Large Depreciation Research Articles

Wars as Large Depreciation Shocks

In this paper, we propose a theoretical framework to investigate the impact of conflicts and wars on key macroeconomic aggregates and welfare. Using a panel data with 9 countries from 1870 onwards, we first show that the consumption-to-output ratio is minimal during WWII for participants. While this can be explained by an increase in public spending in the USA, this can not be the case in other countries that participated in WWII, as they experience a large fall in output during wartime. To account for this, we build a variation of a Real Business Cycle model first proposed by Hercowitz and Sampson (1991). We extend the initial model to account for specific shocks that destroy private and public capital stocks -- as conflicts do -- by assuming an (exogenously) time-varying depreciation rate of the stock of capital. In addition, the model imbeds generalized TFP shocks capturing standard technological factors as well as the potential effects of war on the labor force. The model is estimated and used (i) to assess the importance of depreciation shocks during war episodes, and (ii) to quantify the welfare effects of conflicts. We show that depreciation shocks are crucial to account for the macroeconomic dynamics of countries that have experienced large war-related destruction, and that the welfare losses from fluctuations can be quite large when considering data samples that include major war episodes.

Monetary policy and the first- and second-moment exchange rate change during the global financial crisis: Evidence from Thailand

Using a sample of monetary policy announcements in Thailand over the period 2003–2011, I show that a monetary policy surprise tends to affect the return and volatility of the Thai baht. In the full sample, a 1% unexpected increase in the policy rate leads to an about 1.8% depreciation of the baht against the Japanese yen. During periods of high interest rate differentials, an unexpected increase in the policy rate leads to a substantial depreciation of the baht against the US dollar (about 1%) and the British pound (about 2.6%). While Thai monetary policy surprises have no effect on the baht against the dollar in the spot market, they have a significant effect on the baht against the dollar in the forwards market. During the non-financial crisis period, an unexpected increase in the policy rate on average results in a large depreciation of the baht/dollar forward rates: 6.6% and 13.7% for two-month and three-month forward rates, respectively.

Monetary Policy Announcements and Exchange Rate Movements in and Emerging Market Country in Asia

Using a sample of monetary policy announcements in Thailand over the period 2003–2011, I show that a monetary policy surprise tends to affect the return and volatility of the Thai baht. In the full sample, a 1% unexpected increase in the policy rate leads to an about 1.8% depreciation of the baht against the Japanese yen. During periods of high interest rate differentials, an unexpected increase in the policy rate leads to a substantial depreciation of the baht against the US dollar (about 1%) and the British pound (about 2.6%). While Thai monetary policy surprises have no effect on the baht against the dollar in the spot market, they have a significant effect on the baht against the dollar in the forwards market. During the non-financial crisis period, an unexpected increase in the policy rate on average results in a large depreciation of the baht/dollar forward rates: 6.6% and 13.7% for two-month and three-month forward rates, respectively.

Housing Appreciation (Depreciation) and Owners’ Welfare: An Alternative View

Based on a lifetime consideration, previous research has extended Frank’s graphical model with borrowing, property taxes and moving costs to analyse the welfare effects of housing appreciation and depreciation, and has shown that appreciation can make homeowners worse off, but homeowners’ welfare cannot decrease with depreciation. The latter is counter-intuitive, especially for owners with a high portion of mortgage in a housing slump. Alternatively, this paper treats property tax as an annual taxation and measures mortgage loan as a portion of house value when it was purchased. It is shown that if a house owner adjusts his/her house size in response to a price change, then with a low mortgage loan (or no mortgage), the owner will be better off only when there is a large appreciation or depreciation, while he/she cannot be better off under depreciation if he/she bought that house largely via a mortgage loan.

PERSISTENT EFFECTS OF TRANSITORY EXCHANGE RATE SHOCKS ON FIRM DYNAMICS

Recent evidence demonstrates that exchange rate movements can affect firm survival and entry. However, there is little evidence on whether there are asymmetric effects of an appreciation versus depreciation. This article uses firm‐level data over a period of a large currency appreciation followed by a large depreciation to examine possible asymmetries in firm survival and entry resulting in the endurance of exchange rate effects. We find that when real currency appreciations precede depreciations, appreciations reduce firm entry rates to a greater degree than depreciations increase that rate; but appreciations reduce the probability of firm survival at a magnitude not significantly different from the increase in probability that results from a depreciation. Taken together, we find that a 10% reciprocal episode of exchange rate appreciation and depreciation will result in 1,647 (5.2%) fewer firms compared with a regime with no change in the exchange rate. These results are consistent with exchange rate hysteresis whereby a transitory exchange rate shock has a permanent effect. (JEL F1)

Fear of appreciation

In recent years, the term “fear of floating” has been used to describe exchange rate regimes that, while officially flexible, in practice intervene heavily to avoid sudden or large depreciations. However, the data reveals that in most cases (and increasingly so in the 2000s) intervention has been aimed at limiting appreciations rather than depreciations, often motivated by the neo-mercantilist view of a depreciated real exchange rate as protection for domestic industries. As a first step to address the broader question of whether this view delivers on its promise, we examine whether this “fear of appreciation” has a positive impact on growth performance in developing economies. We show that depreciated exchange rates indeed lead to higher growth, but that the effect, rather than through import substitution or export booms as argued by the mercantilist view, works largely through the deepening of domestic savings and capital accumulation.

Nominal and Real Exchange Rate Models in South Africa: How Robust are They?

This paper addresses difficulties in modelling exchange rates in South Africa. Real exchange rate models of earlier research seem to be sensitive to the sample period considered, alternative variable definition, data frequency and estimation methods. Alternative exchange rate models proposed in this paper including the stock-flow approach and variants of the monetary model are not fully robust to data frequency and alternative estimation periods, either. Nevertheless, adding openness to the stock-flow approach and augmenting the monetary model with share prices and the country risk premium improves significantly the fit of the models around the large (nominal and real) depreciation episodes of 2002 and 2008. Interestingly, real commodity prices do not help explain the large depreciations. While these models do a reasonably good job in-sample, their out-of-sample forecasting properties remain poor.

Exchange rate movements and foreign direct investment (FDI): Japanese investment in Asia, 1987–2008

The paper estimates the impact of exchange rate movements on foreign direct investment (FDI). By using the panel data of Japanese FDI flows to nine dynamic Asian economies during 1987–2008, the paper finds that (i) FDI declined with a depreciation of the yen against host country currencies; (ii) it increased with exchange rate volatility; and (iii) it was little affected by the Asian financial crisis, especially when disguised financial flows were removed from the data. A novel result concerns the negative response of FDI to the third moment of monthly exchange rate changes: the volume of FDI was smaller when the distribution was positively skewed (i.e., when the yen was biased towards relatively large depreciation shocks). If skewness proxies for expected mean-reverting changes, this supports the idea that source country investors care about the future stream of revenues and returns denominated in their own currency. These results are robust, with other standard control variables having statistically significant coefficients with expected signs.

The relationship between investment and large exchange rate depreciations in dollarized economies

We use a simple financial friction in an economy with high degree of liability dollarization – and currency mismatch – to show that the negative balance-sheet effect of an exchange rate depreciation may be observable only if the magnitude of the depreciation is large enough. This result justifies the difficulty to find strong empirical evidence for balance-sheet effects and suggests the convenience of including a “large depreciation” term in empirical analyses. We review some of the related empirical literature and provide some new evidence of this large depreciation effect.

Lessons from a collapse of a financial system

The paper draws lessons from the collapse of Iceland’s banking system in October 2008. The rapid expansion of the banking system following its privatization in the early 2000s is explained, as well as the inherent fragility due to the size of the banking system relative to the domestic economy and the central bank’s reserves, market manipulation enabling bank capital to expand rapidly and the weak and understaffed public institutions. Most of Iceland’s banking system was traditionally in state hands but was privatized and sold to politically favoured entities at the turn of the century, with laws and regulations subsequently changed to facilitate the expansion of the banking system. Political connections and the tacit support of the authorities enabled senior bank managers and key shareholders to extract significant private benefits while shifting risk to domestic and foreign taxpayers and foreign creditors. These problems were exacerbated by symptoms of what the paper terms the small country syndrome. The size of the banking sector made the central bank incapable of serving as the lender of last resort. The domestic supervisor, the central bank and the ministries in charge of economic affairs were understaffed and lacking in experience in how to manage a large financial sector. The rapid growth was also ultimately unsustainable due to high levels of leverage and a weak capital base due to both the rapid expansion of balance sheets and lending to finance investment in own shares. The episode demonstrates the importance of closely monitoring rapidly growing financial institutions and even possibly slowing growth when institutions are systemically important. One lesson to be drawn from the crisis relates to the role of politics in a financial crisis. The Icelandic authorities as a matter of policy encouraged the creation of an international banking centre. This involved the privatization and deregulation of the banking system, rules and regulations being relaxed and the neglect of financial supervision. Another lesson is that floating exchange rates can be hazardous in the presence of large capital flows. The central bank raised interest rates during the boom years in order to meet an inflation target. This created an interest rate differential with other countries that encourages a large volume of carry trades and incentivized domestic agents to borrow in foreign currency. Both conspired to create an asset price bubble, excessive currency appreciation and – counter-intuitively – high inflation. The result was that monetary policy as conducted was ineffective at curbing domestic demand. The eventual large depreciation of the currency made a large section of the economy insolvent. Finally, there are lessons about the European passport system in financial services and the common market. The Icelandic banks had the right to set up branches in the European Union by means of the passport on the explicit assumption that home regulators were exercising adequate controls. The collapse of the banks left the United Kingdom and the Netherlands with significant costs, demonstrating the inherent weakness in the passport when one member country can undercut the supervisory standards of other member countries. For the passport system to work, the home supervisor must be trustworthy. — Sigridur Benediktsdottir, Jon Danielsson and Gylfi Zoega

Informed Finance and Technological Conservatism*

This paper studies an economy in which firms can operate either a mature or a new technology and lenders acquire information on the productive assets of the borrowing firms that are eligible as collateral. We demonstrate that when contracts are imperfectly enforceable informed lenders offer inexpensive funding for the mature technology but may choose not to finance the new one, seeking to preserve the value of their information on the mature assets. Using firm-level data from Italy, we find that banks that establish long-term relationships with firms promote technological progress on average. However, we find that relationship banks inhibit innovations that entail a large depreciation of existing technology-specific information such as radical innovations. Copyright 2010, Oxford University Press.

Exchange Rate Risk Management: Evidence from East Asia

The recent East Asian financial crisis provides a natural experiment for investigating foreign exchange risk management by nonfinancial corporations. During this period, the financial crisis exposed local firms to large depreciations in exchange rates and reduced access to foreign capital. The authors explore the exchange rate hedging practices of firms that hedged exposure to foreign debt in eight East Asian countries between 1996 and 1998. They identify and characterize East Asian companies that used foreign currency derivatives, documenting differences in size, financial characteristics, and exposure to domestic and foreign debt. They investigate the factors improtant in the use of foreign currency derivatives. Unlike studies of US firms, they find limited support for existing theories of optimal hedging. Instead, they find that firms use foreign earnings as a substitute for hedging with derivatives. And they find evidence that firms engage inselectivehedging. They investigate the relative performance of hedgers during and after the crisis. They find no evidence that East Asian firms eliminated their foreign exchange exposure by using derivatives. Firms that used derivatives before the crisis performed just as poorly as nonhedgers during the crisis. After the crisis, firms that hedged performed somewhat better than nonhedgers, but this result appears to be explained by a larger post-crisis currency exposure for hedgers (an exchange rate risk premium), which had limited access to derivatives during this period.

Currency crises and foreign credit in emerging markets: Credit crunch or demand effect?

Currency crises of the past decade highlighted the importance of balance-sheet effects of large devaluations. Currency crisis literature identified a decline in credit as one of the channels through which such crises affect real economic activity. We find empirical evidence of the existence of this channel and quantify its extent and persistence: controlling for a host of fundamentals, we find a decline in foreign credit to emerging market private firms of about 25 percent in the first year following large depreciations. This decline is especially large in the first five months, is less pronounced in the second year, and disappears entirely by the third year. We show that only about a quarter of the initial decline in credit could be attributed to the “credit crunch,” while the rest of the decline is due to contracting demand. After six months, however, most of the credit decline could be attributed to supply effects.

Exchange rate and inflation dynamics in dollarized economies

We use a panel of a hundred-plus countries with differing degrees of dollarization to perform an empirical analysis of the effects on inflation of exchange rate depreciations. The results qualify the common view that countries with higher dollarization exhibit higher inflation pass-through. We show that large depreciations tend to generate a negative impact on the pass-through coefficient, this impact being more intense the higher the level of dollarization of the economy. We interpret this as evidence that, in highly dollarized economies, the classic inflationary effects of a real depreciation—higher internal demand and imported inflation—can be offset or diminished by both the larger financial costs and the balance-sheet effect, especially if the depreciation is “large”. Additionally, the exchange rate regime is shown to matter: countries with fixed exchange rates suffer more noticeably the balance-sheet effects of large depreciations.

The impact of real exchange rate movements on firm performance: A case study of Taiwanese manufacturing firms

Taiwan experienced large depreciations of its currency, the New Taiwan (NT) dollar, in the late 1990s. The largest real depreciation, 13 per cent, occurred during the East Asian Financial Crisis. Since Taiwan was subjected neither to the economic turmoil of the crisis itself nor to the subsequent reforms, its experience provides a good opportunity for studying the effects of exchange rate changes on firm performance. This paper empirically examines the exchange rate effects on firm exports, domestic sales, total sales, value-added and productivity, by using data on firms listed on the Taiwan Stock Exchange merged with customs trade data covering the period of 1992–2000. Our findings indicate that the real depreciation of the NT dollar led to an increase in exports, domestic sales, total sales, value-added, and productivity. In addition, we find that the productivity improvement induced by real currency depreciation may be a result of firm scale expansion.

Is China's Economic Growth Extraordinar or Mediocre? The Role of the Exchange Rate

AbstractResults derived from evaluations using different measures for China's economic growth are divergent, especially when the RMB exchange rate has experienced large depreciation. Focusing on the changes in the RMB exchange rate matching the demands of economic development, we offer some plausible explanations for the variations in the evaluation results. The significant gaps between different economic performance evaluation results before the mid‐1990s, and evidence from international comparisons of factor productivity indicate that the quality of economic growth in China is different from that of other economies. Evaluation of economic development should take into account both quantitative expansion and qualitative improvement. From this perspective, evaluation results indicate qualitative improvement in the Chinese economy after the mid‐1990s.

Depreciation and Impairment: A Tradeoff in a Stewardship Setting

This paper examines the relationship between depreciation and future impairment losses. This relationship exists, since impairment losses can only be recognized if the carrying amount of an asset exceeds a certain recoverable amount that can be defined in different ways. Sufficiently large depreciation charges in the beginning of the asset's useful life make it very unlikely that an impairment acutally occurs in future periods. In the context of a multi-period agency model with ex ante long-term investment, and ex post short-term effort incentives, we will show that this relationship causes a tradeoff during the useful life of the asset. In order to induce efficient investment decisions, the investment cost has to be allocated over future periods according to a specific depreciation schedule. However, those depreciation charges decrease the likelihood that impairment losses will occur in later periods. Therefore the information content of the performance measure will be decreased as well. We apply our result to impairment tests according to IFRS and US-GAAP, the accounting for goodwill, and accounting rules for similar problems.

Dealing sensibly with the threat of disruption in trade with China: the analytics of increased economic interdependence and accelerated technological innovation

There is now widespread concern in Washington over the large and growing U.S.-China trade deficit. This concern is premised on the view that the large trade deficit has reduced U.S. welfare by increasing unemployment and reducing wages. But these alleged negative effects cannot be seen. The average unemployment rate in 1999–2006 was 5 percent compared to 6 percent in 1991–1998; and the total compensation (in 2005 prices) of a full-time worker rose from $46,614 in 1991 to $50,523 in 1998 to $55,703 in 2005. The rise in average labor compensation (measured to include benefits) was not caused by a large income increase for high-skilled workers and a moderate income decline for low-skilled workers. The level of compensation for blue-collar workers also rose in the 1991–2006 period. The continued rise in US labor income in 1991–2006 might appear surprising because the post-1990 integration of the Soviet bloc, India and China into the international division of labor has doubled the number of workers participating in the world economy. Accelerated globalization was, however, not the only significant economic development during this period; accelerated technological innovations were perhaps even more significant in their economic effects. The latter development produced large productivity gains that enabled the US labor income to rise despite the greater competition from imports, continued relocation of production facilities to foreign countries, and increased immigration into the United States. The outcome from the accelerated pace of globalization and the increased pace of technological innovation is a more frequent turnover in jobs in the US, which translates into increased worker anxiety, and hence increased demand for protection. The optimum solution to the present trade tensions is a policy package that emphasizes multilateral actions. It is bad economics and bad politics to dwell only on just one region (China alone must change), and/or dwell on just one instrument (RMB appreciation alone). China should, in the short run, expand state expenditure to soak up excess savings with an emphasis on import-intensive investments; in the short run, accelerate import liberalisation beyond the commitments made in the negotiations for WTO membership; increase the rate of yuan appreciation to reduce the large depreciation against the Euro in 2006–2007, and speed up the appreciation if inflation rises; lower precautionary savings by providing public social insurance; and improve financial intermediation by replacing the monopoly state banking system with a predominantly domestic private banking system. The United States should quicken the reduction in fiscal imbalance; introduce tax incentives to raise the savings rate; and expand and improve trade adjustment programs and social safety nets, especially those that upgrade the skill of the younger workers. Most important in the face of rising protectionist sentiments around the world, the United States and China must work together to bring the Doha Round trade negotiations to a successful conclusion in order to prevent the WTO system from being eroded.

Crisis and Recovery: What We Have Learned from the South Korean Experience?*

This paper analyzes the process of recovery from the 1997 financial crisis in South Korea, and draws some lessons from it. The fast restoration of financial stability due to early closure of non‐viable financial institutions and quick resolution of non‐performing loans was critical for the speedy recovery of the South Korean economy. The swift adjustment in fiscal and monetary policies in addition to the large depreciation of real exchange rates also supported the fast recovery. Corporate and government bond markets played an important role in the financial restructuring and macroeconomic adjustment process. Structural reforms helped to alleviate the weaknesses in the corporate sector, particularly in chaebol groups. However, the fast recovery also generated unwelcome side‐effects. Because of aggressive fiscal expansion through government‐guaranteed bonds and public credit guarantee programs, sovereign liabilities increased greatly and transparency of the official fiscal stance deteriorated. Thanks to structural reform, corporate and financial sectors began to recognize the importance of micro risk management, but increased risk aversion contributed to the slowdown of corporate investment and, therefore, reduced long‐run growth perspective in South Korea. How to revive long‐term growth rates remains an important question in South Korea despite fast recovery from the crisis.

Predicting Sharp Depreciations in Industrial Country Exchange Rates

This paper considers the prediction of large depreciations (both nominal and real) in a panel of industrialized countries using a probit methodology. The current account balance/GDP ratio has a modest but statistically significant effect on the estimated probability of a large depreciation, and gives slight predictive power in an out-of-sample forecasting exercise. The CPI inflation rate also has a modest but statistically significant effect in predicting nominal depreciations and has slight predictive power, but this effect is not present for real exchange rates. The GDP growth rate occasionally has a significant effect. A higher current account balance (surplus) tends to reduce the probability of a sharp depreciation; a higher inflation rate tends to increase the probability of a sharp depreciation; and a higher GDP growth rate perhaps tends to reduce the probability of a sharp depreciation.