Learning the wrong lessons

For a start, Rogoff expressed concern that economists such as Jagdish Bhagwati, Joseph Stiglitz, and Dani Rodrik are emphasizing the wrong lessons from the Asian crisis. They see clear perils but few gains from opening up emerging markets to private capital flows. But this is deeply misleading, he argued, not least because the main culprit in the financial crises was a fixed exchange rate system. Like a metal umbrella that keeps rain out very effectively until lightning strikes, the fixed exchange rate system often brought about brisk economic growth until a crisis hit.

Moreover, Rogoff observed, integration with the global financial market is indispensable to economic development beyond a certain level. Yes, China and India—aided by capital controls—did escape the Asian crisis relatively unscathed, while Korea—with an open capital market—was hit hard. But that argument holds only so far. China and India had per capita income levels about one-tenth of Korea’s, and at some point they, too, will have to cross the bridge and integrate with the global financial market.

Sovereign default and institutions

Rogoff also rejected as naive a view that suggests that the crises of the 1990s could have been averted had different guardians sat at the helm of the international financial system. Sovereign default, he pointed out, is hardly a new phenomenon. It has been with us for more than 500 years and, over the past two centuries, has been associated with emerging markets. In the earlier centuries, these emerging markets were European countries, and they, too, defaulted. Indeed, the all-time record for sovereign defaults (13) is held not by a current emerging market country but by an earlier one—Spain.

Still, Rogoff said, some countries have historically been less capable of bearing debt and more prone to default, and they have defaulted on their sovereign debts repeatedly. Others—in apparently similar economic situations—have rarely or never defaulted. The divergence between these two groups of countries is unmistakable, even allowing for the inherent randomness of the incidence of debt crises, which are triggered by a confluence of irreducible uncertainty and a crisis of confidence.

The roots of this divergence might be gleaned from the cause of the prime puzzle in international finance—namely, why more capital is not flowing into emerging markets. In principle, emerging markets have greater growth potential and offer more profitable uses for capital. In practice, however, emerging markets have great difficulty overcoming the risks associated with weak institutions. The returns in emerging markets, in Rogoff’s assessment, are not high enough to compensate investors for bearing the political and credit risks bred by institutional weaknesses. Domestic institutional factors also appear to determine the proclivity of emerging markets to default.

Why lend? Why borrow?

From a policy perspective, Rogoff suggested, it is valuable to have a better grasp of the reasons that banks lend and countries borrow. On the lending side, the question is why investment banks are willing to continue to lend at low spreads even when defaults are reasonably certain to occur. The answer lies in the global diversification of lenders’ portfolios. Occasional defaults push the returns from affected investments to the bottom, but average returns on global portfolios remain at acceptable levels.

On the borrowing end, political leaders struggling for funds are inclined to welcome capital inflows, viewing them a bit like steroid injections. Government borrowing is behind most emerging market debt crises; even the Asian crisis involved quasi government borrowing. But the same leaders who welcome capital inflows are extremely averse to facing up to the consequences, including debt restructuring, because these imply a loss of power (though not of life, as was the case, for example, in France, where beheading was once a part of the debt-restructuring process).

If crises are to be made less disruptive, Rogoff saw a need to take measures on both sides. For lenders, he said, it should be made more difficult for courts in rich countries to enforce debt contracts, thereby stimulating the development of nondebt instruments of financial flow. For borrowers, it should be made less difficult to work out debt restructuring arrangements.

Argentina, he said, offers a vivid example. The country now finds itself in a tight spot, short of a debt work-out agreement. High growth would encourage creditors to drive a tough bargain; low growth would keep creditors at bay but would be a Pyrrhic victory for Argentina. (And contrary to common perception, Rogoff said, the IMF is certainly not opposed in principle to debt restructuring, as is evident from the foiled attempt by First Deputy Managing Director Anne Krueger to introduce a systematic mechanism for restructuring sovereign debts.)

What lies ahead?

So given all of this, what does lie ahead for emerging markets? Rogoff viewed indiscriminately narrow spreads on emerging market bonds with alarm, suggesting that these spreads were highly likely to foment major crises for several countries. The risk is heightened, he added, by uniformly low inflation rates. Some countries cannot readily afford low inflation. Without recourse to inflation taxation to supplement small revenues, the deficits of these countries could result in even higher levels of debt. The current prevalence of flexible exchange rates will help avert some but not all crises. And thus Rogoff’s prognosis: the world is likely to see two or three major emerging market crises within as many years.

Rogoff also alluded to what he termed the “mother of all debt problems” unfolding in the United States. Its external borrowing probably exceeds that of the rest of the world, he noted, and, at 25-30 percent, the U.S. ratio of net external liability to GDP even exceeds that of many crisis countries. Policymakers have typically condoned this extra-ordinary level of debt, arguing that it simply reflects the ongoing deepening of international financial markets. But Rogoff was unconvinced, warning that openness of the real economy determines the depth of adjustment when markets turn sour, and that does not bode well for the relatively closed U.S. economy.

In closing, Rogoff emphasized the need to learn how to live with risks and saw a ray of hope emanating from past experience. Markets tend to be more forgiving of countries that have shown momentum toward prudent and sound policy-making. The worst awaits countries that are caught on their heels.