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1. GLOBAL FINANCIAL SHOCKS & NEWZEALAND’S ECONOMY arifanees.com - Information - Inspiration - Transformation 1

2. 2 The world can be a large and dangerous place for a small open economy like New Zealand in the face of global shocks. At present we are coming out of just this type of event – a financial crisis which started with subprime mortgages in the U.S., spread through derivatives to the global banking system and led to a credit crunch and a global recession. The shocks that New Zealand has recently faced in an environment of increasing globalization have resonance to the first era of globalization in the years 1880-1914. Globalization has been associated with an increased incidence of financial crises, banking crises, debt crises and sudden stops. INTRODUCTION arifanees.com - Information - Inspiration - Transformation

3. 3 Introduction With globalization business cycles have become increasingly synchronized across countries. They have been connected by common global shocks which are often financial. In such an environment a small open economy can be hit hard by financial crises leading to recessions. It can also be hit by real shocks that reduce the terms of trade and the volume of its exports. What factors can prevent global shocks from being so damaging? arifanees.com - Information - Inspiration - Transformation

4. 4 Introduction This lecture provides summary evidence for a panel of countries from 1880 to the present on the incidence of various types of financial crises and on the international synchronization of business cycles. It then summarizes evidence on the determinants of various types of crises. Based on this research we can isolate variables that can attenuate the impact of shocks. These include macro fundamentals and institutional variables. We then turn to the case of New Zealand. We consider how it fared within the historical context of global financial crises. The record suggests that New Zealand did quite well in avoiding serious financial stress as did other countries with sound institutions and policies. arifanees.com - Information - Inspiration - Transformation

5. 5 Introduction Unlike financial crises, New Zealand has been significantly affected by global real shocks, especially terms of trade shocks and declines in exports consequent upon foreign recessions. In reaction to the massive global shocks in the 1930s, New Zealand shifted to a policy of insulationism, instigating a wide range of controls within the context of the Bretton Woods pegged exchange rate regime. This approach may have provided some insulation but at the expense of a slower growth rate. Many of the controls were rolled back in the mid 1980s along with the abandonment of pegged exchange rates. The subsequent liberalized financial regime with floating exchange rates exposed New Zealand again to global financial shocks but the floating exchange rates may have provided some insulation from their real effects. arifanees.com - Information - Inspiration - Transformation

6. 6 Road Map Introduction Some facts on crises and the international synchronization of business cycles Evidence on the determinants of crises for 30 countries New Zealand’s experience with crises New Zealand’s experience with global real shocks Policy lessons arifanees.com - Information - Inspiration - Transformation

7. 7 2. Some facts on crises2.1 Banking and Currency Crisis 1880 to 1997 As background I present evidence on the incidence of financial crises. Bordo, Eichengreen, Kliengebiel, and Martinez-Peria(2001), provide evidence for a panel of 21 countries for 120 years and 56 countries for the 4 recent decades on: the frequency, duration and severity of currency, banking and twin crises across 4 policy regimes. We compare output losses and recovery times in crises with their counterparts in recessions where no crises occurred. We define financial crises as episodes of financial turbulence leading to distress – significant problems of illiquidity and insolvency—among major financial market participants and/or to official intervention to contain those consequences. arifanees.com - Information - Inspiration - Transformation

8. 8 2. Some facts on crises2.1 Banking and Currency Crises 1880 to 1997 We identified currency crisis dates using an “exchange market pressure” measure and, alternatively, survey of expert opinion. We use the union of these indicators and an EMP cutoff of 1.5 standard deviations from the mean. For banking crises, we adopted World Bank dates for post-1971 period, and used similar criteria (bank runs, bank failures, and suspensions of convertibility, fiscal resolution) for earlier periods. Twin crises: banking and currency crises in same or consecutive years. Crises in consecutive years counted as one event. arifanees.com - Information - Inspiration - Transformation

9. 9 We distinguish four periods: 1880-1914: prior period of financial liberalization and globalization 1919-1939: period of exceptional currency, banking and macro instability 1945-1971: Bretton Woods period of tight regulation of domestic financial systems and of capital controls 1973-1998: second period of financial liberalization and globalization arifanees.com - Information - Inspiration - Transformation

10. 10 Frequency of Crises We divide the number of crises by the number of country year observations in each sub-period. (See Figure 1.) Alarmingly, all crises appear to be growing more frequent. Crisis frequency of 12.2% since 1973 exceeds even the unstable interwar period and is three times as great as the pre 1914 earlier era of globalization. Results driven by currency crises, which have become much more frequent in recent period. This challenges the notion that financial globalization creates instability in foreign exchange markets since pre 1914 was the earlier era of globalization. May be due to a combination of capital mobility and democratization. arifanees.com - Information - Inspiration - Transformation

11. 11 Figure 1 Crisis Frequency (per cent probability per year) arifanees.com - Information - Inspiration - Transformation

12. 12 Frequency of Crises In contrast, incidence of banking crises only slightly larger than prior to 1914, while twin crises more frequent in the late twentieth century. Note that interwar period had highest incidence of banking crises. Bretton Woods period was notable for the absence of banking crises due to financial repression. A comparison of crisis frequency between emerging and industrial countries (see Figure 2), suggests that with the exception of the interwar period, the majority of crises occurred in the emerging countries. arifanees.com - Information - Inspiration - Transformation

13. 13 Figure 2 Frequency of Crises – Distribution by Market arifanees.com - Information - Inspiration - Transformation

14. 14 Duration of Crises We define the duration of crises as the average recovery time. The number of years before the rate of GDP growth returns to its 5-year trend preceding the crisis. (See Table 1.) Recovery time today for currency crises is longer than preceding 2 regimes but shorter than pre 1914. Banking crises last not much longer now than in earlier periods. Recent period twin crises produce the longest slump for emerging markets. The dominant impression from comparison of pre 1914 and today for all crises is how little has changed. To the extent that crises have been growing longer, we have simply been going back to the future. arifanees.com - Information - Inspiration - Transformation

15. 15 Table 1 Duration and Depth of Crises arifanees.com - Information - Inspiration - Transformation

16. 16 Depth of Crises We calculate the depth of crises by calculating, over the years prior to full recovery, the difference between pre-crisis trend growth and actual growth. (See Table 1 – which shows cumulative output loss as a percentage of GDP.) We find that output losses from currency crises were even greater before 1914 than today. The difference is most pronounced for emerging countries. Output losses from banking crises also greater in pre 1914 regime than today. Twin crises show comparable output losses for today and pre-1914 for emerging markets. Key unsurprising fact is the large output losses in the interwar from both currency and twin crises. arifanees.com - Information - Inspiration - Transformation

17. 17 2.2 Evidence on Debt Crises and Sudden Stops I have extended the historical comparisons to include Debt Crises (1880–1913 versus 1972-1997) (Bordo and Meissner 2006) and Sudden Stops (1880-1913 versus 1980-2004) (Bordo, Cavallo, and Meissner 2009). See Figures 3 and 4. In terms of output losses, sudden stops were less serious than other crises but when combined with other financial crises the results are dramatic. Sudden stops associated with crises produced 10 to 12 times greater collapses in growth than those not associated with crises. See Table 2. arifanees.com - Information - Inspiration - Transformation

18. 18 Figure 3 Crisis Frequency in Percentage Probability per Year 1880-1913 vs. 1972-1997 arifanees.com - Information - Inspiration - Transformation

19. 19 Figure 4 Frequency of Different Types of Crises 1880-1913 In percent probability per year arifanees.com - Information - Inspiration - Transformation

20. 20 Table 2 Sudden Stops and Financial Crises arifanees.com - Information - Inspiration - Transformation

21. 21 2.3 Evidence on Contagion Contagion refers to the bunching of crises in several countries. See Figures 5 and 6 which show the countries affected by crises in the same year from the sample of countries in Bordo et al (2001). arifanees.com - Information - Inspiration - Transformation

22. 22 Figure 5 Countries Affected by Crises From a Sample of 21 Countries, 1880-1914 Source: Bordo and Eichengreen (1999) arifanees.com - Information - Inspiration - Transformation

23. 23 Figure 6 Countries Affected by Crises From a Sample of 21 Countries, 1919-1939 Source: Bordo and Eichengreen (1999) arifanees.com - Information - Inspiration - Transformation

24. 24 Carmen Reinhart and Kenneth Rogoff (2008) have extended the data base of financial crises in Bordo et al (2001) to include many more countries, to include episodes back to 1800 and forward to 2008. The incidence of banking crises they show in Figure 7 (the proportion of countries with crises weighted by their shares of income) presents a pattern for banking crises which echoes that in Bordo et al (2001), with the highest incidence in the interwar and a recurrence of crises since the early 1970s. The recent episode promises to be as severe as the crises of the 1990s. arifanees.com - Information - Inspiration - Transformation

25. 25 Figure 7 Proportion of Countries with Banking Crises, 1900-2008 Weighted by Their Share of World Income arifanees.com - Information - Inspiration - Transformation

26. 26 2.4 Evidence on the Synchronization of Business Cycles Bordo and Helbling (2009) find that synchronization based on bilateral correlations for log output growth shows higher positive correlation coefficients across the four exchange rate regimes. See Figure 8. arifanees.com - Information - Inspiration - Transformation

27. 27 Figure 8 Bilateral Output Correlation Coefficients by Percentile arifanees.com - Information - Inspiration - Transformation

28. 28 2.4 Evidence on the Synchronization of Business Cycles This pattern is largely driven by a sequence of global shocks that occur during periods of worldwide downturns. See Figure 9. arifanees.com - Information - Inspiration - Transformation

29. 29 Figure 9 Global Shocks, 1887-2008 arifanees.com - Information - Inspiration - Transformation

30. 30 Figure 9 Global Shocks, 1887-2008 arifanees.com - Information - Inspiration - Transformation

31. 31 2.4 Evidence on the Synchronization of Business Cycles These common shocks are related to a global financial conditions index based on the first principal components of a cross-section of financial indicators. See Figure 10. arifanees.com - Information - Inspiration - Transformation

32. 32 Figure 10 Global Financial and GDP Shocks, 1887-2001 arifanees.com - Information - Inspiration - Transformation

33. 33 Figure 10 Global Financial and GDP Shocks, 1887-2001 arifanees.com - Information - Inspiration - Transformation

34. 34 3. The Determinants of Crises 3.1 A Framework linking Integration to Crises and Crises to Growth Our framework for thinking about financial crises follows Mishkin (2003) and Jeanne and Zettelmeyer (2005). This view follows an open-economy approach to the credit channel transmission mechanism of monetary policy. Balance sheets, net worth and informational asymmetries are key ingredients in this type of a framework. See Figure 11. arifanees.com - Information - Inspiration - Transformation

35. 35 Figure 11 A Crisis Framework arifanees.com - Information - Inspiration - Transformation

36. 36 The Chain of Logic: Crises Real shocks (rise in international interest rates) transmit into the Banking system. Worsens banking sheets. Reduces lending. Capital Flows Reverse. Reserves decline/currency crisis or devaluation. Crisis could be prevented with LLR, financial depth, credible peg, fiscal probity. Sudden stops or devaluation could adversely affect balance sheets if original sin present. arifanees.com - Information - Inspiration - Transformation

37. 37 The Chain of Logic: Crises Scenario worse if country is financially fragile/underdeveloped. Depends on the currency mismatch. Possibility of debt crisis and default depends in part on fiscal control and political system. Accordingly to Kohlcheen (2006) presidential democracies were more likely to default than parliamentary democracies. arifanees.com - Information - Inspiration - Transformation

38. 38 Evidence 3.2 Sudden Stops Bordo, Cavallo and Meissner (2009) find evidence on the determinants of sudden stops 1880-1913 for 30 countries including New Zealand. Their results are similar to those of Calvo et al (2004) for the recent period. Their results from a panel probit show that countries which are open, have lower levels of original sin (hard currency debt relative to total debt) and have strong fundamentals have lower probabilities of being hit by a sudden stop. They also found based on a treatments effects growth regression that sudden stops reduces growth by close to 5% from the long-run average growth rate. Sudden stops that accompany financial crises reduce growth considerably. arifanees.com - Information - Inspiration - Transformation

39. 39 3.3 Currency Crises Bordo and Meissner (2009) using a panel probit for 30 countries (including New Zealand) 1880-1913 find that a large positive change in the current account to GDP and low levels of reserves to notes are associated with high probabilities of a currency crisis. Currency crises were driven by current account reversals and sudden stops. High levels of original sin and a low foreign currency debt mismatch also lead to currency crises. For the 1972-2003 period results are similar. arifanees.com - Information - Inspiration - Transformation

40. 40 3.4 Banking Crises Bordo and Meissner (2005) find that a key determinant of banking crises 1880-1913 was original sin. But countries with a high level of original sin like the British dominions and Scandinavia have a low probability of banking crises. Countries like Argentina and Italy with a moderate amount of original sin were crisis prone. The key difference between the two groups of countries is poorer fundamentals and lower financial development . Also the risk of crisis is offset by having sufficient hard currency assets to match hard currency liabilities. For the 1972-97 period Bordo and Meissner (2006) find that original sin and a high mismatch is associated with a greater chance of a banking crisis but that countries with higher income can avoid crises. arifanees.com - Information - Inspiration - Transformation

41. 41 3.5 Debt Crises The likelihood of debt crises in both eras of globalization increases significantly with the level of foreign currency debt exposures but in the pre 1914 era countries with sound fundamentals like the British dominions were less exposed. Institutional factors include a low level of currency mismatch, adherence to the gold standard, and being a Parliamentary democracy. arifanees.com - Information - Inspiration - Transformation

42. 42 3.6 The Bottom Line Debtor countries with sound fundamentals and institutions could avoid financial crises. In the first era of globalization countries like the British dominions, Sweden and Denmark with very high ratios of foreign currency debt to total debt could avoid crises by having high export receipts in foreign currency or large international reserves. They also had “country trust” (Caballero Cowan and Kearns 2006) based on sound institutions, the rule of law and stable political systems. Key institutional factors were the commitment and ability to maintain adherence to the gold standard in the British dominions. For example, New Zealand banks held large sterling asset positions in London. Many dominion debt issues had the guarantee of the British government. arifanees.com - Information - Inspiration - Transformation

43. 43 3.6 The Bottom Line By contrast other countries like those in Latin America and Southern and Eastern Europe that embraced global financial flows but did not adequately fortify their financial systems faced severe financial crises enveloping the banking system, the currency and the national debt. In the recent era high per capita income countries with high original sin like New Zealand have limited exposure to capital account crises. The countries most exposed to such crises were middle income emerging countries with high original sin. Their fragility to current account reversals and crises was evident in the 1990s. Today countries like Iceland, the Baltics and some eastern European countries are in the same boat. arifanees.com - Information - Inspiration - Transformation

44. 44 4. New Zealand: Financial Crises New Zealand has had a relatively benign crisis experience. Table 3 contains a chronology of New Zealand’s financial crises. New Zealand experienced 2 banking crises, 7 currency crises, 8 sudden stops, no debt crises or twin crises. arifanees.com - Information - Inspiration - Transformation

45. 45 4. New Zealand: Financial Crises Table 3 A Chronology of New Zealand Crises * * SS1 in bold arifanees.com - Information - Inspiration - Transformation

46. 46 4.1 Banking Crises First banking crisis 1890-95 involved Bank of New Zealand. Crisis triggered by a land boom which collapsed in the mid 1880s. Causes include a decline in wool prices, a sudden stop engineered by the Bank of England, the Baring crisis of 1890 and the Australian crisis of 1893. The BNZ financed and owned much of NZ mortgages. The BNZ was recapitalized by the government in July 1895. The cost of the bailout was 1.6% of GDP which was a small fraction of Australia’s cost. arifanees.com - Information - Inspiration - Transformation

47. 47 Banking Crises Second banking crisis 1987 to 1990 also involved the BNZ and a property boom consequent upon financial deregulation after 1984. The bust followed the October 1987 Wall Street crash which led to sharp drops in NZ equities. The BNZ was recapitalized in 1990 at a cost of 1% of GDP. arifanees.com - Information - Inspiration - Transformation

48. 48 4.2 Currency Crises We identify currency crises based on an EMP index supplemented with historical narrative. New Zealand had 7 currency crises which occurred during pegged exchange rate regimes. The crises of 1931 and 1933 occurred as a consequence of the 1937-38 recession. It led to the imposition of a strict exchange control and import licensing regime. NZ joined the IMF in 1961. The crisis of 1967 followed the collapse of the wool market in 1966 which caused deterioration in the current account and a depletion of New Zealand’s reserves. NZ devalued by 19.45% following sterling’s devaluation in November. The 2 oil price shocks of the 1970s led to crises in 1974-74 and 1979. Each led to devaluations. The last crisis was in 1984 following deregulation of the financial sector and the elimination of exchange and capital controls, the NZ dollar was devalued by 20%. arifanees.com - Information - Inspiration - Transformation

49. 49 4.3 Sudden Stops We measure sudden stops by a sharp drop in net capital inflow accompanied by a drop in real GDP (SS1) and (SS2) measured as a large decline in net capital inflows regardless of the impact on output. Sudden stops preceded the 1890s banking crisis, the 1930s crises and the 1970s crises. Sudden stops in 1997/98 and 2008/09 did not lead to crises in New Zealand. arifanees.com - Information - Inspiration - Transformation

50. 50 4.4 Some Evidence for New Zealand from Pooled Probit Regressions Using cross country regression models for the two eras of globalization Mizhuo Kida of the RBNZ and I ascertain the variables which made New Zealand more or less vulnerable than the average countries in the Bordo, Meissner sample to the risks of being hit by currency crises and sudden stops. Figure 12 shows the predicted probabilities of having a currency crisis in New Zealand versus the average country 1880 – 1913. arifanees.com - Information - Inspiration - Transformation

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52. 52 4.4 Some Evidence for New Zealand from Pooled Probit Regressions New Zealand performed better in avoiding currency crises by maintaining a large trade surplus and having positive terms of trade shocks which offset its relative vulnerabilities from having a relatively large hard currency mismatch. Figure 13 shows that in the first era of globalization New Zealand was slightly more vulnerable to having a sudden stop (SS1) than average because it had higher original sin and slightly lower gold reserves on average. arifanees.com - Information - Inspiration - Transformation

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54. 54 4.4 Some Evidence for New Zealand from Pooled Probit Regressions For the recent period of globalization 1972 – 1992, when New Zealand had three currency crises, Figure 14 shows that New Zealand had a somewhat higher risk of a currency crisis than others because it had a higher mismatch, higher debt relative to GDP, higher long term interest rates and lower reserves. These effects were not fully offset by its high per capita income (as a proxy for a better set of institutions, more developed financial system and/or better management of debt). However, what differentiated New Zealand from other countries which suffered more frequent currency crisis in the recent period was its relatively high per capita real income and the characteristics that goes with it. arifanees.com - Information - Inspiration - Transformation

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56. 56 4.4 Some Evidence for New Zealand from Pooled Probit Regressions Thus New Zealand was less exposed to the risks of a currency crisis than the average in the first era of globalisation because of its better fundamentals but this was not the case in the second era. Moreover, in the 1880 – 1913 period New Zealand was vulnerable to sudden stops because of its high level of original sin. arifanees.com - Information - Inspiration - Transformation

57. 57 4.5 Insulationism In reaction to the Great Depression New Zealand followed a policy of insulationism to protect the economy from the vagaries of the global economy. (Singleton 2008, Hawke 1985). The goals were to maintain full employment, develop manufacturing and suppress imports while maintaining exports, and remaining on the sterling peg. Policies followed included import licensing, high tariffs and financial controls like interest rate ceilings. The regime maintained full employment through the 1960s and fostered an inefficient manufacturing industry. NZ was hit by the external shocks of the 1970s leading to currency crises and recession. arifanees.com - Information - Inspiration - Transformation

58. 58 4.5 Insulationism Increasing evidence of relatively poor growth performance led to the end of import controls and deregulation of the financial sector as well as adoption of a floating exchange rate in 1984. A credible nominal anchor was instituted in 1989, with the RBNZ getting operational independence and focusing on price stability. Did the policy of insulationism really achieve the goal of protecting New Zealand from outside shocks or did it weaken NZ sufficiently to make it more vulnerable to the bigger shocks that followed in the 1970s? To answer this question requires a counterfactual exercise to ascertain whether alternative arrangements such as shifting earlier to a regime of floating exchange rates, without the extensive controls, would have done a better job. arifanees.com - Information - Inspiration - Transformation

60. In a benchmark regression we regressed a three year moving average growth rate of real NZ per capita income on: the terms of trade; the real sterling exchange rate; and U.S. real GDP. (See table 4, column 1).arifanees.com - Information - Inspiration - Transformation

61. 60 5. Real Shocks and the New Zealand Economy Table 4 Regression of NZ growth of real per capita GDP on key drivers of growth arifanees.com - Information - Inspiration - Transformation

63. In column 2 of the table we added indicators of financial crises to the regression. Both indicators of currency crises and sudden steps were not statistically significant.

64. The two long periods of banking crises have a negative impact on growth although the coefficient is not precisely estimated or significant. The coefficient is consistent with a four year banking crisis reducing output by about 2.5 percentage points.

65. A measure of variability in capital inflows comparable to the SS2 sudden stop indicator is significant. This suggests that slowing or reversals of capital controls are deleterious for growth.arifanees.com - Information - Inspiration - Transformation

71. This could reflect both the extensive controls imposed between 1938 and 1984 (shaded in blue) and the use of floating exchange rates as an economic buffer post 1984.

72. It is difficult to see much of a difference in the coefficients of the three variables between the 1938 – 84 period and the subsequent float.

73. This could suggest that the costs of the economic distortions in the controls regime may have been avoided if New Zealand had turned to a more liberal regime with floating earlier, as for example Canada did in 1950. arifanees.com - Information - Inspiration - Transformation

75. This may reflect the mild nature of many of the crises in New Zealand history.

76. These results suggests that avoiding banking and currency crises will not be sufficient to avoid the domestic economic impact of major disruptions to the global business cycle.

77. The bottom line is that it is not difficult to find strong evidence that New Zealand has been crucially influenced by global factors.arifanees.com - Information - Inspiration - Transformation

79. Similar factors have been at work in the recent past.arifanees.com - Information - Inspiration - Transformation

81. Countries can avoid financial crises by following sound policies and adopting sound institutions.

82. Having sound polices and institutions certainly helped the British dominions, the advanced countries, and some emerging countries, avoid crises in the first era of globalisation.

83. And our panel probit regression evidence shows, in the first era of globalization that New Zealand’s predicted probability of having a currency crisis was somewhat lower than the average country.

84. Having sound policies and institutions helped avoid crises for some emergers and small open advanced countries in the current era of globalisation.arifanees.com - Information - Inspiration - Transformation

86. Moreover, real shocks can have serious real effects on small open economies like New Zealand which follow basically sound policies and have solid institutions.

87. The evidence in this lecture suggests that shocks to U.S. real GDP as a proxy for global output and shocks to the terms of trade have material and significant effects on New Zealand’s growth.arifanees.com - Information - Inspiration - Transformation

89. In reaction to global shocks New Zealand shifted to a policy of insulationism in the late 1930’s.

90. The subsequent controls regime did succeed in battening down the hatches for 4 decades and may have provided shelter from foreign winds.

91. But at the cost of economic inefficiency and relatively slow growth.arifanees.com - Information - Inspiration - Transformation

93. Evidence for Canada since 1950 and many other countries since 1973 suggests that a floating exchange rate is the best insulation against foreign shocks.

94. But floating can create problems of it’s own for a small open economy.

95. An alternative for New Zealand could be a monetary union with Australia but taking such a step would remove the ability to use domestic monetary policy to offset asymmetric shocks.arifanees.com - Information - Inspiration - Transformation

97. But the benefits of increased integration for a monetary union are not insignificant.

98. This is an issue that will continue to be debated for years to come.arifanees.com - Information - Inspiration - Transformation