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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.