Lessons from Systemic Financial Crises

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Lessons from Systemic Financial Crises

• Guillermo Calvo
• Columbia University

India Policy Forum 2009. Sponsored by NCAER and
The Brookings Institution. New Delhi, July 14-15,
2009
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Sudden Stop, SS

• Definition Large and largely unexpected cutback
  in credit flows to a country or large sector
  (e.g., real estate).
• NB It does not require a fall in credit stock.
• India is likely going through a SS episode, but
  total credit stock continues to increase.
• However, portfolio credit stock has recently
  started to fall.

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Why is SS dangerous?

• If SS is provoked by an exogenous shock, it
  brings about unplanned contraction in the
  affected country/sectors demand for goods and
  services,
• unless the country/sector has enough liquid
  assets to offset the SS (international reserves)
• The fall in demand may cause a major change in
  relative prices (e.g., real estate prices, real
  exchange rate).

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• Changes in relative prices are largely unexpected
  
• Thus, if country/sector borrowed to buy assets
  which prices sharply declined, this could cause
  severe stress for lenders (e.g., local banks).
• If banks suffer liquidity crunch, they will be
  forced to cut credit across the board, causing
  contagion.
• Therefore, the credit crisis might spread to the
  rest of the economy.

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Aggravating Factors

• Government and large firms may replace the sudden
  cutback in external loans by borrowing from
  domestic banks.
• This crowds out firms with limited access to
  external financing
• typically, small and medium-sized firms who
  utilize labor-intensive techniques, putting
  strong downward pressure on employment and real
  wages.

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Fortunately, India has momentarily cushioned the
blow by injecting liquidity through a decline
in International Reserves.
7
India. Net Capital Flows
( of GDP, last 4 quarters, last value 2008-IV)
Note Other Flows include Loans, Banking
Capital, Rupee Debt Service and other
unclassified flows. Source Reserve Bank of India.
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India. International Reserves
(quarterly data, of GDP)
Source EIU and IFS.
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Capital Controls and SS

• If capital inflows are positive, as in India, one
  cannot prevent SS by imposing controls on capital
  outflows.
• Because for SS to happen it is enough that the
  rate of capital inflows falls, as it is actually
  happening in India
• capital flow reversal need not take place!

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• Controls on capital inflows cannot prevent SS,
  unless inflows are zero, and capital outflows are
  forbidden
• This is especially difficult to implement when
  multinational firms are involved.
• Controls on capital outflows may dampen
  incentives for Foreign Direct Investment because
  it makes profitability harder to assess ex ante.
  
• This shows why capital controls could have
  deleterious effects on growth or simply be
  ineffective in preventing SS.

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Bank Regulation

• While controls on capital flows are highly
  debatable, this does not rule out bank
  regulation, which sometimes is akin to controls
  on capital flows.
• Banks should be tightly regulated because their
  failure brings about systemic shocks.
• In some cases bank failure paralyzes the payments
  system (e.g., Argentina 2002).
• Keep an eye on banks short-term foreign-exchange
  liabilities
• both on and off-balance-sheet

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India and Emerging MarketsThen and Now

• For India, the present external front is not very
  different from that in 1997/1998 Asian/Russian
  crisis.
• But for Emerging Markets 1997/1998 represented a
  major blow
• Interest rates skyrocketed
• and Current Accounts suffered a major adjustment.

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India. Current Account Terms of Trade
(Current Account Balance as of GDP, Terms of
Trade 2005100)
Terms of Trade
Current Account
At 2005 prices
Note e estimate Source EIU.
14
EMs Then
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External Financial Conditions for EMs
(EMBI sovereign spread Current Account Balance
in EMs, millions of USD, last four quarters)
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.
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LAC 7 INVESTMENT (LAC-7, s.a. Investment,
1998.II100)
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LAC 7 GROWTH (LAC-7, s.a. GDP, 1998.II100)
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EMs Now much better from BOP view point
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External Financial Conditions for EMs(daily
data, EMBI, bps, last value 04/07/09)
ENRON Effect
Greenspans conundrum testimony
Lehman Brothers files for bankruptcy
Fears of FED tightening
Basis points
Yields
Pre-Asian Crisis Yield
?-12
Spreads
?54
Pre-Asian Crisis Spread
Beginning of improvement in international
financial conditions
Source Bloomberg.
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US Junk EM Bonds (yields in , last value
04/07/09)
US Junk
EM Sovereign
EM Corporate
Note (1) EM Corporate Credit Suisse Corporate
Bond. (2) EM Sovereign JP Morgan EMBI
Sovereign. (3) US Junk MSCI High Yield
Bonds. Source Bloomberg.
21
EMBI Yield Terms of Trade in LAC(quarterly
data, Terms of Trade Index 1997-I 100, EMBI
Yield)
Note Terms of trade series include Argentina,
Brazil, Chile, Colombia, Mexico and Peru. Simple
average. Source IADB and Bloomberg.
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Implications

• Capital markets for Emerging Markets have not
  been a source of major disturbance
• Except for countries that exposed themselves to
  vulnerabilities clearly identified by research
  (e.g., Eastern Europe), namely,
• High Current Account Deficit
• Liability Dollarization (foreign-exchange
  denominated debt)
• This is an important lesson looking forward.

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Estimated Sudden Stop Probabilities
(Based on Calvo, Izquierdo and Mejia, NBER
Working Paper 14026, 2007)
Notes Simple country averages. LAC7 includes
Argentina, Brazil, Chile, Colombia, Mexico, Peru
and Venezuela. CAC5 includes Costa Rica,
Guatemala, Honduras, Nicaragua and Dominican
Republic. Eastern Europe includes Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, and
Turkey.
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India Financial Strengths

• Liability dollarization is not a major issue
• although one must keep track of trade credit as
  economy opens up to trade. Recall Korea,
  Thailand in 1997 and Brazil in 2002.
• Reserves cover a good share of M2
• A large share of International Reserves has been
  acquired with seigniorage (money printing)
• associated with an increase in the demand for
  money triggered by high output growth.
• This source of reserve accumulation will tend to
  dry up if growth declines.

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India. International Reserves and Money
Source IFS.
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India. International Reserves Accumulation and
Seigniorage
(quarterly data, Billions of USD, q-o-q change,
last value 2008-QI)
Correlation 0.8
Note Correlation coefficient statistically
significant at 1 level. Source IFS.
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India. Bank Loans

• The level of international reserves is large with
  respect to M2.
• However, M2/GDP has increased very rapidly since
  mid 2000 and the proportion of loans to private
  sector with respect to public sector has more
  than doubled.
• This flashes a yellow warning light, because
  Sudden Stops are usually preceded by high growth
  in bank credit.

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India. M2 as share of GDP
Source IFS
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India. Ratio of Banks Claims on Private/Public
Sector
Source IFS
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EM Collapses the US Great Depression
Similarities
- Bank Credit -
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Bank Credit during Systemic Collapses
(Average Credit to the Private to Credit to the
Public Sector ratio, trough (t)100)
GDP
All Episodes
90s
Note Public sector includes only the Central
Government. Source Own estimates base of the
IMF-IFS data.
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India Fiscal, Inflation Risks

• Domestic debt is large
• and fiscal deficit is approaching 9-10 of GDP.
• Inflation could be contained by draining
  international reserves, but this would increase
  the chances of Sudden Stop.
• Therefore, there seems to be little room for
  fiscal stimulus.
• Further devaluation could help, but if global
  green shoots fade out, its effect will likely be
  minor.

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Public Debt
( GDP)
Note e estimate / f forecast. Source EIU.
35
Inflation Exchange Rate
(y-o-y change)
Inflation
Exchange Rate
Source IMF.
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GDP growth
(y-o-y growth rate)
India
USA
Source EIU.
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Lessons from Systemic Financial Crises

• Guillermo Calvo
• Columbia University

India Policy Forum 2009. Sponsored by NCAER and
The Brookings Institution. New Delhi, July 14-15,
2009