Journal Issue

Managing financial crises: Drawing lessons for Latin America

International Monetary Fund. External Relations Dept.
Published Date:
May 2003
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IMF Survey: How did the IMF mine its previous experience in crisis management to help it deal with deepening problems in Argentina?

Collyns: In early January 2002, the IMF’s management asked that a group of staff with relevant country and policy expertise be assembled to look at issues emerging in Argentina.

Management wanted operational recommendations drawn from any direct parallels with earlier crises—notably in the 1990s—and from any differences. When the exercise proved useful, a second task force was put together, in the summer of 2002, to address similar questions for other Latin American countries that were beginning to face serious strains.

The task forces found a number of similarities between the then-current and previous crises. Like Asia, many of the affected countries in Latin America had a variety of soft-peg exchange regimes—or in the case of Argentina, an ostensibly very hard peg—that cracked under the strain. These economies had to find ways to reestablish a credible nominal anchor, and Asia offered relevant experience for how to do this.

A second parallel was that once the exchange rate began to move, and move substantially, the financial and corporate sectors suffered major balance sheet damage. This phenomenon was at the core of the deep economic disruptions in Asia, and we expected similar difficulties in Latin America—perhaps to a greater extent than in Asia.

But there were important differences, too. In Asia, the crises came after 10 years of rapid growth and low inflation. As a result, the markets had a basic belief in the ability of the authorities to pursue responsible macroeconomic policies. In Latin America, where hyperinflation in the 1980s was followed by persistent weaknesses in fiscal policy in the 1990s, it was much more difficult for the authorities to reestablish credibility.

IMF Survey: Were there aspects of what happened in Argentina and Latin America that the IMF had simply not seen before?

Kincaid: Many. One was the abandonment of the currency board in Argentina. After earlier crises, involving essentially soft-peg exchange rate regimes, the received wisdom was that exchange rates should either float—including being lightly managed—or move to a hard peg, like a currency board or dollarization. Indeed, the resilience of Argentina’s currency board in the face of the tequila crisis in Mexico and the Russian crisis seemed to validate this so-called bipolar approach.

The crisis in Argentina and its abandonment of its currency board has called this view into question, though it is still too early for firm conclusions.

Argentina’s experience does not necessarily mean that all currency boards are not viable, but it does underscore how important it is to have consistent policy support for those regimes, notably through appropriately flexible labor market policies, disciplined fiscal policy, and sustainable debt management.

Collyns: Latin American countries had unusually high degrees of dollarization, and this complicated crisis management. This made their banking systems much more vulnerable to deposit runs, because their central banks could not function as credible lenders of last resort. The authorities could very quickly get into a situation where they were forced to take rather extreme administrative measures. For example, after Argentina lost a sizable portion of its bank deposits and reserves, it was forced to impose a comprehensive freeze on bank deposits.

Kincaid: High degrees of dollarization also meant that these countries faced a much more complicated trade-off than in the Asian countries between intervention policy, using dollars to bolster the domestic currency, and support of their banking systems, which also required dollars. In Asia, governments were able to extend blanket guarantees to depositors to restore confidence in their banking systems. Argentina’s government and central bank lacked the dollars to do so credibly. Moreover, with the default on its sovereign debt, Argentina could not recapitalize its banking system using government bonds as effectively as in Asia.

IMF Survey: Are there new lessons to be drawn on the role of the exchange rate in managing crises?

Collyns: Countries faced with a loss of confidence and a plummeting exchange rate typically find it difficult to resist the temptation to intervene in the exchange market. But, as the Asian crises made clear, the only way to stabilize the market in a crisis is to let the rate float until it finds a level that can be supported by the market. A tight monetary policy can usefully signal the authorities’ desire to avoid a surge in inflation, but it cannot substitute for letting the exchange rate decline until expectations begin to turn around.

This is the advice we gave to Argentina. Its exchange rate depreciated very rapidly for a time, but eventually the bottom was established after an overall tightening of financial policies, and now it is seeing much more stability—in fact, there has recently been a strong appreciation of the exchange rate. The authorities have begun to relax the controls they had introduced. There is even a concern that the appreciation might be moving too quickly.

Kincaid: There was also concern that there might be a large pass-through to inflation from the sharp currency depreciation. The task force examined experiences in Latin America, Asia, and Russia that demonstrated that the pass-through can, with appropriate policies, be rather small. Indeed, with a limited increase in base money, Argentina has experienced so far a small pass-through to inflation. And with improved confidence in central bank policy—and in economic policies more broadly—inflation has come down to very low levels.

IMF Survey: How large a problem did Latin America’s fiscal situation pose?

Collyns: It was a central issue. In Asia, relatively sound underlying fiscal positions meant that fiscal policy was available as a countercyclical tool to support activity. In virtually all the cases in Latin America, the key to stabilizing the situation was a determined effort to bring fiscal deficits down to levels that could be financed in a stable way without recourse, for example, to inflationary financing from the central bank. Governments successfully restored stable financial environments and eventually laid the basis for a return to growth, but this reflected a restoration of confidence rather than fiscal stimulus.

IMF Survey: Initially, the underlying assumption seemed to be that Argentina’s problems were its own. Were the IMF and Latin American governments slow to recognize the potential for contagion?

Kincaid: I don’t think governments were at all slow, and I would dispute the characterization that IMF staff thought this crisis would be confined to Argentina. In fact, as the crisis unfolded from November 2001 through January 2002, the staff was surprised that Argentina did not have a bigger impact. The crisis seemed to unfold in slow motion.

Consequently, management asked the task force to look at spillover effects. The purpose was to make sure IMF mission chiefs were aware of possible channels of contagion transmission and various early-warning techniques. We did witness direct contagion to Uruguay and Paraguay. In addition, we saw questions being raised in the region about the choice of policy mix and the value of reforms.

Collyns: At the same time, the IMF did its best to contain the contagion by emphasizing the unique features of the Argentine situation and by supporting, in a very deliberate way, neighboring countries with strong policies. In Uruguay, for example, we came in quickly, with far larger financing for their adjustment program than the normal access limits would suggest. We saw Uruguay as a country with basically good policies that was heavily affected by special linkages with Argentina. The situation was mushrooming, and we tried to address it forcefully and eventually succeeded.

Similarly, Brazil had followed and continued to follow basically good policies despite being hit by the uncertainty in the markets related to the political transition in October 2002. Eventually the continuation of those good policies, with timely and very large financial support from the IMF, helped Brazil survive those difficult times. Our judgment that Brazil had a basically sound policy framework was, in the end, vindicated by the outcome.

IMF Survey: What were key lessons that the task forces learned, and how has the IMF absorbed them?

Kincaid: One set of lessons pertained to debt sus-tainability. A problem encountered in Argentina was that overoptimistic projections about real growth and other variables made the country’s debt seem more sustainable than it was. To remedy this, the IMF’s Executive Board in mid-2002 endorsed a new framework for analyzing debt sustainability that is designed to be more objective. It employs historical values for projections and applies country-specific historical shocks for sensitivity analysis. Based on a retrospective application, one task force report showed that this approach does a better job of testing robustness of debt sustainability, though it’s not perfect. Indeed, debt ratios were underpredicted owing to the higher costs for recapitalizing the banking system and larger-than-expected real exchange rate depreciation.

Sustainable public debt ratios are also much lower than many had previously thought. Indeed, staff work indicates that when debt ratios exceed 40 percent of GDP, the probability of running into debt difficulties increases rather sharply. Governments therefore need to pay more attention to their funding risks and avoid becoming too dependent on international capital markets, in part by developing domestic financial markets, giving them an alternative, and perhaps more secure, source of funding.

The task forces also examined past experience with debt restructuring, often using a two-track approach. One track dealt with household and corporate debts issued under domestic law, and the other track tackled sovereign debt restructuring under foreign law. In the first track, the most effective approach combined elements of a credit-driven, debtor-by-debtor process with a government-led, across-the-board process that could be tailored to each country’s circumstances. In the second track, the finding was that the economic costs of default were reduced the sooner the restructuring occurred. Drawing on previous country experience, the task forces developed a step-by-step roadmap to debt restructuring.

Collyns: Another lesson Asia taught us is that, when you have a crisis, the poor are particularly exposed. We realized early on in Latin America that it was essential to strengthen social safety nets even before IMF-supported adjustment programs were fully in place. In Argentina, we worked very closely with the World Bank and the Inter-American Development Bank. It was very important to cushion the impact of the crisis on the poor. And giving a social dimension to the adjustment program helped build support for the program. People could see that the burden of adjustment was being fairly distributed.

Kincaid: Argentina also prompted the IMF to reex-amine how it conducts surveillance in program countries. One issue was whether the IMF, in the context of Argentina, gave clear enough advice about exiting the currency board at an appropriate time, say, after the tequila crisis but before the Russian crisis. Did the IMF give sufficient stress to the need for supporting policies for the currency board arrangement?

The IMF’s surveillance of program countries is a topic that our Executive Board has discussed extensively, and more discussions can be expected. Various experiments are under way to increase the fresh surveillance perspective in program countries, including having different staff from the area department or from other departments conduct the surveillance discussions.

Argentina also raised questions about the use of exceptional IMF access in capital account cases. The IMF Board agreed in September 2002 to more clearly defined criteria for such exceptional access and to strengthened procedures, including raising the burden of proof and formalizing early Board consultations on these requests.

We have not yet learned all the lessons. We therefore look forward to the report by the Internal Evaluation Office on capital account crises and Argentina.

Collyns: Finally and more broadly, the IMF is fully aware that emerging crises must be dealt with quickly, flexibly, and forcefully, given how rapidly a situation can deteriorate.

Photo credits: Denio Zara, Michael Spilotro, Pedro Márquez, and Denio Zara for the IMF. Jae-Ku Choi for AFP, page 137.

Illustration: Massoud Etemadi, pages 148-9.

The value of a rapid and decisive response has been illustrated recently in Bolivia. In February, the IMF had a mission in the field negotiating a three-year adjustment program financed under the PRGF [Poverty Reduction and Growth Facility]. Those negotiations were taking time because PRGFs are very complicated. Unfortunately, there was a sudden outbreak of violence and a tragic loss of life. The mission had to be evacuated, and, amid all this turmoil, Bolivia had a run on its heavily dollarized banking system that could have very quickly led to an unraveling of its macroeconomic situation.

This also happened to be the weekend of the massive East Coast snowstorm. The IMF’s headquarters were closed and the mission team was stuck overseas because Washington’s airports were shut down. But via e-mail, phone, and teleconference, we managed to rethink the situation, discuss it with management, and develop a new approach jointly with the Bolivian authorities. It was decided to step away from the PRGF for the interim and try to negotiate a streamlined Stand-By Arrangement that could stabilize the situation. We negotiated a stabilization program with a Bolivian team in Washington by the following weekend. Other bilateral and multilateral creditors had also stepped in to increase and rephase their financial support. The combined effort of the authorities and the international community helped stabilize the situation in Bolivia. I am pleased to say that things are now much calmer, and we have since returned to La Paz to negotiate the PRGF.

Occasional Paper No. 217, Managing Financial Crises: Recent Experience and Lessons for Latin America, edited by Charles Collyns and G. Russell Kincaid, includes an overview by Collyns and Kincaid and chapters on

• assessing vulnerabilities in Latin America, by Javier Hamann, Kalpana Kochhar, Timothy Lane, Guy Meredith, Jürgen Odenius, David Ordoobadi, Hélène Poirson, and David Robinson;

• macroeconomic consequences of a financial crisis, by Kochhar, Lane, and Miguel Savastano;

• reestablishing a credible nominal anchor, by Andrew Berg, Sean Hagan, Christopher Jarvis, Bernhard Steinki, Mark Stone, and Alessandro Zanello;

• dealing with banking crises in dollarized economies, by Anne-Marie Gulde, David Hoelscher, Alain Ize, Alfredo Leone, David Marston, and Marina Moretti;

• public debt dynamics and fiscal adjustment, by Richard Hemming and Teresa Ter-Minassian;

• corporate debt restructuring, by Hagan, Eliot Kalter, and Rhoda Weeks-Brown; and

• applying the Prague Framework in crisis resolution, by Cheng Hoon Lim and Carlos Medeiros.

Copies of the Occasional Paper are available for $25.00 each (academic rate, $22.00) from IMF Publication Services. See page 141 for ordering details.

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