rather than increasing it.34 Not only does this relationship hold up when
we move from OLS to instrumental variables, but it appears stronger. The degree of
trade openness is a powerful predictor of these capital account shocks: moving from
33 To the best of my knowledge, the increasingly popular expression Sudden Stops was first used by
Dornbusch, Goldfajn and Valdes (1995). The first analytic approach to the problem of sudden stops is
Calvo (1998).
34 A more complete set of results is reported in Cavallo and Frankel (2004).
170
Table 2.
Effect of Openness (Trade/GDP) on Vulnerability

to Sudden Stops and Currency Crashes
To Predict Sudden Stops1
Ordinary probit
Trade opennesst
Foreign debt/GDPt1
Liability dollarizationt1
IV
20.53
(0.259)**
20.080
(0.217)
0.316
(0.195)
22.45
(0.813)**
0.196
(0.275)
0.591
(0.256)**
24.068
(1.297)**
27.386
(2.06)***
22.544
(0.63)***
778
21.73
(0.723)**
1,062
Exchange rate rigidity

CA/GDPt1
ln reserves in months
of importst1
Constant
Number of Observations
To Predict Currency Crashes2

Ordinary probit
IV
20.57
(0.269)**
0.23
(0.231)
0.027
(0.249)
0.13
(0.094)
20.272
(1.392)
20.26
(0.082)***
20.99
(0.749)
557
21.73
(0.918)*
0.59
(0.373)
0.18
(0.234)
0.22
(0.113)*
0.66
(1.455)
20.37
(0.099)***
0.304
(0.786)
841
Source: Cavallo and Frankel (2004)

Notes: Robust standard errors reported in parentheses. *** = statistically significant at 1 percent.
** = statistically significant at 5 percent. * = statistically significant at 10 percent. Estimation performed with regional dummies and year fixed effects. IV is the gravity-based instrumental variable
for trade openness from Frankel and Romer (1999) and Frankel and Rose (2002).
1Calvo, Izquierdo, and Talvi (2003), definition.
2Frankel and Wei (2005), definition.
Argentinas current trade share (approximately .20 of GDP) to Australias average

trade share (approximately .30 of GDP) reduces the probability of a sudden stop by
32 percent. The results for openness are the same when we seek to explain currency
crashes. Trade protectionism does not shield countries from the volatility of world
markets, as proponents might hope. On the contrary, less trade openness leads to
greater vulnerability to sudden stops and currency crashes. In fact, out of the set of
controls we tried, openness is the only variable that is virtually always statistically
significant.35
V. Conclusion
There are thus at least two ways of seeking to minimize vulnerability to sudden
stops, devaluations, and associated economic contractions: keeping the economy
open to trade and keeping balance sheets strong by avoiding a shift to short-term dollar debt as a means of procrastination. This lecture began by noting the frequency
35 The current account deficit as a share of GDP is always highly significant in the probit regressions
to determine sudden stops, and liability dollarization sometimes is, but not in the currency crash equation.
The reserve-to-import ratio is always highly significant in the currency crash regression and sometimes
foreign debt-to-GDP and nominal exchange rate rigidity are as well, but not in the first equation.
171
Jeffrey A. Frankel
with which political leaders and ministers lose office after a devaluation. But seeking to hold on to political viability is presumably the precise reason governments
often procrastinate and feel they have to postpone adjustment to balance of payments deficits and instead run down reserves, shorten the maturity of the debt, and
borrow in dollars. So the openness strategy may be the most robust option in the
long run, politically as well as economically.
APPENDIX 1.
Currency Crashes and Frequency of Changes
of Policymakers in Developing Countries
There are 103 countries in the sample.
A. Change in Premier or Chief Executive: One-Year Horizon, 19702003
12-Month Period Following a Devaluation
All Other 12-Month Periods
51
(27.1 %)
137
(72.9%)
188
679
(20.5%)
2,635
(79.51%)
3,314
Change observed
No change observed
Total
P-value for the difference is 0.126.
Graph of number of episodes of devaluations and number of premier changes over time.
Developing CountriesSix-month period
Number of Currency Crash Episodes and Premier Changes Across the World
(19702003)
25
Premier change
Devaluation episode
20
15
10
Note: The correlation between the two series is 18.1 percent.
Note: The correlation between the two series is 18.1 percent.
172
1976
1975
2003
1977
1979
1978
1981
1980
1982
1984
1983
1986
1985
1988
1987
1989
1991
1990
1993
1992
1994
1996
1995
1998
1997
1999
2001
2000
2002
1971
1972
1970
1974
1973
B. Change in Premier or Chief Executive: One-Year Horizon, 19702003

Change observed
41
(29.1%)
100
(70.9%)
141
No change observed
Total
459
(21.4%)
1,683
(78.6%)
2,142
Note: Own turnoverThe reference set is only those developing countries that have experienced a currency crash at some point. P-value for the difference is 0.013.
C. Change in Premier or Chief Executive: Six-Month Horizon, 19702003

Change observed
36
(19.05 %)
153
(81.0%)
189
No change observed
Total
812
(11.6%)
6,192
(88.4%)
7,004
Note: P-value for the difference is 0.004; t-statistic is 2.71.
D. Change in Premier or Chief Executive: Six-Month Horizon, 19702003

6-Months Period Following a Devaluation
31
(22.0%)
110
(78.0%)
141
492
(11.5 %)
3,792
(88.5%)
4,284
Change observed
No change observed
Total
Note: Own turnoverreference set is only for those developing countries which have experienced currency crash at some point. P-value for the difference is 0.002.
E. Change in Finance Minister or Central Bank Governor: One-Year Horizon.
Change of Governor observed

No change of Governor observed
(41.7%)
Total
When a Devaluation Occurred
All Years
14
(58.3%)
10
(64.1%)
24
212
(35.8%)
380
592
Note: The data pertain to the IMF Board of Governors membership from 19951999, inclusive.
The probability of the IMF governor of a country changing is 1.63 times larger when there was a currency crash. T-statistic is 3.56. P-value is 0.001.
173
Jeffrey A. Frankel
F. One-Year Horizon, Change in Premier or Chief Executive by Income Level

(1) Rich Countries
1-Year Period Following a Devaluation
All Other 1-Year Periods
0
()
0
()
0
212
(28.3%)
536
(71.7%)
748
Change observed
No change observed
Total
(2) Middle-Income Countries
Change observed
No change observed
Total
29
(29.3%)
70
(70.7%)
99
508
(20.2%)
2,012
(79.8%)
2,520
Note: P-value for the difference is 0.342.
(3) Poor Countries

Change observed
No change observed
Total
22
(24.4%)
68
(75.6%)
90

171
(16.8%)
845
(83.2%)
1,016
G. Six-Month Horizon, Change in Premier or Chief Executive by Income Level

(1) Rich Countries
Change observed
No change observed
Total
174
0
()
0
()
0
235
(15.7%)
1,261
(84.3%)
1,496
(2) Middle-Income Countries

22
(22.2%)
77
(77.8%)
99
581
(11.5%)
4,459
(88.5%)
5,040
Change observed
No change observed
Total
(3) Poor Countries

14
(15.6%)
76
(84.4%)
90
195
(9.6%)
1,837
(90.4%)
2,032
Change observed
No change observed
Total
H. Changes in Leadership According to Political System

(1) One-Year Horizon, Change in Premier or Chief Executive by Income Level
and Political System
Low-Income
Countries
Presidential
Parliamentary
Nondemocracy
All
Developing
Countries
Job losses
(job losses/
devaluations)
Devaluations
Job losses
(job losses/
devaluations)
Devaluations
Job losses
(job losses/
devaluations)
Devaluations
Job losses
(job losses/
devaluations)
Devaluations
11
Middle-Income
Countries
23
All Developing
Countries
34
(31.4%)
35
0
(38.3%)
60
3
(35.8%)
95
3
(0.0%)
2
10
(15.8%)
19
4
(14.3%)
21
14
(18.9%)
53
21
(20.0%)
20
30
(19.2%)
73
51
(23.3%)
90
(30.3%)
99
(27.0%)
189
175
Jeffrey A. Frankel
(2) Six-Month Horizon, Change in Premier or Chief Executive by Income Level

and Political System
Low-Income
Countries
Presidential
Parliamentary
Nondemocracy
All
Developing
Countries
Job losses
(job losses/
devaluations)
Devaluations
Job losses
(job losses/
devaluations)
Devaluations
Job losses
(job losses/
devaluations)
Devaluations
Job Losses
(job losses/
devaluations)
Devaluations
Middle-Income
Countries
All Developing
Countries
18
25
(20.0%)
35
0
(30.0%)
60
1
(26.3%)
95
1
(0.0%)
2
7
(5.3%)
19
3
(4.8%)
21
10
(13.2%)
53
14
(15.0%)
20
22
(13.7%)
73
36
(15.6%)
90
(22.2%)
99
(19.0%)
189
I. Change In Premier, Controlling for Start of an IMF Program

(Within 3 Months on Either Side of a Currency Crash)
This table summarizes the statistics of devaluations, job loss, and IMF programs in the 1990s
and 2000s.
Cases with an IMF

program
Cases without an IMF
program
Total
Premier Change Occurred

Within 6 Months
Premier Change Did Not

Occur Within 6 Months
4
(21.05%)
(20.00%)
16
(21.92%)
(80.00%)
20
15
(78.95%)
(20.83%)
57
(78.08%)
(79.17%)
72
Total
19
73
92
The t-test below compares the probability that devaluation leads to a premier change within six
months when there is an IMF program (21 percent) with the probability of a premier change
occurring within six months (in general). The P-value is much larger, at 20 percent.
Ha: diff < 0
t = 0.8781
P < t = 0.196
176
Ha: diff = 0
t = 0.8781
P > )t) = 0.391
Ha: diff > 0

t = 0.8781
P > t = 0.804
Comparing IMF and non-IMF devaluation cases, and the probability with which each leads to
a change of leader within six months, shows that there is no significant difference between the
two groups.
Ha: diff < 0
t = 0.0803
P < t = 0.532
Ha: diff= 0
t = 0.0803
P > )t) = 0.937
Ha: diff > 0

t = 0.0803
P > t = 0.468
When comparing the probability that devaluation without an IMF program leads to a change of
leader within six months with the probability of premier change occurring within six months
under normal circumstances, we find the former is significantly higher than the latter.
Ha: diff < 0
t = 1.901
P < t = 0.031
Ha: diff = 0
t = 1.901
P > )t) = 0.061
Ha: diff > 0

t = 1.901
P > t = 0.969
177
178
3/10/2000
6/28/1995
11/17/1995
12/20/1996
9/12/1995
1/29/1992
12/2/1998
9/14/2001
3/15/1991
4/17/1992
4/11/1994
7/19/1996
4/11/1997
9/25/1998
12/20/1991
Stand-By
Stand-By
EFF
Stand-By
EFF
Stand-By
EFF
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Albania
Algeria
Algeria
Algeria
Argentina
Argentina
Argentina
Argentina
Argentina
Armenia
Azerbaijan
Azerbaijan
Belarus
Brazil
Brazil
Brazil
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Cameroon
4/12/1996
2/4/1998
6/3/1991
5/27/1994
5/22/1995
7/29/1991
3/31/1992
8/26/1992
Stand-By
Country
Begin
Date
Program
Type
371.9
627.62
28
10585.5
43.88
58.5
58.5
196.28
1500
10419.84
2193
279
155
139.48
400
720
2080
300
457.2
1,169.28
780
4020.25
20
Commitment
Amount
(Millions SDRs)
371.9
523
8
3834.3
13.5
58.5
53.24
50
127.5
7869.15
0
279
124
116.24
80
613
0
225
385.2
1,169.28
292.5
4020.25
13.12
Drawn Amount
(Millions SDRs)
Comments
Followed by another stand-by on 4/17/1992.

Approved after expiration of 3/15/1991 stand-by.
Approved amount increased in 9/1994.
Cancelled prior to expiration date of 3/18/1998.
Replaced by another stand-by on 4/11/1997.
Replaced the 6/19/1996 stand-by.
Amounts exclude SRF drawing of SDR 2.6 billion.
Extended from 12/19/1999 to 3/19/2000.
At time of approval, purchase schedule decided

through 11/1998.

Extended from 3/30/1995 to 4/30/1995 and then
to 3/30/1996. Approved amount increased.
Cancelled.

Replaced by ESAF on 7/14/1993.
IMF Country Programs, with Dates of Approval
APPENDIX 2.
Jeffrey A. Frankel
3/23/1994
12/20/1999
8/27/1990
5/27/1994
4/8/1991
4/19/1993
11/29/1995
9/20/1991
10/14/1994
3/12/1997
3/19/2001
3/17/1993
1/7/1991
4/3/1992
8/28/1991
7/9/1993
12/11/1991
5/11/1994
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Czechoslovakia
Dominican
Republic
Dominican
Republic
Ecuador
Ecuador
Ecuador
Egypt
Egypt
Egypt
El Salvador
El Salvador
4/19/2000
5/17/1991
9/20/1993
10/11/1996
8/27/1990
1/6/1992
3/14/1994
9/27/1995
3/28/1994
Stand-By
Stand-By
Stand-By
Cameroon
Cameroon
Central African
Republic
Chad
Colombia
Congo, Rep of
Congo, Rep of
Costa Rica
Costa Rica
Costa Rica
Cte DIvoire
Croatia
Croatia
Croatia
Czech Republic
Czechoslovakia
226.73
234.4
400
271.4
35.6
41.5
75
173.9
31.8
39.24
236
16.52
1957
27.98
23.16
33.64
21.04
52
82.75
65.4
353.16
200
177
619.5
81.06
67.6
16.48
113.35
147.2
0
0
0
0
18.56
98.9
16.8
39.24
36
10.32
0
4
12.5
25.64
0
0
33.1
13.08
28.78
0
70
619.5
21.91
28.2
10.71

(continued)
Precautionary arrangement.
Extended from 11/30/1992.
Approved amount increased in 11/1994.

Extended from 3/6/1992. Followed by another

stand-by on 4/3/1992.
Cancelled prior to expiration date 4/2/1993.
(Czechoslovakia ceased to exist on 1/1/1993.)

179
180
Program
Type
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Country
El Salvador
El Salvador
El Salvador
El Salvador
Estonia
Estonia
Estonia
Estonia
Estonia
Estonia
Gabon
Gabon
Gabon
Gabon
Georgia
Guatemala
Haiti
Honduras
Hungary
Hungary
Hungary
Hungary
India
India
7/29/1996
12/17/1997
3/1/2000
9/30/1991
3/30/1994
11/8/1995
10/23/2000
6/28/1995
12/18/1992
3/8/1995
7/27/1990
3/14/1990
2/20/1991
9/15/1993
3/15/1996
1/18/1991
10/31/1991
4/11/1995
7/21/1995
2/28/1997
9/23/1998
9/16/1992
10/27/1993
5/10/1993
Begin
Date
13.95
16.1
29.34
28
38.6
110.3
92.58
72.15
54
20
30.5
159.21
1114
340
264.18
551.93
1656
13.95
37.68
37.68
37.68
27.9
11.63
47.11
Commitment
Amount
(Millions SDRs)
0
0
0
4
38.6
60.67
13.22
22.2
0
16.4
30.5
127.37
557.23
56.7
0
551.93
1656
0
0
0
27.9
11.63
Drawn Amount
(Millions SDRs)
APPENDIX 2. (continued)

Extended from 11/7/1998 to 3/7/1999.


Extended from 3/9/1994. Amount increased 11/1994.
Comments
Jeffrey A. Frankel
0
0
27.45
30
6/5/1995
7/17/1996
12/13/1999
12/4/1997
5/12/1993
9/14/1992
12/15/1993
4/21/1995
5/24/1996
EFF
EFF
Stand-By
Stand-By
EFF
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Jordan
Jordan
Kazakhstan
Kazakhstan
Kazakhstan
Kazakhstan
Korea
Kyrgyz
Republic
Latvia
Latvia
Latvia
Latvia
2/9/1996
4/15/1999
1/26/1994
2/4/2000
3/23/1990
6/28/1991
12/11/1992
2/26/1992
5/25/1994
54.9
22.88
185.6
309.4
329.1
15500
27.09
238.04
127.88
123.75
3638
82
43.65
109.13
44.4
189.3
54.9
9.15
185.6
154.7
0
14412.5
11.61
202.52
36.54
74.25
851.15
82
43.65
86.75
44.4
130.32
3797.7
EFF
Stand-By
Stand-By
EFF
Stand-By
EFF
5383.1
Indonesia
Jamaica
Jamaica
Jamaica
Jordan
Jordan
8/25/1998
3669.12
EFF
8338.24
Indonesia
11/5/1997
Stand-By
Indonesia

Approved after expiration of 4/21/1995.
(continued)
Approved under IMFs emergency procedures.


Extended from 12/10/1995 to 2/24/1996 and 3/16/1996.
Approved amount increased in 9/1994 and 2/1995.
Replaced by another EFF 2/9/1996.
Approved amount increased from 200.8 in 2/1997.
Approved under IMFs emergency procedures.

Access increased 7/15/1998. Cancelled prior to
expiration date of 11/4/2000.
Prior SBA cancelled, replaced by EFF.
EFF to cover remaining period of SBA.
Cancelled before expiration date of 11/5/2000,
replaced by EFF on 2/4/2000.
181
182
Program
Type
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Country
Latvia
Latvia
Latvia
Lesotho
Lesotho
Lesotho
Lithuania
Lithuania
Lithuania
Lithuania
Lithuania
Macedonia, FYR
Macedonia, FYR
Malawi
Mexico
Mexico
Moldova
Moldova
Moldova
Mongolia
Morocco
Morocco
Nicaragua
Niger
7/7/1999
12/17/1993
3/22/1995
5/20/1996
10/4/1991
7/20/1990
1/31/1992
9/18/1991
3/4/1994
10/24/1994
3/8/2000
8/30/2001
5/5/1995
11/29/2000
11/16/1994
2/1/1995
9/23/1996
10/21/1992
10/22/1993
10/10/1997
12/10/1999
4/20/2001
9/23/1994
7/31/1995
Begin
Date
3103
51.75
58.5
135
22.5
100
91.98
40.86
18.6
134.55
61.8
86.52
22.3
24.115
15
12070.2
7.17
56.93
25.88
33
33
33
8.37
7.17
Commitment
Amount
(Millions SDRs)
1939.5
51.75
32.4
87.5
13.75
48
18.4
17.03
11.1
134.55
0
0
22.3
1.15
12.72
8758.02
0
56.93
5.18
0
0
0
0
0
Drawn Amount
(Millions SDRs)
APPENDIX 2. (continued)

Extended from 8/15/1996. Initial amount

approved 2/1/1995 and increased 6/30/1995.

Cancelled. Replaced by another stand-by on 7/31/1995.
Comments
Jeffrey A. Frankel
791.2
545.66
300.2
383
128
334.2
791.2
1020.79
7/1/1996
6/24/1999
3/12/2001
2/20/1991
6/24/1994
4/1/1998
2/5/1990
EFF
Stand-By
Stand-By
Stand-By
EFF
Stand-By
EFF
EFF
EFF
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Pakistan
Pakistan
Panama
Panama
Panama
Panama
Peru
Peru
Peru
Peru
Philippines
Philippines
Philippines
Poland
11/29/1995
12/10/1997
6/30/2000
3/18/1993
10/20/1997
11/29/2000
2/24/1992
12/13/1995
545
84.3
120
64
1018
454.92
465
74.17
562.59
357.5
160.5
0
0
334.2
84.3
40
0
642.69
113.74
150
54.57
294.69
123.2
Stand-By
379.1
Pakistan
2/22/1994
0
0
88
EFF
319
788.94
265.4
Pakistan
1/9/1991
8/4/2000
9/16/1993
Stand-By
Stand-By
Stand-By
Nigeria
Nigeria
Pakistan
(continued)
This arrangement followed by

another EFF on 7/1/1996.
Approved amount increased.
Extended from 8/19/1992 to 12/31/1992 and 3/31/1993.
Amount includes augmentation of 70.
Arrangement extended from 6/23/97 to
7/23/1997, 12/31/1997, and 3/31/1998.
Access increased 7/18/1997.
Approved after expiration of 6/24/1994 EFF.
Extended from 3/31/2000 to 6/30/2000.
Then extended to 12/31/2000.
Extended from 12/23/1993. Amount decreased

from 93.68 in 12/1993.
Approved amount increased from 69.8.
Cancelled prior to expiration date 9/15/1994.

Replaced by an EFF/ESAF in 2/1994.
EFF and parallel ESAF replaced by a
stand-by approved by IMF Board 12/13/1995.
Three purchases made under EFF.
Cancelled on 12/13/1995 prior to expiration.
Amount increased 12/17/1996.
This EFF approved along with an ESAF.
183
184
8/5/1992
4/11/1995
3/26/1996
7/28/1999
3/2/1994
7/22/1994
4/20/2001
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Poland
Poland
Poland
Romania
Romania
Romania
Romania
Romania
Russian
Federation
Russian
Federation
Russian
Federation
Russian
Federation
Senegal
Slovak
Republic
Sri Lanka
4/22/1997
8/5/1999
4/11/1991
5/29/1992
5/11/1994
4/18/1991
3/8/1993
8/5/1994
EFF
Stand-By
Stand-By
Country
Begin
Date
Program
Type
200
47.56
115.8
3300
13206.57
4313.1
719
301.5
400
380.5
314.04
320.5
1224
476
333.3
Commitment
Amount
(Millions SDRs)
103.35
30.91
32.15
471.43
5779.71
4313.1
719
120.6
139.75
318.1
261.7
94.27
76.5
357
283.3
Drawn Amount
(Millions SDRs)
APPENDIX 2. (concluded)
Arrangement terminated on 3/26/1999 prior to

3/25/2000 end date.

Approved amount increased in 10/1994,
then decreased to 333.3 in 9/1995.
Extended from 12/10/1995 and cancelled
prior to expiration date of 4/24/1997.
Replaced by another stand-by on 4/22/1997.
Replaced the 5/11/1994 stand-by.
Extended from 3/31/2000 to 5/31/2000.
Then extended to 2/28/2001.
Comments
Jeffrey A. Frankel
7/8/1994
12/22/1999
4/7/1995
5/10/1996
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
Stand-By
EFF
EFF
Stand-By
Stand-By
Ukraine
Ukraine
Uruguay
Uruguay
Uruguay
Uruguay
Uruguay
Uruguay
Venezuela
Vietnam
Zimbabwe
Zimbabwe
Zimbabwe
Zimbabwe
1/24/1992
9/11/1992
6/1/1998
8/2/1999
10/6/1993
12/12/1990
7/1/1992
3/1/1996
6/20/1997
3/29/1999
5/31/2000
7/12/1996
8/25/1997
9/4/1998
5/8/1996
8/20/1997
4/20/1990
Stand-By
Stand-By
Stand-By
Tajikistan
Thailand
Trinidad and
Tobago
Turkey
Turkey
Ukraine
Ukraine
340.8
114.6
130.65
141.36
145
94.8
50
100
125
70
150
975.65
398.92
1919.95
610.5
8676
997.3
598.2
15
2900
85
71.2
86.9
39.2
24.74
108.8
9
15.97
0
114.2
0
0
350
181.33
712.15
460.5
2843.8
538.65
598.2
15
2500
85

Only one purchase made as BOP position
strengthened, creating pressure on
public spending and sending program off track.
Cancelled prior to extended date 12/31/1994
(original date was 10/5/1994).
EFF cancelled prior expiration date 1/23/1995.
Approved amount increased 5/27/1999.

Arrangement extended to 8/15/2002.

Extended from 9/7/1995. Amount increased 4/1995.
185
APPENDIX 3.
One-Year Horizon
In a sample of currency crashes, chief executives were 1.7 times as likely to lose their jobs over
the subsequent 12 months if their government had said it would not devalue (23) than if it had
not said so ( 718).
A. Promises by Premiers, Finance Ministers, Central Bank (CB) Governors
(1) Summary Table
Promise
No Promise
Total
Changes
in Premier
No Changes
in Premier
4
7
11
2
11
13
Frequency of Change
in Premier
2/3
7/18
Total
Case Studies
6
18
24
(2) Background Table 1 (Changes in Premier)

Month of
Devaluation
Date of
Premier Change
Presence of Promise
(by whom)
Newspaper
(date of report)
Argentina
Argentina
Argentina
Argentina
Korea
Mexico
Mexico
03/75
04/81
04/89
01/02
12/97
09/76
02/82
03/24/75
12/11/81
07/08/89
01/02/02
02/25/98
12/01/76
12/01/82
Lebanon
Sierra Leone
Venezuela
Syrian Arab
Republic
08/90
08/97
02/02
01/88
12/24/90
03/10/98
04/13/02
11/01/ 88
No
No
Yes (CB governor)
Yes (premier)
No
No
Yes (premier and
CB governor)
No
No
Yes (CB governor)
No
La Prensa
La Prensa
La Prensa (03/31/89)1
La Prensa (12/27/01)2
Maeil Business Daily
El Excelsior
El Universal
(02/06/82)3
Al Hayat
Sierra Leone News
El Diario (02/08/02)4
Al Baath
Country
1Central Bank Governor Jose Machinea denied yesterday that modifications to the exchange
rate markets are under study and announced a monetary policy tightening through a strong increase
in the interest rates in order to stop the increase of the dollar.
2We dont want to be slaves, said the president [Alberto Rodriguez Saa] during an effusive
speech at the CGT. There he made transcendental announcements that there will be neither devaluation nor dollarization; and that there will be a new third currency, the argentinian, backed by the
governmental real estate.
3In a vibrant announcement the president [Jose Lopez Portillo] pointed out the most important
aspects of the strategy to follow . . . The peso will keep floating and to compensate for its floating path
it has been set compensatory tariff and license system. Romero Kolbeck [Banco de Mexico director]
denied the rumor of a devaluation, the peso will keep floating . . . There is no chance for a devaluation for our currency and therefore the floating scheme will keep going, said Gustavo Romero
Kolbeck. If these rumors were true, that a devaluation is being structured then I wouldnt be here
right now, said a smiling Romero Kolbeck. The famous quotation that Lopez Portillo would defend
the peso like a dog was evidentially made in a State of the Union address in August 1981, a year
before the devaluation, and did not receive the newspaper attention contemporaneously that it did ex
post.
4Castellanos [president, Central Bank of Venezuela] claimed that the decision of the government to address the fiscal problem of the country and develop other public initiatives will allow the
186
(3) Background Table 2 (No Change in Premier)
Country
Month of
Devaluation
Date of
Premier Change
Presence of Promise
(by whom)
Newspaper
(date of report)
Chile
Chile
Chile
Kenya
Lebanon
Nigeria
Nigeria
Peru
Peru
Uganda
Uruguay
Uruguay
Zambia
07/71
03/75
07/85
04/93
01/85
10/86
03/92
06/76
12/87
06/81
03/72
11/82
10/85
09/11/73
03/11/90
03/11/90
12/30/02
06/01/87
08/26/93
08/26/93
07/28/80
07/28/90
07/27/85
07/13/76
02/12/85
11/02/91
No
No
No
Yes (finance minister)
No
No
No
No
Yes (finance minister)
No
No
No
No
El Mercurio
El Mercurio
El Mercurio
Daily Nation (03/23/93)1
Al Anwar
Daily Times
Daily Times
El Comercio
El Comercio (11/27/87)2
Uganda Times
El Dia
El Dia
Zambia Daily Mail
1The Kenyan government went back to forex control. It rejected all IMF rules; Finance Minister
Musalia Mudavadi said that Kenyan economy could no longer absorb further devaluation of the
shilling. [Nonetheless, devaluation occurred on April 21].
2Saberbein [minister of the economy and finance] said that the devaluation would be progressive next year. The exchange rate or the price of dollar would move along with wholesale prices during the next year as a clear export-supporting policy, for the aim is keep growing fostering external
sector. [Despite Saberbeins statement the devaluation actually took place December 15].
B. Promises by Premiers
Summary Table
Promise
No Promise
Total
Changes
in Premier
No Changes
in Premier
Frequency of Change
in Premier
Total
Case Studies
2
9
11
0
13
13
2/2
9/22
2
22
24
187
Jeffrey A. Frankel
APPENDIX 4.
Half-Year Horizon
In a sample of currency crashes, chief executives were more than twice as likely to lose their
jobs over the subsequent six months if their government had said it would not devalue (12) as
if it had not said so (29).
A. Promises by Premiers, Finance Ministers, Central Bank Governors
Summary Table
Promise
No Promise
Total
Changes
in Premier
No Changes
in Premier
Frequency of Change
in Premier
Total
Case Studies
3
4
7
3
14
17
1/2
2/9
Changes
in Premier
No Changes
in Premier
Frequency of Change
in Premier
Total
Case Studies
1
6
7
1
16
17
1/2
6/22
2
22
24
6
18
24
B. Promises by Premiers
Summary Table
Promise
No Promise
Total
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IMF Staff Papers

Vol. 52, Number 2

Mundell-Fleming Lecture: Contractionary Currency

t is a great honor to give this fifth annual Mundell-Fleming lecture.

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

same as that in Frankel and Rose (1996).

We also tried segregating countries according to three kinds of political structure:

breakdown by income and democratic structure is given in Parts D, E, and F of Appendix 1.

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

A better explanation is that devaluation is politically costly to leaders, and so

is duplicitous or at least is ignorant of the speculative pressures he or she is up

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

Figure 1a. Attaining Internal and External Balance: Traditional Version

i (interest rate), or other expenditure-reducing policy

Krugman, Latin Americas Swan Song, at http://web.mit.edu/krugman/www/swansong.html.

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

i (interest rate), or other expenditure-reducing policy

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

to a sample of 11 industrialized countries. Otani, Shiratsuka, and Shirota (2003)

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

Table 1. Determination of Pass-Through to Imported Goods Prices:

Source: Frankel, Parsley, and Wei (2005).

Figure 2. Pass-Through and Income, Average 19902001

One might wonder if this estimated decline in the pass-through coefficient

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

Figure 3. Exchange Rate Pass-Through to Domestic Prices

dominated in terms of attention from researchers, appropriately so. Domestic banks

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

Shifts on the Balance Sheet During the Procrastination Phase

Broner, Lorenzoni, and Schmukler (2004).

In billions of U.S. dollars

3-month moving average

Source: IMF, International Financial Statistics.

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

Figure 5. Evolution of Mexican Debt According to Currency

Tesobonos/total domestic debt

Source: Mexican Ministry of Finance and Public Credit.

Figure 6. Evolution of Mexican Debt According to Maturity, 199295

Percent long term/(long + short) - left axis

Average maturity in days - right axis

Source: Mexican Ministry of Finance and Public Credit.

the relationship between a countrys openness and whether it is prone to sudden

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

Effect of Openness (Trade/GDP) on Vulnerability

Exchange rate rigidity

To Predict Currency Crashes2

Source: Cavallo and Frankel (2004)

Argentinas current trade share (approximately .20 of GDP) to Australias average

All Other 12-Month Periods

Note: The correlation between the two series is 18.1 percent.

Note: The correlation between the two series is 18.1 percent.

CONTRACTIONARY CURRENCY CRASHES IN DEVELOPING COUNTRIES

B. Change in Premier or Chief Executive: One-Year Horizon, 19702003

All Other 12-Month Periods

C. Change in Premier or Chief Executive: Six-Month Horizon, 19702003

All Other 6-Month Periods

Note: P-value for the difference is 0.004; t-statistic is 2.71.

D. Change in Premier or Chief Executive: Six-Month Horizon, 19702003

All Other 6-Month Periods