Reforming the International Monetary and Financial System

Comments: Emerging Market Crises: Origins and Remedies

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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Much of the discussion of what happened in Mexico, Russia, Brazil, and Asia cannot accept a simple proposition: the central reasons for currency crises are severe mismanagement of national balance sheets, exchange rate policy, and political irresponsibility. Is it a surprise then that many of the crises occurred shortly after an election? And shouldn’t we be curious enough to ask whether this is mere coincidence or, instead, a pattern?

Similarly, in looking for solutions, much of the discussion is hampered by attempting to look for answers within the confines of existing institutions. There are perfectly good answers that, although not panaceas, offer real remedies in many instances. The answer, of course, is to push for private sector solutions instead of calling for an expanded role for international institutions and limitations on private initiative.

What Went Wrong?

The reaction to the Asian crisis was striking. Asian leaders and most observers were astounded that Asian economies crashed the way they did. After all, these economies had no inflation to speak of and no history of mismanaged public finance. On the contrary, the Asian economies were known to have high national saving and investment rates, as well as a labor force with a hard work ethic. This was not Latin America where crises were as much a part of the landscape as night and day. Given these considerations, it was natural for George Soros and Prime Minister of Malaysia, Mahathir Mohamad to concur that the markets were out of control, institutions were deficient, and “the beast” was loose. Just how to tame and contain it might give rise to differences of opinion, but something had to be done to limit the speculative excesses of private capital.

It is useful, at the outset, to make a distinction between the old-style and new-style currency crises.1 The old-style crises centered on the current account. With limited reserves and limited borrowing ability, overspending and misaligned currencies would ultimately lead to a crisis simply because the money to finance payments deficit would run out. Moreover, when resources ran out, it was clear for everyone to see. There might be some discussion on how a government, by using controls and other expedients, could gain a few extra months but, ultimately, the days of the exchange rate (and of the finance minister) were numbered. And then the crisis would occur and it would be almost anticlimatic—a devaluation, the demise of the finance minister, and soon the beginning of another round of overspending and overvaluation. The basic characteristic of these old-style crises are three: (1) they are not really crises because nothing much happens when the currency plummets; (2) they are highly predictable in that they are slow-motion events; and (3) there is little fallout because they typically occur in a situation of repressed finance.

By contrast, currency crises today focus on the balance sheet and are the result of a country’s large and liquid liabilities relative to its ability to raise assets on short notice. These are fast-action crises and they are highly explosive because they bring down not just the currency but much of the national financial sector and public finance. These balance sheet crises emerge in the aftermath of financial deregulation, both domestic and across borders, and they reflect a reckless approach to value at risk (VAR). The national balance sheet, the balance sheet of the financial system, and those of large corporations are misaligned in both their domestic and cross-borders components with respect to maturity and currency denomination.

The value-at-risk perspective is central to understanding these crises. In the aftermath of Mexico’s earthquake in 1986, many high-rise buildings were found to have been constructed in violation of safety standards—too much sand and too little cement. Corruption in building supervision was, of course, the explanation. Much of the same applies to the balance sheets of the crisis countries: tesobonos in Mexico, the public debt and the banking system’s unhedged dollar exposure in Mexico, the investment banks’ Brady bond assets, short-term dollar liabilities in Korea, and on and on the story goes. What all of these cases have in common is the utter inability of the balance sheets to reflect bad news and the destructive interaction of foreigncurrency- denominated debt and the extremely short maturity of the liabilities. Asian economies, indeed, saved much and invested much but they also ran reckless balance sheets, just as Russia or Mexico or Brazil did. This is the common feature that needs emphasis, not the precipitous and devastating withdrawal of capital in reaction to the bad news. The notion of sound versus unsound balance sheets hinges precisely on the economy not being exposed to unmanageable withdrawal risk, that is, not allowing a single event—withdrawal cum devaluation—to bring down the financial sector like a house of cards.

The balance sheet and value-at-risk perspectives distinguish between the immediate reason for why a crisis occurs (e.g., a government’s inability to keep interest rates high or a movement in the dollar/yen rate) and the devastating character of the crisis, which cannot be explained without getting back to the appalling state of the balance sheets. Not focusing on the balance sheets avoids the main issue unless one is interested in a cover-up, which, of course, many policymakers are. In the aftermath of a crisis, however, when the goal is a better institutional setup, nearly exclusive focus should be on the balance sheet issues rather than on the details of what “straw broke the camel’s back.”

No Panacea

Much of the official reaction to the recent crises was the recognition that, yes, there were balance sheet issues but emerging market economies have little institutional capacity to remedy them. Therefore, the answers that were proposed were predominantly in the area of exchange rate management and a call for increased resources for the IMF. Surely, that is not a panacea.

Increased exchange rate flexibility, for example, in the form of flexible rates cum inflation targeting (the latest conventional wisdom), is hardly a mechanism for avoiding currency overvaluation, the buildup of bad balance sheets in the process, and the ultimate prospect of a currency crisis. In fact, inflation targeting was precisely what got Chile into problems in the late 1970s, and Mexico, and Russia.

Increasing resources for the IMF is a tempting solution (the forces of public order should be able to “outgun the hooligans”), but the IMF is, in fact, utterly incapable of exerting the kind of discipline that goes along with being a lender of last resort. The IMF is completely political, its actions are determined by what is convenient for member countries, most importantly the United States. Far from avoiding crises, the IMF does not even see them coming! Any increased resources would have to be put toward decreasing the emphasis on balance sheet risk. There could be room for a lender of last resort, but not without supplementary policies that create more incentives for sound finance.

Getting to the Right Answers

Recognition that currency crises come from the interaction of bad domestic financial policies and bad balance sheets leads logically to three reform proposals: currency boards and the closing of national central banks; commercial, offshore lenders of last resort; and market mechanisms for an automatic lengthening of debt maturities. These measures are not a panacea for removing every kind of instability, but they certainly would take us far in the direction of reduced vulnerability to crises. For countries in compliance with this agenda, it may even make sense to consider a lender of last resort that focuses on systemic interests.

Lenders of Last Resort and Supervision

If the terrible balance sheets of financial institutions were not the immediate cause of the crises, surely they strongly affected the magnitude of the crises. Of course, the state of these balance sheets was not just a happenstance, but was rather the result of a course of inaction based on the fallacy that in high-growth and high-savings countries, balance sheets are irrelevant because the mere passing of time will solve all problems, combined with a deeply corrupt process of governance. How to do better? The argument that administrative capacity in organizing bank supervision is lacking may well be right but it is not the last word.

An obvious solution is one that is along these lines—mobilize offshore private lenders of last resort. For a commitment fee these lenders will be available to provide capital when banks are in a difficult situation. Because the arrangement is on a commercial basis, these lenders of last resort will have the incentive to measure and control the risks involved. The private lenders will do two important things: (1) exercise the due diligence and the supervision that governments are unwilling or unable to provide, and (2) charge competitive prices that reflect the expected risks. These prices, in turn, provide feedback to the owners of banks and encourage them to run less risky balance sheets. Even governments have a role to play. High commitment costs imply a high national cost of capital and, hence, poorer performance on growth. To reduce these costs and improve growth performance, governments will have incentive to contribute to a macroeconomic environment that is more congenial to financial stability. Decentralizing the problem and using a private market solution will create a virtuous cycle and a far better banking system.

As with all arrangements, some homework will have to be done on how to create contracts that are enforceable—specifically, making sure that banks providing guarantees actually pay up when the circumstances demand it. This is no different, however, from any other credit lines or commitment arrangements agreed to by guaranteeing institutions. And there is no evidence that guaranteeing institutions routinely default on credit commitments. For many countries private lenders of last resort might be a good first approach to risk reduction and risk management in national balance sheets.

Maturity Risk

In crises, the magnitude of currency collapses and the resulting damage to balance sheets, credit, and economic activity is closely related to the mismatching of maturities. Balance sheet liabilities are very liquid and assets such as real estate or corporate loans are, at best, medium term and absolutely illiquid. The mismatching implies that at the slightest sign of trouble, debt rollover is denied and a big gap opens up on the external account side as a country is put in the impossible situation of paying off much of the external debt upon very short notice. The expectation, of course, is a currency collapse and that very expectation adds capital flight to the outflow.

The answer is a better management of maturities. An attractive way of doing this is to include a contingency in contracts. If an international institution, say the BIS (or any other mutually agreed party) were to declare a state of illiquidity, loans would automatically be rolled over and maturities would automatically be lengthened. Of course, this would be part of standard loan agreements and loans would be priced accordingly. Countries that are highly stable would get access to credit more easily and on more favorable terms; countries that appear to be less predictable and more vulnerable would pay higher fees.

The incentives work by leading countries to see that there is much to be gained in creating better institutions and implementing better policies so that the cost of capital declines. This is just another version of the lender-of-lastresort option except that in this instance there is an automatic rollover, which prevents the liquidity crisis and thus creates a mechanism that prevents pervasive bankruptcies, debt default, and overdepreciation. It is a market-based approach for “bailing-in” the private sector. As such, it is much preferable to the current approach of pressuring banks to roll over debts that are basically unpayable.

Currency Boards

National central banks have been key players in creating the financial vulnerability that was the backdrop for the crises in the 1990s. Closing down the central bank is a thoroughly modern response to a world of high capital mobility and powerful international speculation. The great hope of emerging market economies is to get their interest rates as close to New York rates as possible, but currency risk and credit risk leave spreads that can be extreme. The currency risk part is redundant because it is a premium paid for misdirected national pride and the option of debasing the currency.

There are few advantages for having a national money and none for a mismanaged one. The common argument is, of course, seigniorage—the 1 or 2 percent of GDP in revenues accruing to a national treasury from the issue of a sound money. This argument is correct but, of course, against it must be held the cost of financial crises that may occur as a result of having a national money. It is not at all obvious that the balance of the argument is unfavorable to the currency board option.

The other strong argument involves the loss of relative price flexibility. With a currency board, easy adjustment of relative prices via exchange rate movements is removed. Instead, there is the more difficult path of adjusting via wage and price deflation. Again, the argument is correct but two caveats carry the day. First, governments do not actually use the flexibility in a timely fashion. On the contrary, they overvalue currencies in search of disinflation and then protect the overvaluation with high real rates until they ultimately undergo the crisis. Examples such as Mexico or Brazil or Asia amply make this point. Second, reserving the option of devaluation carries a currency premium in interest rates. Accordingly, the cost of capital increases and that may have as much or more of an adverse effect on competitiveness as a misaligned fixed exchange rate. In other words, the devaluation option of a discretionary exchange rate regime adds to the cost of capital and deteriorates competitiveness, and the more so the worse are the country’s macroeconomic tradition and prospects.

Even if the need for greater relative price flexibility is recognized, it is useful to ask just how much flexibility we need. The answer is almost always very little. In a world of extensive capital mobility, transitory disturbances can and should be financed rather than adjusted to. That is the message of intertemporal economics. What is left then are permanent disturbances as the only instances under which relative prices should be adjusted. It is obvious from trade patterns that a currency board model suits Latin America, using the dollar, and Eastern Europe with the euro as the reference. But there is a genuine question of what to do with Asia—pegging to the yen is one answer, or the yuan, although that is obviously premature. In the meantime, simply pegging to the dollar may be a better solution (as in Hong Kong) than suffering mismanaged pegs or ad hoc policies.

There are two basic approaches to reforming of the international system. One is to expand the scope of an option that has failed thus far—more money for the IMF. Calomiris and Meltzer (1999) express well the skepticism concerning this approach. The alternative approach is to pose an entirely different question—how can private market options contribute to solving the problem? Even with this approach, there will no doubt be crises. But maybe the crises do not need to be quite as frequent, as large, and, above all, as predictable as those we saw in the 1990s.


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