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Learning from Recent
Financial Turmoil
Guillermo Calvo
June 25, 2008
15th World Congress of the International Economic Association,
Istanbul, TURKEY, June 25-29
OUTLINE
Setting the Global Financial Stage
Sudden Stop and Phoenix Miracles
I.
II.
1.
2.
3.
4.
Incredible Effects of Asia/Russia Crises on
Latin America
Systemic Sudden Stop: Empirical Analysis.
Output Rebound after Sudden Stop.
Volatility and Growth after Output Rebound.
III. Policy Lessons.
IV. Subprime crisis: Contrasts and
Conclusions.
I.
Setting the Global
Financial Stage
North vs. EM, 1980-2002
Stability vs. Disarray
Great Moderation was the rule in advanced
economies since early 1980s until recently.
while . . .
Sudden Stop was the rule in many Emerging
Markets, EM, since 1980s until 2002, e.g.,
–
–
–
–
Debt crises, 1982-1990
Tequila crisis, 1994-5
Asia/Russia crises, 1997/1998
Argentina/Turkey crises, 2001/2002
but . . .
Subprime crisis seems to have turned the tables:
Immoderation in the North, Moderation in EMs!
Disarray in Emerging Markets
gave rise to the literature on
Sudden Stop (of capital inflows)
II.
SUDDEN STOP AND
PHOENIX MIRACLES:
Basic Facts and Empirical Results
Sudden Stop, SS
SS is defined as a large and largely
unexpected fall in capital inflows.
When accompanied by across-the-board
increase in interest spreads, we call them
Systemic Sudden Stops, 3S.
SS is associated with BOP crisis, large
devaluation, and harmful contraction in
aggregate demand:
– output falls and unemployment rises.
External Financial Conditions for EMs
(EMBI sovereign spread & Current Account Balance in EMs, millions of
USD, last four quarters)
Tequila
Crisis
150000
Asian
Crisis
Russian
Crisis
2500
50000
1500
0
1000
-50000
500
-100000
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
Jul-97
Jan-97
Jul-96
Jan-96
Jul-95
Jan-95
Jul-94
Jan-94
Jul-93
Jan-93
Jul-92
Jan-92
0
Jul-91
-150000
EMBI spread (basis points)
2000
Jan-91
Current Account (millions of USD)
100000
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.
II.1
Incredible Effects of
the Asia/Russia crises
on Latin America
LAC 7: INVESTMENT
(LAC-7, s.a. Investment, 1998.II=100)
Annualized growth: 10.6%
2002.IV-2004.III
Russian Crisis
110
Annualized growth: 7.4%
1990.I-1998-II
100
90
80
Annualized growth: - 4.1%
1998.II-2002-IV
70
60
2004.I
2003.I
2002.I
2001.I
2000.I
1999.I
1998.I
1997.I
1996.I
1995.I
1994.I
1993.I
1992.I
1991.I
1990.I
50
LAC 7: GROWTH
(LAC-7, s.a. GDP, 1998.II=100)
Annualized growth: 5.5%
2002.IV-2004.III
Russian Crisis
115
110
105
100
95
Annualized growth: 4.4%
1990.I-1998.II
Annualized growth: 0.2%
1998.II-2002.IV
90
85
80
75
70
2004.I
2003.I
2002.I
2001.I
2000.I
1999.I
1998.I
1997.I
1996.I
1995.I
1994.I
1993.I
1992.I
1991.I
1990.I
65
II.2
Systemic Sudden Stops:
Empirical Analysis
From “Systemic Sudden Stop: The
Relevance of Balance-Sheet Effects
and Financial Intermediation,” Calvo,
Alejandro Izquierdo and Luis Fernando
Mejia. NBER Working Paper No. 14026
Covers 110 countries, from 1990 to 2004.
Probability of 3S is linked to:
– Domestic Liability Dollarization, DLD.
– Current account deficit relative to Tradables’
output (not GDP), CAD.
– Financial Integration with the rest of the world.
DLD and CAD
SS eventually lowers expenditure on tradables and a
fall in CAD.
The larger the current account adjustment, the larger
is real currency devaluation.
The paper conjectures that the larger is CAD, the
larger is real currency devaluation.
DLD, is foreign-currency denominated loans to
domestic residents by local banks. DLD may produce
harmful effects on the face of large real currency
devaluation, e.g., paralyze domestic payments
system.
Therefore, the paper claims that probability of a fullfledged SS increases with DLD and CAD.
– this is the key balance-sheet effect in the paper.
Financial Integration
Financial integration is measured following
Lane and Milessi-Ferretti (2006), e.g.,
assets+liabilities of FDI and portfolio flows
as a share of GDP.
Results suggest that financial integration
may increase the probability of SS until it
reaches a critical level, after which the
probability falls as financial integration
increases.
– most EMs are in the range in which the harmful
effects of financial integration are largest.
SS, DLD and Omega (1-CAD)
Low dollarization
Average dollarization
High dollarization
0.20
0.15
0.10
0.05
0.00
0.60
0.80
1.00
Omega
1.20
1.40
SS and Portfolio Integration
0.20
Probability of SS
EMBI+
Other
Developed
0.15
0.10
0.05
0.00
0.0
0.1
0.2
0.3 0.4 0.5 0.6 0.7
Portfolio Integration
0.8
0.9
1.0
Summary of 3S paper
The paper shows that a 3S may
result in SS for any given country,
the larger is DLD and CAD, and
that financial intermediation is a
contributing factor to SS, unless
financial intermediation is already
sufficiently deep.
Empirical analysis has nothing to say
about what makes a SS systemic.
II.3
Output Rebound
After Sudden Stop
Phoenix Miracles
3S results in output contraction. Thus, it is
important to learn about the characteristics of
output rebound.
I will report on “Phoenix Miracles in Emerging
Markets” by Calvo, Alejandro Izquierdo, and
Ernesto Talvi, NBER Working Paper No. 12101.
Surprisingly, the rebound takes place without
much:
– Domestic credit
– Current account deficits
– investment
Real Exchange Rate
(Average 3S Episode)
Emerging Markets
Collapse
110
Turkey 2001
105
Recovery
110
Recovery
105
RER
100
108
Collapse
(vis à vis US Dollar)
100
108
95
GDP
104
85
80
90
104
85
75
102
GDP
102
80
70
100
65
t-2
*Median
t-1
t
t+1
t+2
100
75
2000
2001
2002
RER (vis a vis USA)
GDP
RER*
(vis à vis US Dollar)
106
GDP
106
RER (vis a vis USA)
95
90
Current Account & Output
(Average 3S Episode, CA in % of GDP)
Emerging Markets
Recovery
Collapse
3
Recovery
110
2
2
1
0
106
GDP
-1
-2
104
Current
-3
Account
-4
102
0
GDP
106
GDP
GDP
1
108
Current Account (%GDP)
108
-1
Current
Account
-2
104
-3
-4
102
-5
100
-6
t-2
t-1
t
t+1
t+2
3
110
-5
100
-6
2000
2001
2002
Current Account (%GDP)
Collapse
Turkey 2001
Bank Credit & Output
(Average 3S Episode, Bank credit deflated by CPI)
Emerging Markets
Collapse
Turkey 2001
Recovery
Collapse
121
Recovery
130
110
110
120
116
108
GDP
GDP
111
106
104
GDP
106
Bank Credit
GDP
106
110
100
104
90
Credit
102
Credit
100
t-2
t-1
t
t+1
t+2
101
102
96
100
80
70
2000
2001
2002
Bank Credit
108
Investment & Output
(Average 3S Episode, annual Investment)
Emerging Markets
Collapse
110
Turkey 2001
Recovery
185
110
Collapse
Recovery
180
175
170
108
165
108
160
155
135
104
Investment
150
106
140
104
130
125
115
102
120
102
105
100
95
t-2
t-1
t
t+1
t+2
Investment
100
110
100
2000
2001
2002
Investment
GDP
145
GDP
106
GDP
Investment
GDP
Phoenix Miracles: Summary and
Conjectures
Output collapse is associated with sharp
credit contraction.
Paradoxically, however, output rebound
does not require domestic or external credit.
The main conjecture is that firms’ working
capital is rebuilt by:
– lower investment (possibly sacrificing technical
progress),
– lower real wages,
– inter-enterprise arrears
– paying lower taxes, etc.
II.4
Volatility and Growth
after Output Rebound
In “Relative Price Volatility under
Sudden Stops,” by Calvo, Izquierdo and
Loo-Kung, Journal of International
Economics 2006, we show that RER
volatility increases after SS.
Moreover, volatility is enhanced by DLD
and CAD.
The growth literature suggests that
volatility may make it hard for output to
reach its trend prior to SS.
This is supported by “Growth Dynamics:
the Myth of Economic Recovery,” by
Cerra and Saxena, IMF Working Paper
WP/05/147
Therefore, Sudden Stops
may have large and persistent
negative effects on growth,
significantly enhancing
their welfare costs.
III.
Systemic Sudden Stops
and Phoenix Miracles:
Policy Lessons
3S are financial shocks which effects are
worsened by domestic financial
vulnerabilities.
Given the greater frequency of systemic
financial shocks, and potentially high
welfare costs, countries should be strongly
advised to prioritize strengthening their
financial systems.
Further financial integration may increase
the probability of SS, especially for those
EMs which exhibit weak domestic financial
systems, like India and China.
3S require the help of the international
financial community.
A global central bank would be ideal but it
is riddled with myriad political problems.
Less ambitious initiatives may still help:
– IMF Contingent Credit Line, CCL
– Calvo, Emerging Market Fund, EMF, to
stabilize an index like the EMBI+.
IV.
SUBPRIME CRISIS
Contrasts and Conclusions
Parallels and Contrasts
Both involve the financial sector,
but while SS shuts off a country from the
credit market, Subprime started by
shutting off a sector from the credit
market.
Both give rise to contagion,
but, interestingly, contagion seems to be
confined to the corresponding asset class:
– EMs in SS
– Advanced economies in Subprime.
External Financial Conditions for EMs
(EMBI+, bps)
1450
ENRON
Effect
Greenspan’s
“conundrum”
testimony
Fears of FED
tightening
1250
Yields
1050
Pre-Asian Crisis EM Yields
850
=-32.1%
650
Spreads
450
Pre-Asian Crisis EM Spreads
=-48.1%
250
Beginning of improvement
in international financial
conditions
Sep-07
Jul-07
May-07
Mar-07
Jan-07
Nov-06
Sep-06
Jul-06
May-06
Mar-06
Jan-06
Nov-05
Sep-05
Jul-05
May-05
Mar-05
Jan-05
Nov-04
Sep-04
Jul-04
May-04
Mar-04
Jan-04
Nov-03
Sep-03
Jul-03
May-03
Mar-03
Jan-03
Nov-02
Sep-02
Jul-02
May-02
Mar-02
Jan-02
50
Asia/Russia 97/98 vs. Subprime:
A/R were not protected by Lender of Last
Resort, and neither were the other EMs.
Russia 98 crisis spilled over the G7 through
LTCM, and only then the Fed orchestrated a
bailout, after which interest rates were cut.
In contrast,
– Subprime crisis was quickly met by massive
liquidity infusion from powerful Lenders of Last
Resort,
– EMs followed conservative financial policies:
high international reserves
current account surplus
banks did not get involved with subprime-type bonds.
Conclusions
Financial crises visit both saints and
sinners.
Balance-sheet imbalances are at the core
of all recent crises.
Financial vulnerabilities facilitate contagion.
Central challenges of financial globalization
are to develop global financial institutions
that
– mimic some of the roles of a Lender of Last
Resort,
– improve financial supervision in order to
prevent a race to the bottom.