Tag Archives: Emerging Markets

Larry Summers on Preventing and Fighting Financial Crises

This fall I am taking a course on the “international financial crisis” taught by Jon Macey and Greg Fleming (yes, the former COO of Merrill Lynch). The first assigned reading is a speech that Larry Summers gave at the AEA in 2000 entitled “International Financial Crises: Causes, Prevention, and Cures,”* summarizing the state of the art in preventing and combating financial crises. It’s based on experiences from emerging market crises in the 1990s, and doesn’t even contain a hint that something similar might happen here; however, few people could fault Summers for making that oversight back in 2000, and I certainly won’t.

Many people, including Simon and me, have discussed the similarities between our recent financial crisis and the emerging market crises of the 1990s, so I’ll be brief. The main similarities are excessive optimism that creates an asset price bubble, a sudden collapse of confidence that causes the rapid withdrawal of money and credit, a liquidity crunch, and rapid de-leveraging that threatens solvency. (We have also argued that there are political similarities, but let’s leave that aside for now.) The biggest difference is that instead of being compounded by flight from the affected country’s currency and government debt, in our case the exact opposite happened; investors fled toward the U.S. dollar and Treasuries, making things easier for us than for, say, Thailand. Also, to a partial extent, the parallel requires an analogy between emerging market countries and United States banks; for example, the issue of bailouts and moral hazard arises in the context of the IMF bailing out Indonesia and in the context of the United States government bailing out Citigroup.

Summers’s speech makes a lot of sense, so I’ll just highlight a few points he makes that I think are particularly instructive given our recent experience. I think these are all excellent points. For each one, I’ll quote from Summers, and then comment on its relevance to our situation.

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More Convergence of Views

Yesterday I highlighted an op-ed written by Desmond Lachman, a veteran of the IMF and Salomon Smith Barney (and currently at the American Enterprise Institute), comparing the United States and the current crisis to an emerging market crisis.

Saturday evening, Nicholas Brady, Secretary of the Treasury from the end of the Reagan administration through the entire Bush I administration, gave a speech at the Institute of International Finance – comparing the current crisis in the United States to an emerging market crisis, only in that case the banks were in the U.S. and the bad assets were in the emerging markets.

There are uncanny parallels between the situation we find ourselves in today and the one the Bush administration confronted a generation ago. . . . First of all there was a serious LDC [Least Developed Country] debt crisis. It’s easy to forget that in 1988 our banking system was in dire straits because the commercial banks held billions of dollars of loans in countries whose economic prospects had ground to a halt.

The solution, according to Brady, was identifying the fundamental problems and forcing all parties to recognize them.

Among the indisputable points we laid out were that new money commitments had dried up in the past 12 months and that many banks were negotiating private sales of LDC paper at steep discounts while maintaining their claim on the countries that the loans were still worth 100 cents on the dollar. There were more, and they were equally sobering. We used these irrefutable facts as a starting point in all subsequent meetings. Our rule was that no suggestions were permitted to be discussed if they didn’t accept the Truth Serum. They were off the table. Goodbye. Don’t waste time. . . . [W]e persuaded the international commercial banks—at first with great difficulty—to write down the stated value of the loans on their books to something close to market value in exchange for that lesser amount of host-country bonds backed by U.S. zero-coupon Treasuries.

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IMF Emerging Markets Veteran on the U.S.

One of the central themes of our Atlantic article was that the current crisis in the U.S. is very similar to the crises typically seen in emerging markets, and that resolving the crisis will require (some of) the measures often prescribed for emerging markets. This, Simon said, would be the assessment of IMF veterans who had worked on emerging markets crises.

At the exact same time that we were writing that article, Desmond Lachman – who worked at the IMF for 24 years, and then worked on emerging markets for Salomon Smith Barney for another seven years – was writing an article for the Washington Post saying many of the same things.* Here are the first three paragraphs:

Back in the spring of 1998, when Boris Yeltsin was still at Russia’s helm, I led a group of global investors to Moscow to find out firsthand where the Russian economy was headed. My long career with the International Monetary Fund and on Wall Street had taken me to “emerging markets” throughout Asia, Eastern Europe and Latin America, and I thought I’d seen it all. Yet I still recall the shock I felt at a meeting in Russia’s dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia’s economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia’s economic czar at the time.

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What the IMF Would Tell the United States, If It Could

From 1945 until around 1980, the financial sector was one industry among many in the United States. Then something happened.

compensation4

People in finance started making more money,* jobs in finance became more desirable, financial institutions became more influential, and the linkages between the financial sector and the political establishment became stronger. At the same time that our financial sector became more leveraged and more risky, it also became more powerful. The result was a confluence of interests between Wall Street and Washington – one more normally found behind the scenes of emerging market crises, the kind the IMF is called on to resolve.

Simon and I tell this story – and the story of what happened next – in “The Quiet Coup,” an article in the May issue of The Atlantic. (Many thanks to The Atlantic for putting the online copy up as early as they did.) The working title of the article was, “What the IMF Would Tell the United States, If It Could.” Enjoy.

* The data in that chart are from Table 6.6 of the National Income and Product Accounts tables available from the Bureau of Economic Analysis.

Update: Henry Seggerman recently sent us an article he wrote in 2007, comparing the Korean crisis of 2007 to the then-current situation in the United States. He discusses not only the economic similarities, but also some of the political ones.

Update 2: A reader sent us an article about Mark Patterson, formerly Goldman’s chief lobbyist and now Tim Geithner’s chief of staff. Unfortunately, the article was published too late for us to use any of it in our Atlantic article.

By James Kwak

The IMF Sends A Message

The IMF communicates its view of the world economy in two ways.  The first is quite explicit, in the form of a World Economic Outlook with specific growth forecasts.  The latest update to the Outlook, published last week, recognized that world growth is slowing down, but anticipated a V-shaped recovery (there is a reassuring V in their Figure 1, or you can look at the Q4 on Q4 numbers for 2009 in the pdf version - the US does not contract during the coming year, according to this view.)

According to the forecast – which factors in only actual policies in place; no assumed miracles allowed – this is not much of a global crisis, particularly for emerging markets (e.g., emerging market growth dips to 3.3% for 2009 and then pops back up to 5% for 2010 in the annual average data; China’s growth will accelerate from now through end of 2010, etc.)  Given that, among other things, the IMF is the point organization for emerging market troubles, the message seems to be a soothing one.

But the IMF also communicates with both its lending to countries in difficulties, and with statements on and around this lending.  Here the news is in striking contrast to the forecast.  Continue reading

The Perils of Exports

The steep decline in U.S. consumer spending is clearly taking its toll on the U.S. economy. But still, the U.S. has one advantage over many of its trading partners. Theoretically at least, our government has the tools it needs to boost domestic demand and thereby increase production. This is not true of the many countries who depend on exports for a large share of their economic growth.

I was taking a tour of the world’s news today and came across the following (courtesy of the FT):

  • Japanese exports fell 27% year-over-year in November, the largest fall ever; remember, exports were a major reason Japan finally emerged from its decade-long slump a few years ago.
  • Thai exports fell 19% year-over-year in November, the first decline since 2002 – and exports make up 70% of GDP. The numbers may have been artificially reduced by political conflict in late November, but political conflict is hardly a good thing in itself.
  • China is looking less and less like the big winner of the global recession and more and more like a significant loser. 10 million migrant workers have lost their jobs by the end of November. In response, “the State Council, China’s highest governing body, issued a decree to local governments over the weekend ordering them to create jobs for migrant workers who had returned to their home towns.” Prime Minister Wen Jiabao went as far as saying that a government priority is to “make sure all graduates have somewhere constructive to direct their energy” – somewhere other than social protest, that is.

One of the challenges of an export-driven economy is that when your consumers (Americans and Europeans) stop buying, you have few direct tools to get them buying again. There has been speculation that China could take the opportunity to stimulate domestic consumption and shift its economy away from reliance on exports, but that clearly can’t happen fast enough. Another trick exporters can use is to devalue their currencies, but that will crimp domestic purchasing power and potentially lead to a round of competitive devaluations, with wealthy countries printing money in an effort to stave off deflation and thereby devaluing their own currencies. In the meantime, everyone will be watching the Obama stimulus plan carefully.

When Consumers Get Depressed

The Return of Depression Economics, by Paul Krugman, is certain to be one of the most gifted books this holiday season; that’s what happens when you combine a Nobel Prize with a massive economic crisis and book with the word “depression” in the title. Here’s another reason to buy it for someone, as I found out: it’s so short you can read it in a couple of hours before wrapping it up.

The title of the book refers broadly to the recurrence of a need to deal with Depression-style economic threats, a theme that originally (in the 1999 edition) referred to the emerging markets crisis of 1997-98 and and the stagnation in Japan caused by the collapse of their housing bubble at the beginning of the 1990s. More particularly, however, it refers to the problems brought on by a collapse in economic demand – “insufficient private spending to make use of the available productive capacity,” as Krugman puts it. And it seems clear that that’s where we are today. The Case-Shiller index of housing prices reached its peak in real terms sometime in 2006, but the economy continued to grow until the end of 2007, even as housing prices fell significantly. Although the negative wealth effect of falling housing must have had some effect, people still wanted to spend. When the severe phase of the crisis began in September 2008, it was widely described as a credit crunch, meaning that reductions in the supply of credit were making it difficult for borrowers to get the money they needed, either for investment or consumption. Today, however, as Simon has said before, falling demand for credit may be just as big a problem. People just don’t want to borrow money any more, and if that’s the case, then increasing the supply of credit (by funneling cash into banks) will have only a limited effect, as we’ve seen. This is what Krugman finds most worrying about the current situation: the “loss of policy traction,” in which even dramatic moves by the Fed have only a limited impact ont he real economy.

He doesn’t quite come out and say it in so many words, but a lot of Krugman’s story has to do with what might be called psychology. He describes how economic crises may be the product of poor governmental policies and weak economic fundamentals – or they may be entirely the product of panics that have the very real effect of destroying wealth and setting countries back for years. Seen from this perspective, the scale of the current crisis may not have any proportional relationship to the fundamental flaws of our economy (or the global economy). It may simply reflect the fact that the scale, liquidity, and leverage of the global financial system have made it possible for panics to have much greater damage than they did in the past. (I know we’re still not dealing with anything on the scale of the Great Depression, but while the financial system was simpler then, it also had a simpler flaw – the lack of deposit insurance – and a simpler mistake – the failure to expand monetary policy in response to the downturn.)

The fact that you are reading this blog probably means that you would not learn a lot about the current crisis from Krugman’s book (especially if you’ve already read his article in The New York Review of Books), but you might learn something about the crisis of the 1990s, and the dynamics of currency crises. In 1997-98, multiple unrelated emerging market countries suffered panics and currency crises, and the response of “Washington” (the U.S. and the IMF) was to demand fiscal austerity – higher interest rates, lower government spending, higher taxes – in exchange for bailout loans. Now, of course, when large parts of wealthy country economies need to be bailed out, few people are calling for austerity; in the U.S., liberals and (most) conservatives differ only on whether the deficit should be increased through government spending or through tax cuts. Ten years ago, perhaps the austerity argument was defensible: in order for countries to gain credibility (and be able to pay back their loans), they needed to improve their government balance sheets. And at the time, the U.S. could be confident that reduced purchasing power in Thailand, South Korea, and Russia would have little effect on our economy. Today, however, the entire world is facing a steep downturn, and an economic stimulus will be most effective if it is roughly coordinated across countries, including emerging markets. So far the IMF appears to be using a gentler hand than last time, although so far most countries are attempting to steer clear unless absolutely necessary. The fact is that preventing an economic collapse in emerging markets will be an important of our recovery this time, both because of the importance of foreign trade and because of the amount of cross-border investment (think about the massive inflows into international stock funds in the past ten years).

In any case, it’s a quick read, and for those who are nervous about Krugman’s politics they make only a very brief entry near the end.

We Are All in This Together

Dani Rodrik has a short, clear post on (a) why countries are tempted to engage in protectionism during recessions and (b) why they shouldn’t. It only uses 1st-semester macroeconomics. The bottom line is that the preferred outcome is for all countries to engage in fiscal stimulus at the same time. The hitch is that most of the developing world can’t afford to. The implication is that it is in the interests of the wealthy countries to find a way to support the developing world.

The Importance of China

So, the global economy is falling apart, but not in the way people expected. Under the de facto arrangement sometimes known as “Bretton Woods II,” emerging market countries pegged (officially or unofficially) their currencies to developed world currencies at artificially low rates, having the effect of promoting exports and discouraging consumption by emerging market countries and promoting consumption and discouraging exports in developed countries. Of course, the classic example of this was China and the U.S. The U.S. trade deficit and Chinese trade surplus created a surplus of dollars in China, which were invested in U.S. Treasuries and agency bonds, keeping interest rates low and indirectly financing the U.S. housing bubble and consumption binge of the last decade (and, therefore, growth in Chinese exports).

The general fear was that U.S. indebtedness would lead China to diversify away from U.S. assets, causing the dollar to fall and U.S. interest rates to rise, hurting the U.S. economy and making it harder to finance the national debt. This may yet happen someday. But instead of demand for Treasuries collapsing, it’s been demand for every other type of asset that has fallen. Treasury yields have collapsed and the dollar has appreciated about 20%. Still, despite this increased purchasing power, the fall in U.S. (and global) consumption is having a severe impact on growth of the Chinese economy. Even though the Chinese government has signaled that it will do everything in its power to keep growth above 8% per year (down from 11-12% in the past few years), the slowdown has severely constrained the ability of the urban manufacturing sector to absorb internal migration from the countryside, and there are signs of a reverse migration that is aggravating the problem of rural poverty in China. Although China may seem to have all the cards – high economic growth, large foreign currency reserves – it could yet turn out to be a major loser of the global economic crisis.

This is of course just a brief introduction. For more I recommend Brad Setser, among others: some of his posts are here, here, and here.

Emerging Markets Snapshots

GM, mortgage restructuring, and the G20 have sucked up most of the attention recently, but the crisis continues to take its toll around the world. A few vignettes:

  • In Ukraine, industrial production in October fell by 7.6% from September (that’s not an annualized rate) and 19.8% from October 2007.
  • Russia’s second-largest coal company reported that its Q4 sales would be only one-third the planned level – and that payments from its steelmaker customers since September were only 21% of the value of shipments.
  • Credit default swap spreads on Greek sovereign debt are up over 160 bp – higher than at the previous peak in mid-October. (Note that Greece is in both the EU and the Eurozone.)

On the “plus” side, Pakistan and the IMF agreed on a $7.6 billion loan, ensuring economic stability in a particularly important part of the world – at least for a few months. Pakistan’s government says they need a total of $10-15 billion.

Russia Tries to Stop Ruble from Falling, Gives Up

The emerging markets rout continues: Russia, she of the $500 billion war chest of foreign currency reserves, spent 19% of those reserves trying to fight off a currency devaluation. Today, Russia didn’t quite give up the fight, but conceded some ground, widening the allowed trading range and at the same time increasing interest rates. Just goes to show: fighting those nasty currency speculators rarely works, if ever.

(Thanks to Free Exchange for catching this.)

Financial Crises, Political Consequences

Hard economic times have political consequences, many of them unfortunate.

In Argentina, we’ve already seen the government nationalize the private pension system in what many believe to be a naked grab for cash with only a distant relationship to the rule of law.

In Russia, a central government with a war chest of over $500 billion in foreign currency reserves (at least when the crisis started) now has the power to determine which of the billionaire oligarchs will survive and which will be bankrupted. Yesterday the government provided $2 billion (WSJ, subscription required) to the Alfa Group, Mikhail Fridman’s conglomerate, to avoid save him from giving up his 44% stake in a cellular carrier to Deutsche Bank. On Friday, another billionaire will have to come up with $4.5 billion to avoid giving up 25% of the metals company OAO Norilsk Nickel to Western banks including Merrill Lynch and Royal Bank of Scotland, and will likely turn to the government.

Arguably the government’s power in this situation is analogous to the powers the US has granted to the Treasury Department to choose winners in the financial sector. Still, given the other things we know about Russian politics, it is not too far-fetched to see government money used to protect Vladimir Putin’s political allies, impoverish his opponents or nationalize their assets, and keep Russian assets out of Western hands. (Whether the government will have enough money for the job is another question.)

Another likely reaction of governments faced by financial and economic crisis is a return to (or, in many cases, an increase in) protectionism. Richard Baldwin describes how the current state of global trade agreements makes this not only possible but likely, further hurting the global economy.

Finally, there’s (still) Zimbabwe, forgotten by the world, where power-sharing talks are still going nowhere.

Emerging Markets: The Differences from Last Time

Arvind Subramanian has a new article on the financial crisis in emerging markets. He focuses on some of the differences between the 1997-98 crisis and the present day. For one, increased global trade makes emerging markets more susceptible to economic conditions in wealthy nations – and, as we all know, those conditions are considerably worse now than ten years ago.

We Have Problems; Emerging Markets Have Big Problems

The increasing damage the global financial crisis is inflicting on emerging markets has been getting a lot of attention lately (those are four separate links, for those with time on their hands), much of it very thoughtful. I would like to immodestly point out that my co-authors Simon and Peter were early to call this one (along with Nouriel Roubini, no doubt), in an op-ed in Forbes.com back on October 12.

That aside, it seems more and more likely that we are witnessing a repeat of 1997-98, just on a grander scale. Credit default swaps on Russian sovereign debt are trading at over 1,000 basis points, which essentially means that investors think the country is more likely to default than not – this just months after the high price of oil seemed to make Russia a dominant regional economic power, and just weeks after Russia was negotiating to lend money to Iceland (as of a couple days ago, it was still possible that Russia would participate in the IMF bailout of Iceland). Argentina, as Simon pointed out earlier, has the honor of being the first country to expropriate private property under the cover of the financial crisis. The Economist published a chart showing CDS spreads on sovereign debt across Eastern Europe showing that Ukraine, the Baltics, Hungary, Romania, and Bulgaria are all at risk. (Many of those spreads are already much higher than in the chart: Ukraine at 2617 bp, Russia at 1038, Turkey at 775, the Baltics between 650 and 1000.) Hungary in particular is showing eerie echoes of 1997-98, as the government takes emergency steps, including increasing interests rates by three full percentage points, to combat speculators betting that the currency will fall – a battle that few countries were able to win a decade ago.

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Argentina on My Mind

In the various measures of vulnerability for emerging markets (middle income countries open to capital flows) that are now being examined and re-examined carefully, Argentina does reasonably well.  Its banking system does not appear to be highly exposed to problems in the US and Europe, and its macroeconomy – while not in great shape by any means – is far from being among the most dependent on continued capital inflows from abroad.

Argentina does produce and export a lot of commodities, and these prices are falling, so this creates a potential difficulty for government finances.  Still the government’s proposed response is a stunner: President Cristina Fernandez de Kirchner announced Tuesday that she plans to take over (i.e., nationalize) 10 private pension funds (the Argentine Congress would have to approve this; we’ll know soon how that will go).  The pension funds hold a great deal of government debt, so grabbing them would presumably get the government off the hook for that debt.  But what about people’s pensions?!?

Most importantly, does this indicate that governments around the world feel they can break contracts and expropriate property freely just because all economies have encountered some sort of trouble and many industrialized countries are “recapitalizing” something?  If the global crisis is becoming a smokescreen for confiscation, then our problems just got a lot worse.