Atl Econ J (2012) 40:191–209

DOI 10.1007/s11293-011-9300-4

Effects of Currency Devaluations on the Economic

Growth in Developing Countries: The Role of Foreign
Currency-Denominated Debt

Giacomo Saibene & Silvia Sicouri

Published online: 17 April 2012

# International Atlantic Economic Society 2012

Abstract Assuming that a developing country has to denominate its debts in the
currencies of the principal creditor countries, how is the country’s economic perfor-
mance affected when currency devaluation occurs? The aim of this paper is to prove
that devaluation can be contractionary and that its occurrence can be the result of a
self-fulfilling prophecy. Assuming credit constraints on firms’ borrowing capacity
and nominal price rigidities, a sharp change in the value of the domestic currency
leads to an increase in the real costs of foreign currency-denominated debt. Hence,
firms’ profits as well as their borrowing capacity decrease, provoking a drop in future
investment and output. Moreover, expectations about future output can alone trigger a
currency devaluation, confirming the initial expectations in a self-fulfilling way.
Finally, it is discussed in an empirical analysis the impact of devaluation on the
economic growth in a sample of five countries.

Keywords Foreign currency denominated debt . Devaluation . Growth . Developing

countries

JEL F30 . International Finance

Introduction

Assuming that a developing country needs capital inflows from foreign investors, either
to pursue economic growth or as a result of trading activities, and that to access
international capital markets it has to denominate its debts in the currencies of the

We are grateful to Fabio Sdogati, our professor of International Economics, and to Davide Suverato for
supporting us with their precious comments.
G. Saibene (*) : S. Sicouri
Dipartimento di Ingegneria Gestionale, Politecnico di Milano, Milan 20100, Italy
e-mail: giacomo.saibene@mail.polimi.it
S. Sicouri
e-mail: silvia.sicouri@mail.polimi.it
192 G. Saibene, S. Sicouri

principal creditor countries and financial centres (i.e., U.S. Dollar, Yen, Euro, Sterling, and
Swiss Franc), how do these assumptions affect the country’s economic performance
when a currency devaluation occurs?
In economic textbooks, the conventional answer to currency devaluations is analyzed
within the Mundell-Fleming model and the result is a positive effect on the current
account. Thus, devaluation is expansionary in terms of GDP since exports increase more
than imports. This model might be naturally extended by considering many other
important features, which determine the degree of the reaction of the current account,
such as: (i) the price elasticity of world’s (country’s) demand for tradable goods, i.e., the
variation of the exports (imports) in response to a real exchange rate variation; and (ii)
the presence of supply shocks effects due to the presence of intermediate inputs and raw
materials, e.g., oil, which might generate inflationary pressures.
Nonetheless, given the fact that the country’s debt is denominated in foreign
currencies, a real exchange rate variation can also cause some important balance
sheet effects. First, government spending can be significantly reduced if constrained
by rules aimed at avoiding a deficit increase, since a larger amount of money would
then be required for interest payments over sovereign debt. Second, private invest-
ment and consumption can diminish, given that debt service costs increase, profits
shrink, and bank lending is constrained (since it relies on the collateral that the firm
can provide, i.e., the firm’s value calculated as the net present value of its future
returns). The result is a level of investment that is negatively affected. Moreover, the
banking sector can be negatively hit by currency devaluation because of the currency
mismatches between its assets and liabilities; hence the probability of a financial
crisis increases, a fact that would severely worsen the country’s economic condition.
Finally, a negative wealth effect on national investors, who mainly have assets
denominated in national currency and debts denominated in foreign currency, might
amplify the volatility of capital flows and introduce the possibility of sudden stops,
current account reversals, and self-fulfilling crises. This paper evaluates the net effect
of a real exchange variation, focusing on the impact of balance sheet effects and
demonstrating that currency devaluations can be contractionary.
Different aspects point out the importance of this issue: a better understanding of
the Asian financial crisis of 1997 and the way it was managed; the rising importance
of developing countries in the global financial system and their relationships with
debt; the currency in which it is denominated; the consequences of the existence of
some currencies that are more important than others; and the increasing amount of
global debt. Moreover, it may suggest some indications about the current Greek debt
crisis, since some have argued that a hypothetical solution is a temporary exit from
the Eurozone, which would then allow them to devaluate the currency and improve
its competitive problems, thus avoiding a default on its debts. But are they denomi-
nated in Euros, a forthcoming foreign currency, or not?
The rest of this paper is organized as follows. In the next section, a review is
presented in brief of the literature that focuses on the causes of foreign currency debt,
then the strand of literature that introduced the contractionary effects of devaluations
is explored, and finally the third generation of currency crisis models is presented. In
following section, there is a detailed description of the model, mainly based on
Aghion et al. (2001), in order to use it as the theoretical foundation of empirical
analysis that is done in the section after that. The conclusions are in the final section.
Effects of Currency Devaluations in Developing Countries 193

Literature Review

Dealing with Foreign Currency Debt

In order to access international capital markets, a developing country has to denominate

its debts in the currencies of the principal creditor countries and financial centres: U.S.
Dollars, Yen, Euros, Pounds, and Swiss Francs. How robust is this hypothesis?
Citing Eichengreen and Hausmann (2005), at the end of 2001, Americans held $84
billion of developing country debt, but only $2.6 billion was denominated in the
currencies of the developing countries. Of the $434 billion of debt securities issued by
developing countries in international markets that was outstanding on average be-
tween 1999 and 2001, less than $12 billion was denominated in the currency of these
countries. The disproportion between these figures suggests that the problem cannot
be entirely explicable in terms of the weakness of policies and institutions. If the issue
is fear that a borrower may be tempted to inflate away debt denominated in their own
currency, then we should observe inflation-indexed debt, not dollar-denominated
debt. Therefore this problem has at least as much to do with the structure and
operation of the international financial system as with any institutions’ weakness. It
is as if emerging markets suffer from an inherited burden, almost irrespective of the
policies of their governments. This is why the difficulty they face in borrowing
abroad in their own currencies is referred to as original sin (1999). Evidence suggests
that the relative size of an economy is a robust factor accounting for the incidence of
original sin, and this would be the predicted result if economies of scale, network
externalities or liquidity effects were important.
Yet again, Eichengreen et al. (2003) pointed out the differences between three
concepts widely used in the literature on balance sheet factors in emerging market
financial crises: original sin, debt intolerance, and currency mismatches. The first two
seek to explain the same phenomenon, but while the debt-intolerance school traces the
problem to institutional weaknesses of emerging-market economies, the original-sin
school points at the structure of global portfolios and international financial markets.
The literature on currency mismatches, in contrast, is concerned about the consequences
of these problems and how the macroeconomic and financial authorities manage them.
Another important issue is the analysis of the breakdown of a country’s balance
sheet, because it can better show the vulnerabilities to reversals in external financing
flows and helps to examine the genesis of such reversals. Indeed, weaknesses in
certain sectorial balance sheets may contribute to the creation of a countrywide
balance of payments crisis, yet they may not appear in a country’s aggregate balance
sheet. An important example is foreign currency debt between residents, which is
netted out of the country’s aggregated balance sheet. Nevertheless, if the government
is unable to roll over its hard currency debts to residents and must draw on its reserves
to honor its debts, such a situation can trigger an external balance of payments crisis.
The risk that difficulties rolling over domestic debts can spill over into a balance of
payments crisis is particularly severe in a world where capital accounts have been
liberalized (Allen et al. 2002).
In a recent article, Hausmann and Panizza (2010) updated their measures of
original sin with respect to the current situation: the outstanding stock of international
bonds issued by developing countries grew from approximately $200 billion in 1993
194 G. Saibene, S. Sicouri

to just above $1 trillion in 2007; and the value of international bonds denominated in
the developing countries' currencies went from nil in 1993 to $193 billion in 2007.
They concluded that emerging countries are now making greater use of their domestic
bond market, but nevertheless original sin has diminished only marginally and
continues to make financial globalization unattractive, pointing out that developing
countries have opted for abstinence rather than sin.

Early Contractionary Theories

The traditional point of view, well explained by the Mundell-Fleming model, argues that
devaluations are expansionary: not only do exports increase, but a depressed aggregate
demand for imports also occurs, and this has a positive effect on the trade balance.
In the economic development literature, early doubts about this statement were
expressed by Alejandro (1963) and Krugman and Taylor (1978). These authors
identified various channels through which devaluation may have contractionary
influences on aggregate demand.
Alejandro (1963) formulated a model in which the effect of devaluation is distin-
guished in two stages: the initial effect and the reversal effect. The initial effect, as it is
said in the traditional view, is the consequence of changes in relative prices, i.e., a terms
of trade improvement, and can be simply determined by the price elasticity of demand
and supply of imports and exports. The reversal effect is instead a contractionary effect
and it is mainly due to a decrease of domestic output, which is determined by the level of
domestic demand, under the model hypothesis. What happens is a redistribution of
income that favors profit in the traded goods sector and disfavour real wages. However,
since saving propensity is higher for profits than for wages, the economy’s average
propensity to save will rise and this will cause a contractionary effect on demand.
Afterwards, Krugman and Taylor (1978) summarized and extended that strand of
research, pointing out the various channels through which contractionary influences
on aggregate demand may reverse the expansionary effects of the expenditure’s
switching following devaluation. The idea is that unless the trade account is initially
balanced, devaluation changes the country’s income distribution, causing an income
transfer from workers to capitalists and from the private sector to the government. By
redirecting income to high savers, devaluation can therefore create an excess of
savings over planned investment, causing a reduction in real output and imports.
The contractionary effects arise in the following scenarios:

1. If the country has an initial trade deficit. The contractionary effect stems from
the fact that, due to the devaluation, changed price of traded goods immediately
reduces the country’s real income while increases it abroad. Thus, terms of trade
will worsen, producing an immediate net real transfer towards foreigners if the
country shows a trade deficit, hence deteriorating the domestic output in the short
run. Moreover, the larger the initial deficit, the greater the contractionary
outcome.
2. Through distributional effects. Devaluation raises the cost of traded goods
relative to home goods, giving rise to windfall profits in export- and import-
competing industries. Since consumption behavior differs between wage
and profit earners, this will redistribute income from wages to profits and
Effects of Currency Devaluations in Developing Countries 195

rents. This concept is fully discussed below, reviewing the work of

Alejandro (1963).
3. Through fiscal effects. If there are ad valorem taxes on exports or imports, there
is a redistribution of income from private to government sector following deval-
uations. According to the state of government budget, if: (i) it is not initially
balanced, there is an income effect comparable to the income effect of devalu-
ation in the presence of a trade deficit, namely the value of foreign savings goes
up ex-ante and aggregate demand goes down ex-post; (ii) there are progressive
income taxes, or higher taxes on profit than wages, and the government claims an
increased share of income; (iii) there are ad valorem taxes on exports and
imports, it can be seen as the private sector paying more for imports than what
it earns from exports.
The scenario of Alejandro (1963) and of Krugman and Taylor (1978) was com-
pleted by Van Wijnbergen (1986), who instead focuses on the supply side. He
outlined three channels through which devaluation has a direct negative impact on
aggregate supply:
1. Domestic currency costs of intermediate imports. Since mostly intermediate
goods, denominated in foreign currency, represent developing countries’ imports,
devaluation will increase their cost, leading to a contractionary effect.
2. Real wage indexation. Assuming a real wage indexation on the CPI (that
includes foreign goods), a devaluation leads to an increase in foreign prices,
causing a raise of CPI, and therefore of wages. The increase in wages leads to an
amplification of both the labor cost and the demand of working capital, adding an
unambiguously contractionary element.
3. Volume of real credit to firms. Assuming that the devaluation is passed on one-
for-one in domestic prices and wages, the domestic prices will change of a
proportion equal to the percentage increase of the nominal exchange rate. Other
things being equal, this implies a reduction in the monetary base and in the
supply of loans. These decreases are matched by an incipient excess credit
demand, leading to a rise in the interest rate. The net effect is not only a decrease
in aggregate demand but also, because of a higher cost of working capital, a
decrease in aggregate supply.

Modern Currency Crisis Models

The Asian financial crisis of 1997/98 breathed new life into the debate, given that the
existing crisis models proved inadequate. Since then, the economic literature has
placed more emphasis on the financial channel rather than on the standard trade
channel, emphasizing that a devaluation has effects on domestic economic activity
also via its impact on the capital account, not only via the current account. Indeed, it
is unlikely that the conventional contractionary effects can explain the magnitude and
ferocity of some economic contractions that followed devaluation as it happened
during these Asian crises.
Thus, third-generation models of financial crises began to emerge, most of all
having in common the idea that a crisis should be seen as a result of a shock that was
amplified by what has been called the financial accelerator mechanism in Bernanke et
196 G. Saibene, S. Sicouri

al. (1998), in light of the dollarization process taking place in a number of emerging
economies over the last decades, which created a mismatch between foreign currency
denominated debt and domestic currency denominated revenues. The crucial point of
the financial accelerator mechanism is that the size of the premium on external funds
depends on the firm’s balance sheet condition.
Referring to the scheme of Gilchrist and Zakrajsek (1995), illustrated in Fig. 1, the
dd line represents the demand for funds; it is a downward-sloping function of the cost
of funds. The ss line represents the supply of funds. Up to the point W (the firm’s net
worth, defined as: the borrowers’ liquid assets plus collateral value of illiquid assets
less outstanding obligations), lenders are willing to lend at the open market interest
rate. Beyond W, however, lenders charge a premium over the open-market rate to
compensate for the increased probability of opportunistic behavior of borrowers.
Because of this, the supply-of-funds curve for the individual firm is upward-
sloping, leading to a market clearing investment level I*, which is below the level
IP that would be in case of perfect information and efficient markets. If a currency
depreciation leads to a deterioration in the net worth (for instance, an increase in the
value of foreign currency debt of the firm), the external finance premium, ceteris
paribus, will increase and the investment level will be lower than before.
In order to set out an analytical framework based on the balance sheet approach,
we refer to Allen et al. (2002), in which the focus is on the examination of stock
variables—instead of flow variables—in the aggregate balance sheet of a country and
the balance sheets of its main sectors. There are four types of balance sheet mis-
matches which can undermine a country’s ability to service debt in the face of shocks:
(i) maturity mismatches, where a gap between liabilities due in the short term and
illiquid assets leaves a sector unable to honor its contractual commitments if the
market declines to roll over debt or creates exposure to the risk that interest rates will
rise; (ii) currency mismatches, where liabilities are denominated in a foreign currency
while assets are denominated in domestic currency, leading to severe capital losses
when there is a sharp change in the nominal value of domestic currency; (iii) capital
structure problems, where a heavy reliance on debt rather than equity financing leaves
a firm/bank less able to withstand income shocks; and (iv) solvency problems, where
assets—including the present value of future revenue streams—are insufficient to

Fig. 1 The premium for external funds

Effects of Currency Devaluations in Developing Countries 197

cover liabilities, including contingent liabilities. It is worth mentioning that a poor

capital structure, maturity mismatches, and currency mismatches can all contribute to
solvency risk, but solvency risk can also arise from simply borrowing too much or
from investing in low-yielding assets. Our analysis will focus on the strand of
literature that has stressed the role of balance sheet imbalances deriving from
currency mismatches, which differently affect the different sectors of any economy,
as illustrated in Table 1.

Third-Generation Models

A key contribution was given by Krugman (1999a, b). First, in contrast to other
contemporary attempts to produce a model that could explain the Asian crisis, he
argued that a bank-centered view does not get at the essential nature of what went
wrong. Indeed, describing the crisis as the consequence of a self-fulfilling loss of
confidence that turned into a bank run or as a problem regarding a moral-hazard-
driven lending that subsidized investment until it collapsed when visible losses led
governments to withdraw their implicit guarantees (as argued in Corsetti et al. (1998))
certainly captures some aspects of what happened to Asia, but both descriptions
seem inadequate to the task of explaining the severity of the event. Accordingly,
Krugman proposed another candidate for third-generation crisis models, which
emphasizes two new factors: the role of companies’ balance sheets in constraining
investment, and that of capital flows in affecting the real exchange rate.
The idea is the following: suppose that investment is often wealth-constrained, as
argued by Bernanke et al. (1998); and that for some reason many firms have a
substantial share of debts denominated in foreign currency. Then, two bad outcomes
can emerge. First, a loss of confidence by foreign investors can be self-justifying, since
harsh capital outflows lead to a plunge in the value of the currency, and the balance-sheet
effects of this plunge lead to a collapse in domestic investment. Second, the normal
monetary policy in response to a recession becomes ineffective, even counter-productive,
because it would reinforce the currency depreciation, and thereby worsen the balance-
sheet crunch. Hence the Asian crisis: seemingly irrelevant events caused a self-fulfilling
loss of confidence, and conventional macroeconomic remedies were not available. More-
over, once the crisis occurred, it had a sustained impact on the economy because of the
large drop in investments and the subsequent decapitation of the entrepreneurial class.
The model is real— that is, without the money market— and through its equations
endogenously determines the equilibrium real exchange rate, the entrepreneur’s
wealth and the level of investment, actually considering different binding constraints.

Table 1 How currency mismatch risks apply to different sectors

Government Banks Firms Households

Debt denominated Difference between Debts denominated Difference between

in foreign currency foreign currency in foreign currency foreign currency assets
(domestic and external) assets (loans) v. (domestic and external) (deposits) v. foreign
v. hard currency assets foreign currency v. hard currency currency liabilities
(reserves). liabilities (deposits/ generating assets. (often mortgages).
interbank lines).
198 G. Saibene, S. Sicouri

Yet some other assumptions are made: the goods produced in the country are not a
perfect substitute for traded goods produced elsewhere (along with the domestic
marginal propensity to spend on imports being constant) and the currency composi-
tion of debt is given. The conclusions of the model are: (i) currency crises that lead to
exchange rate movements and balance sheet effects are self-fulfilling; and (ii) mul-
tiple equilibria might exist, one with a normal exchange rate and one with a hyper-
depreciated exchange rate and a bankrupt corporate sector. Furthermore, the factors
that can make financial collapse possible are: high leverage, low marginal propensity
to import, and a relevant level of foreign-currency debt relative to exports.
This sequence of events had been commented on, both in another of Krugman’s
works (1999a, b) and in Aghion et al. (2001), who added some new important
features in their model: (i) the presence of the money market, that includes the
standard LM and Uncovered Interest Parity equations and lends itself naturally to
the analysis about the appropriate monetary policy response to prevent or solve
currency crisis; (ii) the presence of sticky nominal prices, so as to allow substantial
and persistent deviations from purchasing power parity following an exchange rate
shock; (iii) the dynamic aspect of the model, which allows it to analyse a multi-period
scenario, which in turn makes it easier to apply it to a real set-up; and (iv) the output
is formally determined as a function of the wealth, which in turn is a function of the
firms’ profits, which actually depend on the real exchange rate and on the country’s
interest rate.
The dynamics of the model are the following: since nominal prices are sticky, a
currency depreciation leads to an increase in the foreign currency debt repayment
obligations of firms, and thus to a fall in their profits; this reduces firms’ borrowing
capacity and therefore investment and output in a credit-constrained economy, which
in turn reduces the demand for the domestic currency and leads to further
depreciation.
The model’s main conclusions are: (i) a currency crisis may occur both under a
fixed or a flexible exchange rate regime; (ii) public sector imbalances can have
destabilizing effects on the domestic currency, provoking a currency crisis; and (iii)
multiple equilibria are admitted, including the “currency crisis” equilibrium with low
output and a depreciated domestic currency. The point that still requires a better
comprehension is the dependence of the credit multiplier on the nominal or on the
real interest rate.
Another contribution was provided by Céspedes et al. (2004), whose model is
a dynamic general-equilibrium, solvable analytically. In contrast with other models of
balance sheet effects, it accounts for the effects both on the liability side and on the
asset side. As a result, a real devaluation has two different outcomes: a negative
impact on the liability side, due to the currency mismatches, that raises the risk
premium required by the lenders, hence reducing the net worth; and a shift in the
domestic demand towards domestic goods, which in turn raises output and the returns
earned by entrepreneurs, i.e. their net worth. Therefore the net effect on the net worth
depends on the relative strength of the two effects, which depends on the level of
indebtedness and the resulting financial vulnerability (or robustness) in the steady
state. Their analysis goes further and compares the performance of fixed versus
flexible exchange rate regimes in the presence of this liability dollarization, conclud-
ing that the latter is better.
Effects of Currency Devaluations in Developing Countries 199

The Model

In this section we refer to and expand the model of Aghion et al. (2001). We consider an
infinite-horizon small open economy with a controlled exchange rate, in which only
the entrepreneurial class, which own capital and investments, is fully described by
equations, so as to simplify the discussion. Absolute purchasing power parity (PPP)
holds only ex ante, meaning that the price of the only good present in the economy is
determined at the beginning of each period and remains fixed for the entire period:
Pt ¼ Pt Eet ¼ Eet , where Pt is the good’s domestic price, Ete is the expected nominal
exchange rate (the price of foreign currency in terms of domestic currency) at the
beginning of period t, and the foreign price level is considered constant and equal to
one (P* 01). Another important assumption is that entrepreneurs face restrictions on
credit availability, this being modelled by a fixed multiple of their current wealth that
will determine the amount of credit available for each period. Finally, it is assured full
international capital mobility.
The real side of the economy is represented by the production function of equation
(Eq. 1):
yt ¼f ðkt Þ¼ð1 þ μÞ wt ð1Þ

where kt ¼ ðWt þ dt Þ is the amount of capital disposable for investment in period t,

and is the sum of capitalists’ wealth and debt. Borrowing capacity is limited by a credit
multiplier, μt, supposed constant within each period (μt 0 μ). For simplicity it is taken
for granted that the total amount of debt available is entirely borrowed, thus: dt 0 μwt.
Debt is denominated both in domestic and in foreign currency, and the entrepre-
neurs’ debt composition is: dt ¼ dct þ df t where d tc is the quantity of domestic
currency debt in period t while d f t is the quantity of foreign currency debt in period
t. We expand the model of Aghion et al. (2001) by including the endogenous
determination of currency composition of debt, hence assuming that the share of
dct+1 in respect to df t+1 is a negative function of the variation in the exchange rate:
dctþ1 =df tþ1 ¼ g ðEt =Et1 Þ. We justify this assumption in respect to the entrepreneurs’
behavior: an appreciation of the domestic currency (Et<Et-1) will lower the real cost
of foreign currency debt, thus inducing the entrepreneurs to increase their share of
foreign currency debt in the next period in an adaptive way, and vice versa. If our
argument is correct, after sharp currency devaluations (revaluations) it is likely to
observe an adjustment in the debt’s currency composition: foreign currency
denominated debt should decrease (increase) while foreign currency reserves
increase (decrease).
Wealth, in equation (Eq. 2), is a positive function of the profits saved from the
period before (assuming: α 0 share of profits distributed to individuals) that in turn
depends on the debt service repayments. Profits are precisely equal to revenues less
debt service, which depends on conditions set in the precedent period, as in equation
(Eq. 3).
wtþ1 ¼ ð1  aÞ p t =Pt ð2Þ

p t ¼Pt yt  ð1þit1 Þ Pt1  dct  ð1þi Þ ðEt =Et1 Þ Pt1  df t ð3Þ

200 G. Saibene, S. Sicouri

Combining (1), (2), and (3), we obtain the determination of real output in period t+1,
defined as a negative function of the nominal exchange rate Et, as shown in equation
(Eq. 4), which we will refer to as the W-curve and can be represented in the (Et, yt+1)
space as in Fig. 2.
n h io
ytþ1 ¼f ð1þ μ Þð1  aÞ yt  ð1þit1 Þ ðPt1 =Pt Þ dct  ð1þi Þ ðEt =Et1 Þ ðPt1 =Pt Þ df t

ð4Þ
It is important to observe that the slope of the curve is parameterized on the
amount of foreign currency denominated debt (d f t ). If d f t is zero, the W-curve will be
vertical since the output will no longer be more dependent on the nominal exchange rate.
The monetary side of the economy is represented by the standard money market
equilibrium (LM) and the uncovered interest rate parity (IP) curves, equations (Eqs. 5
and 6).
LM : MSt ¼ Pt md ðyt ;it Þ ð5Þ

UIP :ð1þit Þ¼ð1þi Þ Eetþ1 =Et ð6Þ

As regarding the IP condition, i* refers to the international interest rate, which is
considered constant for simplicity, while the current exchange rate, Et, can be the
source of exogenous and unexpected shocks, as will be later discussed. As regarding
the LM curve, MSt is the nominal money supply in period t and md the money
demand function with the usual properties of being increasing in yt and decreasing in
it. Moreover, md(0, it) is assumed to be positive.

Dynamics of a Shock

We will now analyze the occurrence of a shock affecting the exchange rate E1 in
period 1, which is caused by a pure shift in expectations regarding the output in
period 2. This happens after the price P1 has been set, so that: P1 ¼ Ee1 6¼ E1 . In
period 1, since prices are sticky and output is predetermined by the precedent period’s

Et

y t+1

Fig. 2 The W curve

Effects of Currency Devaluations in Developing Countries 201

wealth, only the money and the asset market will adjust and absorb the shock.
Therefore, the LM and IP curves are supposed to determine the interest rate
in period t01, which in turn is given by the expectations about the future exchange
rate and by the monetary policy response. For the sake of simplicity, we do not
explicitly deal with the new equilibrium reached in the money market or the actual
monetary policy response—if any; let us just assume as given the interest rate in
period 2, say, because monetary policy maintains it at a given constant level.
Combining equation (Eq. 5) relative to period 2 and equation (Eq. 6) to period 1,
and recalling the PPP assumption relative to period t02 (i.e., P20E e20E2), a negative
relationship between E1 and ŷ2 can be outlined, obtaining equation (Eq. 7) in which
ŷ2 is the expected output for period 2:
 
E1 ¼½ð1þi Þ=ð1þi1 Þ MS2 =md ðb
y2 ;i2 Þ ð7Þ
We will refer to equation (Eq. 7) as the IPLM-curve, represented in the (Et, ŷt+1)
space, in Fig. 3.
The IPLM-curve describes how the future expected output ŷt+1 affects the nominal
exchange rate Et today. The curve slopes down since any increase in future expected
output ŷt+1, by incrementing money demand, in turn generates a currency apprecia-
tion in that period; hence, an expected currency appreciation tomorrow induces a
currency appreciation already today, i.e., a decrease in E1. Of course, the IPLM-curve
can be shifted by changes in monetary policy at date t01,2. For instance, a tight
monetary policy shifts the curve upward.
Combining the W-curve (4) and the IPLM-curve (7) on the same graph, three
different scenarios are possible, depicted in the next Fig. 4a, b, and c.
Figure 4a shows the good case where just one point of equilibrium is possible.
Figure 4b represents instead the bad case, where the equilibrium is in yt+1 0 0; indeed,
for any given level of the expected output, the depreciation will be so large that it will
take profits down to zero, and so yt+1.
An intermediate case is shown in Fig. 4c, where multiple equilibria are possible.
Indeed, the markets being in equilibrium, the future output expectation (and so the
actual future output) can be either at a low or high level. If everyone expects that the
future output will be at the lower level, this will lead to a sharp depreciation today that
will actually confirm the initial expectation in a self-fulfilling way; on the other hand,
if the future output is expected to be at the higher level, then no depreciation takes

IPLM
t+1
Fig. 3 The IPLM curve
202 G. Saibene, S. Sicouri

a
Et

IPLM

yt+1, t+1

b
Et

IPLM

W
yt+1, t+1

c
Et

IPLM

yt+1, t+1
Fig. 4 The equilibrium: three possible scenarios

place, and the equilibrium will be with a higher level of output and a non-depreciated
exchange rate.
As represented in Fig. 5, the mechanism through which the equilibrium point is
reached can be explained in this way: for any given expectation of the future output,
for instance ŷt+10, the equilibrium in the IPLM curve requires a certain exchange rate
Et0; given the exchange rate so far determined, the future output will be actually
determined by the W curve, therefore it will be yt+10, but this is higher than the
expected. If agents are rational and their initial expectation is wrong, they will adjust
it (for example, assuming this simple tuning rule: b ytþ1kþ1 ¼ ytþ1k > bytþ1k ), and the
story repeats until an equilibrium point is reached. As a result we can deduce that: if
Effects of Currency Devaluations in Developing Countries 203

Et

B W
B

Et 0
A IPLM

yt+1, t+1
0
y* t+1 yt+10
Fig. 5 Rational expectations and equilibria

the initial expectation y t+10 is higher than y*, then the equilibrium will be in A;
instead, if it is lower, the equilibrium will be the ‘bad’ equilibrium, i.e., any point on
the Et axis that is higher than B.

Existence of Multiple Equilibria

A necessary (but not compelling) condition for having a multiple equilibria scenario
is that the W curve intercepts the Et-axis below the IPLM curve, or equivalently as
represented in equation (Eq. 8).
y1  ð1 þ i0 Þ dc1  ðP0 =P1 Þ ð1 þ i Þ MS2
< ð8Þ
  f
ð1 þ i Þ d 1 ð1 þ i1 Þ md ð0; i2 Þ P1

Supposing that in period 2 money supply will adjust

 so as to equal
 demand, which
by rearranging it is equal to the condition MS2 = md ð0;i2 Þ P1 ¼ 1, and that the
international asset market will be in equilibrium, i.e. ðð1þi Þ=1þi1 Þ¼ 1, what
remains is therefore equation (Eq. 9).

y1 <ð1þi0 Þ dc1  ðP0 =P1 Þþð1þi Þ df1 ð9Þ

Given the simplifications of the model, the real output y1 corresponds only to the
added value of the corporate sector, thus excluding wages and government spending;
nonetheless, entrepreneurs are the only agents in the economy modelled, hence the
assumption it is not as restrictive. Briefly, the condition of multiple equilibria
existence requires that real output of period 1 (which is already wholly determined
in the previous period) is not enough to cover the debt service on both domestic and
foreign debt in period 1, in real terms. Otherwise, output in period 1 will be
sufficiently high to allow entrepreneurs to invest and generate demand in the sequent
period, regardless of any exchange rate variation. If the condition holds, an unex-
pected large enough devaluation can actually cut off the whole profits of period 2,
lowering output in real terms and thus making the debt sustainability of the corporate
204 G. Saibene, S. Sicouri

sector unbearable, since firms that were expecting to reimburse their debts thanks to
profits of period 2 cannot do it anymore.
Another critical condition is the proportion of foreign currency denominated debt
(dtf), because it affects the slope of the W-curve: if higher, it is more likely that the W-
curve intercepts the IPLM-curve twice, hence creating the circumstances for a currency
crisis.
It is also possible that a real shock (a fall in productivity, a change in the multiplier
μ, a variation of the parameter α, an alteration of the function yt0ƒ(kt), …) can shift
the W-curve downwards, as illustrated in Fig. 6, thus making possible the existence of
a multiple equilibria scenario.

Empirical Analysis

The aim of this section is to validate the empirical relevance of the research question
through analyzing the effect of an exchange rate variation (Rt) in period t on sequent
period output (yt+1). In the theoretical model presented before, this relationship is
described by the W-curve, in equation (Eq. 4). A high share of foreign currency
denominated debt is an important condition for the relevance of this relationship,
indeed if the share is zero then the relationship does not subsist anymore. The IPLM-
curve, equation (Eq. 7), will not be considered, because its exogenous variable (the
future output’s expectation) simply cannot be quantified, but it is assumed that the
occurrence of a sharp variation of the exchange rate is possible and is coherent with
the theoretical model.
The data presented are yearly, and we introduced a temporal lag ‘k’ between Δyi,t+k
and ΔRi,t. In fact, as a sharp devaluation is a temporary circumscribed shock within a
yearly period, the choice of the lag will be discretional, depending on which time of
the year the devaluation occurs. For instance, if it occurs at the end of the year (as
happened with the Asian Financial crisis), it will affect the next year’s output; instead,
if it occurs in the beginning of the year it will have an effect already on the same
year’s output. Therefore, the following equation (Eq. 10) is used as our framework:
 
Δyi;tþk ¼ai þbi  ΔRi;t  di;tf ;% þdΔytþk þ"i;t ð10Þ

Et

IPLM

y t+1
Fig. 6 Shifts in the W curve
Effects of Currency Devaluations in Developing Countries 205

The left side of the equation, i.e., the dependent variable, is the variation rate of real
GDP, measured in national currency at constant price (Δyi,t+k). The independent
variable, ΔRi,t, is the percentage change in the real exchange rate, and it is multiplied
by di,tf,%, the share of external debt denominated in foreign currency in respect to
GDP, in order to account for the relevance of this condition. The world GDP growth
rate, Δyt+k*, is taken as the control variable, to depurate the country’s GDP from the
evolution of the world economic cycle.
Using a panel of five countries (i0Thailand, Indonesia, Mexico, India, South
Africa), we expect the coefficient βi to be negative, and also a stronger correlation
between the output change and the exchange rate variation whether di,tf,% is high. It is
important to notice that this relationship is relevant only in dynamic states, after the
occurrence of an exogenous shock; indeed, during steady states there is no
more a significant casual relationship between the two variables—as for what
the theoretical model takes into account. A critical point of the empirical analysis is
the inquiry of the data on foreign currency composition of debt for each country, since
there does not exist any precise measure of it. The solution is to use an approximation:
di;tf ;% ¼½ðOSIN External DebtÞ=GDP, where OSIN is the measurement built by
Eichengreen et al. (2003) that estimates the currency composition of external debt,
and external debt is used as an approximation of the total outstanding debt which
could be denominated in foreign currency.

Graphical Analysis

Through this analysis we get a first view on how the relationship between real GDP
growth and real exchange rate variations is graphically detectable. The countries
which have been taken into account are the following, listed in descending order of
the ratio of external foreign currency denominated debt in respect to GDP. The figures
are reported in the Appendix A.

Thailand (Fig. 7a, b) The country was the epicentre of the Asian Financial
crisis, which began on 2 July 1997 when the exchange rate was set free to
float, and rapidly the Thai currency (bath) devaluated. The GDP growth con-
tracted from previous steady levels of 8% p.a. increase to −1% in 1997 and −10% in
1998. Almost certainly other factors contributed to this drop, but nevertheless this
sequence seems to attest a strong and negative causality between the variables
considered, in accordance with the model. The country’s share of external debt
denominated in foreign currency in respect to GDP, which is one of the higher
in the sample, reached a peak during those very years, and then it gradually
declined, as forecasted by our theoretical model.

Indonesia (figure Indonesia (Fig. 8a, b) Although the country was seen as having a
strong economy, its currency (rupiah) started to devaluate in November 1997, reach-
ing the peak in 1998, when it arrived at a depreciation of 187%, while the GDP fell by
−13.3%. In our analysis, Indonesia registers both the worst drop of GDP growth and
the highest percentage of foreign currency denominated external debt.
206 G. Saibene, S. Sicouri

Mexico (figure Mexico (Fig. 9a, b) The country suffered a financial and economic
collapse beginning in March 1994. The ratio of foreign currency denominated
external debt is lower than the ratio of the previously analyzed countries, but
nonetheless is still significant (average of 31%). After the year 1996, the
inverse correlation between real exchange rate variation and GDP growth seems
to become negligible; despite this, there is no evidence of any inversion in the
causality of the relationship.

India (figure India (Fig. 10a, b) A sharp depreciation of its currency (rupees)
occurred in 1990. After that the exchange rate remained floating and volatile, even
without any other variation as large. The share of foreign currency denominated
external debt remains constant, and it is lower than the previously analyzed
countries. There seems not to be any evident relationship between the two
variables, although in the early nineties the GDP growth may seem to be
apparently constrained by the devaluations of those years.

South Africa (figure South Africa (Fig. 11a, b) The percentage of external debt
denominated in foreign currency in respect to GDP is the lowest of the sample,
often close to zero. The volatility of the real exchange rate is yet considerable,
although there are no marked currency devaluations as in the other countries
considered. However, it does not appear to affect the real GDP growth in any
way.

Correlation Matrix Analysis

In Table 2 there are correlation coefficients between the country’s GDP growth
and the two principal variables of our empirical equation,1 namely the real
exchange rate variation multiplied by the percentage of foreign currency
denominated debt and the world’s GDP growth. The two countries considered
are the most different in respect to the amount of foreign currency denomi-
nated debt, i.e., Thailand and South Africa. The dataset covers the period
1991–2007.
As for Thailand, there is a very strong negative correlation between the
endogenous variable and the real exchange rate variation weighed with the
level of foreign currency denominated debt (the third column). This correla-
tion seems to be stronger when no delay is considered, i.e., when k00. As for
South Africa, it seems instead that the country’s GDP is more correlated to the
world’s GDP (in the fourth column) rather than with the real exchange rate
variation. Moreover, when considering a lag of k01, the correlation between
the latter and the endogenous variable changes sign, from −0.0780 to
0.0271.

 
1
Equation: Δyi;tþk ¼ ai þ b i ΔRi;t  di;t f ;% þ dΔytþk þ "i;t
Effects of Currency Devaluations in Developing Countries 207

Table 2 Correlation coefficients

   
Lag (k) Corr Δyi;tþk; ΔRi;t  di;t f ;% Corr Δyi;tþk; Δytþk 

Thailand k00 −0.9114 −0.4677

k01 −0.1551 −0.4946
South Africa k00 −0.0780 0.7027
k01 0.0271 0.6783

Conclusions

Currency devaluations are contractionary for countries with a large amount of debt
denominated in foreign currency, whereas they are not for countries whose debt is
denominated in their own currency, other things being equal. The contractionary
channel lays in the balance sheet effects that currency devaluations cause. Indeed,
after sharp currency devaluations, the debt burden increases in real terms, leading to
the following chain of events: firms’ profits decrease, bank lending is constrained,
and thus the amount of investment is sharply reduced, reducing also next period
output.
The relationship between the firm’s profits and the investment’s level of
the next period is straightforward, and it is enhanced by the financial
accelerator mechanism that also considers the credit availability, while ex-
change rate variations affect the firms’ profits through the balance sheet
channel. The relationship becomes stronger as the level of foreign currency
denominated debt increases, in particular if non-residents own this debt.
Furthermore, it has been proven that the occurrence of a currency crisis
(and the following recession) can be simply triggered by a shift in future
output expectations, which will turn out to be self-fulfilling when the
amount of foreign currency denominated debt is sufficiently high. Nonethe-
less, the model does not take into account the direct effects of devaluations
on the flow variables (as the quantity of imported/exported goods, etc.), but
we believe that these effects are negligible in case of large currency devaluations and
in a short-run period. As the level of foreign currency debt diminishes, the contraction-
ary effect of devaluations reduces as well, until it is so low to lose relevance in the
context of this analysis.
Assuming the model to be correct, a significant question would be how does
the economy recover from the crisis? Indeed, a major problem is that the firms
and entrepreneurs who drove investment and growth before the crisis are now
bankrupt and unable to raise capital. So, such crises might have long-term
negative effects on the country. If this is true, the key to resuming growth is
either to rescue those entrepreneurs, to grow a set of new ones, or both. A
likely source of new entrepreneurs and investment is from abroad. Is it the
beginning of a phase of large foreign direct investment, or will the country not
accept such an inflow of foreign capitals, being stubbornly frightened by the
kind of crisis it has experienced?
208 G. Saibene, S. Sicouri

Appendix A

SOURCE: WORLD BANK. SOURCE: BANK OF THAILAND; WORLD BANK.

Fig. 7 Thailand

SOURCE: WORLD BANK. SOURCE: IMF, FEDERAL RESERVE, WORLD BANK.

Fig. 8 Indonesia

SOURCE: WORLD BANK. SOURCE: IMF,WORLD BANK,FEDERAL RESERVE.

Fig. 9 Mexico

SOURCE: WORLD BANK. SOURCE: IMF, WORLD BANK, RESERVE BANK OF SA.
Fig. 10 India
Effects of Currency Devaluations in Developing Countries 209

SOURCE: WORLD BANK. SOURCE: IMF, WORLD BANK.

Fig. 11 South Africa

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