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Latest Generation of Systemic Crises: “I don’t think we are in Kansas anymore” Augusto de la Torre The World Bank Finance Forum June 20-22, 2002 Key facts on recent financial crises Increasing frequency of severe twin crises Twice as disruptive as currency crisis, adding 15% to cumulative output loss (Bordo et al. 2001) Sudden stops Current account deficits are not new Large & sustained deficits/surpluses during gold standard era What is new: speed of major current account reversals Linked somehow to financial globalization Sudden stops have exogenous components and international capital markets are imperfect Russian contagion, “globalization hazard” (Calvo 2002), weak framework of international institutions Key facts on recent financial crises (2) …but not explained by globalizatin per se Gold standard era—greater financial globalization… …with less frequent currency and twin crises With isolationism per se not preventing crises Frequent currency crises in Bretton Woods, despite domestic financial repression and capital controls Emergence of new, disturbing varieties Triple (currency, banking, and public debt) crises Widespread breakdown of contracts/property rights Crises have become more frequent… 14.00 Banking Crises Frequency (annual % probability) 12.00 Currency Crises Twin Crises 10.00 All Crises 8.00 6.00 4.00 2.00 0.00 1880-1913 Source: Bordo et al. 2001 1919-1939 1945-1971 1973-1997 (21 countries) 1973-1997 (56 countries) …but not more severe, on average… All countries 1880-1913 Currency Crisis Banking Crises Twin Crises All Crises 2.6 2.3 2.2 2.4 Currency Crisis Banking Crises Twin Crises All Crises 8.3 8.4 14.5 9.8 1973-1997 21-nations 1919-1939 1945-1971 Average duration of crises in years 1.9 1.8 1.9 a 2.4 3.1 2.7 1.0 3.7 2.4 1.8 2.6 Average crisis depth (cumulative GDP loss in %) 14.2 5.2 3.8 a 10.5 7.0 15.8 1.7 15.7 13.4 5.2 7.8 Notes: a indicates no crises Source: Bordo et al. 2001 1973-1997 56-nations 2.1 2.6 3.8 2.5 5.9 6.2 18.6 8.3 Contagion Risk (Runs) Anguish zones under financial globalization Multiple equilibria Current account / fiscal deficits Overvalued currency II Highly indebted government IV Wretched Trinity: Weak currency Fear of floating Weak institutions Currency mismatches Low currency & maturity mismatches I Blessed Trinity: International currency Flexible exchange rate Sound institutions III Weak institutions Incentive Distortions Contagion Risk (Runs) Anguish zones under financial globalization Multiple equilibria Highly indebted government Run on the currency Depositor run on system Current account / fiscal deficits II IV Run by foreign portfolio investors Low currency & maturity mismatches I Currency mismatches III Depositor flight to quality Incentive Distortions Type IV crises: Management and resolution issues Containment Loss allocation Restructuring Regeneration International financial architecture Type IV crises – containment issues Contract-abiding containment proves insufficient Defenses of currency (int’l reserves, interest rate hikes) and of banks (LOLR)—inconsistent and break down Full deposit guarantee (to retain depositors at home while facilitating bank closures) lacks credibility Huge coordination/discernment problems Forcible containment—through contract violation Deposit freeze (“corralito”) and deposit securitization Stock pesification cum float Generalized internal and external defaults Alternative to consider Stock dollarization cum pesification at the margin Type IV crises – loss allocation issues Allocation through administrative measures or negotiation (not via hyperinflation) Pressures on government to “compensate” agents for the effects of extreme policies Not independent of nature of forcible containment Huge coordination/discernment problems Dominance of political economy dynamics Process depends significantly on quality of governance and power of traditional oligarchies Burden sharing takes on new meaning Type IV crises –restructuring issues Fear of bank closures in midst of runs Post-freeze securitization could help restructuring By shrinking banks’ balance sheets But asset management/disposal still a major issue Special problems for bond-based recapitalization How to value debt issued by government in default? Bank nationalizations Can recapitalization debt be made senior without violating negative pledge and other clauses? Innovative corporate restructuring frameworks Type IV crises – regeneration issues Growth regeneration depends on… Confidence and capital reflows Degree of openness in trade structure Speed/effectiveness of loss allocation and restructuring …but its sustainability requires regeneration of financial intermediation… Establishment of currency as “store of value” Questions on new industrial organization of sector (narrow banks, offshores, etc.) Segmentation of access …and institutional regeneration Contractual and regulatory environment Democratic governance Type IV crises – int’l architecture issues Imperfections of int’l financial markets Contagion (Calvo’s EMF) Defaults (int’l bankruptcy, exit consents, UDROPs, floor to debt to facilitate agreement on haircuts) Potential role of IFIs in peso debt markets development Externalities of fluctuations in international currencies Fixing them would benefit EMs the most… …but incentives for industrial countries are weak Multilateral & regional institutions have a major responsibility