|
European
Economic Perspectives 21
From
Russia with Love
Just as in the 1890s, the question of how to
predict the financial collapse of nations is high on the international
agenda. New CEPR research explores some lessons from a century ago.
The
Asian crisis and its aftermath once again illustrate the perils of
international finance. But while the policy implications of the crisis,
in particular the future role of multilateral agencies like the IMF,
remain far from obvious, a number of private bodies are taking action to
minimize their exposure to currency risk. For example, several
investment banks, including Credit Suisse First Boston, JP Morgan and
Lehman Brothers have developed models that seek to predict currency
crashes.
From
the point of view of policy, it is essential to understand the logic of
this research agenda. The potential emergence of a private standard of
risk perception must influence future IMF interventions since if all
market participants believe that, say, a low level of reserves signals
an impending crisis, they will liquidate their positions, thus provoking
the crisis. The multilateral agencies are in turn bound to factor in the
effects of market opinions, whatever they think of the actual severity
of the situation. Alternatively, they may want to propose a different
standard. At the very least, it is vital for them to understand what
forces shape market sentiment.
Macroeconomists
have surprisingly little to say on this issue, although a growing body
of literature addresses the related question of what explains the grades
given by rating agencies. From a theoretical perspective, there are only
models of ‘perfect foresight’ where everything is correctly
forecast, or of ‘bubbles’ where everything is self-fulfilling. From
an empirical perspective, there is the problem of disentangling market
opinion from the actions of the multilateral agencies. For example, the
expectation of bailouts by public bodies may make investors complacent,
reducing their awareness of risk and so distorting their incentives to
acquire information and process it in original ways.
To
study the market mechanism ‘in the wild’, it is worth examining the
pre-1914 period when bailouts were not, as a rule, to be expected. In a
recent CEPR Discussion Paper, Marc Flandreau focuses on the experience
of Crédit Lyonnais, then a standard of prudence and planning.
Lyonnais
was one of the largest international banks of the time, in a country
that was second only to Britain as the largest global creditor. The
bank’s management was obsessive about limiting exposure to market risk
while at the same time assuming a leading role in syndicated loans. So
it became very concerned to provide finance only to those countries that
it judged sound and, given its pre-eminence in European finance,
Lyonnais opinion became extremely important in influencing the market
mechanism. Each financial crisis brought a new wave of caution and
analysis, to a point in the 1890s where its research department - 100
members strong at the turn of the century - produced a sovereign debt
crisis indicator.
The
development of the Lyonnais indicator was a direct consequence of the
collapse of Barings in 1890 as a result of excessive exposure to
Argentine debt. As the crisis spread through contagion reminiscent of
today’s turmoil, Lyonnais began to construct a precise measure of debt
sustainability. Its database sought to distinguish unproductive from
productive borrowing, as well as measuring the efficiency of past
borrowing. This led the bank to estimate the value of government assets
- which could be very large since a number of governments, notably in
continental Europe, were involved in infrastructure development and
heavy industry such as railroads and mines - in order to discount this
item from public indebtedness.
The
estimates was then applied to past data, and the Lyonnais economists
found that problems had only ever occurred in countries where the ratio
of interest service (net of revenues from state-owned infrastructure) to
total government revenue exceeded 40%. The ratio in Argentina, for
example, had exceeded 50% when it collapsed in 1890.
This
measure was then combined with other indices to serve as the basis of a
formal ‘rating’. There were three categories: first, ‘sound
countries’; second, intermediate countries, a group that included
Britain because of its high debt though it was treated as a ‘blue
chip’ country; and third, bankrupt countries, such as Brazil and
Argentina.
Interestingly,
the measure was responsible for an indicator that designated Russia as
‘safe’. Because most loans to the Russian government were used for
industrial investments and because those investments provided a revenue,
Russia’s ‘indebtedness’ remained moderate in the eyes of the
Lyonnais economists. This in turn led the French to invest massively
into Russia with what, of course, turned out to be disastrous
consequences.
Several
lessons can be drawn. First and foremost, this episode indicates how
late nineteenth century investors reacted to the absence of official
data, formal ratings and international bailouts. A second lesson is the
considerable importance of investors’ perceptions in shaping the
market mechanism itself. In particular, the markets’ preference for
investment finance - as opposed to consumption finance - proved decisive
in comparing sovereign risks.
Third,
and somewhat discouragingly, the experience underlines the problems of
basing predictions on past history. Regardless of Lyonnais’ caution in
trying to avoid a recurrence of the Argentine problem, it entirely
missed a different kind of problem. What went wrong with Russia was not
the result of unproductive use of foreign resources. Instead, it came
when a new regime, aiming for autarky, decided to renege on its foreign
commitments, while retaining the plants, mines and railroads for which
foreign capital had paid.
The
last lesson concerns the economics of financial opinion. The Lyonnais
view of the world was not an individual voice in a broad market of
opinions: it was the voice of an international institution. So while the
bank’s desire to retain credibility certainly encouraged it to do its
homework, this probably led other banks to pay far less attention to
risk. And the absence of other serious competing opinion - at least in
France - probably induced other banks to join Lyonnais-led syndicates
without due caution. But finance is a game where you make money not
because you are right but because your view becomes the market view: the
externalities of being a market leader cannot be ignored.
These
conclusions may help to shed some light on current developments and
suggest a few policy implications. First, the aggressive move that
today’s investment banks have taken towards research on emerging
market risk seems to provide evidence that contrary to a popular view,
bailouts are not systematically expected by the market - otherwise, why
should they pay so much attention? In a sense, Credit Suisse First
Boston, Lehman Brothers and JP Morgan are just doing what Crédit
Lyonnais did one century ago - and for the same reasons.
Second,
yesterday as today, there is the striking influence of past collapses on
the design of current indicators. The Lyonnais method was a formidable
tool to track Argentine-like crises but was totally powerless in
alerting investors to the risks of Russian default. This problem is
still a serious challenge for today’s ‘data miners’, whose
predictors are based on past data.
Third,
the Lyonnais tale should warn multilateral agencies against the dangers
of relying on market sentiment as represented by private indicators when
designing their policies. Because opinion is a public good as much as
anything else, private endeavours to define a standard of risk are open
to manipulations and should thus be taken with a grain of salt.
This
article reviews research reported in ‘Caveat
Emptor: Coping with Country Risk without the Multilaterals’ by
Marc Flandreau, CEPR
Discussion Paper No. 2004 (October 1998). Flandreau is at OFCE
and CNRS in Paris, and a Research Affiliate in CEPR’s International
Macroeconomics programme.
|