Dealing with Financial Crises

CHAPTER FOURTEEN Dealing with Financial Crises — Does the World Need a New International Financial Architecture?

I. Fundamental Issues

1. How have recent developments in global capital markets differed across regions? 2. What are some of the problems pervasive to financial markets, and what is a financial crisis? 3. What is the difference between portfolio capital flows and foreign direct investment, and what role did these types of capital flows play in recent financial crises? 4. What are the main activities of the International Monetary Fund and the World Bank? 5. What aspects of IMF and World Bank policymaking have proved controversial in recent years? 6. What changes in the international financial architecture have economists proposed in recent years?

II. Chapter Outline

1. International Capital Flows a. Explaining the Direction of Capital Flows b. Capital Allocations and Economic Growth c. Capital Misallocations and Their Consequences d. Where Do Financial Intermediaries Fit In? 2. Capital Flows and International Financial Crises a. Are All Capital Flows Equal? b. Policy Notebook: Is Capital Market Liberalization the Right Policy? c. The Role of Capital Flows in Recent Crisis Episodes 3. Financial Crises and Multilateral Policymaking a. The Current Multilateral Structure b. Evaluating the Status Quo c. Policy Notebook: Is the European Bank for Reconstruction and Development Promoting Corruption in Russia? 4. Does the International Financial Architecture Need a Redesign? a. Can Policymakers Predict International Financial Crises? b. Rethinking Economic Institutions and Policies c. Management Notebook: Do Financial Markets Predict Financial Crises? 5. Questions and Problems

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III. Chapter in Perspective

This chapter has two main themes. The first half of the chapter deals with capital flows among countries, and the role of capital flows in the financial crises of the last decade. The second half of the chapter discusses the purposes of the IMF and the World Bank, with particular emphasis on IMF lending practices, IMF loan conditionality and the moral hazard problem of bailing out countries in crisis. The possibility of predicting financial crises with early warning systems is briefly covered, and the chapter concludes with several proposals for reform of the IMF.

IV. Teaching Notes

1. International Capital Flows

The international financial architecture includes the governmental and nongovernmental institutions and the policies that govern international monetary and financial activities. The first part of this chapter deals with types of capital flows in the global system.

a. Explaining the Direction of Capital Flows

Foreign direct investment (FDI) is the acquisition of foreign assets that result in 10 percent or more ownership control. FDI is a major component of capital flows and despite the many recent international crises, FDI is growing more rapidly than international trade. FDI is however concentrated among developed economies. By the 1990s, over 70 percent of FDI inflows went to developed economies. A major reason for this is the growth of cross- border mergers and acquisitions. The formation of the EU, relaxing antitrust standards, changes in tax codes, perceived economies of scale and scope and desire for market entry have spurred a large amount of cross-border M&A activity in recent years, much of it in Europe and between the U.S. and Europe. FDI to developing nations has grown also, particularly in Asia, and portfolio investment flows (defined in the text as short-term capital flows with less than 10 percent control) have increased as well.

b. Capital Allocations and Economic Growth

Capital is required to grow an economy. Capital and productivity growth are two of the main determinants of the level of economic growth over time. Many developing economies must rely on foreign capital to support growth. In developed economies, foreign capital can continue to provide funding sources when the domestic economy might be in a downturn or when domestic demand for fund is greater than domestic supply. In this case, foreign capital inflows could have the twin effects of keeping interest rates low and maintaining the value of the currency. Domestic savers that provide foreign capital outflows on the other hand gain for themselves diversification benefits from investing overseas and potentially can earn higher rates of returns, particularly in emerging economies (at least when times are good). Dealing with Financial Crises — Does the World Need a New Intl. Financial Architecture? 155

Teaching Tip: In many developing economies, there is a dearth of local capital for various reasons. First, in poor countries substantial private saving do not usually arise until income rises above subsistence level. Second, developing economies often do not have sound intermediaries to channel funds to borrowers even if savings exist. Finally, to generate substantial domestic savings there must be a bond of trust among the public, its financial institutions and the government. This bond is built by creating a legal foundation that protects savers, creating institutions such as regulators of financial intermediaries, having a lender of last resort, non-inflationary monetary policy and perhaps (implicit or explicit) deposit insurance along with favorable tax policies that encourage saving and investment.

As a developing economy matures, its financial sector develops. This usually entails increased competition among financial intermediaries, development of payment systems and appropriate regulatory safeguards and at some point growth of internal capital markets.

Usually the banking system develops and grows prior to growth of equity and bond markets. This is probably appropriate, as properly regulated banks are, theoretically, better at analyzing and monitoring unique risks, as compared to capital markets in developing economies that are characterized by low trading volume, an absence of regulation, and few participants. In other words, many capital markets in developing economies lack the depth, breadth and regulatory framework to approach efficiency. Appropriately regulated banks that compete may do a better job allocating capital in these situations.

Some economists worry that financial sector development leads to declines in savings as intermediaries offer more credit to the public. This argument seems to imply that the public will engage in excessive consumption today at the expense of lower available consumption in the future. If this is true the result in free markets should be to raise borrowing rates to the point where the public no longer chooses to consume more today. The fear is that the higher interest rate then may slow investment and future growth. 156 Chapter 14

Other economists have postulated that the development of the financial sector should not affect long run economic performance because only changes in real variables matter. Markets and financial intermediaries, however, are critical elements in channeling funds from savers to borrowers. Inefficiencies in these systems result in deadweight losses and reduced capital formation, which in turn results in higher costs of capital, less investment and lower growth.

c. Capital Misallocations and Their Consequences

According to economic theory, capital should be allocated to its highest valued uses, so that economic growth is maximized. There are two main reasons why capital is often misallocated. The first is asymmetric information, and the second is policy created distortions. Asymmetric information generates other financial market imperfections. These imperfections include adverse selection, moral hazard, and herding behavior (which also can lead to contagion). Herding behavior occurs when some investors mimic the actions of other investors they believe are better informed than themselves. Contagion occurs when, because of herding behavior, financial instability in one market spreads to another market. Fears of contagion can be overblown, but the Asian crises in 1997 provide a good example of the dramatic effects of contagion on multiple countries in a region.

Capital flows are also affected by policy created distortions. Any number of examples could be used here, but some of the most common would include tariffs on imports, subsidies for specific industries, differential regulations, misallocations due to corruption, including bribes and the ability for some to obtain capital with little transparency, etc. The best way to limit the number of these distortions would seem to be multilateral policy cooperation and coordination. Dealing with Financial Crises — Does the World Need a New Intl. Financial Architecture? 157

Financial instabilities will result when a financial sector is no longer capable of allocating capital to the best possible uses. Instabilities eventually lead to a financial crisis where the affected financial markets stop functioning. In developing economies, a crisis may start in any sector but is likely to cause a crisis in the nation’s banking industry, a currency crisis and a crisis in repaying foreign debt. These types of crises can severely damage a developing economy and can lead to violence so it is an important policy aim to limit crises.

Teaching Tip: It has been said that, “When the U.S. catches cold, Latin America gets pneumonia.” What does this statement mean as applied to economic and financial crises? To what extent is it a valid statement and what does it apply about the need for multilateral policy cooperation and coordination?

d. Where Do Financial Intermediaries Fit In?

Intermediaries serve a useful purpose in helping channel funds from savers to borrowers. In most economies, the ultimate savers are households, whereas businesses and government entities are typically net borrowers. Funds demanded by individual borrowers are usually larger than the funds that can be supplied by individual savers. One purpose of intermediaries is then to pool savers’ funds and invest them in capital market securities. Intermediaries then can enjoy economy of scale benefits in investing and can pass on the benefits to the saver. Much of the funds available to savers are small-denomination, short-term, and needed for liquidity. Borrowers, however, desire to invest in risky projects for longer time periods. There is thus a market for intermediaries to repackage claims to savers. Intermediaries purchase risky claims from borrowers (loans, bonds, etc) and finance them by offering many low-denomination, short- term liquid claims to savers. The difference in risk and maturity of the claims allows the middle man (the bank, for example) to make a profit.

The text discusses the following benefits of intermediaries:  Investment pooling (described above).  Reduction of information asymmetries: The bank investigates the creditworthiness of the capital market security issuer so that the saver does not have to. Associated benefits may include better risk assessment and risk pricing and more continuous monitoring.  Risk reduction by pooling: The bank has a more diversified investment portfolio than an individual saver is likely to achieve, resulting in reduced risk. 158 Chapter 14

Teaching Tip: It is important to realize that capital markets provide many of the same benefits that intermediaries do. In particular, capital markets assess and price risk and monitor security issuers, just like banks do. In some cases, money and capital markets can provide this assessment more cheaply, without having to provide a profit margin for the intermediary. The recent rapid growth in the commercial paper market is a case in point. In situations that are more specialized however, intermediaries probably can do a better job at providing the risk assessment and monitoring functions than money and capital markets.

2. Capital Flows and International Financial Crises

a. Are All Capital Flows Equal?

Portfolio investment is the acquisition of foreign financial assets that results in less than a 10 percent ownership share in the entity. As compared to FDI, portfolio investment has the following characteristics:  Portfolio investment tends to be short term focused and of short maturity.  Portfolio investment tends to have a lower funds cost than FDI.  Portfolio investment is easier to obtain than FDI.

Because of the short-term nature of portfolio investment, these funds tend to be volatile (meaning that an inflow can be quickly reversed into an outflow, and that these funds appears to be subject to herding behavior). The fear is that a sudden outflow of portfolio investment could destabilize a country’s financial intermediaries and imperil the viability of its exchange rate regime. FDI is thought to be more productive in generating growth for the economy and to be more stable, so FDI may be preferable to portfolio investment.

b. The Role of Capital Flows in Recent Crisis Episodes

A lesson to be learned from the recent international crises in Mexico, Russia, Asia and elsewhere is that an over reliance on foreign portfolio investment can be destabilizing even though portfolio investment was not the root cause of the crises. FDI, on the other hand, is considered stabilizing because it is long term. Dealing with Financial Crises — Does the World Need a New Intl. Financial Architecture? 159

c. Policy Notebook: Is Capital Market Liberalization the Right Policy?

For Critical Analysis: As a policymaker in a developing or emerging economy, which types of capital flows would you encourage? What policy actions would you take to encourage the desired capital flows?

As explained earlier, there are benefits and costs associated with both portfolio and direct investment capital flows. A diversified portfolio of both types of flows should be encouraged. It is usually more difficult to attract long-term flows, however. Hence, policymakers should work to establish a stable economic environment, transparency in policymaking, a modern infrastructure and a well-educated workforce. These attributes encourage longer-term capital flows.

3. Financial Crises and Multilateral Policymaking

a. The Current Multilateral Structure

This part of the text provides a brief look at the functions of the IMF and the World Bank.

The IMF is discussed in Chapter 7, recall from there that the original purpose of the IMF was to provide short-term adjustment assistance for balance of payments imbalances where needed. When a country joins the IMF, the country must deposit funds equal to its quota subscription with the IMF. The quota determines how much money the country can borrow and its voting shares in the IMF. The quota subscription is measured in units of special drawing rights (SDRs). A SDR is a composite currency based on the values of the currencies of five members of the fund. 160 Chapter 14

The IMF often imposes conditions on a loan made to a member country. Low conditionality requires the borrowing government to make a general commitment to adhere to IMF conditions, whereas high conditionality requires the government to meet specific criteria (called performance criteria) as a condition of the loan. The penalty for not meeting the criteria is generally limited to not receiving the next scheduled loan disbursement. In either type of conditionality, at least part of the loan may be granted before the conditions are met. Text Table 14-2 on page 458 gives the main financing facilities of the IMF and their function. Most of the IMF financing is designed to provide short-term assistance, although they do make 10-year loans under their Poverty Reduction and Growth Assistance Facility.

The World Bank is actually comprised of five major entities listed and briefly explained in Text Table 14-3 on page 459. The purpose of the World Bank is to provide long-term assistance to developing nations to fund development and growth that cannot be funded through the private sector.

b. Evaluating the Status Quo

Both the IMF and the World Bank have faced serious criticisms in recent years, and probably for good cause. Good readable sources on these problems can be found in the following:  “The International Monetary Fund 50 Years after Bretton Woods,” New England Economic Review, 1994,  “Rethinking the International Monetary System: An Overview,” J. Little and G. Olivei, New England Economic Review, Nov/Dec 1999,  “Why the Interest in Reforming the International Monetary System?” New England Economic Review, Sept. Oct 1999. IMF conditionality is supposed to help reduce the moral hazard problem, but in many cases it appears not to have done so. Perhaps this is because the IMF does not make public the loan conditions, so private investors may not learn of a problem until the IMF announces they will withhold a scheduled loan payment. Unfortunately, this practice can contribute to a crisis atmosphere. The IMF also usually does not employ high conditionality until after a loan is made and conditions have once again gone awry. Dealing with Financial Crises — Does the World Need a New Intl. Financial Architecture? 161

Teaching Tip: The World Bank has also had its share of critics. The World Bank has a bit of a conflicting agenda in that the Bank’s funds donors desire to earn a steady income stream from their donations, but the World Bank is chartered to limit market failures that have positive externalities. In other words, the Bank’s job is to provide financing when it is not profitable, or it is too risky, for the private sector to do so. The Bank is not likely to be able to generate a “steady income stream” from these types of loans. As a result, the World Bank has become increasingly involved in financing projects of more developed countries that are more likely to be paid back and can sustain a reasonable interest rate rather than providing financing for projects in the world’s poorest countries. For instance, Africa has many of the world’s poorest nations but it receives only about $1.8 billion per year in assistance from the World Bank. China however receives between $2 and $3 billion per year, even though China has foreign currency reserves of $150 billion and has a large current account surplus. The World Bank has been accused of competing with private capital sources to finance investments in middle-income countries where the risk is much lower than in truly lesser developed countries.

c. Policy Notebook: Is the European Bank for Reconstruction and Development Promoting Corruption in Russia?

For Critical Analysis: What actions could the EBRD take to ensure that the funds it lends to Russian companies are used only to develop Russian resources?

Keeping the funds in Russia might be accomplished if the IMF imposes ex-ante high conditionality, including meeting generally accepted accounting principles as promulgated by the IASB, instituting periodic audits, preferably conducted by well known international private sector firms, requiring funding recipients to end all ties to organized crime and requiring local investment and foreign private funding participation as well. The EBRD also needs to convince borrowers that the moral hazard problem of misallocating resources will not result in additional funding. This problem may be lessened by asking the Russian government to enforce fraud penalties for such actions or perhaps agree to give jurisdiction to the EU. The EBRD could also insist on knowing more about the business owners and managers and/or require participation, perhaps through a joint venture, of a reputable non-Russian firm. 162 Chapter 14

4. Does the International Financial Architecture Need a Redesign?

Before we get into specifics, a cursory analysis would indicate that the probable answer is that an overhaul is warranted. Today’s institutions were created almost 70 years ago, when global trade and capital flows were a fraction of what they are now. Granted, the institutions and policies have grown from their original mission and have evolved with the system. Bureaucracies being what they are though, they will tend to evolve more slowly than the market and may perhaps be more concerned more with their own survival rather than with modernizing the system. In any case the question is at least worth asking.

a. Can Policymakers Predict International Financial Crises?

What determines a financial crisis? This turns out to be a more complicated question than one might think. Countries that attempt to fix their currency’s value may fall victim to speculative attacks. To say that a speculative attack causes a financial crisis begs the question of the real source of the problem, however. Why did a speculative attack occur? These usually occur because of one or more of the following:  The exchange rate peg is inconsistent with the nation’s economic fundamentals. Recall that a country cannot maintain a currency peg indefinitely if they have relatively higher inflation than another country and/or relatively poorer economic prospects. This usually shows up in balance of payments problems. These were noticeably absent in the Asian crisis of 1997.  Sometimes a crisis is a result of self-fulfilling expectations. This is perfectly consistent with informational market efficiency under rational expectations with asymmetric information. An increase in the risk premium of assets denominated in a given currency can spur capital flight and speculative attacks on a currency, even if there is no major misalignment between (perceived) economic fundamentals and the fixed exchange rate. This is especially likely to result in trouble if traders perceive that the country’s policymakers do not have a consensus on whether and how to respond to speculative attacks.  Sufficient misallocation of resources as induced by policy distortions, the moral hazard and adverse selection problems will have to show up somewhere and can result in a crisis. Any and all of these are perhaps predictable, but the variety of sources indicate that many variables (financial crisis indicators) should be examined in attempting to formulate an early warning system that could be used to predict an impending crisis. Dealing with Financial Crises — Does the World Need a New Intl. Financial Architecture? 163

b. Management Notebook: Do Financial Markets Predict Financial Crises?

For Critical Analysis: Does the fact that the EMBI spread clearly failed to predict the start of the Asian crisis necessarily mean that it is not a useful crisis indicator?

The failure of the Emerging Market Bond Index (EMBI) spread to predict the Asian crisis does not indicate that the indicator is not useful, merely that it is not perfect. There is no perfect indicators. The EMBI measures the difference between average yield rates on bonds issued in emerging economies and U.S. Treasury yields. As it increases, capital flows tend to slow, and if the spread increases sharply, capital flows decrease sharply. The indicator appeared to predict the Mexican crisis, and the Russian and Brazilian crisis.

Nevertheless, its failure to predict the Asian crisis reminds us not to put too much emphasis on any one indicator. One test of the usefulness of an indicator is whether anything else can be found that is a better predictor. Market based measures such as the EMBI may do better than other indicators because market based variables are the results of the best guesses of self- interested traders who are risking their own wealth.

Unexpected economic shocks will occur, unanticipated shifts in comparative advantages will continue, capital continues to be “misallocated” ex-ante and changes in perceptions of risk are likely to remain unpredictable. It is thus unlikely that crises will ever be perfectly predictable by any system or individual. 164 Chapter 14

5. Answers to End of Chapter Questions

1. An increase in U.S. interest rates would cause an increase in the demand for the dollar relative to the Mexican peso. Hence, there is pressure for the peso to depreciate relative to the dollar. The Bank of Mexico would need to sell foreign reserves (U.S. dollar reserves) thereby increasing the supply of the dollar relative to the supply of the peso. If they are able to sell enough reserves, this action could eliminate the pressure on the peso to deprecate. 2. Portfolio capital, being short term in nature, tends to be easier to arrange, has lower borrowing costs, and does not require a loss of financial control of the enterprise. Foreign direct investment involves long-term commitments, typically results in the building of important supply-chain relationships, and can be a stabilizing influence on an economy. Portfolio capital can leave an economy quickly and be a destabilizing factor. Foreign direct investment can be more difficult to arrange than portfolio capital. 3. When there is a portfolio inflow, there is pressure for the domestic currency to appreciate. The central bank would need to buy foreign reserve, in effect increasing the relative supply of the domestic currency. When there are portfolio outflows, there is pressure for the domestic currency to depreciate. The central bank would need to sell foreign reserves, in effect increasing the supply of the foreign currency relative to the domestic currency. 4. Suppose that a multinational bank (MNB) headquartered in a developed economy enters a developing economy. The MNB had gained considerable expertise in working as a financial intermediary, and likely has achieved economies of scale in doing so. By entering a foreign market, it helps to allocate the saving more efficiently through its intermediation services; which in turn will lead to additional economic development. Specifically, it should help to make sure the best investment projects are funded. Moreover, the competition it introduces into the capital market helps to improve the quality of the indigenous financial intermediaries. This, in turn, should also add to financial stability. Dealing with Financial Crises — Does the World Need a New Intl. Financial Architecture? 165

5. Savers and borrowers can also benefit from the regulation of financial intermediaries when portfolio capital flows dominate a country’s capital inflows. It can be argued that regulation to limit short-term inflows can stabilize the economy and that these regulations can be gradually lifted as the economy becomes more stable (financial markets develop) and resilient to external shocks. These regulations do impose costs in that they require resources to enforce, and may inhibit otherwise helpful capital inflows which may aid economic development. However, these costs must be considered against the potential losses that may be incurred if the absence of capital controls would lead to more volatile capital markets (which may deter the inflow of foreign capital). 6. The IMF may repeat it loans to Russia, even though Russia had historically defaulted on some of its loans, because Russia’s economic growth impacts more countries than just Russia. The development of Russia’s economy has effects throughout the increasingly global economy. The IMF could do either or both of the following to minimize the possibility of such default happening again. First, it could make the loan agreement public, such that there would be additional public pressure for Russia not to default. Second, the IMF could impose high conditionality rules immediately to catch possible misuse earlier in the loan period. 7. The World Bank was initially established to help countries rebuild after WWII, and was expanded in the 1960s to make long-term loans to developing nations in order to help reduce poverty and improve living standards. Recently, some of the World Bank’s activities have begun to overlap the IMF’s activities to finance long-term structural adjustments and provided refinancing for some heavily indebted countries. Critics may argue that the tasks that are duplicated by the IMF and the World Bank create conflicting goals for the World Bank. Thus, the two organizations may each benefit by focusing on different aims. For instance, the IMF may return to financing shorter-term objectives and leave the World Bank to worry about longer-term projects. 166 Chapter 14

Another conflicting line of reasoning involves donors’ expectation that the World Bank maintain a revenue stream from its projects. This can be argued as unrealistic, however, in that the poorest countries are less likely to yield a payoff for the needed projects; and these are precisely the countries that the World Bank is designed and intended to help. On the other hand, less risky projects that could provide a positive revenue stream are likely to attract private capital. 8. Cause Indicator Potential to Predict Inconsistent economic Divergences between various A large EMBI spread fundamentals economic variables, such as the would indicate an exchange rate, interest rates, income, impending crisis. and money supply. The Management Notebook: “Do Financial Markets Predict Financial Crises?” offers the J.P. Morgan emerging market bond index (EMBI). Speculative attacks Misalignment of official exchange Large difference between values with a value consistent with official exchange values economic fundamentals. and those predicted by economic fundamentals Trading volumes of a currency. and rapidly increasing trading volumes would indicate a potential crisis. Self-fulfilling Country risk ratings by market Relatively easily expectations and participants interpreted to indicate a contagion effects potential crisis Structural moral hazard Credit ratings of country debt Relatively easily problems interpreted to indicate a potential crisis Dealing with Financial Crises — Does the World Need a New Intl. Financial Architecture? 167

9. Answers will vary. A potential strength of this proposal would be the centralized, and assumedly unified, efforts to stabilize the global economic environment. If it works, the global economy would be more stable. A potential weakness involves the question of how practical this proposal would be, and how easy it would be to match individual countries’ domestic policy goals with the organization’s global goals and economic interventions. A potential of conflict between the organization’s interventions and national interests could be a significant weakness. 10. It can be argued that such below-market interest rates are critical for a developing nation’s economy, in order for the economy to grow unburdened by high interest payments when it is trying to funnel profits back into the economy and sustain growth. Conversely, providing these non-market rate loans can also be argued to distort the market for loanable funds, and attract inefficient investment. Students’ perspectives will vary as to which argument is the best. 168 Chapter 14 BLANK PAGE