Conference on World Capital Markets and Financial Crises

Eric Le Borgne & Pongsak Luangaram

A two day conference on ‘World Capital Markets and Financial crises’, organised by CEPR in conjunction with the ESRC’s GEI Programme, was held at the University of Warwick, Coventry, on 24/25 July 1998. The organisers were Marcus Miller (University of Warwick and CEPR), William Perraudin (Birkbeck College and CEPR), and Jonathan Thomas (University of Warwick and CEPR). There were ten papers, together with a round table on crisis prevention and management in global capital markets.

The aim of the conference was to discuss the origins of the recent East Asian financial crisis and its implications. The crisis involves neither the fiscal profligacy nor the political temptations to devalue (to reduce unemployment), which lie at the root of “first and second” generation models of speculative attack. Excessive short-term dollar liabilities and over-optimistic bank lending, in an under-regulated environment, seem to lie at the source of the financial turmoil.

 This theme was developed in “Paper Tigers?” presented by Giancarlo Corsetti (Università di Roma Tre and Yale University), co-authored with Paolo Pesenti (Princeton University), and Nouriel Roubini (New York University and CEPR). The authors offered a “preliminary assessment of the Asian crisis” by first analysing the effects of promised government bail-outs, and second providing empirical evidence on the role of fundamentals in the build-up to the crisis. Though fiscal deficits were low in East Asia, the authors argued that, with government bail-outs, current external private debt will translate into future public liabilities. So, assuming perfect foresight, speculative attacks should take place when the stock of external debt is sufficiently high to induce expectations of a sustained permanent money expansion. Using data from 24 emerging economies, including those in East Asia, the authors concluded that both the magnitude of current account deficits (a measure of external imbalance) and the share of non-performing loans (a measure of the fiscal costs of financial bail-out) are crucial in determining the likelihood of a crisis and its severity.

Do people really look ahead to the future cost of government bail-outs prior to the crisis? Richard Portes (London Business School and CEPR) was sceptical about the degree of foresight this involves. He also questioned the robustness of the empirical support claimed by the authors and wondered why there is no explicit role in the model for real exchange rate – one of the key elements in determining the domestic burden of external debt.

In “Asian Currency and Financial Crises: Lessons from Vulnerability, Crisis, and Collapse”, David Vines (Balliol College, Oxford, and CEPR) and Jenny Corbett (St Antony’s College, Oxford, and CEPR) explored the interactions between currency and financial crisis and argued that it is these interactions which lead to collapse. The critical feature was the prior build-up of massive unhedged foreign borrowing.

This meant that, when the currency initially devalued, foreign depositors no longer trusted the government guarantees. Fears of sovereign insolvency triggered capital flight and currency collapse. The paper ended with implications for crisis management and lessons for global economic institutions.

Christopher Bliss (Nuffield College, Oxford) noted that the slowdown of rapid economic growth by itself could easily expose financial weaknesses. The existence of implicit bail-out promises, so much emphasised in the Asian context, is too widespread to be the principal explanation. Will East Asia recover as quickly as Mexico did in 1995? Maybe not. As Vinod Aggarwal (University of California, Berkeley) pointed out, the role of the US had very important signalling effects in term of debt renegotiation which helped Mexico to regain access to private capital markets more quickly.

There were two papers which focused on the role of credit market imperfections in causing instability. First, Philippe Aghion (University College London, EBRD, and CEPR) presented “Capital Markets and the Instability of Open Economies”, co-authored with Philippe Bacchetta (Studienzentrum Gerzensee, Université de Lausanne and CEPR) and Abhijit Banerjee (MIT). The authors constructed a model of a small open economy in which a firm’s creditworthiness depends on its current cash flow. With credit-constrained firms, a rise in the price of non-traded inputs (such as land) squeezes profits and brings the boom to an end: a fall helps recovery. They warned that premature liberalisation can set in train a repeated cycle of this sort. It is also suggested that a policy of never bailing out insolvent banks (or that of closing down a large number of banks) can be counter-productive as it runs the danger of making firms less able to borrow and prolongs the slump. In addition, foreign direct investment (FDI) in this slump can help avoid output volatility.

Gianluca Femminis (Università Cattolica del Sacro Cuore, and CEPR) stressed that the role of land as a collateral for loans is more relevant to emerging economies than the cash flows costs of paying rent. He observed that land prices in East Asia started falling some time before the crisis, contrary to the sequence suggested by the authors. David Vines noted that if the markets for non-traded goods are not allowed to clear unlimited foreign investment might not stabilise the economy. Manmohan Kumar (Credit Suisse First Boston) wondered about the timing: why not allow FDI before the crisis hit? Giancarlo Corsetti contrasted this approach with Krugman’s model in which the moral hazard problems arise in the banking sector. In conclusion, Philippe Aghion warned that a no bail-out policy may induce banks to hide their bad loans by refinancing non-performing customers.

Secondly, Marcus Miller presented “Asset Bubbles, Domino Effects and Lifeboats”, co-authored with Hali Edison (Federal Reserve Board, Washington) and Pongsak Luangaram (University of Bristol). Following the approach taken in Kiyotaki and Moore (“Credit Cycles” JPE, 04/97), it was argued that rising land prices add to a boom as they enhance the collateral that firms can pledge against loans. It is a fall in land prices that leads to a slump, where negative shocks are greatly magnified as credit relations collapse. The authors suggested that these credit market effects have played an important role in East Asia, especially in Thailand. After a brief account of policy interventions proposed in the literature – such as temporary financing, lifeboats (i.e. mergers with healthy banks) and nationalisation – they analysed the measures adopted by the Thai government to prevent financial collapse.

Jagjit Chadha (Bank of England) suggested that transversality condition for the existence of an asset bubble be examined and its bursting be endogenized; he also suggested the authors incorporate bank behaviour. Regarding the financial stabilisation policy as suggested in the paper, where finance houses provided temporary financing to property companies, Manmohan Kumar stressed that changes in market sentiment can have powerful effects, as when the operation of finance houses in Thailand was suspended. If these finance houses had continued to operate, contingent government liabilities would have been even greater and stabilising market sentiment could have been more difficult.

Two economists from the IMF presented a theoretical model of emerging markets with imperfect financial systems designed to capture recent events in Asia, where a period of relatively low capital flows was followed by a fast buildup of capital flow, and ended with a large capital outflow (crisis). In “Financial Crises and Financial Intermediation – with Reference to the Asian Crisis” by Jorge A Chan-Lau and Zhaohui Chen, there exists a stage in which the economy could be subject to financial crisis – but this is usually preceded by a period of large capital inflows. To avoid staying in the risky stage of financial reform for too long, the authors suggested that policy should try to ensure solid domestic fundamentals and monitor (and influence) credit market interest rates.

Kenneth Kletzer (University of California, Santa Cruz) noted that the results of the paper depend crucially on the assumed structure of monitoring cost. He suggested the authors extend the model by using imperfect information to derive the cost structure of the intermediary. Kletzer also noted that endogenising interest rates would be useful, for example, in studying the effects of financial liberalisation. Zhaohui Chen replied that the reason for assuming fixed prices is that the interest rates in East Asian economies are typically either controlled by the government or fixed by monopolistic banks. John Driffill (University of Southampton and CEPR) added that it would be interesting to aggregate the micro model for macro analysis.

While multiple equilibrium models of speculative attacks have gained acceptance among many commentators, in “A Theory of the Onset of Currency Attacks”, Hyun Song Shin (Nuffield College, Oxford) and Stephen Morris (University of Pennsylvania) criticised such an approach since the shift in beliefs which moves the system from one equilibrium to another is left unexplained. The authors presented a model in which, if there is full knowledge, there may be multiple equilibria so that, for a single level of fundamentals, there are two equilibria on which speculators might coordinate – either crisis or no-crisis. They then demonstated how, if each speculators has a small amount of uncertainty as to the information set of the others, this can remove the possibility of such multiple equilibria as fundamentals act as a coordinating device. They concluded that the exact timing of the shift in expectations can be found “inside” the model which is not the case in other second generation models of speculative attacks.

Jonathan Thomas (University of Warwick) suggested the authors examine the robustness of the unique equilibrium, for example, when the size of depreciation is dependent on the magnitude of the attacks. He doubted the relevance of the uniqueness result in explaining the crisis in East Asia, as this was perceived to come as a surprise. Kevin Chang (University of Southern California and CSFB) said that it would be interesting to see empirical work, and to incorporate contagion effects.

On the second day of the conference, In-Ho Lee (University of Southampton) presented “Korean Financial Crisis: A Price for a Miracle”. He argued that although the Asian financial crisis involves several countries, a unique background exists for each country. His chronicle of the events showed how the Korean economy moved from a trajectory of fast growth – which Robert Lucas in 1993 described as a “miracle” – to turmoil in the financial markets, leading to disruption in the real sector, massive layoffs and wholesale restructuring of the economy. In-Ho Lee’s explanation of the Korean crisis relied on self-fulfilling expectations and attributed a key role to short-term debt. The author noted that during the period of rapid economic growth, the Korean economy had similar foreign account problems in the early 1980s as in 1997, but only in the latter has there been a crisis. This is because the proportion of short-term debt was higher, so foreign lenders’ unwillingness to rollover short-term debt led to further depreciation of the Korean won. (As to why Korean firms relied so heavily on short-term debt, Lee noted that the allocation of funds was mostly decided by political, rather than economic, considerations.) One policy implication of the self-fulfilling approach of In-Ho Lee was the importance that alarm signals and the release of economic data play during a crisis.

In the ensuing discussion, Olli Castren (Bank of Finland) remarked that the short-term Korea-US interest rate differential had been quite stable up until 1997 despite the large borrowing needs of the Korean Economy. It is therefore not surprising, according to Olli Castren, that Korean firms and banks found it attractive to borrow abroad. Richard Portes noted that the short-term debt position of Korean firms deteriorated rapidly, suggesting that the devaluation had not been expected. Lee replied that the possibility of a devaluation had been considered but Korean banks expected the government to guarantee their loans. Philippe Aghion argued that the boom and bust cycle of the Korean economy is part of the growth process. During booms, bank competition increases and banks try to pre-empt one another; this leads to less monitoring and therefore a deterioration of the loan portfolio.

In an empirical paper on “Predicting Emerging Market Currency Crises”, William Perraudin (Birkbeck College, London, and CEPR) and his co-authors Manmohan Kumar (CSFB) and Uma Moorthy (Birkbeck College) look at the value of lagged information about financial and macroeconomic variables in forecasting crisis. Their analysis is intended for macroeconomic policy-makers, private investors, and financial regulators. The authors criticise the existing empirical literature on two grounds. First it uses contemporaneous variables, and furthermore these studies are mainly descriptive which is not very useful for decision-making. Second, in the few studies where forecasts exist, these are “in sample”. The authors remedy both these problems. They use a large dataset comprising 32 emerging countries on which they have over 40 variables at a monthly frequency from 1985 to 1998. The authors conclude that using lagged monthly, simple logit models possess significant explanatory power. Major crisis episodes are correctly forecast and out-of-sample trading strategies yield profits.

Giancarlo Corsetti was surprised that, given that the authors aim at analysing trading strategies, they focus only on depreciations of the exchange rate and ignore appreciation periods. Analysing both periods would reduce the profitability of the trading strategy they report. Paul Mizen (University of Nottingham, Bank of England, and CEPR) doubted whether one could really quantify the vulnerability of a country to a crisis. Mizen was also unsure whether the information about crises that Perraudin et al. report can be timely enough so that policy-makers can have enough time to react. Richard Portes noted that the crisis definition of the authors (which does not include foreign exchange reserves), leaves out many events which would qualify as crises and that the authors also ignore successful defences of the currency. He also observed that because of the importance of forward positions, the data used by the authors could have serious limitations. Manmohan Kumar replied that their approach was to see whether, in spite of these forward positions, the available data could still be used to predict crises.

Alessandro Missale (IGIER, Universita Degli Studi di Brescia, and Bank of England) presented “High Public Debt and Currency Crises: Fundamentals versus Signalling Effects”, a paper co-authored with Benigno Pierpaolo (Princeton University). The aim of their complex analysis is to see how public debt, policy-makers’ credibility and external circumstances all affect the probability of exchange rate devaluations. Their fully specified model enables the authors to study several important issues, such as measuring the credibility of the foreign exchange regime after a devaluation and assessing the probability of an imminent devaluation (using the short-term interest rate), and of a devaluation in a long run (using the forward rate). Key features in this model are the “debt burden effect” and the “signalling effect”.

Berthold Herrendorf (University of Warwick, and CEPR) remarked that the model was quite complex and that several of the main results of the paper could well hold in a more parsimonious version. He also noted that as the paper offered many precise predictions, it would be worthwhile to test them with data. Berthold Herrendorf questioned the robustness of the results to a change in the time horizon and in particular to an infinite horizon (the model of Missale has three periods). This is an important point if we want to test empirically the model. Marcus Miller noted, although Missale and Pierpaolo’s model was developed with the Italian experience in mind, it might be useful in relation to the Asian crisis for its analysis of the interest rate as a signalling device and Manmohan Kumar added that the model yielded interesting propositions regarding the currency composition issue (i.e. local and foreign currency denominated debt). Kevin Chang thought the model could also be quite useful with regard to the convergence criteria in the European Monetary Union.

A round-table on the policy implications of financial crises then followed. The chair was Jim Rollo (Foreign and Commonwealth Office). Richard Portes opended the round-table with a talk on early warning indicators and lender-of-last-resort. Portes argued that the IMF, via its rescue packages, is creating a considerable moral hazard problem. Portes further argued that the IMF has played the role of an international lender-of-last-resort without the key supporting structures that are necessary to do so. As a result, Portes favours a market-based solution. Portes ended his talk by expressing strong doubts about the validity and usefulness of the empirical literature on early warning indicators. Philip Turner (Bank for International Settlements) spoke about risk in financial markets and the role of the public sector in that context. Turner noted that although the recent crises have lead to more quantitative analysis of risk, these studies still need improving. Pricing risk correctly is necessary if countries want to benefit from capital flows. Charles Goodhart (London School of Economics) then talked about the impact of external events on the exchange rate and also about the treatment of foreign currency debt (which has implications for IMF programs). Comparing the Asian crises with the Nineteenth century financial crises, Goodhart argues these crises had numerous factors in common. A key difference was on the external side. In the nineteenth century, the exchange rate peg, when abandoned, was believed to be only short-term, and was expected to quickly revert to its underlying anchor. This led to a virtuous circle. Credibility issues meant that this phenomenon did not occur during the Asian crisis. David Vines followed with a discussion on minimising vulnerability. To do so, Vines argued that two preconditions are necessary. Firstly, to have better kinds of financial structures in place prior to liberalisation. Secondly, to have a macroeconomic strategy that is appropriate to open international capital markets. This is not fixed exchange rates, Vines argued. He favours some form of inflation target. Finally, Vinod Aggarwal  ended the roundtable with a talk about the US as a political actor in the Asia crisis and the implications of that.Aggerwal, reflecting on past debt crises resolution, argued that the IMF itself has never been able to resolve these crises; it has always been with the backing of a strong government. A country’s government, however, reflects the economic, financial and political interests of this domestic country. As a result, a necessary precondition for improved institutional design of international institutions, is to start at home and to fully understand the respective roles that creditor governments and institutions will play.

The conference ended with a presentation by Joshua Aizenman (Dartmouth College) on “Capital Mobility and Crises in a Second Best World”. The aim of this paper is to study the welfare effects of financial integration in the presence of moral hazard. In Aizenman’s model, entrepreneurs face a trade-off between risk and return: banks may mitigate the resultant excessive risk by costly monitoring. The author shows that a drop in banks’ cost of funds increases the risk tolerated by banks. (Likewise, a less efficient intermediation technology, higher macroeconomic volatility, and a more generous deposit insurance, all raise the riskiness of projects). A key result of the model is that, with relative scarcity of funds, financial integration is welfare reducing if financial intermediation is relatively inefficient. This leads to important policy recommendations, namely that, if a country starts with a highly inefficient banking system, then a pre-condition for a beneficial financial integration is to reform and improve the banking system.

John Driffill was puzzled by the connection made with Bhagwati’s “immiserizing growth” given that the Asian economies, even if there was too much investment and it was too risky, were still growing incredibly fast. Kumar, who agreed with Aizenman’s main point, asked whether the introduction of political considerations in the process of financial liberalisation could affect the analysis. Aizenman concluded by saying that his paper questioned, in an important way, the orthodox view that the opening of financial markets is a good thing. A key practical policy implication of Aizenman’s paper is that, instead of opening financial makets, we might consider linking the inflow of capital to proper capital adequacy ratios that are contingent on the sophistication of the domestic financial system. Aizenman’s analysis is especially relevant for international financial institutions and the policy they advocate.