## _wp14160 - EXECUTIVE SUMMARY

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### Overview
- Prior to the 1990s balance-of-payments crises in emerging market economies (EMEs) were usually flow crises driven by current account deficits and money-financed fiscal imbalances.
- Since the mid-1990s crises originating in balance sheet vulnerabilities have been central.
- The paper distinguishes between Conventional and Insidious balance-sheet crises.

### Conventional balance-sheet crises: characteristics and mechanics
- Triggered by external imbalances and balance sheet vulnerabilities following large capital inflows and a build-up of foreign currency exposure.
- Typical sequence:
  - Capital inflows raise foreign currency exposure of domestic balance sheets.
  - A jump in the risk premium forces authorities to choose among: (a) depreciation, (b) higher interest rates, or (c) a combination.
  - Depreciation most directly harms FX borrowers; higher rates may also precipitate balance-sheet distress.
  - Banking-sector stress tends to transmit to government finances.
- Generic illustrative balance-sheet (Table 1, billion dollars):
  - General government (to foreigners): Assets 40, Liabilities 1030
  - Short-term: Assets 40, Liabilities 238
  - Medium-and long-term: Assets 0, Liabilities 8 (-8)
  - Commercial banks: Assets 37, Liabilities 370
  - Domestic foreign currency position: Assets 30, Liabilities 30
  - Nonbank: Assets 175, Liabilities -74
  - Total: Assets 78, Liabilities 122, Net assets -44
- Policy-relevant observations:
  - If FX borrowers are exporters with FX revenues, depreciation losses can be manageable; if FX borrowers are nontraded-sector firms with local-currency income, depreciation can be crippling.
  - Authorities often face a “fear-of-floating” constraint that limits depreciation and complicates policy responses.

### Country illustrations of Conventional crises
- Thailand (1992–2000; crisis in 1997–98):
  - Net capital flows into Thailand averaged about 10 percent of GDP in the five years through 1996.
  - Current account deficit increased from around five percent of GDP to eight percent in 1995 and 1996.
  - Capital account reversal: net inflows equivalent to 10 percent of GDP in 1996 gave way to net outflows of almost a similar magnitude in 1997 and larger outflows in 1998.
  - Outcomes: large exchange rate depreciation, spike in external debt (in domestic currency terms), compressed consumption and sharply lower investment, GDP fell, current account swung to large surplus in 1998; growth recovered to 4½ percent in 1999 but banking-sector repair and fiscal costs persisted.
- Latvia (2002–2010; crisis around 2008–09):
  - Peak net capital inflows in 2006 equivalent to about 30 percent of GDP; current account deficit well above 20 percent of GDP in 2007–2008.
  - Wage growth accelerated from 9½ percent in 2004 to 32 percent in 2007.
  - Membership in the EU and a hard peg to the euro reduced default risk perceptions and encouraged foreign-currency borrowing intermediated in euro.
  - When wholesale funding tightened in late 2007–early 2008, capital inflows stopped and turned negative; GDP fell by 25 percent from peak to bottom.
  - IMF and EU support helped maintain the peg; by 2009–2011 domestic saving rose, current account swung to surplus, reserves began to rise, external debt ratio declined, and growth resumed, but GDP remained below pre-crisis trend.

### Insidious balance-sheet crises: characteristics and mechanics
- Triggered by internal imbalances and balance sheet vulnerabilities when a long credit/asset-price/construction boom becomes unsustainable.
- Typical features:
  - Occur in countries with lengthy histories of rapid growth and rising incomes where a positive narrative dulls risk sensitivity.
  - Relative prices shift: nontraded goods and asset prices (especially real estate) rise faster than traded goods due to inelastic supply of nontraded goods.
  - Resources reallocate into nontraded sectors; exports lose traction without necessarily creating external-financial alarms.
  - When price appreciation becomes incorporated into expectations, leverage-fueled speculation and overshooting can create bubbles.
  - Leverage and implicit or explicit guarantees of bank liabilities amplify risks; concentration of bank credit in real estate is a red flag.
- Distinguishing features relative to Conventional crises:
  - Can occur even when external positions are strong.
  - Do not necessarily involve foreign currency exposure or reliance on foreign borrowing.
- Policy challenges:
  - Bubbles and overshooting are observable mainly in retrospect; ex ante detection of overshooting is extremely difficult.
  - Political pressure to sustain growth and to ease policy as exports lose momentum can exacerbate vulnerabilities.
  - Tightening early invites accusations of stifling growth; acting late can be very costly.

### Country illustrations of Insidious crises
- Japan (1980s–early 1990s):
  - Japan’s per capita GDP (PPP) rose from 21 percent of the US level in 1950 to 83 percent in 1990.
  - Asset-price boom in late 1980s: housing prices and equity surged; domestic demand and construction boomed; investment rose as percent of GDP.
  - When the Bank of Japan tightened in mid-1989 the asset-price bubble deflated: equity and land prices plummeted, leading to prolonged low growth, large NPLs, and cumulative losses on disposal of NPLs.
  - Post-crash outcomes included prolonged financial sector repair and a prolonged rise in the government debt ratio.
- Ireland (1990s–2010):
  - Ireland’s per capita GDP (PPP) rose from 44 percent of the US level in 1984 to 86 percent in 2007.
  - From the mid-1990s the investment share rose sharply attributable entirely to construction; housing prices relative to CPI increased 360 percent between 1995 and 2007.
  - Net wholesale funding of Irish banks peaked at some 236 percent of GDP; loan-to-deposit ratio rose to almost 230 percent by end-2008.
  - Exports as share of GDP and export growth declined from 2002 onward while domestic demand and construction dominated growth.
  - Contagion from the global financial crisis and a fall in housing prices precipitated rising loan delinquencies, bank collateral concerns, and large fiscal costs when authorities pledged to back bank liabilities.
- China (2000s–2013; potential insidious vulnerabilities):
  - China’s GDP per capita (PPP) rose from 5 percent of the US level in 1990 to 21 percent in 2013.
  - Official reserves (excluding gold) rose from $168 billion to $3.8 trillion in 2013.
  - Between 2003 and 2012 construction has more than tripled (index; 2003=100).
  - “Social financing” increased from 127 percent of GDP in 2008 to 200 percent in 2013.
  - Observed patterns: rising unit labor cost–based real exchange rate, slowing export growth after 2007 (partly global recession), boosted domestic investment, rapid expansion of real housing prices, and a falling current account surplus.
  - Despite apparent immunity to Conventional crises (huge reserves, capital controls), the scale of shifts toward nontraded-sector investment and exponential construction growth create substantial potential for credit-driven bubbles analogous to Japan and Ireland.

### Policy implications and instruments
- For Conventional crises:
  - Governments and central banks have learned to monitor risk indicators and to employ tools to limit surges in capital flows: macroeconomic policies (exchange rate, monetary, fiscal), capital controls, macro-prudential measures, reserve accumulation, swap lines, and IMF agreements.
  - Recognition that fixed exchange rates or one-way bets can act as implicit guarantees and encourage excessive FX exposure.
- For Insidious crises:
  - More difficult to detect and manage; standard inflation indicators may remain benign even as asset-price and credit vulnerabilities rise.
  - Robust prudential regimes and avoidance of implicit guarantees can help, but financial innovation may circumvent safeguards.
  - Policy responses require frequent reassessment of data, readiness for hard decisions, and judgment under political pressure; there is no simple cookbook.

### Conclusion: monitoring, prevention, and judgment
- Conventional Balance-Sheet Crises are better understood and many EMEs now deploy a variety of instruments to contain exposure to volatile global capital flows.
- Insidious Crises pose a harder challenge: identifying when equilibrating relative price changes are overshooting is extremely difficult; ex ante policy tightening is politically fraught yet delaying action risks severe costs.
- Effective prevention demands careful monitoring of relative price shifts, credit growth, concentration of bank exposures (especially to real estate), strong prudential frameworks, and policymakers able to act decisively in the face of political pressures.

*Source: EXECUTIVE SUMMARY of _wp14160*

### Executive Summary ......................................................................................................

### Executive Summary

### Document structure and major sections
- Executive Summary (page 3)
- I. Introduction (page 4)
- II. Conventional Macroeconomic Balance-Sheet Crises (page 6)
  - A. Thailand (page 8)
  - B. Latvia (page 12)
  - C. Insidious Crises (page 16)
  - D. Japan (page 18)
  - E. Ireland (page 24)
- III. Can Governments Correct Vulnerabilities Before They Become Crises? (page 29)
- IV. Conclusion (page 36)
- References (page 37)

### Case studies and thematic focus
- Thailand: analyzed as a boom-bust episode (see Figures 1–2)
- Latvia: analyzed as a boom-bust episode (see Figures 3–4)
- Japan: discussed under “Insidious Crises” with emphasis on exports, real effective exchange rate, domestic demand, and nonperforming loans (see Figures 5–8)
- Ireland: analyzed with attention to exports, real effective exchange rate, and domestic demand (see Figures 9–11)
- China: included in figures on exports, real effective exchange rate, domestic demand, and economic indicators (see Figures 12–14)

### Figures inventory (by number and caption)
- Figure 1. Thailand: Boom-Bust, BOP Developments
- Figure 2. Thailand: Boom-Bust, Economic Indicators
- Figure 3. Latvia: Boom-Bust, BOP Developments
- Figure 4. Latvia: Boom-Bust, Economic Indicators
- Figure 5. Japan: Exports and Real Effective Exchange Rate
- Figure 6. Japan: Domestic Demand Boom
- Figure 7. Japan: Economic Indicators
- Figure 8. Japan: The NPL Problem
- Figure 9. Ireland: Export and Real Effective Exchange Rate
- Figure 10. Ireland: Domestic Demand Boom
- Figure 11. Ireland: Economic Indicators
- Figure 12. China: Exports and Real Effective Exchange Rate
- Figure 13. China: Domestic Demand Boom
- Figure 14. China: Economic Indicators

*Source: _wp14160 - Executive Summary (PDF chapter/section)._

### EXECUTIVE SUMMARY

### _wp14160 - EXECUTIVE SUMMARY

### Overview
- Prior to the 1990s balance-of-payments crises in emerging market economies (EMEs) were usually flow crises driven by current account deficits and money-financed fiscal imbalances.
- Since the mid-1990s crises originating in balance sheet vulnerabilities have been central. The paper distinguishes between Conventional and Insidious balance-sheet crises.

### Conventional balance-sheet crises: characteristics and mechanics
- Triggered by external imbalances and balance sheet vulnerabilities following large capital inflows and a build-up of foreign currency exposure.
- Typical sequence:
  - Capital inflows raise foreign currency exposure of domestic balance sheets.
  - A jump in the risk premium forces authorities to choose among: (a) depreciation, (b) higher interest rates, or (c) a combination.
  - Depreciation most directly harms FX borrowers; higher rates may also precipitate balance-sheet distress.
  - Banking-sector stress tends to transmit to government finances.
- Generic illustrative balance-sheet (Table 1, billion dollars):
  - General government (to foreigners): Assets 40, Liabilities 1030
  - Short-term: Assets 40, Liabilities 238
  - Medium-and long-term: Assets 0, Liabilities 8 (-8)
  - Commercial banks: Assets 37, Liabilities 370
  - Domestic foreign currency position: Assets 30, Liabilities 30
  - Nonbank: Assets 175, Liabilities -74
  - Total: Assets 78, Liabilities 122, Net assets -44
- Policy-relevant observations:
  - If FX borrowers are exporters with FX revenues, depreciation losses can be manageable; if FX borrowers are nontraded-sector firms with local-currency income, depreciation can be crippling.
  - Authorities often face a “fear-of-floating” constraint that limits depreciation and complicates policy responses.

### Country illustrations of Conventional crises
- Thailand (1992–2000; crisis in 1997–98):
  - Net capital flows into Thailand averaged about 10 percent of GDP in the five years through 1996.
  - Current account deficit increased from around five percent of GDP to eight percent in 1995 and 1996.
  - Capital account reversal: net inflows equivalent to 10 percent of GDP in 1996 gave way to net outflows of almost a similar magnitude in 1997 and larger outflows in 1998.
  - Outcomes: large exchange rate depreciation, spike in external debt (in domestic currency terms), compressed consumption and sharply lower investment, GDP fell, current account swung to large surplus in 1998; growth recovered to 4½ percent in 1999 but banking-sector repair and fiscal costs persisted.
- Latvia (2002–2010; crisis around 2008–09):
  - Peak net capital inflows in 2006 equivalent to about 30 percent of GDP; current account deficit well above 20 percent of GDP in 2007–2008.
  - Wage growth accelerated from 9½ percent in 2004 to 32 percent in 2007.
  - Membership in the EU and a hard peg to the euro reduced default risk perceptions and encouraged foreign-currency borrowing intermediated in euro.
  - When wholesale funding tightened in late 2007–early 2008, capital inflows stopped and turned negative; GDP fell by 25 percent from peak to bottom.
  - IMF and EU support helped maintain the peg; by 2009–2011 domestic saving rose, current account swung to surplus, reserves began to rise, external debt ratio declined, and growth resumed, but GDP remained below pre-crisis trend.

### Insidious balance-sheet crises: characteristics and mechanics
- Triggered by internal imbalances and balance sheet vulnerabilities when a long credit/asset-price/construction boom becomes unsustainable.
- Typical features:
  - Occur in countries with lengthy histories of rapid growth and rising incomes where a positive narrative dulls risk sensitivity.
  - Relative prices shift: nontraded goods and asset prices (especially real estate) rise faster than traded goods due to inelastic supply of nontraded goods.
  - Resources reallocate into nontraded sectors; exports lose traction without necessarily creating external-financial alarms.
  - When price appreciation becomes incorporated into expectations, leverage-fueled speculation and overshooting can create bubbles.
  - Leverage and implicit or explicit guarantees of bank liabilities amplify risks; concentration of bank credit in real estate is a red flag.
- Distinguishing features relative to Conventional crises:
  - Can occur even when external positions are strong.
  - Do not necessarily involve foreign currency exposure or reliance on foreign borrowing.
- Policy challenges:
  - Bubbles and overshooting are observable mainly in retrospect; ex ante detection of overshooting is extremely difficult.
  - Political pressure to sustain growth and to ease policy as exports lose momentum can exacerbate vulnerabilities.
  - Tightening early invites accusations of stifling growth; acting late can be very costly.

### Country illustrations of Insidious crises
- Japan (1980s–early 1990s):
  - Japan’s per capita GDP (PPP) rose from 21 percent of the US level in 1950 to 83 percent in 1990.
  - Asset-price boom in late 1980s: housing prices and equity surged; domestic demand and construction boomed; investment rose as percent of GDP.
  - When the Bank of Japan tightened in mid-1989 the asset-price bubble deflated: equity and land prices plummeted, leading to prolonged low growth, large NPLs, and cumulative losses on disposal of NPLs.
  - Post-crash outcomes included prolonged financial sector repair and a prolonged rise in the government debt ratio.
- Ireland (1990s–2010):
  - Ireland’s per capita GDP (PPP) rose from 44 percent of the US level in 1984 to 86 percent in 2007.
  - From the mid-1990s the investment share rose sharply attributable entirely to construction; housing prices relative to CPI increased 360 percent between 1995 and 2007.
  - Net wholesale funding of Irish banks peaked at some 236 percent of GDP; loan-to-deposit ratio rose to almost 230 percent by end-2008.
  - Exports as share of GDP and export growth declined from 2002 onward while domestic demand and construction dominated growth.
  - Contagion from the global financial crisis and a fall in housing prices precipitated rising loan delinquencies, bank collateral concerns, and large fiscal costs when authorities pledged to back bank liabilities.
- China (2000s–2013; potential insidious vulnerabilities):
  - China’s GDP per capita (PPP) rose from 5 percent of the US level in 1990 to 21 percent in 2013.
  - Official reserves (excluding gold) rose from $168 billion to $3.8 trillion in 2013.
  - Between 2003 and 2012 construction has more than tripled (index; 2003=100).
  - “Social financing” increased from 127 percent of GDP in 2008 to 200 percent in 2013.
  - Observed patterns: rising unit labor cost–based real exchange rate, slowing export growth after 2007 (partly global recession), boosted domestic investment, rapid expansion of real housing prices, and a falling current account surplus.
  - Despite apparent immunity to Conventional crises (huge reserves, capital controls), the scale of shifts toward nontraded-sector investment and exponential construction growth create substantial potential for credit-driven bubbles analogous to Japan and Ireland.

### Policy implications and instruments
- For Conventional crises:
  - Governments and central banks have learned to monitor risk indicators and to employ tools to limit surges in capital flows: macroeconomic policies (exchange rate, monetary, fiscal), capital controls, macro-prudential measures, reserve accumulation, swap lines, and IMF agreements.
  - Recognition that fixed exchange rates or one-way bets can act as implicit guarantees and encourage excessive FX exposure.
- For Insidious crises:
  - More difficult to detect and manage; standard inflation indicators may remain benign even as asset-price and credit vulnerabilities rise.
  - Robust prudential regimes and avoidance of implicit guarantees can help, but financial innovation may circumvent safeguards.
  - Policy responses require frequent reassessment of data, readiness for hard decisions, and judgment under political pressure; there is no simple cookbook.

### Conclusion: monitoring, prevention, and judgment
- Conventional Balance-Sheet Crises are better understood and many EMEs now deploy a variety of instruments to contain exposure to volatile global capital flows.
- Insidious Crises pose a harder challenge: identifying when equilibrating relative price changes are overshooting is extremely difficult; ex ante policy tightening is politically fraught yet delaying action risks severe costs.
- Effective prevention demands careful monitoring of relative price shifts, credit growth, concentration of bank exposures (especially to real estate), strong prudential frameworks, and policymakers able to act decisively in the face of political pressures.

*Source: EXECUTIVE SUMMARY of _wp14160*

### REFERENCES

### _wp14160 - REFERENCES

### References (selected)

- Ando, A., 1998, "Demographic Dynamics and the Causes of the Japanese Recession" (unpublished), Philadelphia: University of Pennsylvania
- Aslund, A. & V. Dombrovski, 2011, How Latvia Came Through the Financial Crisis, Peterson Institute for International Economics (Washington, D.C.).
- Bakker, B.B., & A. Gulde, 2010, “The Credit Boom in the EU New Member States: Bad Luck or Bad Policies?" IMF Working Paper 10/130 (Washington, D.C.; International Monetary Fund).
- Bakker, B. B., & L. Lipschitz, 2011, Monetary Policy Challenges in the CESEE Region: Architecture for an Earthquake Zone. Post-Crisis Growth and Integration in Europe: Catching-up Strategies in CESEE Economies (Cheltenham, UK: Edward Elgar).
- Bakker, B.B., & C. Klingen, 2012, How Emerging Europe Came Through the 2008/09 Crisis: an Account by the Staff of the IMF’s European Department, (Washington, D.C.; International Monetary Fund).
- Bayoumi, T. & C. Collyns, 2000, “Post-Bubble Blues: How Japan Responded to Asset Price Collapse” (Washington, D.C.; International Monetary Fund).
- Blanchard, O. J., M. Griffiths, & B. Gruss, 2013, “Boom, Bust, Recovery: Forensics of the Latvia Crisis” Brookings Papers on Economic Activity, Fall 2013 (Washington, D.C.;  Brookings Institution).
- Calvo, Guillermo A., L. Leiderman & C. Relnhart, 1993, “The Capital Inflows Problem: Concepts and Issues” IMF Policy Discussion Papers 93/10 (Washington, D.C.; International Monetary Fund).
- Calvo, G., 1998, “Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops,” Journal of Applied Economics, Vol. 1, No. 1.
- Calvo, G., A. Izquierdo & L.F. Mejia, 2004, "On the Empirics of Sudden Stops: The Relevance of Balance-Sheet Effects," NBER Working Papers, No. 10520 (Cambridge, MA: National Bureau of Economic Research).
- Calvo, G., 2006, “Monetary Policy Challenges in Emerging Markets: Sudden Stop, Liability Dollarization and Lender of Last Resort,” NBER Working Papers, No. 12788 (Cambridge, MA: National Bureau of Economic Research).
- Cerra, V. & S. Chaman Saxena, 2008, “Growth Dynamics: The Myth of Economic Review” The American Economic Review, Vol. 98, No. 1, pp. 439-457.
- Economic Research Note, 2013, “China: The Concept of Total Social Financing”, JP Morgan Economic Research Global Data Watch, February.
- Ghosh, A., 1996, “Capital Account Crises: Lessons for Crisis Prevention”, Prepared for the High Level Seminar on Crisis Prevention, Singapore, July 10–11, 2006, available at http://www.perjacobsson.org/external/np/seminars/eng/2006/cpem/pdf/overvi.pdf
- Krugman, P., 1998, "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity: 2, pp. 137–205 (Washington, D. C.; Brookings Institution).
- Lane, T., A. Ghosh, J. Hamann, S. Phillips, M. Shulze-Ghattas & T. Tsikata, 1999, “IMF-Supported Programs in Indonesia, Korea, and Thailand: A Preliminary Assessment”, IMF Occasional Paper No. 178 (Washington, D.C.; International Monetary Fund).
- Lipschitz, L., T. Lane & A. Mourmouras, 2002a, “The Tosovsky Dilemma: Capital Surges in Transitional Countries”, Finance and Development, 39 (3) September.
- Lipschitz, L., T. Lane and A. Mourmouras, 2002b, “Capital Flows to Transition Economies: Master or Servant?” IMF Working Paper 02/11 (Washington, D.C.; International Monetary Fund), October (subsequently, Czech Journal of Economics and Finance (2006), 56, 5–6).
- Lipschitz, L., T. Lane & A. Mourmouras, 2004, “How Capital Flows will Influence EU Accession Countries of Central and Eastern Europe in Supervisory Systems, Fiscal Soundness and International Capital Movement: More Challenges for New EU Members”, Vienna: SUERF, The European Money and Finance Forum, SUERF Studies 2004/1.
- Lipschitz, L., “Wising Up About Finance”, Finance and Development, March 2007,  Volume 4, Number 1.
- Lipschitz, L., C. Rochon & G. Verdier, 2011, “A Real Model of Transitional Growth and Competitiveness in China”, Journal of Asian Economics, Vol. 22, pp. 267–283.
- Luengnaruemitchai, P. & S. Schadler, 2007, “Do Economists’ and Financial Markets’ Perspectives on the New Members of the EU Differ?”, IMF Working Paper 07/65, March  (Washington, D.C.; International Monetary Fund).
- Ogawa, K. & S. Kitasaka, 1998, "Bank Lending in Japan: Its Determinants and Macroeconomic Implications" (unpublished), (Osaka: Osaka University)
- Posen, A., 1998, “Restoring Japan's Economic Growth” Washington, D.C.; Institute for International Economics.
- Purfield C., & C. Rosenberg, 2010, “Adjustment Under a Currency Peg: Estonia, Latvia, and Lithuania During the Global Financial Crisis 2008–09” IMF Working Paper 10/213 (Washington, D.C.; International Monetary Fund)
- Schadler, S., Carkovic, M., Bennett & R. Kahn, 1993, “Recent Experiences With Surges in Capital Flows”, IMF Occasional Paper No. 108 (Washington, D.C.; International Monetary Fund).

*Source: _wp14160 - REFERENCES*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14160.pdf_