Comments: Who Is to Blame for the Crises?
- Alexander Swoboda, and Peter Kenen
- Published Date:
- December 2000
The first sentence of Mussa, Swoboda, Zettelmeyer, and Jeanne’s paper reads, “The emerging market crises of the 1990s—in particular, the shock of the Asian crisis and its global repercussions—have generated a perception of deep inadequacies in the international financial system and an intense debate on global financial reform, particularly regarding capital flows to emerging markets.” Having spent 18 months observing market behavior from inside the belly of the beast, I would have written instead, “The emerging market crises of the 1990’s … have generated a perception of deep inadequacies of national financial policies in key crisis countries, and the global crisis has laid bare the failure of the IMF—the only institution with a global surveillance mandate—to recognize these policy failures early and to prevent or mitigate their global impact by inducing the relevant countries to implement effective and timely remedial policies.”
This is not to say that inflows into emerging markets and outflows of short-duration money, particularly short-term bank exposures, were not a significantly aggravating factor—they definitively were. But I am more in sympathy with the BIS’s 1999 Annual Report, which states that “While current problems in the financial systems of emerging market countries were primarily domestically generated, international capital flows clearly exacerbated them.”
There is abundant, objective evidence that the key crisis countries (Thailand, Korea, Indonesia, Brazil, Russia) had allowed severe disequilibria to build up in the financial sectors and, in some cases, also in the traditional macroeconomic variables. There is no need to review the massive domestic credit expansion by financial systems ill-equipped to ensure the integrity of such credit, the buildup of corporate leverage ratios, the explosion of corporate currency exposures, the growing levels of corruption, and the glaring liquidity risks incurred by the shortening of cross-border bank credit exposures—much of it supported by implicit or explicit governmental guarantees. This economic and financial mismanagement created the necessary conditions for the financial crises during the last two years, and without it, there would not have been a crisis.
Likewise, with regard to contagion, the paper points the finger at international markets: “International linkages created contagion across emerging economies that were distant and dissimilar.…” But here too the spread of the crisis was, to a large extent, driven by shortcomings in the financial systems of the crisis countries themselves, rather than by the unwarranted reaction of international investors. For example, the insured deposits of Korean merchant banks were channeled into below-investment-grade debt of Asian corporates, as well as into high-yield, local, currency debt in Russia. Peregrine, the illustrious Asian investment bank, deserves most of the credit for creating the ill-fated Asian junk bond markets with indirectly insured funding by linking Korean lenders to Indonesian borrowers. Peregrine has now left the stage (like Drexel did more than a decade earlier). The appetite of Brazilian banks and investors for leveraged Russian paper and Brazil’s own Brady bonds spread the October 1997 crisis to Brazil. Indeed, Brazilian investors were, in the first half of 1998, the most eager for information on Russia. And again, the government-protected Japanese banks were the biggest losers in Asia. The unwinding of these cross-border emerging market exposures was a major contributor to the spread of the crisis from country to country.
How Did Global Markets Contribute to the Crisis?
There were primarily two ways in which weaknesses in the structure of global markets and in international investor behavior contributed to the severity of the crises. First, the paper’s authors correctly point to the growth in short-term “cross-border” bank lending (much of it interbank) as one of the main culprits in the drama of the last two years. I completely agree, and the numbers speak for themselves. Such bank lending was driven by increased competition in home markets (particularly second-tier European banks), attempts of some banking systems to earn their way out of massive book losses (particularly Japanese banks), inadequate or nonexistent credit-risk management in the individual institutions (mostly non-U.S. banks), reliance on being a preferred creditor, and a confidence (strengthened by the Mexican bailout) that internationally coordinated solutions eliminated the risk of catastrophic credit failures.
The nature of interbank lending is such that it allows the exposure to be wound down exceedingly fast. The legal documentation is simple, and unlike corporate borrowers, emerging market bank borrowers are usually internationally known entities that, particularly in the early part of the crisis, fear being cut off from future credits more than the corporate sector. This threat is all the more credible because the number of lenders is relatively small—thus allowing the formation of effective coalitions to keep borrowers with arrears from gaining access to this class of lenders again—unlike the set of bondholders. It was, therefore, possible for international bank lenders to achieve a massive reduction in exposure to emerging market bank borrowers in a very short time without suffering a markdown in the nominal value of their exposure. Liquidity crises were thus precipitated that needed to be resolved through concerted international intervention, as in Thailand and Korea. In comparison, the portfolio and direct investors have not been able to reduce their exposure on a net basis as fast as banks, and they have suffered an immediate downward adjustment in the market value of their investments.
Second, a number of technical factors in international financial markets served to aggravate the financial crisis in emerging market countries. The emerging market investor base is not as stable as that of, say, U.S. corporate debt (even noninvestment-grade corporate debt), and a nondedicated investor base is generally more opportunistic and more willing to change portfolio allocations quickly. The investment is viewed more as a way to temporarily enhance returns than as a buy-and-hold asset class (hence the significant impact that movements in U.S. yields have on flows to emerging markets). Furthermore, the troubled history of emerging market investing leads to rapid withdrawal and reduction in the value of the investments at the first sign of crisis—markets do have memories. Problems in one region or country thus typically lead to “a run for the exits,” that is, across-the-board reductions in emerging market portfolio allocations, more so than one would observe in more mature markets. In addition, the prevailing VAR risk-management methodology in international banks will force sales in an array of asset classes, in order to keep VAR below a predetermined number once losses have pushed the VAR above its limit.1
Solutions Proposed by the Official Sector
Let me briefly address the solutions that have been put forward by a growing number of official committees. First, there are proposals to redress a perceived imbalance in burden sharing between official and private creditors in emerging market debt restructuring. This has led to explicit calls by the IMF and some G-10 governments to include Eurobonds in Paris Club restructuring agreements. Everyone favors the principle of equal treatment in restructuring, but the idea that private creditors “as a group” have not borne their share of losses is difficult to believe. First, total losses sustained during 1997-99 by private creditors—portfolio investors, direct investors, bank lenders—were many times greater than the losses sustained by public sector creditors, and this is as it should be. Second, public sector credits are frequently made on noncommercial terms—military aid, food aid, and other tied bilateral assistance—more akin to aid than commercial credits. Third, a very large group of creditors—the international financial institutions—is entirely excluded from all restructuring proceedings, in particular the IMF and the World Bank. If the call for more equitable burden sharing is to merit attention at all—and I do not think it does—then it is essential that these institutions give up their preferred creditor status.
The second set of solutions proposed by the international public sector involves changing the agreement structures on external debt obligations to make it easier to force creditors to keep exposures at original levels by extending maturities—the so-called bailing-in proposals—and allowing a restructuring of external debt by a qualified majority of creditors. This proposal has some theoretical merit, but in practice it is a nonstarter. First, it is very doubtful that the G-7 would consider encumbering their own sovereign debt obligations with such rollover and restructuring agreements. Could countries like Belgium and Italy, with debt-to-GDP ratios far in excess of those of most emerging market countries, be induced to make investors accept covenants that would make it easier to restructure their debt? The problem with such proposals is they identify beforehand a set of countries as potential problem debtors. By tagging some emerging market debt as being more likely to be rescheduled, this type of asset is even less likely to build the strong “buy-and-hold” investor base needed to achieve less volatility in pricing. It has long been recognized that the threat of not being able to exit will be very expensive to capital-importing countries. Indeed, the price in terms of borrowing cost will deter major sovereign debt managers from even considering such an approach. This is also the reason why it is generally agreed—including by the IMF—that capital controls should only be imposed on capital inflows, not outflows.
There is not much merit in the current proposals to address perceived problems of the international financial system. I hasten to add, however, that the increased funding for the IMF and the improvement in its ability to lend larger amounts more quickly through the CCL is a significant step forward in its ability to resolve global liquidity crises.
Are There Any Effective Solutions to the Recurrent Crises in Emerging Markets?
If we only pay lip service to the fact that emerging market countries themselves created the necessary conditions for the crises to occur (as was clearly evident beforehand) and if we instead focus only on the shortcomings of the private sector of the international financial system (as the authors of the paper do), then we are likely to propose only facile solutions that relieve political pressure to address the more fundamental problems. By acknowledging up front the politically difficult conclusion that it was the policy shortcomings of the countries themselves that created the necessary conditions for the financial and economic crises in the emerging market countries, then we also lay bare the main fault in the architecture of the post-Bretton Woods international financial system.
The Second Amendment to the IMF’s Articles of Agreement in 1978 gave the IMF what is now its main role, namely surveillance over member countries’ policies. The aim of the Second Amendment was to give power to the IMF to identify and prevent unsustainable policies in any member country from adversely affecting the rest of its membership. Obviously, this addition to the international architecture has not prevented any of the last three crises—the 1982 developing country debt crisis, the 1995 tequila crisis, and the current global emerging market financial crisis. Indeed, the IMF’s greatest success under the leadership team of Michel Camdessus and Stanley Fischer—arguably the most outstanding in the IMF’s entire history—has been crisis resolution, not crisis prevention. I hasten to add that this failure is not of their making but, rather, reflects a lack of empowerment by the IMF’s G-10 shareholders.
I believe that identifying unsustainable policies and inducing the offending countries—whether G-10 or emerging market countries—to adopt remedial policies remains the most significant policy challenge for the international community. The current focus on pushing for the restructuring of particular types of sovereign debt or on making marginal changes to bond agreements to facilitate restructuring is an easy way out but it is ineffective. In essence, it is a fig leaf, and a small one at that.
In light of what we now know about the causes of the global crisis there are two areas where reform is achievable and where it will have the greatest return. First, the size and volatility of cross-border interbank flows to emerging markets need to be reduced. For example, the incentive to incur such exposures can be greatly reduced if exposures were to attract significantly higher regulatory capital requirements—linked to the credit ratings of the borrowing institution, as well as to the maturity of the exposure. Interbank lending has traditionally been very sensitive to capital costs—hence the growth of securitized short-term credits—and we can be fairly confident that a rigorous and forceful application of higher regulatory capital controls will bring about an immediate and lasting reduction in such flows. Second, cross-border, short-term bank lending of any kind—on-balance-sheet loans and securities exposures, as well as off-balance-sheet derivatives exposures—should also attract significantly higher regulatory capital charges based on credit ratings and maturity.
Increasing the cost of capital to emerging markets by raising regulatory capital requirements above what has already been proposed will likely meet resistance from recipient countries as well as from the banking community. The BIS has brought up for discussion changes in the current regime of bank capital requirements, which go a long way in the right direction and deserve the strong support of the international community.
Second, the cornerstone of the international financial system—global surveillance and a mechanism for obtaining remedial policies—needs to be strengthened. The IMF’s exceedingly competent staff will have little difficulty in identifying unsustainable financial and economic policies, but the IMF has little or no ability to induce countries to implement remedial policies, particularly when economies are doing well. In contrast, the IMF’s ability to resolve financial crises and prevent contagion is unquestioned, particularly given its new resources and its new lending facility.
Our surveillance model needs to change from one in which the IMF is a trusted advisor whispering into a government’s collective ear, to one in which the IMF is more adversarial and has the power to impose graduated sanctions. Such sanctions could be as light as publication of a negative assessment of a country’s policies and prospects, or it could be as harsh as expulsion from the IMF and denial of all official multilateral and bilateral funding. The IMF staff has argued against using such an approach for fear that it would lead to the country’s refusal to give out its valuable private information. The IMF also fears that public notice of impending problems might precipitate a crisis. Having seen the data made available by countries to valued private financial institutions, I would say that the IMF is getting less privileged information than is usually assumed. Furthermore, the fact that a country chooses to withhold data from the IMF is important information that should be made publicly available. Strengthening surveillance will be politically difficult, but it is the key component of the global architecture that is missing. It is worth recalling that the severity of financial crises in national financial systems was significantly reduced only after national central banks obtained supervisory powers to support their lender-of-last-resort facilities.