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
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