wolf

FIXING GLOBAL FINANCE1. Hopes Unfulfilled: capital flows and the emerging market crisesMartin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

The Bernard Schwartz Forum on Constructive Capitalism

March 28th 2006

2

Prologue: outline of the lectures

“Global capital markets pose the same kinds of problems that jet planes do. They are faster, more comfortable, and they get you where you are going better. But the crashes are much more spectacular.” Larry Summers.

3


• Finance is the heart of capitalism:

– When it works, the financial system provides a uniquely effective mechanism for shifting resources from those who own them, but cannot use them, to those who can use them, but do not own them.

– But when it fails, the financial system generates huge losses and crises, whose costs endure for years.

• Purely domestic crises also occur. But nowadays these are relatively easily managed.

4


• Crises that involve foreigners tend to be both far more costly and more difficult to manage:

– They usually generate exchange-rate crises, which exacerbate domestic insolvency;

– And they make it impossible for the domestic authorities to act as guarantors of last resort.

• The failure to make the global finance system work tolerably has had large adverse consequences for individual countries and even groups of countries.

• It has also had adverse consequences for the world as a whole:

– It has created global economic shocks;

– It has re-awakened export-oriented mercantilism; and

– has undermined the legitimacy of globalisation.

5


• The failures of the financial system have been the biggest economic failure of globalisation.

• Happily, since the emerging market financial crises of 1997-98, the world has not witnessed another global financial crisis.

• This may suggest that stability has at last been attained. But that would be premature.

• Stability is rather the consequence of the new pattern of global capital flows: capital flows “upstream” – from the rest of the world to highly creditworthy high-income countries and, above all, the US.

6


• Meanwhile, emerging market economies “smoke, but do not inhale” in global capital markets.

• This pattern is not only undesirable but almost certainly unsustainable:

– It is undesirable, because one of the most important functions of capital markets – providing a net flow of resources to poor countries – has failed to take off.

– It is unsustainable, because the growth in US external liabilities cannot continue at current rates.

7


• We must ask ourselves two questions:

– What has gone wrong?

– What do we need to do to put it right?

• What has gone wrong? Here are seven failures:– to understand the implications of financial liberalisation;– to understand the risks of international financial integration;– to accept fiscal discipline;– to understand the risks of currency pegs– to understand what it means to live in a multi-currency world;– to abandon an outmoded mercantilism; and– to modernise global institutions.

8


• What must be reformed?

• Here are four main areas for reform:

– The macroeconomic regime:

• exchange rates;

• monetary policy; and

• Fiscal management.

– The financial sector;

– Excessive reliance on exports; and

– The global institutions.

9

Hopes unfulfilled: introduction

“The free market system has failed and failed disastrously.” Mahathir Mohamad, Financial Times, 4th September 1998.

10


“The people who benefit from roiling the world currency markets are speculators, and as far as I’m concerned, they provide not much useful value.” Paul O’Neill, Financial Times, 6th May 2002.

11


• The last 25 years has been an age of globalisation, similar, in many ways, to that before the first world war.

• It has also been similar to that era in the frequency of financial crises.

• What has happened and why?

12

Hopes unfulfilled: outline

• Role of finance.

• The frequency of financial crises

• Anatomy of financial crises.

• Why financial crises happened.

• The legacy of the crises: a burned child fears the fire.

13

2. The role of finance

• “The evidence that financial development and economic growth are linked is quite strong.” (Frederic Mishkin, 2005):

– King and Levine (1993) showed that the greater the financial development in 1960, the larger the economic growth over the subsequent 30 years;

– Levine, Loayza and Beck (2000) showed that a doubling of the size of private credit in an average developing country is associated with a two percentage point annual increase in the rate of economic growth;

14


– Rajan and Zingales (1998) showed that industries and companies dependent on outside finance grow faster in countries with more developed financial systems; and

– Levine (2004) showed that financial development works by generating higher total factor productivity rather than higher investment

• In short, as World Bank (2001) notes “there is now a solid body of research strongly suggesting that improvements in financial arrangements precede and contribute to economic performance”.

15


• In addition, Mishkin (2005), Rajan and Zingales (2003) and others argue persuasively that globalisation can spur financial development:

– Greater openness to trade generates a larger financial sector;

– It does so by increasing competition, which forces companies to seek outside finance;

– This will encourage non-financial companies to lobby for a more efficient and competitive financial sector;

– Globalisation also creates pressure for institutional reforms that promote financial development, such as improved accountancy, property rights, bankruptcy procedings;

16


– Foreign competition forces domestic financial enterprises to improve their terms, if they are not to lose customers;

– Foreign ownership of financial institutions will improve the efficiency and services offered by the financial system, by increasing competition and offering global best practice; and

– Foreign involvement increases the liquidity of the financial system.

17

3. Failings of finance

• So, with all these advantages, what is the problem with financial liberalisation?

• There are well-known difficulties inherent in even the best financial system, since it involves nothing more than trades in promises.

• Trust is always in short supply and knowledge always limited in the financial system.

18


• Inherent difficulties in financial markets are:

– Asymmetric information (which may mean some markets will never appear)

– Adverse selection (which means that providers may impose quantitative limits on their clients, especially in crises)

• Because of the inherent uncertainties, big mood swings occur in markets and sometimes panics:

– When participants know that they do not know what is going on, they may follow a few leaders and so show herding behaviour.

– They are more likely to behave in this way, the more unfamiliar are the markets in which they are engaged.

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• To these inherent dangers must be added those that are prevalent in liberalising emerging market economies:

– Simple ignorance of the consequences of liberalisation;

– Corrupt insider relations between politicians and banks and between owners of banks and of non-financial businesses;

– Non-economic obligations imposed on banks;

– Poor regulation;

– Poor legal systems and inadequate property rights

20


• In addition, emerging market financial system are vulnerable to three (linked) macro-economic dangers:

– Fiscal indiscipline, with risks of large-scale monetary expansion;

– Or, partly as a result of a history of indiscipline, excessive reliance on borrowing denominated in foreign currency;

– And exchange-rate pegging, which gives an illusion of safety to foreign currency borrowing (and lending).

• The combination will inject additional fragility into any financial system.

21

4. Anatomy of financial crises

• Financial crises have come thick and fast.

• The World Bank (2001) estimated that there were 112 systemic banking crises in ninety-three countries between the late 1970s and the end of the twentieth century.

• Eichengreen and Bordo (2002) counted ninety-five crises in emerging market economies and another forty-four in high-income countries between 1983 and 1997:

22


– Seventeen of the crises in emerging market economies were banking crises, fifty-seven were currency crises and twenty-one were “twin crises”, the most damaging of all.

– Nine of the crises in high-income countries were banking crises, twenty-nine were currency crises and six were twin crises.

– Altogether, there were twenty-six banking crises, eighty-six currency crises and twenty-seven twin crises.

23


• The twin crises are more significant and more interesting.

• These represent the interaction of the microeconomics of finance with the macroeconomics of exchange-rate regimes and monetary and fiscal policies.

24


• These crises can be very costly:

– According to Caprio and Klingebiel (2003), there have been 27 crises over the last quarter century with fiscal costs exceeding 10 per cent of gross domestic product and many more with costs of between 1 and 10 per cent of GDP

– These crises have afflicted high-income countries and emerging market economies. But the biggest have been in emerging market economies.

25


CHART 1. FINANCIAL CRISES WITH FISCAL COSTS GREATER THAN 10 PER CENT OF GDP

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Indo

nesia

199

7-

Argen

tina

1980

-82

China

1990

s

Jam

aica

1995

-200

0

Chile

1981

-86

Thaila

nd 1

997-

Mac

edon

ia 19

93-9

4

Turke

y 200

0-

Israe

l 197

7-83

South

Kor

ea 1

997-

Cote

d'Ivo

ire 1

988-

91

Japa

n 19

91-

Urugu

ay 1

981-

85

Ecuad

or 1

988-

Mex

ico 1

994-

97

Venez

uela

1994

-95

Spain

1977

-85

Benin

1988

-90

Seneg

al 19

88-9

1

Mala

ysia

1997

-

Mau

ritan

ia 19

84-9

3

Parag

uay 1

995-

99

Czech

Reu

blic 1

991-

Taiwan

199

7-98

Finlan

d 19

91-9

4

Hunga

ry 1

991-

95

Tanza

nia 1

980s

and

199

0s

Source: Caprio and Klingebiel

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CHART 2. FINANCIAL CRISES WITH FISCAL COSTS LESS THAN 10 PER CENT OF GDP

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

Norway

198

7-93

Russia

199

8-99

Colom

bia 1

982-

87

Mala

ysia

1985

-88

Philipp

ines

198

1-87

Urugu

ay 2

002-

Unite

d Sta

tes S

&L 19

84-9

1

Poland

199

0s

Argen

tina

2001

-

Austra

lia 1

989-

92

Laos

ear

ly 19

90s

Zambia

199

5

New Z

ealan

d 19

87-9

0


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• What is the route to crisis? According to Mishkin (2005), there have been two fundamental errors explaining the emerging market financial crises:

– Mismanaged liberalisation and globalisation; and/or

– Fiscal imbalances.

• The road to the twin crises:

– Stage 1: liberalisation and/or fiscal imbalances;

– Stage 2: run-up to currency crisis;

– Stage 3: currency crisis; and

– Stage 4: currency crisis causes financial crisis.

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• Stage 1 - liberalisation and/or fiscal imbalances:

– Excessive risk-taking by inexperienced (or corrupt) banks;

– Poor (or corrupt) regulation;

– Rapid growth of credit;

– Moral hazard from absolute government guaranties;

– Losses mount and banks cut back on lending;

– Banks fail and contagion affects even healthy banks;

– Further contraction of bank lending;

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– Regulators are overwhelmed;

– Regulatory forbearance also means even more risk-taking; and, above all,

– Foreign lending adds fuel to the flames;

• In the case of Korea, the chaebol’s were no longer making money by the 1990s. The chaebol and the banks they influenced started to borrow directly and indirectly abroad, because they were guaranteed by the government.

• In addition, fiscal imbalances cause crises, particularly in banks: Argentina 2001-2002; Russia 1998; Turkey in 2001.

30


• Stage 2 - run up to currency crisis:

– Higher interest rates abroad undermine credit quality;

– A decline in cash flow and greater need to borrow when it has become more expensive;

– Failure of companies or political turmoil leads to panic;

– Declining asset prices undermines solvency even of good risks, particularly in the property sector (used as collateral);

– People “go for broke” as moral hazard factors become dominant: Mexico, Thailand, South Korea and Argentina all suffered from this.

31


• Stage 3 - currency crisis:

– Residents and foreign speculators start to sell the currency and lenders pull out short-term money – a “sudden stop”;

– This puts governments in a bind: if they raise interest rates, to support the currency, they undermine corporate solvency and worsen the crisis; if they do not raise interest rates then the currency collapses, wiping out companies (including banks) with large net liabilities in foreign currency;

– This gives speculators a “sure thing”;

– Large fiscal deficits also undermine banks, as default comes closer, and cause speculators to run for the exit; and

32


• Stage 4 – currency crisis triggers financial crisis:

– In countries with histories of inflation and default, loans tend to be short-term and denominated in foreign currency;

– Companies producing non-tradeables with foreign currency debt are wiped out;

– This undermines other creditworthy companies and banks;

– The crisis causes multiple bankruptcies in countries that also have inadequate bankruptcy procedures;

– Domestic credit seizes up;

– Inflation surges, as the currency falls, and there is a deep recession;

– Contagion spreads to other similarly-placed borrowing countries

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5. The systemic financial crises

• For the purposes of our story, however there have been a limited number of events with significant legacies:

– The Latin American debt crisis of the 1980s;

– The tequila crisis, which began in Mexico in 1994-95;

– The Asian financial crisis of 1997-98, which spread to Brazil and Russia in 1998 and 1999; and

– The Argentine crisis of 2001-02.

• Of these the most important was the Asian financial crisis, because it was so surprising and because of its wider influence in the region.

34


CHART 3. CURRENT ACCOUNTS BALANCES OF EMERGING MARKET ECONOMIES ($bn)

-$150.0

-$100.0

-$50.0

$0.0

$50.0

$100.0

$150.0

$200.0

$250.0

$300.0

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

e

2006

f

Latin America Africa Asia and Pacific Europe

Source: Institute for International Finance

35


CHART 4. CURRENT ACCOUNT BALANCES(as a share of GDP)

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

f

Emerging Market Economies Latin America

Africa/Middle East Asia/Pacific


36


CHART 5. PRIVATE NET CAPITAL FLOWS TO EMERGING MARKET ECONOMIES, BY REGION ($bn)

-50.0

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

e20

06f

Latin America Europe Africa/Middle East Asia/Pacific Emerging Market Economies


37


CHART 6. COMPOSITION OF NET CAPITAL FLOWS TO EMERGING MARKET ECONOMIES ($bn)

-800.0

-600.0

-400.0

-200.0

0.0

200.0

400.0

600.0

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

f

Private flows, net Official flows, net Resident lending Reserves


38


CHART 7. COMPOSITION OF PRIVATE CAPITAL FLOWS TO EMERGING MARKETS ($bn)

-100.0

-50.0

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.019

80

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

e

2006

f

Direct investment Portfolio investment Commercial banks Non-banks


39


CHART 8. EMERGING MARKET SPREADS(Emerging Market Bond Index, basis points)

0

500

1000

1500

2000

250031

/12/

1997

30/0

6/19

98

31/1

2/19

98

30/0

6/19

99

31/1

2/19

99

30/0

6/20

00

31/1

2/20

00

30/0

6/20

01

31/1

2/20

01

30/0

6/20

02

31/1

2/20

02

30/0

6/20

03

31/1

2/20

03

30/0

6/20

04

31/1

2/20

04

30/0

6/20

05

31/1

2/20

05

COMPOSITE BRAZIL MEXICO TURKEY

Source: JP Morgan

40


CHART 9. COMPOSITION OF NET CAPITAL FLOWS TO LATIN AMERICAN EMERGING MARKET ECONOMIES ($bn)

-100.0

-50.0

0.0

50.0

100.0

150.0

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

f

Private flows, net Official flows, net Resident lending, net Reserves


41


CHART 10. COMPOSITION OF PRIVATE CAPITAL FLOWS TO LATIN AMERICA ($bn)

-40.0

-20.0

0.0

20.0

40.0

60.0

80.0

100.0

120.0

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

e20

06f



42


CHART 11. VALUE AGAINST THE DOLLAR: LATIN AMERICA AND RUSSIA (starting at 100)

0

20

40

60

80

100

120

140

01/0

7/19

94

01/0

1/19

95

01/0

7/19

95

01/0

1/19

96

01/0

7/19

96

01/0

1/19

97

01/0

7/19

97

01/0

1/19

98

01/0

7/19

98

01/0

1/19

99

01/0

7/19

99

01/0

1/20

00

01/0

7/20

00

01/0

1/20

01

01/0

7/20

01

01/0

1/20

02

01/0

7/20

02

01/0

1/20

03

01/0

7/20

03

01/0

1/20

04

01/0

7/20

04

01/0

1/20

05

01/0

7/20

05

01/0

1/20

06

ARGENTINE PESO BRAZILIAN REAL MEXICAN PESO RUSSIAN ROUBLE

43


CHART 12. MACROECONOMIC CONSEQUENCES OF THE LATIN AMERICAN AND RUSSIAN CRISES

(GDP in the year before a crisis and four subsequent years)

80.0

85.0

90.0

95.0

100.0

105.0

110.0

115.0

120.0

125.0

130.0

1 2 3 4 5 6

Argentina 1993-1998 Argentina 2000-2005 Brazil 1981-1986

Mexico 1981-85 Mexico 1993-1998 Russia 1997-2002

44


CHART 13. COMPOSITION OF NET CAPITAL FLOWS TO ASIAN EMERGING MARKET ECONOMIES ($bn)

-400.0

-300.0

-200.0

-100.0

0.0

100.0

200.0

300.0

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

f

Private flows, net Official flows, net Resident lending Reserves


45


CHART 14. COMPOSITION OF PRIVATE CAPITAL FLOWS TO ASIAN EMERGING MARKET ECONOMIES ($bn)

-100.0

-50.0

0.0

50.0

100.0

150.0

200.0

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

f



46


CHART 15. SHORT-TERM FOREIGN-CURRENCY BORROWING AS SHARE OF TOTAL CAPITAL INFLOW (per cent)

78.7% 78.3%

91.9%

12.2%

80.9%

56.7%

63.8%

54.0%

69.5%

56.1%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

Indonesia South Korea Malaysia Philippines Thailand

Between June 1990 and June 1994 Between June 1994 and June 1997

Source: Barry Eichengreen (2004)

47


CHART 16. VALUE AGAINST THE US DOLLAR: EAST ASIA(January 1996 = 100)

0.0

20.0

40.0

60.0

80.0

100.0

120.00

8/0

3/1

99

6

08

/07

/19

96

08

/11

/19

96

08

/03

/19

97

08

/07

/19

97

08

/11

/19

97

08

/03

/19

98

08

/07

/19

98

08

/11

/19

98

08

/03

/19

99

08

/07

/19

99

08

/11

/19

99

08

/03

/20

00

08

/07

/20

00

08

/11

/20

00

08

/03

/20

01

08

/07

/20

01

08

/11

/20

01

08

/03

/20

02

08

/07

/20

02

08

/11

/20

02

08

/03

/20

03

08

/07

/20

03

08

/11

/20

03

08

/03

/20

04

08

/07

/20

04

08

/11

/20

04

08

/03

/20

05

08

/07

/20

05

08

/11

/20

05

08

/03

/20

06

SOUTH KOREAN WON MALAYSIAN RINGGIT PHILIPPINE PESO

INDONESIAN RUPIAH THAI BAHT

48


CHART 17. FOREIGN CURRENCY LIABILITIES OF THE BANKING SYSTEM

(per cent of GDP)

5.9% 5.6%4.8%

12.7%

6.2%

26.8%

17.2%

9.3% 9.2%

5.6%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Thailand Philippines South Korea Malaysia Indonesia

1992 1996

Source: Barry Eichengreen (2004)

49


CHART 18. THE MACROECONOMIC CONSEQUENCES OF THE ASIAN CRISIS

(GDP in the year before a crisis and four subsequent years)

80.0

85.0

90.0

95.0

100.0

105.0

110.0

115.0

120.0

1 2 3 4 5 6

Indonesia 1996-2001 Korea 1996-2001

Malaysia 1996-2001 Thailand 1996-2001

50


CHART 20. FISCAL COST OF SOME OF THE BIG EMERGING MARKET CRISES(per cent of GDP)

55.0% 55.0%

42.0%

34.8%

30.5%28.0%

19.3%

16.4%

7.0% 6.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Indonesia1997-

Argentina1980-82

Chile1981-86

Thailand1997-

Turkey2000-

SouthKorea1997-

Mexico1994-97

Malaysia1997-

Philippines1998-

Russia1998-99


51

6. The legacy of the crises

• These crises have had some beneficial and some malign long-term consequences

• The beneficial consequences have been better understanding of risks by all participants, stronger financial systems and better regulation

– This has occurred within the emerging market economies;

– Inside the global financial system;

– And in the international financial institutions

52

6. A burned child fears the fire

• The malign consequences of the crises has been a widespread fear of deficits:

– Capital markets want to place capital in the emerging market economies, but governments are recycling them in the form of foreign currency reserves.

– As the emerging market economies have moved into surplus in the basic balance of payments (current account, plus private capital), global macroeconomic balance has been secured by a shift into deficit in high-income countries, above all the US.

• How this has happened and the implications for today’s world are the subject of the second lecture.

wolf

Economy & Finance

burned child

emerging market

raise interest

asian financial

financial

foreign currency

financial

financial