Front Matter Page

European Department

Contents

• Abstract

• Executive Summary

• I. Introduction

• II. Conventional Macroeconomic Balance-Sheet Crises

  • A. Thailand

  • B. Latvia

  • C. Insidious Crises

  • D. Japan

  • E. Ireland

• III. Can Governments Correct Vulnerabilities Before They Become Crises?

• IV. Conclusion

• References

• Figures

• 1. Thailand: Boom-Bust, BOP Developments

• 2. Thailand: Boom-Bust, Economic Indicators

• 3. Latvia: Boom-Bust, BOP Developments

• 4. Latvia: Boom-Bust, Economic Indicators

• 5. Japan: Exports and Real Effective Exchange Rate

• 6. Japan: Domestic Demand Boom

• 7. Japan: Economic Indicators

• 8. Japan: The NPL Problem

• 9. Ireland: Export and Real Effective Exchange Rate

• 10. Ireland: Domestic Demand Boom

• 11. Ireland: Economic Indicators

• 12. China: Exports and Real Effective Exchange Rate

• 13. China: Domestic Demand Boom

• 14. China: Economic Indicators

Executive Summary

Until the 1990s balance-of-payments crises in emerging market economies (EMEs) were usually flow crises. They were characterized by current account deficits—usually induced by money-financed fiscal imbalances—and were precipitated by a sudden shift in assessments of sustainability when economic agents realized that the government’s exchange rate policy was fundamentally inconsistent with fiscal and balance-of-payments flows.

Since the mid-1990s, however, crises originating in balance sheet vulnerabilities have been the center of attention, and this paper focuses on these crises and makes a distinction between Conventional and Insidious balance-sheet crises.

Conventional crises are triggered by external imbalances and balance sheet vulnerabilities. They typically occur after capital inflows have led to a substantial build up of foreign currency exposure that leaves domestic balance sheets highly vulnerable to shifts in risk premiums. When the risk premium jumps the authorities face a choice of (a) a depreciation to the point where an expected appreciation reflects the higher premium, (b) higher interest rates (to reflect the increased premium), or (c) some combination of the two. Option (a) is most directly detrimental to the balance sheets of the FX borrowers, but the other options may not succeed in staving off the balance-sheet distress that spreads to the banking system and then, almost inevitably, to the financial position of the government. The anatomy of conventional balance-sheet crises is discussed and illustrated with data from Thailand in the 1990s and Latvia between 2002 and 2011. It is argued that these crises are now well understood, and that governments and central banks have better instruments and buffers to avoid them.

Insidious crises, which are triggered by internal imbalances and balance sheet vulnerabilities, are more difficult to detect. They occur in high-growth economies when an initially equilibrating shift in relative prices and resources and credit in favor of the nontraded sector overshoots equilibrium. When the shift in relative prices is built into expectations and investment decisions it can lead to highly leveraged asset price booms and bubbles—usually in domestic real estate, the ultimate nontraded asset. Determining when an equilibrating relative price change is overshooting is extremely difficult. Bubbles are notoriously observable only after they have burst. And policy action to forestall this sort of crisis may be stymied by pressure to maintain growth when exports are no longer the principal driver, by the still strong external position and reserve buffer, and by relatively contained conventional price indices. Insidious crises are illustrated with data from Japan in the 1980s and 1990s and Ireland in the 2000s. Successful EMEs where the likelihood of a conventional crisis seems a rather remote contingency may not be immune to insidious crises. Data from China is used to make the case for a more subtle appreciation of potential vulnerabilities.