II Anatomy of Capital Account Crises: Balance Sheet Vulnerabilities and Crisis Triggers
- Atish Ghosh, Juan Zalduendo, Alun Thomas, Jun Kim, Uma Ramakrishnan, and Bikas Joshi
- Published Date:
- May 2008
The financial crises that struck a number of emerging market countries in the 1990s and early twenty-first century were characterized by sudden reversals of capital flows that had pervasive macroeconomic consequences, including abrupt current account adjustment and collapsing real exchange rates and economic activity (Figure 2.1).1 But while the consequences of these crises were broadly similar, their causes appear to be quite different. Turkey (1993), Mexico (1994), and Russia (1998) experienced public sector funding crises. In contrast, the 1997 East Asian crises were mainly private sector phenomena. In Brazil (1998–99), Turkey (2000–01), and Argentina (2002) public sector debt dynamics played a key role; in Turkey, it was both a financial crisis and a banking crisis, while in Argentina, along with the public sector financing problem, there was a run on the banking system, which brought down the currency board and led to currency depreciation and default, as well as a banking crisis. On the other hand, Uruguay (2002) experienced a banking crisis caused by withdrawals of Argentine deposits that spilled into a public sector debt problem and a balance of payments crisis.
Figure 2.1.Selected Macroeconomic Indicators1
Sources: IMF, World Economic Outlook database; and IMF staff estimates.
1 Averages (mean) are given by the solid lines, with standard deviations around the mean given by the dashed lines. The sample consists of Argentina (1995 and 2002), Brazil (1999), Indonesia (1997), Malaysia (1997), Mexico (1997), the Philippines (1997), Russia (1998), Thailand (1997), and Uruguay (2002).
The academic literature has not been able to give a coherent and unified account that explains all of these crises. The first generation of currency crisis models (Krugman, 1979; Flood and Garber, 1984) emphasized the inconsistency between financing a budget deficit through money creation and trying to maintain a pegged exchange rate regime. Since these models did not seem to fit the 1992/93 European Exchange Rate Mechanism crises, a second generation of crisis models (Obstfeld, 1994) was developed in which an inconsistent policy stance, combined with self-fulfilling shifts in investor sentiments, could give rise to multiple equilibria. Yet neither variant could explain the East Asian crises, necessitating a third generation that incorporated foreign exchange exposure of the private financial and corporate sectors. But this third generation of currency crisis models could not explain subsequent crises, such as Argentina (2002). And while the collapse of Argentina’s currency board resulted from an incompatible fiscal policy stance and a deposit run that forced the abandonment of the currency board, the crisis was not in the mold of the first-generation models as the government was bond financing its deficit in a deflationary, rather than an inflationary, environment.2
All this suggests that understanding capital account crises—surely a prerequisite to preventing them— requires a more general analytical framework. The central thesis of this section is that a capital account crisis requires—and is caused by—a combination of balance sheet weaknesses in the economy and a specific crisis trigger. The diversity of capital account crises is therefore not surprising because balance sheet weaknesses can take various forms, as can the specific factors that trigger the crisis. Thus an economy can live with currency and maturity mismatches in private or public sector balance sheets for years if, serendipitously, nothing triggers a crisis. Yet there are many possible crisis triggers, both external—contagion, a terms of trade shock, a deterioration in market conditions—and domestic, such as an inconsistent macroeconomic policy stance, political shocks, or other turmoil (Table 2.1). This section reviews some insights about vulnerabilities that the balance sheet approach can reveal—setting the stage for the possible role of IMF support in crisis prevention.
|crisis||Balance SheetVulnerability||Crisis Trigger|
|Mexico (1994)||Government’s short-term external (and foreign-|
|Tightening U.S. monetary policy; political shocks|
(Chiapas; assassination of the presidential candidate).
|Argentina (1995)||Banking system short-term external and peso- and|
|Mexican (“Tequila”) crisis.|
|Thailand (1997)||Financial and nonfinancial corporate sector external|
liabilities; concentrated exposure of finance
companies to property sector.
|Terms of trade deterioration; asset price deflation.|
|Korea (1997)||Financial sector external liabilities (with substantial|
maturity mismatch) and concentrated exposure to
chaebols; high corporate debt/equity ratio.
|Terms of trade deterioration; falling profitability of|
chaebols; contagion from Thailand’s crisis.
|Indonesia (1997)||Corporate sector external liabilities; concentration|
of banking system assets in real estate/property-
related lending; high corporate debt/equity ratio.
|Contagion from Thailand’s crisis; banking crisis.|
|Russia (1998)||Government’s short-term external financing needs.||Failure to implement budget deficit targets; terms of|
|Brazil (1999)||Government’s short-term external liabilities.||Doubts about ability to implement budget cuts and|
loose budget proposal for 1999; current account
deficit; contagion from Russian default.
|Turkey (2000)||Government short-term liabilities, banking system|
foreign exchange and maturity mismatches.
|Widening current account deficit, real exchange rate|
appreciation, terms of trade shock; uncertainty
about political will of government to undertake
reforms in the financial sector.
|Argentina (2002)||Public and private sector external and foreign-|
|Persistent failure to implement budget deficit targets;|
inconsistency between currency board arrangement
and fiscal policy.
|Uruguay (2002)||Banking system short-term external liabilities.||Argentine deposit freeze leading to mass withdrawals|
Balance Sheet Vulnerabilities
Traditional flow-based analysis focuses on the gradual buildup of unsustainable budget and current account deficits. The balance sheet approach (BSA) complements such analysis by considering how shocks to stocks of assets and liabilities in sectoral balance sheets can lead to large adjustments that are manifested in capital outflows (and corresponding current account surpluses as external financing is withdrawn).
While further disaggregation is possible, BSA typically analyzes four main sectoral balance sheets: the government sector (including the central bank), the private financial sector, the private nonfinancial sector (households and corporations), and the external sector (or “rest of the world”). This sectoral decomposition can reveal important vulnerabilities that are hidden when considering the country’s consolidated balance sheet (or its net position vis-à-vis the rest of the world). In particular, weaknesses in one sectoral balance sheet may interact with others, eventually spilling into a country-wide balance of payments crisis even though the original mismatch was not evident in the country’s aggregate balance sheet. A prime example is the foreign currency debt between residents, which of course gets netted out of the aggregate balance sheet, but may nevertheless contribute to a balance of payments crisis. For example, if the government has foreign currency debt to residents and faces a funding crisis, it will need to draw down the central bank’s foreign exchange reserves, possibly leading to a balance of payments crisis.
More generally, a loss of confidence or a reevaluation of risks in one sector can prompt sudden and large-scale portfolio adjustments, such as massive withdrawals of bank deposits, panic sales of securities, or abrupt halts in debt rollovers. As the exchange rate, interest rates, and other prices adjust, other balance sheets can sharply deteriorate, in turn provoking creditors to shift toward safer foreign assets—resulting in capital outflows and further pressure on the exchange rate and reserves until there is a full-blown capital account crisis. While there is undoubtedly an element of “ex post rationalization” in identifying the crisis triggers, they are nevertheless useful in illustrating how exposures in different sectoral balance sheets can interact to produce vulnerabilities.
Various case studies of capital account crises illustrate how currency and maturity mismatches in sectoral balance sheets, and linkages between them, can contribute to the likelihood that a capital account crisis could be—and ultimately was—triggered. At the same time, given emerging market countries’ still limited ability to borrow in their own currencies (“original sin”), there must be foreign exchange exposure in some sectoral balance sheet in the economy. This also means that any hedging will either be incomplete (or that, in effect, the country is not a net recipient of capital from the rest of the world). Therefore, the key to reducing vulnerability is to try to limit currency, maturity, and capital structure mismatches and ensure that risks—including to real shocks—are ultimately contained by strong balance sheets within the economy.3
Although balance sheet analysis is still in its infancy, analysis so far suggests some conclusions:
The banking system often acts as a key transmission channel of balance sheet problems from one sector into another. A shock in the corporate sector (Asian crisis countries) or the public sector (Russia 1998, Turkey 2001, Argentina 2002) can be transmitted to another sector—typically the banking sector. A deposit run can spark a banking crisis, especially if the government’s own balance sheet is too weak to provide credible deposit insurance or lacks international reserves to provide liquidity support in foreign exchange. By the same token, if banks tighten their lending to prevent their portfolios from deteriorating, then this further complicates the situation of the corporate or public sector that is facing financing difficulties.
If the government’s balance sheet is sufficiently strong, it can serve as a “circuit breaker,” halting the propagation of shocks across domestic balance sheets. In a number of recent crises (e.g., Argentina 2002), however, the government balance sheet was the main source of weakness, precluding such a role. Indeed, banks typically want to hold government securities as they may be the only liquid, domestic-currency-denominated assets. However, if—as in Argentina—the government defaults on its debt, then this can be a source of vulnerability to the banking sector.4
Available foreign exchange reserves or contingent financing may be especially valuable in reducing the economy’s balance sheet vulnerabilities as they can be used to cover short-term financing needs of the public sector, to provide a partial lender of last resort function in dollarized economies, or to help close the private sector’s foreign currency mismatch—insulating the economy from the impact of a devaluation—by providing liquidity to banks. However for contingent financing to be useful, it must be very quickly accessible.
Maturity and currency mismatches are sometimes hidden in indexed or floating rate instruments. For instance, in Brazil during the late 1990s, liabilities were often denominated in local currency but they were also formally linked to the exchange rate.5 Likewise, an asset may have a long maturity but carry a floating interest rate. Such indexation often creates the same mismatches as if the debt were denominated in foreign currency or as if the maturity were as short as the frequency of the interest rate adjustments.
As was the case both in Thailand and in Argentina, balance sheet linkages can transform one type of risk into another without necessarily reducing that risk. For example, the banking system may try to close its foreign exchange mismatch on foreign currency deposits by lending to domestic corporations in foreign currency. However, if the nonfinancial sector recipients of those loans do not have natural hedges (e.g., have export revenues), then the banking system’s currency risk is simply transformed into credit risk.
Off-balance-sheet items can substantially alter the overall risk exposure—reducing or increasing balance sheet exposures according to whether an underlying position is being hedged or the entity is taking a speculative position in the derivatives markets. However, such transactions can also mask vulnerabilities, for instance, as risk from a balance sheet mismatch is transformed into counterparty risk. In aggregate, a sectoral balance sheet may appear hedged through the derivative markets but may still be exposed to the risk if the counterparties are connected.6 For example, in Turkey, the banking system open foreign exchange exposure was small when forward transactions were included, but the main counterparties in these forward transactions were other Turkish banks.
The ultimate buffer for private sector balance sheet mismatches is capital. A major source of vulnerability in the East Asian crises was the very high debt-equity ratios (Table 2.2).
Pegged exchange rate regimes, by offering an implicit exchange rate guarantee, might encourage greater risk taking in the form of open (mismatched) foreign exchange positions. As noted above, to the extent that emerging market countries’ ability to borrow in their own currency is limited, there must be aggregate foreign currency exposure associated with foreign liabilities (i.e., obligations to nonresidents). Nevertheless, there are at least two ways in which pegged exchange rates might exacerbate foreign currency risk:
— The implicit guarantee might encourage more carry trade (arbitrage between low-cost foreign currency borrowing and higher domestic interest rates at a given exchange rate) resulting either in greater total foreign borrowing or a bias toward shorter-maturity foreign liabilities (Thailand 1997, Turkey 2001/02).
— Again by providing an implicit exchange rate guarantee, the pegged exchange rate might encourage more domestic “dollarization”—that is, holding of foreign-currency-denominated assets and liabilities by residents, though neither logic nor empirical evidence particularly supports this.7
The discussion suggests that vulnerabilities might lurk in various sectoral balance sheets, which may interact with specific triggers that result in a full blown crisis. The first step in crisis prevention is to try to avoid such vulnerabilities—in particular, to ensure that the government is not (perhaps inadvertently) providing incentives that exacerbate equity, foreign exchange and maturity mismatches. Second, sound macroeconomic policies—and a consistent policy framework—can also lessen, although not entirely eliminate, the possibility that a crisis will be triggered. Third, the IMF can play an important role in assisting members to avoid crises: how it may do so is the subject of the following two sections.