Lessons from Systemic Lessons from Systemic Financial CrisesFinancial Crises

Guillermo CalvoGuillermo CalvoColumbia UniversityColumbia University

India Policy Forum 2009. Sponsored by NCAER and The Brookings Institution.New Delhi, July 14-15, 2009

Sudden Stop, SSSudden Stop, SS

DefinitionDefinition: Large and largely unexpected : Large and largely unexpected cutback in credit cutback in credit flowsflows to a country to a country or or large sector (e.g., real estate).large sector (e.g., real estate).NBNB: It does not require a fall in credit : It does not require a fall in credit stockstock. . India is likely going through a SS episode, India is likely going through a SS episode, but total credit stock continues to increase.but total credit stock continues to increase.– However, portfolio credit However, portfolio credit stockstock has recently has recently

started to fall.started to fall.

Why is SS dangerous?Why is SS dangerous?

If SS is provoked by an If SS is provoked by an exogenousexogenous shock, shock, it brings about it brings about unplannedunplanned contractioncontraction in in the affected country/sector’s the affected country/sector’s demand for demand for goods and servicesgoods and services, , – unless the country/sector has enough liquid unless the country/sector has enough liquid

assets to offset the SS (international reserves)assets to offset the SS (international reserves)

The fall in demand may cause a major The fall in demand may cause a major change in change in relative pricesrelative prices (e.g., real estate (e.g., real estate prices, real exchange rate).prices, real exchange rate).

Changes in relative prices are largely Changes in relative prices are largely unexpected unexpected Thus, if country/sector borrowed to buy Thus, if country/sector borrowed to buy assets which prices sharply declined, this assets which prices sharply declined, this could cause severe stress for could cause severe stress for lenderslenders (e.g., local banks).(e.g., local banks).If banks suffer liquidity crunch, they will be If banks suffer liquidity crunch, they will be forced to cut credit across the board, forced to cut credit across the board, causing causing contagioncontagion..Therefore, the credit crisis might spread to Therefore, the credit crisis might spread to the rest of the economy.the rest of the economy.

Aggravating FactorsAggravating Factors

Government and large firms may replace Government and large firms may replace the sudden cutback in external loans by the sudden cutback in external loans by borrowing from domestic banks.borrowing from domestic banks.

This crowds out firms with limited access This crowds out firms with limited access to external financingto external financing– typically, small and medium-sized firms who typically, small and medium-sized firms who

utilize labor-intensive techniques, putting utilize labor-intensive techniques, putting strong downward pressure on employment strong downward pressure on employment and real wages.and real wages.

Fortunately, India has momentarilycushioned the blow by injectingliquidity through a decline inInternational Reserves.

(% of GDP, last 4 quarters, last value 2008-IV)

India. Net Capital FlowsIndia. Net Capital Flows

Note: “Other” Flows include Loans, Banking Capital, Rupee Debt Service and other unclassified flows.Source: Reserve Bank of India.

India. International ReservesIndia. International Reserves

Source: EIU and IFS.

(quarterly data, % of GDP)

Capital Controls and SSCapital Controls and SS

If capital inflows are positive, as in India, If capital inflows are positive, as in India, one cannot prevent SS by imposing one cannot prevent SS by imposing controls on capital outflows.controls on capital outflows.

Because for SS to happen it is enough Because for SS to happen it is enough that the rate of capital inflows falls, as it that the rate of capital inflows falls, as it is actually happening in Indiais actually happening in India– capital flow reversal need not take place!capital flow reversal need not take place!

Controls on capital inflows cannot prevent Controls on capital inflows cannot prevent SS, unless inflows are zero, and capital SS, unless inflows are zero, and capital outflows are forbiddenoutflows are forbiddenThis is especially difficult to implement This is especially difficult to implement when multinational firms are involved.when multinational firms are involved.Controls on capital outflows may dampen Controls on capital outflows may dampen incentives for Foreign Direct Investment incentives for Foreign Direct Investment because it makes profitability harder to because it makes profitability harder to assess ex ante. assess ex ante. This shows why capital controls could This shows why capital controls could have deleterious effects on growth or have deleterious effects on growth or simply be ineffective in preventing SS.simply be ineffective in preventing SS.

Bank RegulationBank RegulationWhile controls on capital flows are highly While controls on capital flows are highly debatable, this does not rule out bank debatable, this does not rule out bank regulation, which sometimes is akin to regulation, which sometimes is akin to controls on capital flows.controls on capital flows.Banks should be tightly regulated because Banks should be tightly regulated because their failure brings about systemic shocks.their failure brings about systemic shocks.In some cases bank failure paralyzes the In some cases bank failure paralyzes the payments system (e.g., Argentina 2002).payments system (e.g., Argentina 2002).Keep an eye on banks’ short-term foreign-Keep an eye on banks’ short-term foreign-exchange liabilitiesexchange liabilities– both on and off-balance-sheetboth on and off-balance-sheet

India and Emerging Markets:India and Emerging Markets:Then and NowThen and Now

For India, the present For India, the present external frontexternal front is not is not very different from that in 1997/1998 very different from that in 1997/1998 Asian/Russian crisis.Asian/Russian crisis.

But for Emerging Markets 1997/1998 But for Emerging Markets 1997/1998 represented a major blowrepresented a major blow

Interest rates skyrocketedInterest rates skyrocketed

and Current Accounts suffered a major and Current Accounts suffered a major adjustment.adjustment.

(Current Account Balance as % of GDP, Terms of Trade 2005=100)India. Current Account & Terms of TradeIndia. Current Account & Terms of Trade

Note: e = estimateSource: EIU.

Current Account

Terms of Trade

At 2005 prices

EMs Then

(EMBI sovereign spread & Current Account Balance in EMs, millions of USD, last four quarters)

External Financial Conditions for EMs

Note: Includes Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Slovak Republic, South Africa, Thailand, Turkey and Venezuela.

-150000

-100000

-50000

0

50000

100000

150000

Jan

-91

Jul-

91

Jan

-92

Jul-

92

Jan

-93

Jul-

93

Jan

-94

Jul-

94

Jan

-95

Jul-

95

Jan

-96

Jul-

96

Jan

-97

Jul-

97

Jan

-98

Jul-

98

Jan

-99

Jul-

99

Jan

-00

Jul-

00

Jan

-01

Jul-

01

Jan

-02

Jul-

02

Jan

-03

Jul-

03

Jan

-04

0

500

1000

1500

2000

2500

Cu

rre

nt A

cc

ou

nt

(mill

ion

s o

f U

SD

)

EM

BI s

pre

ad

(b

as

is p

oin

ts)

Tequila Crisis

Russian Crisis

Asian Crisis

LAC 7: INVESTMENTLAC 7: INVESTMENT(LAC-7, s.a. Investment, 1998.II=100)

Annualized growth: 10.6%2002.IV-2004.III

50

60

70

80

90

100

110

19

90

.I

19

91

.I

19

92

.I

19

93

.I

19

94

.I

19

95

.I

19

96

.I

19

97

.I

19

98

.I

19

99

.I

20

00

.I

20

01

.I

20

02

.I

20

03

.I

20

04

.I

Russian Crisis

Annualized growth: 7.4%

1990.I-1998-II

Annualized growth: - 4.1%1998.II-2002-IV

LAC 7: GROWTH (LAC-7, s.a. GDP, 1998.II=100)

Annualized growth: 5.5% 2002.IV-2004.III

65

70

75

80

85

90

95

100

105

110

115

19

90

.I

19

91

.I

19

92

.I

19

93

.I

19

94

.I

19

95

.I

19

96

.I

19

97

.I

19

98

.I

19

99

.I

20

00

.I

20

01

.I

20

02

.I

20

03

.I

20

04

.I

Russian Crisis

Annualized growth: 4.4% 1990.I-1998.II Annualized growth: 0.2%

1998.II-2002.IV

EMs Nowmuch better from BOP view point

Greenspan’s “conundrum”

testimony

ExternalExternal Financial Conditions for EMsFinancial Conditions for EMs(daily data, EMBI+, bps, last value 04/07/09)(daily data, EMBI+, bps, last value 04/07/09)

Source: Bloomberg.

Pre-Asian Crisis Spread

Pre-Asian Crisis Yield

ENRON Effect

Spreads

Yields

Beginning of improvement in international financial conditions

Fears of FED tightening

=+54%

=-12%

Lehman Brothers files for

bankruptcy

US Junk & EM BondsUS Junk & EM Bonds(yields in %, (yields in %, last value last value 04/07/09))

Note: (1) EM Corporate = Credit Suisse Corporate Bond. (2) EM Sovereign = JP Morgan EMBI+ Sovereign. (3) US Junk= MSCI High Yield Bonds.Source: Bloomberg.

EM Sovereign

US Junk

EM Corporate

EMBI+ Yield & Terms of Trade in LACEMBI+ Yield & Terms of Trade in LAC(quarterly data, Terms of Trade Index 1997-I = 100, EMBI+ Yield)(quarterly data, Terms of Trade Index 1997-I = 100, EMBI+ Yield)

Note: Terms of trade series include Argentina, Brazil, Chile, Colombia, Mexico and Peru. Simple average.Source: IADB and Bloomberg.

ImplicationsImplicationsCapital markets for Emerging Markets Capital markets for Emerging Markets have not been a source of major have not been a source of major disturbancedisturbanceExcept for countries that exposed Except for countries that exposed themselves to vulnerabilities clearly themselves to vulnerabilities clearly identified by research (e.g., Eastern identified by research (e.g., Eastern Europe), namely,Europe), namely,– High Current Account DeficitHigh Current Account Deficit– Liability Dollarization (foreign-exchange Liability Dollarization (foreign-exchange

denominated debt)denominated debt)

This is an important lesson looking This is an important lesson looking forward.forward.

Estimated Sudden Stop ProbabilitiesEstimated Sudden Stop Probabilities(Based on Calvo, Izquierdo and Mejia, NBER Working Paper 14026, 2007)

Notes: Simple country averages. LAC7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. CAC5 includes Costa Rica, Guatemala, Honduras, Nicaragua and Dominican Republic. Eastern Europe includes Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Turkey.

44.8%

41.1%

58.4%

3.7%

35.2%

71.3%

0%

10%

20%

30%

40%

50%

60%

70%

80%

LAC7 CAC5 Eastern Europe

1998

2008

India: Financial StrengthsIndia: Financial StrengthsLiability dollarization is not a major issueLiability dollarization is not a major issue– although one must keep track of trade credit although one must keep track of trade credit

as economy opens up to trade. Recall Korea, as economy opens up to trade. Recall Korea, Thailand in 1997 and Brazil in 2002.Thailand in 1997 and Brazil in 2002.

Reserves cover a good share of M2Reserves cover a good share of M2A large share of International Reserves A large share of International Reserves has been acquired with has been acquired with seigniorageseigniorage (money printing) (money printing) – associated with an increase in the demand for associated with an increase in the demand for

money triggered by high output growth.money triggered by high output growth.– This source of reserve accumulation will tend This source of reserve accumulation will tend

to dry up if growth declines.to dry up if growth declines.

India. International Reserves and MoneyIndia. International Reserves and Money

Source: IFS.

India. International Reserves’ Accumulation India. International Reserves’ Accumulation and Seigniorageand Seigniorage

Note: Correlation coefficient statistically significant at 1% level.Source: IFS.

(quarterly data, Billions of USD, q-o-q change, last value 2008-QI)

Correlation = 0.8*

India. Bank LoansIndia. Bank Loans

The level of international reserves is large The level of international reserves is large with respect to M2.with respect to M2.However, M2/GDP has increased very However, M2/GDP has increased very rapidly since mid 2000 and the proportion rapidly since mid 2000 and the proportion of loans to private sector with respect to of loans to private sector with respect to public sector has more than doubled.public sector has more than doubled.This flashes a yellow warning light, This flashes a yellow warning light, because Sudden Stops are usually because Sudden Stops are usually preceded by high growth in bank credit.preceded by high growth in bank credit.

India. M2 as share of GDPIndia. M2 as share of GDP

Source: IFS

India. Ratio of Banks’ Claims on India. Ratio of Banks’ Claims on Private/Public SectorPrivate/Public Sector

Source: IFS

- Bank Credit -

GD

P

Ban

k C

redi

t

Credit

GDP

100

102

104

106

108

110

t-2 t-1 t t+1 t+2

96

101

106

111

116

121

Collapses in EM Economies

Collapse Recovery

GD

P

Ban

k C

redi

t

Credit

GDP

95

100

105

110

115

120

125

130

135

140

19

29

19

30

19

31

19

32

19

33

19

34

19

35

19

36

85

95

105

115

125

135

145

155

165

US Great Depression

Collapse Recovery

EM Collapses & the US Great Depression: Similarities

(Average Credit to the Private to Credit to the Public Sector ratio*, trough (t)=100)

Bank Credit during Systemic CollapsesBank Credit during Systemic Collapses

Note: Public sector includes only the Central Government.Source: Own estimates base of the IMF-IFS data.

GDP

All Episodes

90s

India: Fiscal, Inflation RisksIndia: Fiscal, Inflation RisksDomestic debt is largeDomestic debt is largeand fiscal deficit is approaching 9-10% of and fiscal deficit is approaching 9-10% of GDP.GDP.Inflation could be contained by draining Inflation could be contained by draining international reserves, but this would international reserves, but this would increase the chances of Sudden Stop.increase the chances of Sudden Stop.Therefore, there seems to be little room for Therefore, there seems to be little room for fiscal stimulus.fiscal stimulus.Further devaluation could help, but if Further devaluation could help, but if global global green shootsgreen shoots fade out, its effect will fade out, its effect will likely be minor.likely be minor.

(% GDP)

Public DebtPublic Debt

Note: e = estimate / f = forecast.Source: EIU.

(y-o-y % change)

Inflation & Exchange RateInflation & Exchange Rate

Source: IMF.

Exchange Rate

Inflation

(y-o-y % growth rate)

GDP growthGDP growth

Source: EIU.

India

USA

Lessons from Systemic Lessons from Systemic Financial CrisesFinancial Crises

Guillermo CalvoGuillermo CalvoColumbia UniversityColumbia University

India Policy Forum 2009. Sponsored by NCAER and The Brookings Institution.New Delhi, July 14-15, 2009