Now that the recent emerging
markets crisis has been resolved--or at least is well on its way
toward resolution--it is appropriate to step back and assess what
we have learned from this episode. Perhaps more than anything
else, the crisis has raised an array of questions that demand our
consideration, including the following: What are the major
macroeconomic and financial characteristics that make countries
vulnerable to crises? What factors determine the depth and
severity of such crises, both for a particular country and for the
global financial system as a whole? What is the nature of
contagion? Why does a crisis in a given country adversely affect
other countries that often have little interaction with (or little
similarity to) the initial crisis country? These questions are of
more than just intellectual interest. They have enormous
implications for the formulation of economic policy and directly
affect the welfare of millions of people across the globe. The
economics profession in recent years has made some progress in
formulating answers to these questions, but the limits of our
understanding remain substantial.
Today, I will focus on a subset
of these issues, examining an aspect of the recent emerging
markets crisis that remains something of a puzzle. For many years,
the Asian developing countries have been held up as one of the
global economy's shining success stories. Fueled by high domestic
savings and investment rates, coupled with fiscal restraint and
low inflation, real per capita GDP in these economies has risen
dramatically since the 1960s. In contrast, during large portions
of this period, the Latin American countries have been afflicted
by a variety of economic ailments--including fiscal imbalances,
capital flight, hyperinflation, and currency crashes--that have
depressed domestic savings and investment and hindered economic
growth.
Judged by several measures,
however, the Asian countries were hit much harder by the recent
crisis than were the Latin American countries. Why was this the
case? What vulnerabilities pushed these dynamic Asian economies
into severe crisis? What economic policies or characteristics
allowed the major Latin American countries to weather the storm
with comparatively less damage? One apparent answer to these
questions is that Latin America recently had endured a crisis--the
1994-95 peso devaluation. This observation, however, raises a
complementary set of equally intriguing questions. Namely, in what
sense does a crisis today inoculate a country against crisis
tomorrow? Does this inoculation occur through improved
macroeconomic fundamentals, stronger financial sector performance,
or some other factors? In an effort to answer such questions, I
will focus on two issues. First, I will discuss some evidence
assessing the impact of the recent crisis on the emerging Asian
and Latin American countries. Second, I will offer some working
hypotheses that might explain the differential effects of the
crisis on the two regions.
Before going further, let me
underscore the following point. The Asian economies have proven
themselves to be very competitive in global markets and highly
resilient. Consistent with this observation, the major Asian
crisis countries appear to be well on their way to recovery, with
the possible exception of Indonesia, which remains plagued by
political instabilities. But notwithstanding the underlying
strength of the Asian economies--or perhaps precisely because of
their underlying strength--there is much to be learned in
assessing why they fared poorly relative to their Latin American
counterparts during the recent round of crises.
Comparing the Impact of the
Crisis
The behavior of GDP provides a natural measure for assessing the
severity of the recent crisis in the two regions (exhibit
1). The Asian crisis began in Thailand during July 1997, when
a run on the country's currency--the baht--forced the government
to float the exchange rate. Not coincidentally, real GDP peaked in
mid-1997 and fell more than 10 percent before reaching a trough
during the second half of 1998.1
After the devaluation of the baht, the crisis spread to Malaysia,
Indonesia, and the Philippines. Each of these countries was
eventually forced to allow its currency to float more freely
against the dollar, and each country also experienced a sharp
contraction of its GDP. In Malaysia, output fell 10 percent
between the third quarter of 1997 and the third quarter of 1998.
Indonesia was even more severely afflicted, with GDP plunging more
than 15 percent during that time. The Philippines was relatively
less affected, however, as GDP declined just 3 percent from peak
to trough. Korea, which was the last major Asian country hit by
the crisis, endured sharp declines in the value of its currency
and its domestic financial markets during late 1997 and early
1998. Korean GDP dropped about 8 percent during this period.
Now turning to Latin America,
this region first felt the effects of the financial crisis during
the fall of 1997. At that time, Brazil--the center of the crisis
in Latin America--raised interest rates to high levels and drew
down its stock of international reserves to keep its currency--the
real--from falling. However, pressures on Brazil re-emerged
following the Russian devaluation in August 1998. The high
interest rates necessary to defend the real became
increasingly difficult to sustain, and the authorities floated the
currency in January 1999. The real depreciated about
one-third in the subsequent six months.
To the surprise of most
observers, Brazilian GDP fell only 3 percent from its peak during
the second quarter of 1998 to a trough at the end of that year.
Perhaps even more surprisingly, Brazilian inflation remained
restrained after the devaluation, and the economy registered
strong growth during the first half of 1999, nearly erasing the
contraction that occurred during the second half of 1998.
Ironically, several of Brazil's
neighbors have fared worse. Argentina successfully defended its
exchange rate regime but has suffered a comparatively steep
decline in economic activity. The high interest rates necessary to
defend its peg to the dollar, along with the intensified
uncertainty generated by the crisis and reduced competitiveness
following the Brazilian devaluation, pushed Argentine GDP down 5
percent from mid-1998 to mid-1999. Activity in Chile, Colombia,
and Ecuador has fallen by a comparable amount. Mexico's
experience, however, stands as an interesting contrast. For a
number of reasons, which I will discuss later, economic activity
in Mexico generally has remained strong. The country has endured
only one quarter of negative GDP growth in the past three years.
A second means of assessing the
impact of the crisis on the two regions is the degree of external
adjustment that occurred (exhibit
2 or exhibit 2A). Significantly, Thailand's current account
swung from a deficit of 8 percent of GDP in 1996 to a surplus of
12 percent of GDP in 1998. This startling adjustment in the
current account balance was accomplished entirely by a compression
of imports, as the dollar value of exports was about flat but
imports plunged 40 percent. The story for other major Asian crisis
countries is broadly similar. In contrast, current account
adjustment in the three major Latin American countries has been
much less pronounced. All three countries have remained in
deficit, with total adjustment during the crisis estimated to
amount to only about $15 billion (compared with $120 billion in
Asia) and current account deficits remaining around 3 to 5 percent
of GDP.
The extent of current account
adjustment in Asia was necessitated in part by a sharp tailing off
of private capital flows to the region (exhibit
3). Specifically, gross private financial flows to Korea,
Malaysia, Thailand, and the Philippines plunged from $28 billion
in the second half of 1996 to just $4 billion in the last half of
1998.2
Over this period, new bank loans issued to these economies fell
nearly two-thirds, and bond issuance declined more than 90
percent. Private financial flows to Latin America, in contrast,
did not decline severely until the second half of 1998. Flows to
both regions rebounded during the first half of 1999.
Explaining the Differential
Impact of the Crisis
The available evidence clearly indicates that the Asian developing
countries experienced sharper GDP declines, more severe current
account adjustment, and a steeper falloff in private capital flows
during the recent crisis than did their Latin American
counterparts. I will now consider four broad hypotheses that may
account for the differential impact of the crisis on the two
regions.
First, were macroeconomic
conditions in Asia in worse shape than those in Latin America?
Asia's growth performance in the years immediately preceding the
crisis did not hint of disruptive imbalances. These economies were
registering average annual growth of roughly 7 to 8 percent. While
such rates of expansion might be considered unsustainably rapid,
these countries had maintained such performance for many years
without any apparent adverse effects. By comparison, the Latin
Americans recorded more moderate growth rates in the years before
the crisis. Inflation in both regions generally was well
contained. What about current account imbalances (exhibit
4)? All of these countries ran current account deficits in the
period before the crisis. Although the imbalances in Asia were
somewhat larger than those in Latin America, such
differences--with the possible exception of Thailand--do not
appear to be particularly significant. Moreover, the current
account performance of the three major Latin American countries
deteriorated further during 1998.
Were real exchange rates in Asia
substantially overvalued relative to those in Latin America (exhibit
5)? During the first half of 1997, immediately before the
onset of the crisis, the broad real exchange rates for Thailand,
Indonesia, and Malaysia were only about 5 to 8 percent stronger
than their 1990-96 average, and Korea's real exchange rate was
slightly weaker than its 1990-96 average. The real exchange rate
for the Philippines was more than 20 percent above its average,
but--as previously noted above--this country was relatively less
affected by the crisis. Hence, there is little evidence of
substantial overvaluation of exchange rates in these countries. In
comparison, during the first half of 1998, before the onset of the
Latin American phase of the crisis, the real exchange rates for
Argentina and Brazil were about 10 percent stronger than the
1990-97 average, while Mexico's real rate was about 5 percent
stronger.
Finally, the fiscal position of
the Asian countries (exhibit
6) was no worse--and perhaps somewhat better--than that of the
Latin American countries. Countries in both regions ran small
deficits or slight surpluses. Brazil was the pronounced exception,
with a fiscal deficit well over 5 percent of GDP.
Accordingly, there seems to be
little evidence that Asia's macro fundamentals in the run-up to
the crisis were significantly weaker than those for the Latin
American countries. Indeed, indicators point to roughly comparable
performance and risk in the two regions.
A second hypothesis is that the
financial systems in the Asian developing countries were beset
with greater vulnerabilities than was the case in Latin America.
This explanation seems to be more promising. Consider the case of
Thailand. In the mid-1990s, the country's domestic savings rate
was about 35 percent of GDP, and the current account deficit was
about 8 percent of GDP. This suggests that the financial system
each year was intermediating investment flows on the order of 40
percent of GDP. It is conceivable that an economy with sound
financial infrastructure and well-developed legal and regulatory
institutions could have efficiently allocated such massive flows.
However, in an emerging market economy that is still developing
the institutions required to regulate, supervise, and support a
viable financial system, it is not surprising that over time
financial resources were misallocated and a substantial stock of
bad loans emerged. In the absence of strong prudential regulation,
the financial sector may have had inadequate incentives to assess
risk properly and to monitor borrowers. From this perspective, the
real puzzle may be why the Asian financial system did not falter
sooner.
Stated in slightly different
terms, IMF statistics (exhibit
7) indicate that in 1996 bank claims on the private sector
were about 100 percent of GDP in Thailand and about 60 percent of
GDP in Korea. These numbers far exceed the ratios of roughly 20
percent of GDP that prevailed in Mexico, Argentina, and Brazil,
countries that also experienced considerably slower domestic loan
growth in the years preceding the recent crisis. The systemic
risks implied by weak regulation may be much more severe in
countries with relatively large banking systems. This observation
is not unique to developing countries. Even Japan, one of the
world's advanced industrial countries, has struggled with a
bad-loan problem, partially because of massive bank lending in an
environment of inadequate prudential supervision. Moreover,
countries where the banking system is large relative to GDP may be
forced to endure more-severe macroeconomic disruptions when a
banking crisis actually occurs, since the costs of cleaning up the
crisis are likely to be large compared with the size of the
economy and firms are likely to be highly dependent on banks for
the provision of credit.
In light of these
considerations, it is perhaps not surprising that Asian financial
institutions were hit harder by the crisis than Latin American
institutions. For example, Thailand was forced to close dozens of
finance companies, and deep financial problems in two of Korea's
largest banks persuaded the authorities to temporarily nationalize
those institutions. In addition, an enormous bad-loan problem in
Thailand and Indonesia--and to some extent in the other Asian
crisis countries, including Korea--emerged after the crisis, thus
creating uncertainty about the future economic performance and
financial viability of these economies. In contrast, major Latin
American countries moved to strengthen their financial systems
following the peso crisis in the mid-1990s. As a result, banks in
these countries appear to have sustained minimal new damage.
Argentina is a notable example: Efforts to strengthen the
financial position of the banks, coupled with improvements in
prudential regulation, have allowed the banks to remain relatively
healthy, despite the effects of the crisis and the country's
protracted recession.
This discussion suggests that
financial system vulnerabilities probably were more severe in Asia
than in Latin America. Such a conclusion, however, does not
necessarily imply that Asian financial institutions were
fundamentally less efficient or effective, only that they were
more vulnerable when the crisis hit.3
Suffice it to say that policymakers in Latin America also are
wrestling with sizable financial sector problems.
A third hypothesis is that the
crisis hit Asia harder because investor sentiment shifted more
abruptly than it did in Latin America. In other words, one might
be asked--Did the crisis somehow reveal comparatively more
information about the performance of the Asian developing
countries and their economic prospects? The answer to this
question seems to be "yes." The major revelation--or
wake-up call--that transformed the Asian devaluations into
first-order crises was the (apparently sudden) realization on the
part of investors that the Asian countries were suffering from
deep structural imbalances, particularly in their financial
sectors. This dramatic shift in sentiment was a central feature of
the crisis in Asia. Importantly, there were no similar downside
surprises in Latin America, because investors were already
familiar with the region's structural inefficiencies and
difficulties. It is fair to say that memories of the peso
devaluation in 1994-95 remained fresh in investors' minds.
The sudden shift in investor
perceptions of the Asian countries is reflected in the dramatic
downgrading of sovereign debt ratings that occurred between
mid-1997 and early 1998 (exhibit
8). During this period, Standard & Poor's downgraded
Thailand four notches (from A to BBB-), Indonesia, six notches
(from BBB to B), and Korea, ten notches (from AA- to B+). In
contrast, S&P's credit ratings for Argentina and Mexico were
unchanged during the crisis (at BB), and Brazil's rating was
reduced only one notch (from BB- to B+).4
The less-pronounced reversal in
sentiment regarding Latin America may be partially due to the fact
that the crisis hit Asia first. This gave policymakers in Latin
America an opportunity to implement preemptive measures, such as
interest rate increases and initiatives to improve fiscal
performance, that may have helped minimize subsequent damage.
Another implication of the difference in timing was that "hot
money" was able to leave Latin America gradually rather than
in one frenetic rush. The Latin American countries also may have
benefited because global economic policymakers--including the IMF--had
learned from their experiences in Asia and Russia.
A fourth hypothesis focuses on
the speed and effectiveness of the policy response. Were
policymakers in Asia slower to respond to the crisis than those in
Latin America, and did this have a bearing on the severity of the
crisis? The response to the crisis in the two regions differed in
at least one important respect: The Latin Americans were much
quicker to raise interest rates aggressively. Notably, short-term
interest rates in Thailand did not peak until the second half of
1997, well after the baht was allowed to float. The authorities
were hesitant to raise interest rates rapidly during the first
half of that year, notwithstanding the fact that the currency had
come under severe pressure. As an alternative strategy, the Thai
authorities attempted to defend the pegged exchange rate regime
through substantial foreign exchange intervention, which drained a
significant fraction of official reserves and still failed to
achieve the desired goal. In contrast, the major Latin American
countries raised interest rates significantly as soon as they were
hit by the shock waves from the crisis.
More generally, Thailand's
experience highlights the fact that a half-hearted defense of a
fixed exchange rate regime may drain reserves, reduce the
credibility of the authorities, and ultimately prove unsuccessful.
Accordingly, an emerging consensus in the policymaking community
suggests that, when fixed exchange rate regimes come under attack,
they either should be abandoned as quickly as possible or defended
with all available instruments, including aggressive monetary
tightening.
This discussion suggests a
further observation. Ironically, Latin America's history of
financial crises actually may have helped limit the damage done by
the recent crisis. The regions' previous crises have allowed
policymakers (many of whom are well-trained technocrats) to gain
significant experience in crisis management. The Asian economies,
in contrast, had grown essentially without interruption for many
years. Perhaps as a result, policymakers in the region may have
been less prepared to deal with the crisis. Additionally, since
the Latin American countries had much experience with economic
crises, the turmoil associated with the recent crisis may have
been less damaging to the sentiment of investors and the general
public than was the case in Asia. It seems reasonable to
hypothesize that, when economic crises are a fact of life,
institutions and practices are likely to develop that make
countries more resilient in the face of such crises.
Lessons from Mexico's Recent
Experience
I now turn to Mexico. As mentioned earlier, the Mexican economy
has been particularly buoyant during the recent crisis. Are there
any general lessons that can be drawn from Mexico's experience?
Although the Mexican authorities have raised interest rates at
various times over the past two years to stabilize the peso, they
nonetheless have allowed the peso to depreciate. It is probably
fair to say that any adverse effects of peso depreciation are
small compared with the costs that would have been borne had the
authorities attempted to prevent the currency from weakening. This
suggests that the policies required to defend a pegged exchange
rate--not to mention the disruptions that are endured when such
pegs are blown out--may leave countries with this sort of regime
more vulnerable to downturn when crises occur.
An additional factor that likely
has contributed to Mexico's resilience in recent years is its
close relationship with the exuberant U.S. economy. Roughly
three-quarters of Mexican exports are purchased by the United
States, representing about one-fifth of Mexican output. The
strength of the U.S. economy also has benefited Latin American
countries more generally. On the other hand, the Asian countries
are highly integrated with Japan. It may be more than coincidence
that the Asian crisis erupted after a sustained depreciation of
the yen and as Japan fell into a deep recession. Moreover, during
the darkest days of the Asian crisis, Japanese imports from Asia
declined sharply, and Japanese bank lending to these countries
slowed. Developments in Japan almost certainly exacerbated the
breadth and depth of the Asian crisis.
Some Conclusions
What conclusions can be drawn from this discussion? First, and not
surprisingly, developing countries that are hit with adverse
shocks are likely to fare much better if they are highly
integrated with a large, booming economy. This unfortunately is
more a matter of luck (namely, the position of the partner country
in its business cycle) than a clear prescription for economic
policy.
Second, during times of crisis,
flexible exchange rate regimes appear to have major advantages
relative to more rigid regimes. Flexible regimes may provide
additional room for maneuver, since adjustment to an adverse shock
can come through exchange rate depreciation. Flexible exchange
rate regimes are also less costly to defend.
Third, when adverse shocks
arise, the authorities should move quickly to put appropriate
policies in place to preempt potential difficulties. Particularly,
in the context of a fixed exchange rate regime, monetary policy
should be tightened aggressively to defend the peg, or the regime
should be abandoned.
A fourth lesson from the
discussion is that strong macroeconomic fundamentals are
necessary--but not sufficient--for avoiding crisis. Structural
policies are also of first-order importance.
Fifth, developing countries
should move to strengthen their financial infrastructure, improve
the efficiency of financial intermediation, and ensure that the
regulations and incentives for proper credit assessment and
monitoring are in place. This is particularly important for those
countries with huge quantities of domestic savings; if appropriate
measures are not implemented, such countries may face further
financial crises in coming years.
Finally, probably the major
factor generating the sharp economic decline in Asia was the
dramatic reassessment of prospects for the region, largely
reflecting a "wake-up call" regarding the financial
sector's level of performance. Of necessity, investors will punish
such downside surprises severely. To limit the magnitude of such
downside surprises, policymakers should take action to maximize
financial sector transparency and ensure appropriate disclosure of
information.
Exhibits
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