Finance & Development, December 2002

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A quarterly magazine of the IMF

December 2002, Volume 39, Number 4

Eye of the Storm

New-style crises prompt rethink about prevention and resolution measures.

Like weather forecasters, economists are frequently blamed for getting their predictions wrong. Open the newspaper almost any day of the week, and it seems as if another financial storm is brewing somewhere in the world. Can economists predict these storms better, so that policymakers can take steps to build up their defenses and, if need be, batten down the hatches? And do these storms have to be so destructive?

This issue of Finance & Development takes a look at some initiatives of the international financial institutions, in particular the IMF, to minimize the outbreak of financial crises and resolve them more quickly and less painfully. These crises, involving various combinations of currency, banking, and debt problems (see Box 1), have thrown several emerging market economies into turmoil since the mid-1990s, from East Asia to Latin America and also including Russia and Turkey. They have been characterized by sudden large capital outflows, which have made it clear that the opportunities of globalization do not come without risks. For many developing countries, private financing now plays a far greater role than in the past, relative to official financing. Countries around the globe are increasingly interconnected through trade and financial channels. And external financing difficulties and exchange rate pressures are more strongly linked with distress in the financial and corporate sectors.

Box 1
Currency, banking, and debt crises

A foreign exchange, or currency, crisis occurs when a speculative attack on a country's currency results in a devaluation or sharp depreciation or forces the central bank to defend the currency by selling large amounts of reserves or by significantly raising interest rates. Some analysts distinguish between "old-style" or "slow motion" currency crises, and "new-style" crises. The former climax after a period of overspending and real appreciation that weaken the current account, often in a context of extensive capital controls, and end in devaluation. In the latter, investors have concerns about the creditworthiness of the balance sheet of a significant part of the economy (public or private), which, in an environment of more liberated and integrated capital and financial markets, can lead very rapidly to pressure on the exchange rate.

A banking crisis occurs when actual or potential bank runs, or failures, induce banks to suspend the internal convertibility of their liabilities or force the government to intervene to prevent this by providing banks with large-scale financial support. Banking crises tend to last longer than currency crises and have more severe effects on economic activity. Banking crises were relatively rare in the 1950s and 1960s because of capital and financial controls but have become increasingly common since the 1970s, often in tandem with currency crises.

A debt crisis occurs either when a borrower defaults or when lenders believe default is likely and therefore withhold new loans and try to liquidate existing ones. Debt crises can be associated with either commercial (private) or sovereign (public) debt. A perceived risk that the public sector will cease to honor its repayment obligations is likely to lead to a sharp drop in private capital inflows and a foreign exchange crisis.

Many of these "new-style" crises have been unexpectedly severe and have caught policymakers off guard. This has prompted a reevaluation—both inside the IMF and elsewhere—of the traditional methods of assessing a country's vulnerability to economic shocks (see Box 2).

Box 2
Financial crises: different and yet alike

Since 1994, the world has witnessed a series of severe financial crises in emerging market economies, stretching geographically from Europe (Russia and Turkey) to Asia (Indonesia, Korea, Malaysia, the Philippines, and Thailand) to Latin America (Argentina, Brazil, and Uruguay). The crises have been different in many respects, but they have also often had common features.

Most financial crises have their origins in an unsustainable economic or financial imbalance—such as a large current account deficit, a large fiscal deficit, or some mismatch between the assets and liabilities of financial or nonfinancial companies. These imbalances, in turn, are often associated with unsustainably high asset prices (usually corporate equity or real estate) or an overvalued currency.

Crises can thus be categorized according to the sector in which they originate (public versus private, banking versus corporate sector); the nature of the imbalances (current account and budget imbalances, for example, are flow imbalances, while mismatched assets and liabilities are stock imbalances); and whether the imbalances relate to a borrower's short-term financing needs or longer-term capacity to repay (liquidity versus solvency crises).

The distinctions between crises are not clear-cut, however, because these categories usually overlap. Imbalances in one sector are often mirrored in vulnerabilities in others; persistent flow problems ultimately turn into stock imbalances; and liquidity problems can quickly lead to insolvency. Moreover, once a crisis erupts in one sector, it can quickly feed into others, through both balance sheet interlinkages (such as bank holdings of government bonds or loans to the corporate sector that become nonperforming) and vulnerability to falling asset prices (including currency depreciation).

Sector of origin. The Asian crises of 1997-98 were different from most other crises because they originated in imbalances in the private sector. The fiscal position—which was a key vulnerability in Turkey (1994) and Russia and Brazil (1998)—in contrast, was sound in most Asian countries and public sector debt levels were low. Moreover, external imbalances, measured by current account deficits—which were largest in Thailand—had been driven not by excessive consumption (as in Mexico in 1994) but rather by an unsustainable investment boom, accompanied in many crisis countries by a real estate bubble.

Nature of imbalance. Flow imbalances in the form of protracted fiscal or current account deficits are typical of a precrisis environment. However, Indonesia and Korea demonstrated that crises can erupt even when fiscal and current account positions are not obviously out of line. These countries were vulnerable more because of maturity and currency mismatches in corporate balance sheets resulting from heavy reliance on short-term foreign financing, relative to domestic and longer-term borrowing and equity financing. Such weaknesses can linger for years, becoming visible only when a country suffers a negative shock, at which point creditors may refuse to provide new financing or roll over existing loans, thereby triggering a crisis.

Time horizon of repayment crunch. Liquidity risks are largest when a borrower has high levels of short-term debt (including medium- and long-term debt falling due in the short term) relative to its liquid assets (notably, foreign exchange reserves). Indeed, this ratio has proved to be a strong crisis indicator—and was indeed a weakness (albeit to different degrees) in all of the recent crises. The risk of liquidity problems leading to insolvency is likewise greater in countries with a high overall level of foreign debt relative to exports or to GDP—such as Russia in 1998 and Argentina in 2001. Once a country is perceived as unable to meet its foreign debt-service obligations, a currency crisis may be difficult to avoid, and the resulting depreciation will, in turn, affect the solvency of domestic borrowers with foreign currency liabilities.

The IMF has responded to the crises by introducing reforms aimed at strengthening the architecture—or framework of rules and institutions—of the international monetary and financial system as well as by enhancing its own contribution to the prevention and resolution of financial crises. The IMF has also reconsidered aspects of its policy advice and streamlined the conditions it attaches to its loans in an effort to promote national ownership of strong and effective policies.

To underpin the changes in its approach, the IMF has expanded its toolkit to include early warning systems based on econometric techniques and other ways of evaluating relevant information. Once these instruments are more finely tuned, a challenge will be to translate the wisdom gained into pertinent policy advice and persuade policymakers that the advice is worth heeding. Can policymakers in emerging market economies be persuaded to use the good times to build up more robust shock absorbers for when bad times hit? Can the IMF and the international system more generally provide adequate and more effective support for countries when crises strike—and provide it in ways that do not make them complacent in their crisis-prevention efforts?

Building up defenses

We begin our survey with a look at crisis-prevention efforts. The first article reviews ways of assessing the dangers. One of the keys to improving information about risks that may be growing is the regular assessment of a country's vulnerability to external shocks and changes in market sentiment, given its policies and the buffers it has in place. In recent years, the IMF has worked to make its assessments of country vulnerability more continuous and intensive, and, since mid-2001, IMF management and staff have been conducting, for internal use, regular vulnerability assessments with global coverage, using a variety of data, coupled with expert analysis and interpretation.

As part of their work on vulnerability indicators, IMF researchers have been looking at what level and structure of debt are sustainable for an economy and, especially, as the title of the second article asks, "Debt: How Much Is Too Much?" If a government or country as a whole accumulates more debt than it is able to service in adverse circumstances, a debt crisis can erupt with large economic and social costs. Working out the sustainable level of debt helps the IMF to advise governments on when additional borrowing is or is not appropriate and to identify the exceptional cases when debt restructuring might be necessary.

Improved data gathering and alternative ways of examining the health of economies also enable the IMF to keep an eye on potential domestic balance-sheet problems, as discussed in "The Bottom Line." In many recent crises, countries were unable to deal with external shocks, such as a change in the terms of trade or a loss of investor confidence, because of weaknesses in either the public or the private sector's balance sheets. These weaknesses usually are mismatches of maturities or currencies between assets and liabilities along with problems in the size of debt or the reserve buffer. Identifying them and analyzing other indicators can help policymakers decide what measures to take in a crisis or to avert a crisis.

Readying responses

What should we do when, as is inevitable, crises break out? Our final article, "Riding Out the Storm," examines some current efforts to improve crisis resolution. Certainly, times have changed, as has the situation typically facing a country in crisis. Aside from the increased importance of private capital flows, there has been a major shift in public sector and corporate finance from bank loans to bond issues. Since 1980, gross bond issuance by emerging market countries has grown, on average, by 25 percent a year according to one measure, or four times as fast as syndicated bank loans. This indicates that private creditors have become increasingly numerous, anonymous, and difficult to coordinate. They are also less likely to have long-term commercial links with the countries to which they lend.

The international community has been working to adjust to this new environment by clarifying the "rules of the game" in ways that preserve the economic activity of the borrower country and the asset value for creditors and provide enough flexibility to take each crisis on its own merits. The emphasis will be on market-oriented, voluntary solutions when possible and on action to ensure that, if all else fails, the private sector bears unavoidable losses quickly. One plan is to put collective action clauses in all foreign bond contracts to limit the ability of maverick bondholders to hold up a settlement. Another approach, spearheaded by the IMF, is to create a sovereign debt restructuring mechanism to reorganize a country's debts speedily, definitively, and in cooperation with its creditors. Among the other actions the IMF is taking to strengthen its ability to respond to crises are refining its policy on country access to exceptionally large financial packages; revising lending rules for countries whose payments to private external creditors are in arrears; and revamping IMF lending facilities.