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Financial Crises, Liquidity, and the International Monetary System
By Jean Tirole PRINCETON UNIVERSITY PRESS
Copyright © 2002 Princeton University Press
All rights reserved.
ISBN: 978-1-4008-2852-4
CHAPTER 1
Emerging Markets Crises and Policy Responses
Many excellent books and articles have documented the new breed of "twenty-first century" financial crises. I will therefore content myself with a short overview of the main developments. This chapter can be skipped by readers who are familiar with Emerging Markets (EM) crises.
The pre-crisis period
No two crises are identical. At best we can identify a set of features common to most if not all episodes. Let us begin with a list of frequent sources of vulnerability in recent capital-account crises.
Size and nature of capital inflows. The new breed of crises was preceded by financial liberalization and very large capital inflows. In particular the removal of controls on capital outflows (the predominant form of capital control) has led to massive and rapid inflows of capital.
Instead of inducing onshore capital to flow offshore to earn higher returns, these removals have enhanced the appeal of borrowing countries to foreign investors by signaling the governments' willingness to keep the doors unlocked.
At the aggregate level, the net capital flows to developing countries exceeded $240 bn in 1996 ($265 bn if South Korea is included), six times the number at the beginning of the decade, and four times the peak reached during the 1978–82 commercial lending boom. Capital inflows represented a substantial fraction of gross domestic product (GDP) in a number of countries: 9.4 percent for Brazil (1992–5), 25.8 percent for Chile (1989–95), 9.3 percent in Korea (1991-5), 45.8 percent in Malaysia (1989–95), 27.1 percent in Mexico (1989–94) and 51.5 percent in Thailand (1988–95).
This growth in foreign investment has been accompanied by a shift in its nature, a shift in lender composition, and a shift in recipients. Before the 1980s, medium-term loans issued by syndicates of commercial banks to sovereign states and public sector entities accounted for a large share of private capital flows to developing countries, and official flows to these countries were commensurate with private flows.
Today private capital flows dwarf official flows. On the recipient side, borrowing by the public sector has shrunk to less than one-fifth of total private flows. As for the composition of private flows, the share of foreign direct investment (FDI) has grown from 15 percent in 1990 to 40 percent, and that of global portfolio bond and equity flows grew from a negligible level at the beginning of the decade to about 33 percent in 1997. Bank lending has evolved toward short-term, foreign currency denominated debt. Such foreign bank debt, mostly denominated in dollars and with maturity under a year, reached 45 percent of GDP in Thailand, 35 percent in Indonesia and 25 percent in Korea just before the Asian crisis.
There are several reasons for the sharp increase in the capital flows in the last twenty years: the ideological shift to free markets and the privatizations in developing countries; the arrival of supporting infrastructure such as telecommunications and international standards on banking supervision and accounting; the regulatory changes that made it possible for the pension funds, banks, mutual funds, and insurance companies of developed countries to invest abroad; the perception of new, high-yield investment opportunities in Emerging-Market economies; and the new expertise associated with the development of the Brady bond market.
Banking fragility. Up to the 1970s, balance of payment crises were largely unrelated to bank failures. The banking industry was highly regulated, and banking activity was much more limited and far less risky than it is now. It operated mostly at the national level and foreign borrowings were strictly constrained by exchange controls. Various regulations, such as licensing restrictions and interest rate ceilings, kept banks from competing against each other. There were also far fewer financial markets and derivative instruments to play with.
The 1970s and 1980s witnessed a trend toward openness and deregulation, but the subsequent expansion in banking activities and exposure in capital markets made banking riskier. In response, the Basle Committee on Banking Supervision in the past several years has been involved in instituting new banking regulations, concerning minimum capital standards for credit risk (the Basle Accord in 1988), and risk management (the 1996 Amendment to the Accord to account for market risk on the banks' trading book), and is proposing some further reforms.
A common feature of the new breed of crises is the fragility of the banking system prior to the crisis. Often, the relaxation of controls on foreign borrowing took place without adequate supervision. For example, banking problems played a central role in the Latin American crises of the early 1980s. The widespread insolvency of Chilean institutions in 1981–4 resulted in the Chilean government guaranteeing all foreign debts of the Chilean banking system and owning 70 percent of the banking system in 1985. Similarly, the banks of the East Asian countries that suffered crises in 1997 (Thailand, Korea, Indonesia, Malaysia) were very poorly capitalized. [More generally, overleverage was not confined to banks as firms' balance sheets also deteriorated prior to the crises. For example, leverage doubled in Malaysia and Thailand between 1991 and 1996, according to the World Bank (1997).]
Currency and maturity mismatch. Some of the domestic debt and virtually all of the external debt of EM economies is denominated in foreign currency, with very little hedging of exchange rate risk, a phenomenon labeled "liability dollarization" by Calvo (1998). For example, before the Asian Crisis, Thailand, Korea, and Indonesia created incentives to borrow abroad through implicit and explicit guarantees and other policy-induced incentives. To be certain, banking regulations usually mandate currency matching, but such regulations have often been weakly enforced. Furthermore, even if the banks' books are formally matched, they may be subject to a substantial foreign exchange risk through their non-bank borrowers' risk of default. For example, the Indonesian private sector engaged heavily in liability dollarization, and so the banks faced an important "credit risk" (de facto a foreign exchange risk) with those borrowers who had borrowed in foreign currencies.
The second type of mismatch was on the maturity side. For instance, 60 percent of the $380 bn of international bank debt outstanding in Asia at the end of 1997 had maturity of less than one year. Often, the short-term bias has been viewed favorably and even encouraged by policymakers. Mexico increased its resort to de facto short-term (dollar-denominated) government debt, the Tesobonos, before the 1995 crisis. South Korea favored short-term borrowings and discriminated against long-term capital inflows. Thailand mortgaged all of its government reserves on forward markets. As documented by Detragiache–Spilimbergo (2001), short debt maturities increase the probability of debt crises, although the causality may, as they argue, flow in the reverse direction (more fragile countries may be forced to borrow at shorter maturities).
Macroeconomic evolution. Despite attempts at sterilizing capital inflows in many countries, aggregate demand and asset prices grew. Real estate prices went up substantially.
In contrast with earlier crises, which had usually been preceded by large fiscal deficits, the new ones offered more variation in fiscal matters. While some countries (such as Brazil and Russia) did incur large fiscal deficits, many others, including the Asian countries, had no or small fiscal deficits.
Poor institutional infrastructure. Many crisis countries have been marred by poor governance, low investor protection, connected lending, inefficient bankruptcy laws and enforcement, lack of transparency, and poor application of accounting standards.
Currency regime. As Stan Fischer (testifying to the Meltzer Commission, 2000) notes, all countries that have lately suffered major international crises had fixed exchange rates (or crawling pegs in the case of Indonesia and Korea).
Summers (2000) usefully summarizes the major sources of vulnerability in recent major capital-account crises. As Table 1 shows, traditional determinants of exchange-rate crises (current-account and fiscal deficits) played a role in only some economies. In contrast, banking weaknesses and a short debt maturity seem to have been present in most of the crises.
The crisis
Crises are usually characterized by the following features (in no particular chronological order):
Sudden reversals in net private capital flows. Large reversals of capital flows in a short time interval had a substantial impact on the economies. The reversal reached 12 percent and 6 percent of GDP in Mexico in 1981–3 and 1993–5, respectively, 20 percent in Argentina in 1982–3, and 7 percent in Chile in 1981–3. In Indonesia, Korea, Malaysia, Philippines, and Thailand, the combined difference between the 1997 outflows and 1996 inflows equaled $85 bn, or about 10 percent of these countries' GDPs.
Exchange rate depreciation/devaluation. Most countries suffering a crisis were countries with well-integrated capital accounts and with a fixed exchange rate (or crawling peg). The attacks forced the central banks to abandon the peg or more generally to let their currency depreciate. Figure 1 illustrates this in the case of Asian crises. For example, South Korea's won lost half of its value in 1997. Thailand devalued by 15 percent and after the IMF got involved the baht lost a further 50 percent. The Mexican peso lost 50 percent of its value in a week in December 1994 before the IMF intervened. The exchange rate depreciation reduced incomes and spending.
Activity and asset prices. Bank restructuring proved very costly. Fiscal costs associated with bank restructurings averaged 10 percent of GDP and have reached much higher values. Furthermore, whether banks were liquidated or just put on a tighter leash (which was the case for 40 percent of asset holdings in the case of Korean, Malaysian, and Thai banks), restructuring resulted in a credit crunch, which, combined with the firms' own difficulties, led to severe recessions, in particular in the non-tradable goods sector. Indeed, in Indonesia, Korea, and Thailand, many banks in 1998 not only stopped issuing new loans, but also cut back on trade credit and working capital.
Equity (see, e.g., Figure 2 for Asian countries) and real estate prices tumbled. As stressed by Krugman (1998), the fall in prices resulted in a wave of inward direct investment just after massive flights of short-term capital out of those countries. For example, FDI at fire sale prices occurred in South Korea, whose currency had lost half of its value relative to the dollar, and whose stock market had lost 40 percent of its value in domestic currency. This wave of fire sale FDI in some instances (e.g., in Malaysia) gave rise to political concerns of colonization or recolonization.
Contagion. Some recent crises raised serious concerns about contagion. Contagion occurred in Europe in the ERM crises of 1992–3, in Latin America following the 1994–5 Mexican problems (the Tequila crisis), and in Asia in 1997–8 starting with the crisis in Thailand (the Asian flu). While spillovers have been mostly regional, there are also indications that they can be more widespread. For example, the August 1998 Russian crisis spread to Brazil in the fall, triggering the January 1999 crisis, and started spreading to other Latin American emerging markets. Even though the fundamentals in Brazil were weak (large public deficits and uncertainty about the government's ability to roll over the public debt), this episode dramatically illustrates the global nature of spillovers.
There are several competing hypotheses for the contagious aspect of crises. The portfolio rebalancing hypothesis states that after losing money in one country foreign investors have to readjust their positions in other countries. For example, when Russian markets collapsed, some large portfolio managers faced margin calls and liquidated their positions in Brazil. Kaminsky et al (2000) argue and offer evidence that mutual fund managers prefer to sell in markets that are mostly liquid, as they incur smaller losses in such markets. Capital adequacy requirements may force banks to adopt similar strategies. Van Rijckeghem and Weder (2000), noting that western and Japanese banks had substantial exposures in the four Asian crisis countries (Korea, Indonesia, Malaysia, Thailand), present evidence for the hypothesis that a crisis in a country may spread to countries with common foreign bank lenders, as in the case of Thailand and maybe Mexico and Russia. It is unclear, though, why investors would deprive themselves of very lucrative arbitrage opportunities by failing to manage their regional risks.
A second hypothesis is the trade links hypothesis, which has two versions. In the first, a crisis in a country has repercussions on countries that are tightly commercially related. For example, the collapse of the Soviet Union had a non-negligible impact on Finland. In the second, competitive devaluation version, crises lead to substantial devaluations and increased competition for countries producing similar exports.
The third hypothesis relates to the existence of common shocks (rise in interest rates, increase in the price of oil, perceived change in the international community's willingness to come to the rescue). Although there is then no systemic effect so to speak, the crises exhibit a strong correlation. The fourth, and final, hypothesis is a change in expectations. The wake-up-call story asserts that investors realize the lack of solidity of certain types of economies or the unwillingness of the IMF to help restructure the debt.
Each of these hypotheses probably has some validity, and current research is actively disentangling their respective impacts in specific crises.
Rescue packages. The international community, often through the IMF, designed rescue packages of an unprecedented scale (see Table 2). The 1995 Mexican rescue package involved $50 bn or 18 times the country's quota (while IMF loans have traditionally been limited to three times a country's quota), and similar size packages were offered in Asia in 1997: $57 bn in Korea, $40 bn in Indonesia, and $17.2 bn in Thailand. It should be borne in mind, though, that despite their huge size, such packages by themselves were unlikely to restrain speculative attacks on the currencies. For example, IMF packages in Thailand, South Korea, and Indonesia were much smaller than the countries' short-term foreign liabilities. Besides, even IMF packages that would have been as large as the countries' short-term liabilities might not have been sufficient to prevent the crises; Jeanne and Wyplosz (2001) present some evidence that capital outflows were typically larger than the decrease in short-term liabilities during the crises.
Investor bail-in. The degree of sharing by foreign investors has been crisis-specific. Under the Brady plan (debt writedowns for Latin American countries), creditors got one-third of the face value of their outstanding claim. Investors cashed out at full value in Mexico in 1995. They lost up to $350 bn in total in Asia in 1997 and Russia in 1998.
Global solutions have favored bondholders relative to equity investors (foreign direct investment and equity portfolio investment). Forcing private investors to share the burden has proved hard in the case of sovereign bonds. For example, Eichengreen and Riihl (2000), in studying the extent of bail-ins in Ecuador, Pakistan, Romania, and Ukraine, conclude that attempts at forcing private investors to share the burden have had limited success overall, but have been a little more successful where renegotiation-facilitating collective action clauses were appended to the bonds (Pakistan and Ukraine).
A typical debt restructuring proceeds in the following manner: some fiscal and other adjustment is demanded from the country while bilateral official creditors (the Paris Club) agree to rollover or reschedule some debt claims, and multilateral creditors (the IMF, the World Bank (WB), and other multilateral development banks) bring in new money. The rest of the external financing gap is meant to be covered by the private creditors through "private sector involvement" (PSI). The level of multilateral support is relatively well determined. IMP and WB lending receives priority. The claims of bilateral creditors are junior, and last come private claims. Roubini (2000) argues, though, that Paris Club claims are definitely not senior to private creditors' claims: unlike the latter, they are not subject to litigation risk or acceleration or formal default. Accordingly, some countries have kept access to financial markets even though they were in arrears with bilateral official creditors.
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Excerpted from Financial Crises, Liquidity, and the International Monetary System by Jean Tirole. Copyright © 2002 Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS.
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