Four graphs EM central bankers should study – lessons from two Reserve Banks (1997-98)

This week has brought more turmoil in the global Emerging Markets and this has caused a number of EM central banks to move to hike interest rates to “defend” their currencies (despite most Emerging Markets today officially have floating exchange rate regimes). Most notable the the Turkish central bank on Tuesday in a desperate move hiked its key policy aggressively. So far the aggressive actions from EM central banks around the world have done little to calm nerves in the global markets.

I have in a number of posts warned that this fear-of-floating can have a rather catastrophic macroeconomic and financial impact and that central bankers in Emerging Markets need to remain committed to the floating exchange rate regimes. Indeed I think central bankers need to learn a lesson from history.

In that regard I think it is illustrative to look at the experience of two countries, which had floating exchange rates and inflation targeting regime during the Asian and Russian crisis in 1997-98. I will here look at the conduct of monetary policy by the Reserve Banks of New Zealand and Australia in this period.

While the two Reserve Banks had very similar policy frameworks they reacted very differently to the external shocks in 1997-98. I will illustrate this with four graphs. Four graphs that today’s central bankers in Emerging Markets should study very closely to avoid repeating past mistakes.

The twin currency collapse

In a very similar fashion to today’s sell-off in Emerging Markets currencies in a number of countries came under serious depreciation pressures in 1997-98 as the both the Asian and the Russian crisis played out. That was also the case for the Australian dollar – the Aussie – and the New Zealand dollar – the Kiwi. Hence, during 1997-8 both the Aussie and the Kiwi weakened by 25-30%.

Aussie Kiwi

To hike or not to hike?

The sharp depreciation of the Kiwi and the Aussie caused inflation fears to increase. The Reserve Bank of New Zealand feared that a weaker currency would push up inflation as a result of higher import prices. On the other hand the Reserve Bank of Australia was more concerned with the negative impact of the negative shock to demand coming from a collapse in external demand.

This different perceptions of the risks led to different policy responses. Hence, the RBNZ reacted by pushing up interest rates during 1997 (only later to reverse its policy stance sharply in 1998), while the RBA kept its key policy rate on hold all through 1997-98. It is also notable  that these very clear differences in interest rate developments did little to change the performance of the Kiwi compared to the Aussie. This indicates that aggressive rate hikes will not help much if you want to prop up your currency in such environment.

rates NZ AU

Little difference in inflation performance

Hence, during 1997 there was a marked difference in the development in monetary conditions in the two countries. However, it is notable that there was very little difference in the inflation performance of the two countries.

Despite the sharp sell-off in both the Kiwi and the Aussie inflation remained low and below 2% in 1997-98 in both countries and it is very clear that the “import price effect” was nearly irrelevant compared to the negative demand effect.


New Zealand’s unnecessary recession

While there was very little difference between the inflationary developments in the two countries in 1997-98 the story was very different when it comes to real GDP growth.

Hence, the graph below very clearly illustrates that the RBNZ’s interest rate hikes caused the New Zealand economy to go into recession. Obviously the RBNZ claimed that it was the result of the negative external shock. However, looking the what happened in Australia it is very clear that the recession in New Zealand was a result of monetary policy failure. In fact the RBA by not panicking and keeping its key policy rate unchanged ensured that recession was avoided in Australia despite being as negatively hit by an external demand shock as New Zealand.

This very clearly demonstrates that the central bank has the final word when it comes to nominal spending/aggregate demand in the economy. Any negative demand shock – whether a shock to exports or fiscal tightening – can be offset by monetary policy. The RBA seems to have understood this, while the RBNZ failed to understand it – which rather negative consequences.


The TCMB just repeated the 1997-mistakes of the RBNZ 

The conclusion from the experience in 1997-98 in Australia and New Zealand seems clear – there is very little to gain from fighting a currency weakening caused by a major negative shock and monetary tightening in respond to such a shock is very likely to be recessionary.

This week’s monetary tightening in Turkey is much bigger than what we saw in New Zealand in 1997 and it is therefore only natural to think that the impact on Turkish real GDP could be at least as negative as was the case in New Zealand in 1997-98. Therefore, the Turkish central bank (TCMB) should of course reverse cause as fast as possible. Yes, inflation is likely to increase as a result of a weaker lira, but the monetary policy response could also send the Turkish economy into recession.

Central bankers in Emerging Markets should stop fighting the depreciation of their currency and instead focus on their medium-term nominal policy objectives. Stop-go policies as presently being implemented in Turkey are likely to end in tears.

Instead EM central bankers should stay calm and let markets determine exchanges like the Reserve Bank of Australia did in 1997-98 and then it is likely that they will avoid importing recessions and financial distress and at the same time  any major risks to their nominal policy objectives in the medium-term.

HT David Laidler

Leave a comment


  1. Love the rigor of your analysis. Would you still characterize your certainty in a central bank’s ability to offset impact of ANY external demand shock? I am thinking of the U.S. Oil shock 1973. And if so, is it because of your correct analysis of monetarist theory in Friedman’s quality/quantity theory of many?

    Keep hammering on, love your work!

    WJ Holland

    • Thanks for the kind words William.

      I think it is extremely important to differentiate between demand and supply shocks. What I argue is that the central bank is in full control of nominal spending (aggregate demand) in the economy and hence the central bank can offset any shock to demand and will do so if it is targeting inflation or nominal GDP.
      However, the central bank can’t do anything about supply like oil prices shock (for oil importers). The proper monetary policy response to a negative supply shock like the 1973 oil shock is to keep nominal spending growing at a steady rate. That would cause inflation to rise and real GDP growth to slow, BUT if the central bank respond to the shock by tightening monetary policy then the result will be an even bigger drop in economic activity. On the other hand if the monetary policy is eased in respond to a negative supply shock then inflation will increase MORE than needed for a smooth reallocation in response to the change in relative prices (higher oil prices).

  2. Misspelled “money”. Sorry.

  3. wmeworry

     /  January 31, 2014

    So laissez-faire again is the better alternative. Must be quite an unnerving policy for the central bankers, to do nothing in such circumstances.

    • Central bankers should set clear nominal targets and leave the implementation of monetary policy to the markets and then go golfing. That doesn’t have to be unnerving at all. In fact being a good central banker could easily be a part-time job.

  4. A very nice example of one central bank taking a full view of its aggregate demand responsibilities and another central bank not doing so.

  5. Rajat

     /  January 31, 2014

    Thanks Lars, great post – very grateful.

  6. Tan

     /  January 31, 2014

    The analysis is excellent. But I think you left out one of the major causes of many past EM crises, which is foreign currency borrowings. It’s true that from a real economy standpoint, a country facing a weaker growth outlook should just let the currency depreciate. Just look at the examples of the US and UK in recent years. But a country with a lot of foreign currency debt, whether public or private, could precipitate a financial crisis if the currency dropped sharply because it will cause the debt burden to spike. The alternative of having to defend the currency via sharply higher rates will probably precipitate a credit crunch too. But it’s an invidious choice with no easy way out. This was arguably a key cause of the 1997 Asian Crisis, and the Hungarian/Latvian crises of 2008/2009.

    • Thanks Tan, but I did not leave out anything. What did the Asian countries and Latvia (and the other Baltic countries) in 2008/9 have in common? Fixed exchange rates! Hungary officially had a floating exchange rate regime in 2008, but hike interest rates aggressively when the forint came under pressure in 2008/9. Hence, the key reason for all these crisis were monetary policy failure aka fixed exchange rate regimes. Foreign currency lending is never a problem in floating exchange rate regimes.

  7. Darko Oracic

     /  January 31, 2014

    A nice piece of common sense.

  8. Emrah

     /  January 31, 2014

    In my opinion above analysis misses a few points. AUD/NZD are commodity currencies both countries are net commodity exporters. Where as TRY is a net commodity importer. Additionally, the article says nothing about the current account picture of the countries. Turkey has a long standing current account deficit and HAS to attract foreign capital, either in form of FDI or portfolio inflows. Obviously the CA deficit and commodity imports are closely related. Furthermore, CBRT (Turkish central bank) has punished local savers for the last two years with negative interest real rates i.e. interest rates below inflation. For a country that desperately needs savings that usually spells trouble, and it evidently did as seen by depreciation of the currency. You could argue that the recent interest rate hike was premature/too high etc. but this argument misses the fact that the country i) needs foreign capital and local savings ii) inflation dynamics are different than AUD and NZD, because the Turkey imports oil and gas in foreign currency and if currency tumbles inflation increases even further. These concerns do not exist for AUD and NZD. iii) Turkish corporates are short foreign currency due to their liabilities in EUR or USD. As local currency depreciates especially small-mid size firms could go bankrupt. iv)Turkish currency has already depreciated by around 20%, so we are already in the adjustment process at the moment. Comparing the current state with AUD and NZD’s depreciation back in late 1990s is a bit off the scale, I think.


    • Henry Onslow

       /  February 1, 2014

      The absence of any reply to Emrah is telling. Lars replied almost instantly to those who mostly agreed with him, but will of course be judged on how he are able to argue against those very substantial counter arguments that Emrah here presents.

  9. MAHE Erwan

     /  January 31, 2014

    Hello Lars how are you doing ? And happy new year. Very interesting comparison, but did you take into account the different fiscal policies during these periods, if there as any?

    bets regards

  10. Great analysis. But the trend rate in 97-98 was down whereas Turkey has been up, suggesting very different monetary backdrop.

  11. Simon Hinrichsen

     /  February 1, 2014

    Cool post, Lars. However may I suggest one missing (and important!) piece:
    Link is to a graph of external debt I drew. Pretty big difference.

  12. Hey Lars, great post – the RBNZ realised that it made a mistake in the late 1990s, and they have certainly learnt from it. They bring up these sorts of issues themselves on occasion when discussing monetary policy now.

    Hey Simon, the external debt figures have been significantly revised since then – the New Zealand story isn’t quite as much of an outlier anymore in terms of external liabilities.

  13. Benjamin Cole

     /  February 3, 2014

    Excellent blogging.

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