. 3 Preventing Financial Crises in Developing Countries INANCIAL CRISES OCCUR WHEN FINANCIAL SYSTEMS BECOME ILLIQUID or insolvent. Such crises have recurred throughout the history of capitalism. A collapse in investor confidence, usually after a period of market euphoria, marks such crises—examples include the Dutch tulip mania crisis of 1637–38, the Indian cotton futures market Fcrash of 1866, and the Great Depression of 1929. When foreign lenders are involved, cross-border payments problems arise as well. The East Asian crisis belongs to the class of twin financial crises, in- volving both banking and currency problems. According to modern eco- nomic theory, information asymmetries and financial market failures are central in explaining macroeconomic fluctuations and financial crises.1 Because lenders know less than borrowers about the use of their funds and cannot compel borrowers to act in the lenders’ best interests, lenders can panic and withdraw their funds when they perceive increased risks, in the absence of adequate public regulation and safeguards. That can trigger 121 GLOBAL ECONOMIC PROSPECTS much wider financial crises, with spiraling countries (including the sovereign debt cri- real-sector effects. The costs can be severe. sis of the 1980s in Latin America) stemmed Such crises can bring down the financial from macroeconomic mismanagement, system, cause asset prices to collapse, and including excessive public deficits and over- bankrupt sound as well as unsound banks borrowing abroad. As evident in the light and corporations. The East Asian crisis is of recent events in Russia, reforms and expected to cause output in Indonesia, the policies to avoid such sovereign debt crises Republic of Korea, and Thailand to drop are important and still relevant in develop- 12–24 percent in 1998 (from previous ing countries. The focus of this chapter, trend levels), throwing millions into unem- however, is on the type of crisis which ployment and poverty. involves private-to-private capital flows, and the role of domestic and international ver the past 100 years industrial financial systems in intermediating such O flows. The international setting is impor- countries have reduced the incidence tant because these crises (East Asia in 1997, and severity of systemic crises through Mexico in 1994, and Chile in 1982) are public policy and institutional closely connected to rapidly rising cross- reforms—although they have not border private capital flows. These flows eliminated crises entirely. have grown massively in the past decade, but without the improvements in institu- Over the past 100 years industrial tions and public regulation needed for their countries have reduced the incidence and safe management. severity of systemic crises through public The analysis of financial crises and the policy and institutional reforms. They have appropriate policies needed to prevent not eliminated them entirely, however, as them highlights the way various factors the savings and loan crisis in the United interact and amplify risks. These include States in the 1980s, the banking crises in inadequate macroeconomic policies, surges Nordic countries in the early 1990s, and the in capital flows, fragility of domestic finan- unfolding financial sector problems in Japan cial systems, weak corporate governance, illustrate. In developing countries there is and ill-prepared financial and capital often a mismatch between public policies account liberalization. Policymakers need and the institutional structures (which are to be concerned about these interactions in slow to change) intended to prevent finan- the sequencing and timing of policy and cial crises, and their integration with world institutional reforms. financial markets. Thus the number of such This chapter’s key messages: crises remains large and their costs have • The number and costs of financial been growing. Reducing their incidence calls crises have risen in developing coun- for policy and institutional reforms in both tries since the 1980s, partly because rel- national and international settings. atively small economies are more Until the surge in private capital flows exposed to the risks of international in the 1990s, most crises in developing capital flow reversals. Many recent 122 PREVENTING FINANCIAL CRISES IN DEVELOPING COUNTRIES crises are in fact both currency and and shift the composition to short-term banking crises, including the East Asian and volatile inflows. Flexible exchange crisis (1997) and the Mexican peso cri- rates help regain autonomy for mone- sis (1994). Developing countries have tary policy, improve risk perceptions, recently been exposed to a wave of cap- and reduce incentives for excessive bor- ital inflows but have little experience rowing, but they are not always enough with the institutional and prudential to avoid crises and may result in volatile safeguards needed to minimize associ- and misaligned real exchange rates. ated risks. The easier availability of Countercyclical fiscal policy is impor- cheap international capital in good tant, but it too has tradeoffs (fewer times encourages excessive private risk schools and roads, for instance, to taking, which can turn into a major accommodate more shopping malls and problem when favorable financial sen- office towers). What is needed is a mul- timent erodes. The institutions needed tidimensional approach, often with to minimize the risks of such crises take more flexible exchange rates, greater a long time to develop, while the politi- reliance on fiscal policy, and better and cal constraints on prompt policy tighter domestic financial regulation actions to avert them are often severe. (and, where necessary, restrictions on However, the building of such required capital flows) to reduce excessive capi- institutions and safeguards needs to tal inflows, domestic lending booms, proceed vigorously in all countries, so and risks of financial crises. that the potential benefits of globaliza- • Financial sector liberalization, which tion can be realized with fewer risks. can significantly boost the risk of crisis • Poor macroeconomic policies leave a (particularly in conjunction with open country vulnerable to financial crisis, capital accounts), should proceed care- and prudent policies are the first line of fully and in step with the capacity to defense. In the presence of large capital design and enforce tighter regulation inflows and weak financial systems, and supervision. At the same time, however, the room for maneuver in set- however, efforts to improve prudential ting appropriate macroeconomic poli- safeguards and banking operations will cies to control excessive private bor- need to be accelerated. There is strong rowing and risk taking is constrained evidence of a higher probability of cri- because of the presence of numerous sis following liberalization without tradeoffs and their distributional conse- stepped-up prudential safeguards (even quences. Fixed or pegged exchange in industrial countries). Regulations rates help anchor expectations and that increase safety and stability are reduce uncertainty. But they may also needed. Banking and capital market provide unintended incentives to the reforms, oriented toward better risk private sector to overborrow (as in management, are critical in any strat- Thailand), while sterilizing capital egy to prevent financial crises. Public inflows may be costly and ineffective policy and institutional reforms that 123 GLOBAL ECONOMIC PROSPECTS clamp down on connected bank lend- • Changes are needed in the architecture ing and improve corporate governance of the international financial system in are equally essential to support the view of the excessive volatility (euphoria safety of the financial system. and panics), strong contagion effects, • Capital account liberalization should and increased scope for moral hazard in also proceed cautiously, in an orderly international financial markets. The and progressive manner, given the large most pressing issue is to develop better risks of financial crises—heightened by mechanisms to facilitate private-to-pri- international capital market failures— vate debt workouts—including, under in developing countries. Benefits of some conditions, “standstills” on exter- capital account liberalization and nal debt—and help resume capital flows increased capital flows have to be and increase international liquidity to weighed against the likelihood of crises countries in crisis. Although there are and their costs. Clearly the benefits some compelling arguments in favor of from foreign direct investment (FDI) a lender of last resort, appropriate bur- and longer-term capital inflows out- den-sharing, rules for intervention, and weigh the costs associated with the moral hazard remain difficult and unre- increased likelihood of financial crisis, solved problems. Improved regulation and developing countries should pur- by creditor-country authorities and bet- sue a policy of openness. But for more ter risk management of bank lending to volatile debt portfolio and interbank emerging markets should also help short-term debt flows and the related reduce the probability of crisis. More policy of full capital account convert- timely and reliable information is desir- ibility, there are higher associated risks able, but complete transparency and of financial crisis and greater uncer- better information alone will not pre- tainty about the benefits. Tighter pru- vent crises. Still, better use of warning dential regulations on banks,