September 27, 1996
|Contact:||Morris Goldstein||(202) 328-9000|
Washington, DCThe first line of defense against future international financial crises in emerging markets is better policies in those economies that are host to large, private capital flows. In a comprehensive Institute for International Economics analysis of the origins and implications of the Mexican economic crisis, the authors of Private Capital Flows to Emerging Markets after the Mexican Crisis conclude that a multipronged approach will be necessary. Specifically, host countries need to:
Private Capital Flows
Private capital flows now play the dominant role in external financing for developing countries. The greater integration of developing countries into world capital markets has brought with it important advantages, including the transfer of managerial and technological know-how (via foreign direct investment) and the introduction of a powerful external source of discipline for errant macroeconomic policies. Also, the larger role for nonbank investors and for securitized instruments means that the systemic risk associated with difficulties of sovereign borrowers is much lower than was in the case in the 1980s when banks ruled the roost. At the same time, the Mexican crisis demonstrated that new financial instruments and players do not make private capital flows to emerging markets immune to bouts of overlending and contagion, nor do they prevent shocks and collapses of confidence from inducing serious adjustment strains in borrowing countries.
Improving Private Market Discipline and Emergency Financing
Private market discipline and the provision of emergency financial assistance could each be made to operate better.
Private markets cannot assess and price risk appropriately unless they have timely and comprehensive data on the borrower's creditworthiness. The IMF's Special Data Dissemination Standard is a welcome step forward. But faulty economic analysis is also part of the problem. Some of the authors, who participated in an Institute conference on the topic, therefore support publication of the policy assessments contained in IMF Article IV country reports; others believe this would be either ineffective or counterproductive.
The resources available for emergency financial assistance should be increased. The increasing size and speed of private capital flows, the potential for contagion of financial disturbances across countries, and the disadvantages of adopting a regional rather than an international perspective on official lender-of-last-resort activities argue for increasing the size of the General Arrangements to Borrow (GAB) and the size of IMF quotas. But there was also concern that access to emergency financial assistance not become too easily available, lest the incentive for private creditors to closely monitor the creditworthiness of borrowers be weakened. For that reason, emergency financial assistance should be accompanied by strong policy conditionality, and activation of the GAB (or of the NAB, the New Arrangement to Borrow) should be reserved for "systemic" threats.
There should be orderly workout procedures for sovereign liquidity crises. A formal international bankruptcy code would be impractical. However, informal institutional changes that would bring the restructuring of sovereign bonds closer to that for commercial bank debt and bilateral official debt would be very helpful both in reducing uncertainty and in reducing the likelihood that official emergency financial assistance would be overutilized. The recommendations offered in the recent G-10 deputies' report, The Resolution of Sovereign Liquidity Crises, (i.e., extending the IMF's policy of lending in the face of unresolved arrears to private creditors to also cover sovereign bond debt, and taking a receptive attitude toward majority voting clauses in new bond contracts and the formation of bondholders councils) represent moves in the right direction.
The Institute study addresses these issues in depth, drawing on eight papers presented at a major conference held by the Institute for International Economics and the Austrian National Bank in Vienna last September. A complete table of contents is attached.
Highlights of Major Papers
In their paper on the anatomy of the Mexican crisis and its main lessons, Leonardo Leiderman (Tel-Aviv University) and Alfredo Thorne (J.P. Morgan, Mexico) emphasize growing doubts about the degree of fiscal discipline in 1994, a crucial delay in the shift to more exchange rate flexibility, and an inadequate policy response to shocks as key factors in the loss of investor confidence. In their view, each successive shock reduced the sustainable level of Mexico's current account deficit. At the same time, redemption of tesobonos and strong external adjustment in the aftermath of the crisis lead them to a relatively optimistic outlook for the Mexican economy. The two main remaining risks are weaknesses in the banking system and social and political pressures for a relaxation of the adjustment effort. Guillermo Calvo (University of Maryland), Ratna Sahay (IMF), and Carlos Végh (IMF) analyze the experience of the transition economies of Central and Eastern Europe with their own surge of capital inflows in the 1980s. They not only observe that the share of consumption in GNP rose significantly in these countries but also reach the conclusion that this increase in consumption is better characterized as a move toward equilibrium (since consumption was so low in the earlier period) rather than as an unsustainable binge. They also recommend nonsterilized intervention and currency appreciation as the most appropriate policy strategy for this set of host countries.
Alberto Giovannini (Long-Term Capital Management) examines how the liberalization of financial markets and sharp increases in real interest rates have dramatically changed the way in which governments manage their borrowing in international capital markets. These reforms which cover primary and secondary markets, rules on participating institutions, the development of derivative markets, and the tax treatment of government securities stress efficiency, transparency, and predictability. But they also raise difficult conceptual issues about, inter alia, the appropriate level of risk for sovereigns, the best measure of the cost of debt, how to evaluate performance of the public debt manager, and if and how debt management should be coordinated with monetary policy.
Pier-Luigi Gilibert and Alfred Steinherr (both with the European Investment Bank) appraise private capital flows to developing countries in the 1990s and consider how the larger role of nonbank investors and of securitized instruments affects the resiliency of the system when losses materialize. They argue that the 1990s' surge in portfolio flows to Latin American emerging markets most of it from US institutional investors represented herd behavior that could not be easily justified by reference to traditional fundamentals. On the other hand, they find that systemic risk associated with difficulties of sovereign borrowers is now much lower than was the case in the 1980s, when banks ruled the roost. The large asset price falls experienced during the Mexican crisis are as a close to a "stress test" for the system as one is likely to get.
Sara Calvo (World Bank) and Carmen Reinhart (IMF and Institute for International Economics) consider the factors that influence the contagion of financial disturbances across countries. They find that contagion is greater during periods of financial market turbulence than during more tranquil periods, that contagion runs mainly from large countries to small ones, that contagion usually emanates from a core group of countries rather than a single one, and that contagion operates more along regional than global lines.
Peter Montiel (Williams College) looks at the experience of 14 countries that together accounted for roughly 70 percent of total net inflows of portfolio capital and foreign direct investment to developing countries over 1989-93. He finds that vulnerability to Mexico-type financial crises is significantly reduced when the host country adopts tight fiscal policies and follows an exchange rate policy aimed at maintaining external competitiveness. In addition, he reports that controls on capital inflows seem to be effective in slowing them in some cases (at least temporarily) and that removal of restrictions on capital outflows was ineffective in dealing with the capital inflow problem. He adds that sterilization of capital inflows has proved feasible and effective in keeping the growth of the monetary base in check, but that it often had to be undertaken in massive amounts and didn't typically prevent large increases in asset prices.
Guillermo Calvo (University of Maryland) and Morris Goldstein (Institute for International Economics) consider the role of the official sector in crisis prevention/management. They maintain that many explanations of the Mexican crisis give insufficient emphasis to financial vulnerabilities, particularly mounting maturity and currency mismatches in public debt and in the banking system that together rendered the Mexican government illiquid and produced not only a currency crisis but a debt crisis. In their view, both host countries and international surveillance exercises need to pay closer attention to such indicators of financial vulnerability. They are also in favor of the IMF publishing its appraisals of country policies, deepening its contacts with private capital markets, and conveying a frank view on appropriate exchange rate policy to its members. They support giving the international lender of last resort an updated capacity to respond forcefully and quickly to potential financial crises, as well as further efforts to bring more order and organization to sovereign debt rescheduling.
Finally, Ariel Buira (Bank of Mexico) provides his own assessment of the origins of the Mexican crisis. He finds unpersuasive explanations of the crisis that give a key role to lax monetary and fiscal policies, to exchange rate overvaluation, and to an excessive current account deficit. He agrees that the policy response to shocks was probably inadequate, but only with the benefit of hindsight not in the uncertain environment in which those policy decisions had to be made. In the end, he concludes that the crisis is best characterized as largely accidental the outcome of a series of unpredictable political and criminal shocks, along with an overly optimistic set of expectations associated with the passage of NAFTA.
About the Editors
Guillermo Calvo is Distinguished University Professor at the University of Maryland at College Park and a former Senior Adviser in the Research Department of the International Monetary Fund.
Morris Goldstein is the Dennis Weatherstone Senior Fellow at the Institute for International Economics and a former Deputy Director of the Research Department at the International Monetary Fund.
Eduard Hochreiter is Senior Adviser and Head of the Economic Studies Division of the Austrian National Bank and Lecturer at the University of Economics in Vienna.