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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 Sudden Stop, SS

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Lessons from systemic financial crises l.jpg

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


Sudden stop ss l.jpg
Sudden Stop, SS

  • Definition: Large and largely unexpected cutback in credit flows to a countryor 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.


Why is ss dangerous l.jpg
Why is SS dangerous?

  • If SS is provoked by an exogenous shock, it brings about unplannedcontraction in the affected country/sector’s 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).


Slide4 l.jpg

  • 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.


Aggravating factors l.jpg
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 adecline in

International Reserves.


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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.


Bank regulation l.jpg
Bank Regulation inflows are zero, and capital outflows are forbidden

  • 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


India and emerging markets then and now l.jpg
India and Emerging Markets: inflows are zero, and capital outflows are forbiddenThen 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.


Slide13 l.jpg

India. Current Account & Terms of Trade inflows are zero, and capital outflows are forbidden

(Current Account Balance as % of GDP, Terms of Trade 2005=100)

Terms of Trade

Current Account

At 2005 prices

Note: e = estimate

Source: EIU.


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EMs Then inflows are zero, and capital outflows are forbidden


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External inflows are zero, and capital outflows are forbiddenFinancialConditionsforEMs

(EMBI sovereign spread & CurrentAccount Balance in EMs, millions of USD, lastfourquarters)

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 inflows are zero, and capital outflows are forbidden

(LAC-7, s.a. Investment, 1998.II=100)


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LAC 7: GROWTH inflows are zero, and capital outflows are forbidden

(LAC-7, s.a. GDP, 1998.II=100)


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EMs Now inflows are zero, and capital outflows are forbidden

much better from BOP view point


External financial conditions for ems daily data embi bps last value 04 07 09 l.jpg
External inflows are zero, and capital outflows are forbiddenFinancial Conditions for EMs(daily data, EMBI+, bps, last value 04/07/09)

ENRON Effect

Greenspan’s “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 inflows are zero, and capital outflows are forbidden

(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.


Embi yield terms of trade in lac quarterly data terms of trade index 1997 i 100 embi yield l.jpg
EMBI+ Yield & Terms of Trade in LAC inflows are zero, and capital outflows are forbidden(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.


Implications l.jpg
Implications inflows are zero, and capital outflows are forbidden

  • 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 inflows are zero, and capital outflows are forbiddenSudden 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.


India financial strengths l.jpg
India: Financial Strengths inflows are zero, and capital outflows are forbidden

  • 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 inflows are zero, and capital outflows are forbidden

Source: IFS.


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India. International Reserves’ Accumulation and inflows are zero, and capital outflows are forbiddenSeigniorage

(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.


India bank loans l.jpg
India. Bank Loans inflows are zero, and capital outflows are forbidden

  • 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.


India m2 as share of gdp l.jpg
India. M2 as share of GDP inflows are zero, and capital outflows are forbidden

Source: IFS


India ratio of banks claims on private public sector l.jpg
India. Ratio of Banks’ Claims on Private/Public Sector inflows are zero, and capital outflows are forbidden

Source: IFS


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Collapses in EM Economies inflows are zero, and capital outflows are forbidden

US Great Depression

Collapse

Recovery

Collapse

Recovery

140

165

121

110

135

155

116

130

108

145

GDP

125

GDP

135

111

106

120

125

115

GDP

GDP

Bank Credit

Bank Credit

104

115

106

110

105

105

102

Credit

101

Credit

95

100

95

85

100

96

1929

1930

1931

1932

1933

1934

1935

1936

t-2

t-1

t

t+1

t+2

EM Collapses & the US Great Depression: Similarities

- Bank Credit -


Slide31 l.jpg

Bank Credit during Systemic Collapses inflows are zero, and capital outflows are forbidden

(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.


India fiscal inflation risks l.jpg
India: Fiscal, Inflation Risks inflows are zero, and capital outflows are forbidden

  • 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 inflows are zero, and capital outflows are forbidden

(% GDP)

Note: e = estimate / f = forecast.

Source: EIU.


Slide35 l.jpg

Inflation & Exchange Rate inflows are zero, and capital outflows are forbidden

(y-o-y % change)

Inflation

Exchange Rate

Source: IMF.


Slide36 l.jpg

GDP growth inflows are zero, and capital outflows are forbidden

(y-o-y % growth rate)

India

USA

Source: EIU.


Lessons from systemic financial crises37 l.jpg

Lessons from Systemic Financial Crises inflows are zero, and capital outflows are forbidden

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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