Jomo Kwame Sundaram :
Emerging market governments often draw lessons from previous financial crises – or at least claim to do so – to prevent their recurrence. However, such preventive measures are typically designed to address the causes of the last crisis, not the next one. Hence, some measures adopted may inadvertently become new sources of instability and crisis.
Very rarely are the root causes of crises and vulnerability addressed. In their efforts to prove themselves as worthy emerging markets, they tend to be pro-active in joining the financial globalization bandwagon. But premature financial liberalization – with hasty integration into the international financial system, typically without adequate prudential multilateral mechanisms for speedy and orderly resolution of external liquidity and debt crises – can be very dangerous and costly.
Future currency crises different
Many governments claim to have learnt from the 1997-1998 Asian financial crises and the 2007-2009 global financial crisis. But while measures implemented may be effective in preventing recurrence, they may be inappropriate, inadequate or worse, even counterproductive with changing, deepening financial integration.
After mid-1997, Southeast Asian governments abandoned their informal currency pegs after incurring high costs trying to defend them. Moving to flexible exchange rates ended ‘one-way (sure-win) bets’ for some speculators, while entailing disruptive currency devaluations.
Since the crises, banking regulation and supervision have undoubtedly improved, e.g., reducing currency and maturity mismatches in bank balance sheets. However, in this day and age, stable exchange rates can no longer be ensured with unregulated capital mobility.
In fact, currency crises can occur with either fixed or flexible exchange rates. With flexible rates, inflows cause currency appreciations, encouraging even more inflows, which will inevitably be reversed, often quite abruptly.
Capital inflows into securities markets are far more important today than banks intermediating cross-border capital flows in the 1990s. Corporate bond issues have also grown much faster than international bank lending, whether directly or through local intermediaries. Yet, such measures have not prevented credit and asset price bubbles.
Emerging markets have further liberalized foreign direct investment (FDI) regimes and encouraged foreign participation in equity markets, presuming that equity liabilities are less risky than external debt. Hence, foreign shares of market capitalization have reached unprecedented levels, much higher than in the US. With emerging markets more susceptible, a little foreign investment can ‘make (emerging) markets’, causing large price swings.
Currency mismatches
East Asian authorities have also reduced currency mismatches in their own balance sheets and exchange rate risk exposure by opening domestic bond markets to foreigners and borrowing in their own currencies. Consequently, sovereign debt is now much more exposed to foreign creditors than in reserve currency countries.
Much higher shares of most emerging market sovereign bonds are held by foreigners, usually privately, rather than by central banks. In contrast, most of Japan’s very high sovereign debt is held by Japanese creditors while around a third of US Treasury bonds are held by non-residents.
Encouraging foreign participation in sovereign bond markets has helped pass currency risk to creditors, but also reduced autonomy over long-term rates and increased exposure to interest rate shocks from abroad, e.g., when the US Fed raises interest rates again.
Greater capital account liberalization besides encouraging domestic corporations to borrow from and invest abroad have resulted in massive debt accumulation in low interest rate reserve currencies, especially with recent ‘unconventional’ monetary policies. Thus, reducing sovereign debt currency mismatches has been offset by increased private corporate fragility due to greater exchange rate risks.
Regulatory constraints on resident individuals and institutional investors purchasing foreign securities and real estate have also been relaxed. Capital account liberalization has enabled resident capital outflows claiming these will ‘balance’ foreign inflows. But such private accumulation of foreign assets will not be available to national authorities in case of panicky capital flight.
Hence, national currencies are especially vulnerable when the capital account is open and foreign control of domestic financial assets is significant. As experience has shown, macro-financial volatility may suddenly precipitate massive outflows.
Self-insurance delusion
Since the turn of the century, emerging markets have been seeking ‘self-insurance’ in managing external balances by accumulating ‘adequate’ international reserves from trade surpluses and capital inflows. Hence, foreign reserves in most East Asian countries are often enough to meet conventional external liabilities, but not enough to cope with massive reversals of foreign portfolio investments and capital flight by residents.
Despite the crises of the last two decades, emerging markets’ capital accounts are much freer now than then. Asset markets and currencies of all East Asian emerging markets with ‘enough’ foreign reserves have nevertheless been shaken several times in the past decade.
But such short-lived instability episodes did not cause severe damage as they only involved temporary shifts in market sentiments. Nevertheless, they hint at likely threats when ‘quantitative easing’ in the North could be reversed soon.
As ‘self-insurance’ is probably insufficient to cope with massive capital flight, the usual option is to ‘seek help’ from the IMF and reserve-currency countries. Another involves ‘bailing in’ international creditors and investors using foreign exchange controls, temporary ‘debt standstills’ and other measures to protect jobs and the economy.
But such unilateral measures may be difficult and costly due to resistance from creditor country governments, acting at the behest of the powerful financial interests involved.
(Jomo Kwame Sundaram, a former economics professor and United Nations Assistant Secretary-General for Economic Development, received the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought in 2007).
Emerging market governments often draw lessons from previous financial crises – or at least claim to do so – to prevent their recurrence. However, such preventive measures are typically designed to address the causes of the last crisis, not the next one. Hence, some measures adopted may inadvertently become new sources of instability and crisis.
Very rarely are the root causes of crises and vulnerability addressed. In their efforts to prove themselves as worthy emerging markets, they tend to be pro-active in joining the financial globalization bandwagon. But premature financial liberalization – with hasty integration into the international financial system, typically without adequate prudential multilateral mechanisms for speedy and orderly resolution of external liquidity and debt crises – can be very dangerous and costly.
Future currency crises different
Many governments claim to have learnt from the 1997-1998 Asian financial crises and the 2007-2009 global financial crisis. But while measures implemented may be effective in preventing recurrence, they may be inappropriate, inadequate or worse, even counterproductive with changing, deepening financial integration.
After mid-1997, Southeast Asian governments abandoned their informal currency pegs after incurring high costs trying to defend them. Moving to flexible exchange rates ended ‘one-way (sure-win) bets’ for some speculators, while entailing disruptive currency devaluations.
Since the crises, banking regulation and supervision have undoubtedly improved, e.g., reducing currency and maturity mismatches in bank balance sheets. However, in this day and age, stable exchange rates can no longer be ensured with unregulated capital mobility.
In fact, currency crises can occur with either fixed or flexible exchange rates. With flexible rates, inflows cause currency appreciations, encouraging even more inflows, which will inevitably be reversed, often quite abruptly.
Capital inflows into securities markets are far more important today than banks intermediating cross-border capital flows in the 1990s. Corporate bond issues have also grown much faster than international bank lending, whether directly or through local intermediaries. Yet, such measures have not prevented credit and asset price bubbles.
Emerging markets have further liberalized foreign direct investment (FDI) regimes and encouraged foreign participation in equity markets, presuming that equity liabilities are less risky than external debt. Hence, foreign shares of market capitalization have reached unprecedented levels, much higher than in the US. With emerging markets more susceptible, a little foreign investment can ‘make (emerging) markets’, causing large price swings.
Currency mismatches
East Asian authorities have also reduced currency mismatches in their own balance sheets and exchange rate risk exposure by opening domestic bond markets to foreigners and borrowing in their own currencies. Consequently, sovereign debt is now much more exposed to foreign creditors than in reserve currency countries.
Much higher shares of most emerging market sovereign bonds are held by foreigners, usually privately, rather than by central banks. In contrast, most of Japan’s very high sovereign debt is held by Japanese creditors while around a third of US Treasury bonds are held by non-residents.
Encouraging foreign participation in sovereign bond markets has helped pass currency risk to creditors, but also reduced autonomy over long-term rates and increased exposure to interest rate shocks from abroad, e.g., when the US Fed raises interest rates again.
Greater capital account liberalization besides encouraging domestic corporations to borrow from and invest abroad have resulted in massive debt accumulation in low interest rate reserve currencies, especially with recent ‘unconventional’ monetary policies. Thus, reducing sovereign debt currency mismatches has been offset by increased private corporate fragility due to greater exchange rate risks.
Regulatory constraints on resident individuals and institutional investors purchasing foreign securities and real estate have also been relaxed. Capital account liberalization has enabled resident capital outflows claiming these will ‘balance’ foreign inflows. But such private accumulation of foreign assets will not be available to national authorities in case of panicky capital flight.
Hence, national currencies are especially vulnerable when the capital account is open and foreign control of domestic financial assets is significant. As experience has shown, macro-financial volatility may suddenly precipitate massive outflows.
Self-insurance delusion
Since the turn of the century, emerging markets have been seeking ‘self-insurance’ in managing external balances by accumulating ‘adequate’ international reserves from trade surpluses and capital inflows. Hence, foreign reserves in most East Asian countries are often enough to meet conventional external liabilities, but not enough to cope with massive reversals of foreign portfolio investments and capital flight by residents.
Despite the crises of the last two decades, emerging markets’ capital accounts are much freer now than then. Asset markets and currencies of all East Asian emerging markets with ‘enough’ foreign reserves have nevertheless been shaken several times in the past decade.
But such short-lived instability episodes did not cause severe damage as they only involved temporary shifts in market sentiments. Nevertheless, they hint at likely threats when ‘quantitative easing’ in the North could be reversed soon.
As ‘self-insurance’ is probably insufficient to cope with massive capital flight, the usual option is to ‘seek help’ from the IMF and reserve-currency countries. Another involves ‘bailing in’ international creditors and investors using foreign exchange controls, temporary ‘debt standstills’ and other measures to protect jobs and the economy.
But such unilateral measures may be difficult and costly due to resistance from creditor country governments, acting at the behest of the powerful financial interests involved.
(Jomo Kwame Sundaram, a former economics professor and United Nations Assistant Secretary-General for Economic Development, received the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought in 2007).
