The Years of Emerging Market Crises: A Review of Feldstein

American Economic Association

The Years of Emerging Market Crises: A Review of FeldsteinAuthor(s): John WilliamsonSource: Journal of Economic Literature, Vol. 42, No. 3 (Sep., 2004), pp. 822-837Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/3217254 .

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Journal of Economic Literature Vol. XLII (September 2004) pp. 822-837

The Years of Emerging Market Crises: A Review oT Feldstein1

JOHN WILLIAMSON2

1. Introduction

Early 1997 was a time of great optimism in the developing world. The Mexican

crisis that had erupted in late 1994 was regarded as a hiccup that had been over- come with a V-shaped recovery (not many people knew, or, if they knew, they didn't seem to care, that Mexican wages were still some 20 percent below their pre-crisis level). The flow of capital to emerging markets was hitting new highs. The East Asian miracle was regarded as a permanent part of the scenery (see the enthusiastic report Asian Development Bank 1997), which China and even India were in the process of emulating, or bettering. Latin America had put the debt crisis behind it. Some of the transition economies had emerged from their years of purgatory, and in most of the others there seemed at least to be light at the end of the tunnel. Only Africa and perhaps the Middle East spoiled the picture of a developing world that really was developing.

This dream started to implode on July 2, 1997, when the Thai baht was set free to

float, following strong speculative pressures, and promptly lost about 17 percent of its value. The crisis was not initially assumed to be unduly serious. After all, it had an obvious cause: the Thai baht had long looked overvalued, and Thailand had been running dan- gerously large current account deficits for years.3 I recall Rudi Dornbusch returning from Thailand and reporting that Thailand's public debt was so low (it was 9.3 percent of GDP at the end of 1996) that they would have no trouble recapitalizing the financial system. And I know that when my (Thai) secretary went off for her summer vacation I told her not to worry, that it would all have been sorted out long before she got back.

I was, of course, tragically wrong. My optimism failed to allow for two factors: the dollar denomination of so much of the debt in Thailand, and the panic in financial markets as contagion took hold. The dollar denomination meant that devaluation of the baht resulted in the liabilities of many firms and banks increasing spectacularly relative to the value of their assets, so that many others besides the finance companies that were known to be a problem became insolvent. (Before long, currency mismatches had been elevated to a third theory of currency crises,

1 Martin Feldstein, ed. Economic and Financial Crises in Emerging Market Economies. Chicago: University of Chicago Press for the National Bureau of Economic Research, 2003, Pp. x, 530. ISBN 0-226-24102-2.

2 Senior Fellow, Institute for International Economics. The author is indebted to Nancy Birdsall, William Cline, Morris Goldstein, Howard Pack, and Edwin Truman for comments on a previous draft, and to Fabrizio lacobellis for competent research assistance.

3 I had forgotten the incident, but a friend reminded me that when he asked me soon after the Mexican crisis which country was next, I had named Thailand as the most likely candidate.

822



Williamson: Emerging Market Crises 823

alongside Paul Krugman's first-generation model of inconsistent fundamentals and Maurice Obstfeld's second-generation model of multiple equilibria.) The bankrupt- cies motivated many creditors to get out of Thailand while they could, and so the depreciation intensified and the economy started to collapse. Thailand sought international support from the IMF and a consortium of creditors. The Fund asked for a fairly tradi- tional program, involving fiscal deflation and high interest rates as well as financial-sector reform-specifically, closure of 58 insolvent finance companies.

The United States was conspicuous by its absence from the creditor consortium that supported the IMF operation as a result of the fact that the Congress had temporarily placed sharp restraints on Treasury use of the Exchange Stabilization Fund. This was a reprisal for Treasury's use of the fund to bail out Mexico after Congress had consciously refused to help in January 1995. Some have speculated that this was an important reason behind the fact that, within weeks, the financial panic spread from Thailand to the other market economies of Southeast Asia: Indonesia, Malaysia, and to some extent the Philippines and even Singapore (although the latter suffered no serious ill effects because its fundamentals were so strong, and in addition it had been prudent enough to retain the ability to prohibit foreign borrowing to speculate against its currency). None of these countries displayed symptoms of currency overvaluation like Thailand had, and Thailand was not big enough to produce much in the way of either trade or financial market spillovers, so the channel for this contagion has always been controversial (I discuss the issue in section 3.3). But that there was contagion is history.

Panic intensified and spread north to Hong Kong and Korea in the fall, after the IMF/World Bank annual meetings had taken place in Hong Kong. Just when East Asia (except Indonesia) had begun to recover in 1998, the Russian attempt to use a fixed

exchange rate to disinflate collapsed, and Russia went into a crisis that resulted in both a much-needed devaluation of the ruble and a default on much of its debt. That precipitated both pressure on the Brazilian real (for the first months Latin America had seemed to be immune to the East Asian crisis) and the need for a rescue of LTCM, whose near- collapse was credited by some with ending the raid that had been mounted on several of the smaller floating currencies, like the Australian and New Zealand dollars and the South African rand (Financial Stability Forum 2000). The IMF came to Brazil's rescue, but its program saved Brazil from devaluation only until early 1999. While Brazil itself resumed growth rather quickly after- wards, the effect on its neighbors was devastating, though only Ecuador had gone into crisis by October 2000 (when the NBER conference reported in the volume under review was held).

As we now know, the years of emerging market crises did not end in October 2000. Turkey soon fell victim (shortly after the conference occurred). Argentina held out for just over another year, and was soon followed by Uruguay (the clearest case of contagion, with the most obvious cause, of any of the crises). Panic hit Brazil in the middle of 2002, when it first appeared likely that Lula would be elected president, though a full-scale crisis was averted by the prudent early actions of his administration. To anyone who is prepared to bet that this series of crises has now run its course, this is a natural time to take stock.

2. The NBER Volume

The National Bureau mounted a project focused on emerging-market crises that got under way in 1998. This consisted of three components. A first element was a series of day-long meetings that dealt separately with the experience of eight of the major crisis countries. A second element consisted of two in-depth research studies dealing



824 Journal of Economic Literature, Vol. XLII (September 2004)

respectively with reducing the risk of crises and managing those crises that nonetheless occur. Each of these studies has its own conference volume based on meetings that took place in 2001. The third element is the conference reported in the volume under review here. An earlier (late-1998) conference that focused on capital controls served as background for the 2000 conference. The account of this conference on the web4 is rather good, and actually makes several of the critical analytical issues clearer than anything in the final volume.

The October 2000 conference brought together 42 participants, a mix of officials (including such illustrious names as Robert Rubin and Lawrence Summers), academics, and financial-sector heavyweights. Six or seven came from the crisis countries (depending on whether you count Argentina as a crisis country, since at the time of the conference it was still regarded as a success), though there were no officials from the East Asian crisis countries. Several of the academics who have made a name for themselves in analyzing crises (most notably Guillermo Calvo, Rudiger Dornbusch, Barry Eichengreen, Paul Krugman, and Joseph Stiglitz) were absent, either because they were not invited or did not accept (Krugman starred, however, in the earlier conference on capital controls).

The book starts with an overview by Martin Feldstein. His account is rather more sympathetic to capital controls and distinctly more critical of the IMF than mainstream U.S. opinion as reflected later in the book. In terms of crisis management, he is extremely critical of IMF actions, arguing that the Fund made a major mistake in telling the world that the problems were caused by political corruption, crony capitalism, and sick banking systems, rather than illiquidity caused by market panic. This strengthened the determination of foreign lenders and investors-who had been happy to pour

money into East Asia until mid-1997-to cut and run. Promising large loans that would only be paid out gradually-and were condi- tional on implementing structural reforms- did nothing to restore confidence. Feldstein is critical also of the fiscal and monetary restraint urged by the Fund: everyone, including the IMF, now agrees that the initial fiscal deflation was an error, but Feldstein criticizes also the higher interest rates that the Fund thought (and still thinks) were needed to limit the currency declines. Finally, he is highly critical of the breadth of structural reforms required by the Fund, many of which may have been admirable long-term structural reforms but were irrel- evant to ending the crises. Inevitably, he quotes the Fund's managing director at the time, Michel Camdessus, as saying that the crises were a blessing in disguise because they provided the Fund the opportunity to improve the countries' economic structure and governance.5 He argues that the IMF programs were so painful that they will discourage other countries from signing up until they have no option. And he suggests that, by insulting national pride in the crisis countries, they may have poisoned political relations between the West and the victims.

Feldstein's introductory overview is followed by six chapters dealing with some of the major policy issues that arose during the crises. The first of these, by Sebastian Edwards, reviews what we have learned on exchange-rate policy. What Edwards and his discussants (except Arminio Fraga) seemed to have learned was that exchange rates can either be firmly fixed by something like a currency board or else they can be allowed to float more or less freely, but that any attempt to operate an intermediate regime is doomed to failure. (Fraga wasn't cheering for intermediate regimes either, but he criticized them for a supposed lack

4 The account of the project is at www.nber.org/crisis.

5 "That may be," I recall Stanley Fischer (his deputy at the time) once observing laconically, "but if so I must say it was a very good disguise."




of transparency rather than for infeasibility.) This "bipolar view" sank without trace when the Argentinean economy imploded at the end of 2001, teaching the brutal lesson that a fixed rate can't be maintained by institutions that are supposed to guarantee credi- bility if circumstances make continued fixity sufficiently costly, and that the cost of devaluing after staking all on a fixed rate is enormous. October 2000 was in retrospect too early to have a conference reviewing the lessons from the series of crises that were still in progress at the time, given that such a major lesson had still to be learned.

One might hazard a guess that if the conference had been held after Argentina was forced to abandon its currency board, Edwards and most participants in the conference (other than Domingo Cavallo) would have argued the superiority of floating rather than the merits of the bipolar regime. The reason that pegged exchange rates get such a bad review is that abandon- ing them is so regularly associated with crisis, if only because countries typically refuse to abandon them until a crisis develops. Once abandoned, the legacy of the peg is both a devastating loss of confidence in the government and a high volume of currency mismatches, since the promise of continued maintenance of the peg had typically induced many borrowers to take cheaper dollar loans in place of local currency loans. Much of this is old hat so far as the adjustable peg is concerned (although induced currency mismatches have become more important in recent years), but Edwards clearly believes it applies to other intermediate regimes like crawling bands and even heavily managed floating. A crawling band, after all, has a margin, and a government that heavily manages its float may start de facto to defend a particular rate and thus create the same problem. That there might be an offsetting advantage of such intermediate regimes in terms of curbing misalignments is not a theme that gets articulated until the discussion session.

The second thematic chapter, by Frederick Mishkin, is on financial policies. Since so many of the crises under review (all the three principal East Asian cases plus Ecuador, Mexico, and Russia, and subse- quently Argentina, Turkey, and Uruguay) were twin crises, involving collapse of both the exchange-rate regime and the banking system, this is a topic of obvious importance. Mishkin defines a financial crisis as a situation in which financial markets are unable to channel funds efficiently to those with the most productive investment opportunities (p. 95). Well, that is often a characteristic of a financial crisis, but it is hardly a definition, for it is also a characteristic of a primitive economy, or a socialist economy, without functioning financial markets. A financial crisis happens when a functioning financial system stops functioning, whether to intermediate funds to borrowers with the most productive investment opportunities or to clear transactions or to fulfill one of the other key functions of a financial system.

Fortunately, the substance of the chapter is not dependent on his somewhat quixotic definition of a financial crisis. He outlines how financial crises develop, emphasizing the role of large inflows of short-term capital to the East Asian countries in stimulating a decline in the quality of lending, creating currency mismatches, and stimulating inflation. He diagnoses the subsequent interac- tion with a currency crisis, as a needed increase in interest rates was delayed because of fear of the impact on the financial system. He discusses how to avoid banking crises, with the emphasis on prudential supervision and its various complements like prompt corrective action and elimination of the "too big to fail" syndrome. Curiously, given his emphasis on the role of capital inflows in having laid the ground for the East Asian crises, when he comes to discuss the possible role of capital controls in crisis avoidance, he gets an attack of neoclassical religion. He cites the Graciela Kaminsky and Carmen Reinhart (1999) finding "that



826 Journal of Economic Literature, Vol. XLII (Sevtember 2004)

financial liberalization, rather than balance of payments developments inflows (sic), appear to be an important predictor of banking crises" (p. 118). And capital outflows don't force a country to devalue, because they are merely a symptom of more fundamental causes. A symptom they may be, but the fact is that a country wouldn't have to devalue if the capital outflows didn't happen. Mishkin goes on to denounce exchange controls like those "recently ... adopted in Malaysia" as like throwing the baby out with the bathwater, causing substantial distor- tions and resource misallocation, and any- way of doubtful effectiveness. Tell all that to a Malaysian!

The next chapter, by Jeffrey Frankel and Nouriel Roubini, must be the longest chapter I have ever read (115 pages). It deals with the impact of industrial country policies. The first part is about macro policies and trade, and is hardly likely to be controversial among economists, though all too likely to be ignored by politicians, for it preaches the importance of promoting growth and main- taining open trade. The bulk of the chapter, which was written before Anne Krueger pro- posed a sovereign debt restructuring mechanism be created in the IMF, deals principally with the controversy about private-sector involvement in debt restructuring. This discussion now appears dated, since collective- action clauses have been introduced into sovereign bond contracts issued by emerging-market countries. One may wonder how adequate this reform will prove to be, but for now the topic seems to have dropped off the international agenda.

There is then a chapter by Anne Krueger (written before she became first deputy managing director of the Fund) on IMF stabilization programs. The first part of the chapter lays out a straightforward account of the ingredients of a typical program, with some sketch also of the range of variation between programs. She points out more clearly than others have done the inherent problem in dealing with twin balance of

payments and banking crises: that directly contrary policy actions (at least on the monetary front) are needed to deal with the two types of crisis. The later part of the chapter looks at two particular programs during the period under review, namely those in Korea and Indonesia, with major focus on the former. Extraordinarily, this omits what most of us regard as the most interesting part of the story, the pre-Christmas agreement of 1997 in which the major commercial banks were strong-armed into rolling over for three years the loans that they had been busily liq- uidating, which essentially resolved the crisis. Indeed, she does not acknowledge that the IMF's initial agreement of December 3 had to be renegotiated two weeks later, sim- ply noting that initially it did not resolve the run on the won caused primarily by the refusal of foreign commercial banks to roll over their loans.

Krueger's chapter is followed by two of the most interesting discussant comments in the book. Stanley Fischer, then first deputy managing director of the Fund, gave a char- acteristically lucid, pragmatic defense of the Fund, acknowledging that an internal review had identified topics where they had erred (initial fiscal deflation, the handling of the Indonesian bank closures), where they thought they were right (structural conditionality, monetary policy), and where some of their clients had failed them (inadequate resolution). Jeffrey Sachs made a strong pitch for the multiple equilibria view of the East Asian crisis, arguing that the countries' vulnerability to panic had been aggravated by the IMF's demands for major structural reforms, when (as he believed) what they really needed was a 20-percent depreciation. He was also so unfashionable as to make a plea for regulatory forbearance rather than closing lots of banks in the middle of a crisis.

Chapter 5 is a detailed account of IMF structural conditionality, by my colleague Morris Goldstein. He argues that a start on structural reform was essential to restoring confidence in East Asia, and that the Fund's




Article I can be interpreted as giving it a mandate to concern itself with structural issues (although later he says that the Fund's marching orders are Janus-faced and advocates of restricting Fund conditionality to macro issues can also find a suitable text). However, he also argues that the Fund overdid it with structural conditions that were too broad and intrusive. This chapter strikes me as outstanding: highly original, dealing with an important topic in a knowl- edgeable way, and perhaps even influential, for the Fund has indeed pruned structural conditionality since then.

The last chapter is by William Cline (also a colleague of mine), who deals with the relations of the crisis countries with their creditors. Cline is convinced that receiving capital inflows is good for debtor countries: the ability of Brazil to return to capital markets only months after its 1999 devaluation is seen as signaling the success of the Brazilian program. (Some of us regard the rapid resumption of growth as a good deal more important, although it is of course true that the reason growth resumed so quickly is that the Brazilian private sector was shield- ed from capital losses because all the mismatches were taken over by the Brazilian central bank, at a cost of about 6 percent of GDP. Most economies will grow in the short run if fed by a fiscal deficit that big. The increase in public debt came back to haunt the Brazilian authorities in mid-2002.) Cline sees virtue in default hurting since only then will creditors feel secure in making substantial loans. The orchestrated rollovers in Korea and Brazil are seen as voluntary club- based collective action, in which some small players were allowed to withdraw. His prin- ciples of optimal crisis resolution include making private-sector participation as voluntary as possible. The IMF should, in his view, judge the position of a country that encounters a crisis on a spectrum from pure liquidity problem to insolvency, and use large, temporary, high-interest IMF loans in cases near the former extreme. Even in such

cases, some use of relatively voluntary private-sector participation (such as a collective agreement to maintain credit lines) may be necessary. Toward the insolvency extreme, in contrast, primary reliance will have to be on more involuntary private sector restructuring. In such cases, no set of private sector claims (such as bonds) should be automatically exempt from restructuring, and the public sector should act forcefully to orchestrate a positive-sum outcome where feasible.

As a book, the volume is not an enormous success. It does not contain a systematic account of events during the crisis, although many of the individual chapters recount events in some of the countries (an approach that is at times repetitive). Of course, by combing the other material in the project, notably all the one-day conferences on the crisis countries, one could construct a narra- tive, but that would be unreasonably unwieldy and time-consuming. The organi- zation by policy area results in some of the most interesting controversies that arose during the crises (such as the relative role of fundamentals versus market panic in igniting the crises) getting short shrift, as is indeed true of some of the policy issues that did not get a separate chapter (capital controls being the issue par excellence in this connection). It is not clear whether discussants were supposed to discuss the chapter after which they were scheduled to speak, or their own role in the crisis, for some do one and some the other (and others do something else again). And the problem of premature timing has already been mentioned. But while this may not be the definitive book on the crises, it is a source that cannot be ignored, for so many of the principal actors were present.

3. Critical Issues

Even if there is as yet no definitive treat- ment of the crisis, or crises, we cannot avoid the need for interim judgments on a number of critical issues that arose during the years




TABLE 1 WHO HAD A CRISIS IN 1997? (percent)

Indonesia Hong Kong Korea Malaysia Philippines Singapore Taiwan Thailand

Real GDP growth average 1994-96 7.9 4.6 8.0 9.7 5.0 9.2 6.5 8.0 1996 7.4 4.2 6.5 9.5 5.7 7.8 5.9 5.7 1998 -14.1 -5.1 -6.9 -7.6 -0.6 -0.9 4.5 -11.1 average 1998-2000 -2.8 2.7 4.2 2.1 2.4 4.9 5.3 -0.7

Depreciation against US$ average 1994-96 0.0 4.1 1.5 -2.1 -1.7 -4.6 0.9 0.1 mid 1996-97 4.0 0.1 9.1 0.8 0.7 1.4 0.8 1.7 mid 1997-98 180.5 -0.1 43.6 50.4 46.7 17.9 21.2 49.5 average 1998-2000 0.2 27.3 -9.3 -0.8 7.7 1.0 0.8 -2.9

Sources: World Development Indicators; Central Bank of China.

1997-2002. Those critical issues do not seem to me to be the ones used to organize the NBER volume, although the topics of those chapters are in many cases relevant to one or another of what I would identify as the critical issues. My choice of topics would be: (a) the scope of the crisis; (b) the causes of the crises; (c) the channel of contagion; (d) how to avoid future financial crises; and (e) crisis resolution. In offering answers to those questions I shall of course draw on the NBER volume, and indeed the rest of the NBER project. Like that project, I give primary attention to the crisis in East Asia rather than to the Russian or Latin crises, partly because it is so much more challeng- ing to our understanding, and partly because that is what the book focuses on.

3.1. Scope

The conventional view, embodied inter alia in the NBER volume, is that the East Asian crisis encapsulated five countries: Indonesia, Korea, Malaysia, the Philippines, and Thailand. When one looks at the first four lines of table 1, one may wonder whether these are the right five countries. If one defines an economic "crisis" analogously to the definition of a financial crisis offered above, as an interruption

to the normal functioning of an economy so serious as to interrupt its growth, then Hong Kong rather than the Philippines should be identified as the fifth crisis country. It is true that the Philippine peso depre- ciated and the Hong Kong dollar didn't (the second set of lines), but the Philippine peso was supposed to be floating before the crisis; do we really want to say that countries whose currencies float downwards are by definition in crisis? On a long-term basis the Hong Kong economy has performed vastly more impressively than that of the Philippines. It can also be argued that the stock market and real estate bubbles in Hong Kong had left its economy particular- ly vulnerable to a crisis. But in terms of which was affected most severely by the events of 1997, I submit there is no doubt that the right candidate is Hong Kong rather than the Philippines.

3.2. Causes

The NBER project recorded repeated battles between the advocates of two competing explanations of why a group of East Asian countries that had previously startled the world by their outstanding growth perform- ance entered into crisis in 1997. One theory, advocated most vociferously in the NBER




project by Nouriel Roubini (and also drawing support from the IMF and Alan Greenspan), ascribed this to weak fundamentals, in particular to a financial system undermined by the prevalence of crony capitalism. The alternative view, pushed most strongly in the NBER volume by Jeffrey Sachs and outside it by Steven Radelet and Sachs (1998) and Jason Furman and Stiglitz (1998), saw the crisis as a panic that should be described by a second-generation ("multiple equilibria") crisis model. Which was right?

Neither strikes me as a very satisfactory explanation, though I would judge the second to have more truth than the first. But it seems to me fundamentally wrong to assume that the same cause produced the crises in all five countries. Thailand was a rather simple, familiar story, not that different to the 1980s' debt crisis. A country found it easy to borrow, so it accumulated debt and allowed its exchange rate to become overvalued. The fiscal situation was not a problem, so it was the story of Chile in the 1980s' debt crisis rather than Argentina or Brazil. But that the Thai baht was overvalued and that Thailand had been borrowing too much seemed clear to some of us ex ante and has recently been confirmed in a sophisticated analysis by Jerome Stein and Guay Lim (2003). In contrast, there is no persuasive evidence that any of the other economies of Southeast Asia- not Malaysia, the Philippines, Singapore, or even Indonesia-suffered from an overvalued exchange rate or an excessive debt bur- den. Some of the many authors who have tried to investigate whether their currencies were overvalued have concluded that some were, but the countries judged to be in that situation differ between authors. Stein and Lim, whose calculations are an order of mag- nitude more convincing than the sort of PPP comparisons that form the basis of most prior estimates, found no evidence of overvaluation (or over-indebtedness). These countries were the victims of contagion. When investors found themselves facing losses in Thailand, they asked themselves

whether there were similar countries where their investments would also turn bad if other investors took the same precautionary action that they were contemplating. That was enough to start a panic.

Once currencies began depreciating, financial systems that were hardly models of prudent management in the first place started to creak, weakened primarily by the consequences of currency mismatching. The symptoms of a weak financial system that Nouriel Roubini pointed to in order to support his diagnosis of rotten fundamentals began to appear in spades, though in my view more as consequence than cause of the crisis. That is not to say that corruption had not been present before the crisis erupted, but just that a fair amount of corruption had been there for many years without preventing the remarkable progress that the region had made.6 Nor is it to say that one could not have expected faster and certainly fairer progress if more effort had been made to combat corruption sooner. It is just to argue that the diagnosis of corruption as cause of the crisis is profoundly unpersuasive.

The crisis moved on to engulf Korea and (I would say) Hong Kong in the fall of 1997. There is rather more reason to identify those difficulties with weak fundamentals than there is in the case of the Southeast Asian countries. Stein and Lim did not find evidence that the Korean won was significantly overvalued, but they did conclude that Korea was over-indebted, and in addition there is the fact that several of the largest chaebols had already gone bankrupt earlier in 1997. Stein and Lim did not study whether the Hong Kong dollar was overvalued, but a study by Ramkishen Rajan and Reza Siregar (2002) that compared Hong Kong and Singapore using Stein's NATREX model concluded that it was. There is also the point made earlier that Hong Kong had two ongoing bubbles.

6 The consequences of corruption, unlike those of a deficit, do not automatically cumulate through time.




Most economists agree that in all the other cases except Uruguay (i.e., Argentina, Brazil, Ecuador, Mexico, Russia, and Turkey) the attempt to defend a more or less fixed exchange rate that had become overvalued played a central role, as did the size of the public debt and the danger of unsustainable debt dynamics. Other details dif- fered from one case to another. Poor little Uruguay experienced a bank run when Argentineans who had put some of their sav- ings in Uruguayan banks to diversify their risks and still keep money within shouting distance of Buenos Aires began to withdraw money from their Uruguayan accounts because their Argentinean accounts had been frozen.

There is also a school of thought (although it did not get a lot of attention in the NBER study) that sees moral hazard as an important underlying cause of these crises. According to the majority report of the Meltzer Commission (which was the most prominent source for this line of thought), it was the bailout of investors in Mexican secu- rities in 1995 that encouraged investors to take an uncritical attitude to buying the paper of emerging markets and thus stimu- lated the excessive capital inflows prior to the East Asian crises. The solution is seen as stopping bailouts and leaving investors to take their losses when they make bad loans, which is relied on to instill in them the need for due diligence when making new loans or buying paper on the secondary market.

One does not need a deep econometric investigation to convince oneself that a policy of automatically bailing out bad loans would induce such moral hazard. And there is indeed a puzzle in understanding why so many European and Japanese banks ignored the risks inherent in lending to these countries, especially when these were compound- ed by borrowing yen to make dollar loans (the so-called yen carry trade). But it is a travesty to argue that past and recent policy has amounted to automatic bailouts: the 1980s debt crisis ended with the Brady Plan

with its average write-down of bank loans by about 35 percent; the East Asian crisis resulted in large losses by foreign investors (even if not by banks) that amounted at one stage to as much as $350 billion according to one estimate (Xiaoming Alan Zhang 1999, p. 3); and a series of countries (of which the most prominent were Argentina, Ecuador, and Russia) have reconstructed their debts in a way that imposed losses on their creditors. Two careful studies that have tried to examine whether the Mexican bailout stimu- lated capital flows into East Asia failed to detect an impact (Zhang 1999; Steven Kamin 2002). That is not to say that the balance between preventing moral hazard and reducing the costs of crises has been hit exactly right, but it is to question the rele- vance of moral hazard in explaining most of the crises of 1997-2002.7

3.3 The Channel of Contagion

The commonsense meaning of contagion is that B gets a disease because A had it. Similarly, in the present context country B has a crisis because A had a crisis. This con- flicts with the rather contorted definitions that have been offered by some economists-e.g., that the sensitivity of transmission between A and B increases because of the crisis, or that contagion excludes transmission via economic fundamentals (Paul Masson 1998), or that contagion deals only with immediate impacts and excludes any that operate with a lag (Kaminsky, Reinhart, and Carlos Vegh 2003).

Why should contagion occur? The most familiar channel is via trade: a recession in country A causes a recession in B because A's demand for B's exports declines. Alternatively, devaluation of A's currency decreases demand for B's exports (and increases the flow of B's imports), and so creates pressure for the devaluation of B's currency too. Another unambiguous case is

7Few people doubt that moral hazard was a factor in Russia and Ukraine.




that which impacted Uruguay as described above: inability of Argentineans to access their local bank accounts caused them to attempt to withdraw their deposits from Uruguayan banks on a scale that the latter were unable to honor.

But most of the contagion experienced during this series of crises cannot be explained so readily. One alternative channel was elegantly modeled by Calvo (1999) after the Russian crisis appeared to have initiated a run out of the Brazilian real. This worked through the financial markets: a default on Russian assets obliged leveraged investors in those assets to sell other assets in order to meet margin calls, and less-informed investors who believed that leveraged investors had inside information were induced to sell too. Contagion was therefore passed to other borrowers from the same group of creditors. Similarly, Avinash Persaud (2003) argues that the increasing use of a DEAR (daily earnings at risk) con- straint by banks leads to a positive feedback mechanism that can spread contagion among a group of their borrowers: a bad event in one country will increase the banks' estimates of potential losses in similar countries (or their correlation) and thereby induce a cutback in loans to all of them.

Marcel Fratzscher (2001) estimated that the contagion from Thailand to the other economies of Southeast Asia was partly explained by the close trade linkages among the countries of the region, but stemmed primarily from their financial linkages. However, one needs to ask whether the Thai economy is big enough to have had much impact on the net worth or risk exposure of the investors who held both Thai and Malaysian or Indonesian assets. If one enter- tains doubts about that, then one may be attracted to what Morris Goldstein (1998) called "the wake-up call" channel, in which the Thai collapse alerted investors to the possibility that other countries might have similar weaknesses in their financial systems. Alternatively, investors may suddenly

have begun to fear that other investors would make the same calculations that they decided it was prudent to perform, as out- lined above. That is my candidate for the spark that started the panic that turned a local Thai crisis into a regional crisis that ultimately laid East Asia low.

3.4 Avoiding Future Crises

As countless observers have pointed out, financial crises have occurred for as long as there has been a financial system worthy of the name. Few have drawn the conclusion from this that there is no point in trying to diminish the frequency of future crises. Indeed, it seems rather absurd that a string of such similar crises should have afflicted so many of what were previously regarded as among the best-managed economies on earth (and that includes several of the Latin American economies, where so-called "dream teams" were in charge, not just those of East Asia). The world may never completely rid itself of financial crises, but there surely do not need to be so many similar crises.

Martin Feldstein laid out a five-point agenda for avoiding future crises in his overview of the NBER volume: float the currency; maintain large foreign exchange reserves; keep short-term foreign-exchange liabilities low relative to reserves; maintain a sound banking system; and avoid a large volume of foreign-exchange denominated debt. I have a lot of sympathy with this agenda, at least if one interprets the recommendation to float as one to avoid a commitment to defend particular rates, rather than an obli- gation to avoid thinking about what rate makes long-term sense and to refrain from discouraging the market from driving rates too far away from that level. However, his list is clearly dominated by the Asian crisis: contemplation of the other crises of recent years compels recognition also of the importance of keeping the level of public debt down to what can be carried without gener- ating a fear of unsustainable debt dynamics. One should also note that his latter three




TABLE 2 FOREIGN DEBT (billions of dollars)

Country Pre-crisis Long Term Short Term Rsre Country Year Public Pnvate Total Total Reserves

Argentina 2001 71.1 31.6 102.7 20.0 14.6

Brazil 1998 98.2 108.1 206.3 29.9 43.9

Ecuador 1999 13.6 1.6 15.2 1.1 1.9

Hong Kong 1996 n.a. n.a. 23.7 14.1 63.8

Indonesia 1996 60.0 36.7 96.7 32.2 19.4

Korea 1996 25.4 23.7 49.2 66.5 34.0

Malaysia 1996 15.7 12.9 28.6 11.1 27.9

Mexico 1994 78.3 17.1 95.4 39.3 6.4

Thailand 1996 16.9 48.2 65.5 47.7 38.6

Turkey 2000 56.5 27.8 84.3 28.9 23.5

Uruguay 2002 6.9 0.5 7.4 1.6* 0.8

Notes: n.a.= not available * Excludes bank deposits held by foreigners. Source: Global Development Finance, World Bank.

recommendations describe objectives rather than policies. In the case of the recommendation to maintain a sound banking system we have substantial understanding and agreement on the prudential policies that are needed to pursue the objective. (Anyone who lacks such understanding should read Mishkin's chapter.) But in the other two cases there are substantive issues to be addressed.

The first of these concerns Feldstein's admonition to keep short-term foreign- exchange liabilities low relative to reserves. This was indeed a problem in many of the crisis countries, as table 2 shows. A government can just say no when offered the opportunity of short-term foreign borrowing on its own account, but short-term government borrowing was not a major source of vulnerability in any of the crisis countries except Mexico. Preventing or limiting short- term external borrowing by the private sector is a much more difficult proposition, for it can only be achieved by capital controls. Feldstein himself might not be afraid to

draw that conclusion, but it is not one that would have commanded a consensus at the NBER conference. (Admittedly there is an alternative way of keeping foreign-exchange liabilities low relative to reserves, which is to build up reserves enough whenever foreign- exchange liabilities increase. But since the liabilities normally bear a higher interest rate than reserves, and since the increase in reserves needs to be at least as great as the increase in liabilities to keep security con- stant, this would be an expensive solution. It really is difficult to figure what welfare func- tion is supposed to be furthered by permit- ting free capital mobility if the capital that is borrowed costs more than the yield on the marginal investment that is financed.)

One of the facts that puzzled many observers is why the countries overwhelmed by crisis should have been those that were comparatively well-governed. Maybe not the very best governed (that might be Singapore), but Hong Kong, Korea, and Malaysia, and even Indonesia and Thailand, surely had better governance than China,




Myanmar, the Philippines, Vietnam, or the countries of South Asia.8 (This fact is the basic reason for rejecting the contention that the East Asian crisis was a comeup- pance for crony capitalism rather than the result of investors changing their minds and trying to withdraw the funds they had been putting into the region.) Similarly, the Latin American countries that succumbed to crisis were those run by the "dream teams" that used to get rave write-ups in the jour- nals read by international bankers. The resolution of this paradox is not really very difficult: Countries needed some minimum level of competence in their governance in order to attract the foreign capital whose disorderly exit precipitated the crises. The obvious way to impede this process and thus prevent crises was to discourage the excessive entry of foreign capital, especially the short-term capital that can (and did) exit in a hurry, as Chile attempted to do through its uncompensated reserve requirement (the encaje, in Spanish). There is a common perception that in the mid-1990s the IMF and U.S. Treasury reinforced the pressures of Wall Street to dismantle remaining capital controls, culminating in the (never imple- mented) decision of the IMF at its 1997 annual meeting in Hong Kong to add capital-account liberalization to the purposes of the Fund. To the extent that this perception is valid, and that such pressure did in fact accelerate the premature removal of capital controls, the IMF and U.S. Treasury would have to be assigned a major part of the responsibility for precipitating the Asian crisis. In the hope of illuminating this issue, I circulated a short questionnaire to those who in 1995 had been finance minister or central bank governor of ten emerging- market countries, asking them if they had felt pressured by the IMF, World Bank,

U.S. Treasury, or Wall Street. I received six responses to my twenty questionnaires. The median response was that the IMF had advocated liberalization without exerting pressure, with the World Bank and U.S. Treasury, and even Wall Street, judged even less pressing. My own impression was that there was a fair amount of pressure, for I recall feeling very lonely when making the contrary case in the mid-1990s, but the evidence does not substantiate a charge that countries were dragooned into liberalizing against their better judgment. But whatever the mix of reasons behind the decisions for hasty capital-account liberalization, there seems to me little reason for questioning the conclusion that this was the action that created the conditions in which the crisis could occur.

Feldstein's last admonition is to avoid a large volume of foreign-currency denominated debt. This again seems sensible advice, but still poses the question as to what policy instruments should be employed to achieve it. The government again has the power to determine its own borrowing in a way that will help, and in the case of the private sector it could again use capital controls. But in this instance it also has less drastic policy instruments available. Morris Goldstein and Philip Turner (2004) advocate a series of measures, starting by the government pointing out the dangers of taking on foreign currency debt and urging firms to avoid exposing themselves to danger. Macroeconomic policies should avoid creating incentives for mismatches, while bank supervisors should strengthen prudential supervision of foreign-currency debt. The IMF should publish data on currency mismatches. What they do not suggest, but would also be feasible, is for the government to reinforce these actions by employ- ing tax policy to make it less attractive to borrow in foreign rather than domestic currency. For example, a tax surcharge could be imposed on interest income paid on claims denominated in foreign currency, or the tax

8 For example, Transparency International's Corruption Perceptions Index for 1996 ranked Singapore seventh, the five Asian crisis countries between eighteenth and 45th, and all non-crisis Asian countries other than Taiwan (29th) and Philippines (44th) worse than Indonesia (45th).




exemption on interest payments could be reduced for foreign currency debts.9

3.5 Crisis Resolution

Once again, it was the East Asian crisis that was the occasion for by far the most bit- ter battles on the question of how crises should be resolved. Did the Fund make a fundamental error in encouraging investors to regard the crisis countries as riddled with crony capitalism and needing a raft of basic reforms, as Feldstein asserted? Might a different strategy, of labeling it a panic rather than a blessing in disguise, and throwing in a lot of money quickly with minimal conditionality attached on the Mexican model, have succeeded in stemming the flight of capital and deflecting the tragedy that over- took the region? Were the high interest rates needed to limit the extent of currency over- shooting, or by worsening corporate prof- itability did they serve to undermine investor confidence further, as Stiglitz has argued? Was it an error to close banks in the middle of the crisis, as Sachs has contended?

The most important question is whether there was an alternative strategy that might have calmed market panic. The critical countries were Indonesia and Malaysia, the two other major economies to which the contagion first spread. Consider Indonesia, a country that had done spectacularly well under the long rule of Suharto from the late 1960s on. Consistent, rapid, and broad- based growth had reduced absolute ("dollar- a-day") poverty from around 60 percent to less than 15 percent, perhaps the fastest decline ever recorded in a big country. Oil income had been used to foster growth rather than dissipated in Dutch disease. At the same time, there were some major weaknesses. Corruption was rampant. President Suharto was aging, and in the absence of a vice-president there was no

process (democratic or otherwise) com- manding legitimacy to choose a successor. The banking system had massive nonper- forming loans. A small Chinese minority held much of the wealth and could be expected to seek to expatriate it if the out- look turned threatening. But these weaknesses had been around for a long time, and in the period immediately after the Thai devaluation no new threat appeared to loom on the horizon. On the contrary, the macroeconomic fundamentals looked good. The economy had grown 7.9 percent in 1996, inflation was similar and its balance of payments impact was offset by the crawling devaluation of the rupiah, the fiscal accounts were in surplus, reserves were a healthy $20 billion, and exports had grown 9.7 percent in 1996 (in comparison to a 1.3 percent fall in Thailand). The authorities prudently widened the band to +/- 6 percent in July 1997, but the market exchange rate initially stayed near the strong edge of the band. I was among those who opined (in a videoconference with the World Bank's office in Jakarta) that Indonesia should not have a problem.

All this changed overnight on August 14, after a weakening of the rupiah persuaded the central bank to let the currency float (Paul Blustein 2001, pp. 97-99). The float was applauded by most economists (there is not a hint of criticism in the NBER volume), and by the IMF. But Indonesian corporations that had borrowed unhedged dollars to get the benefit of lower interest rates suddenly found themselves threatened by an unlimit- ed increase in the cost of debt service. They had taken the widening of the band in their stride, but this was different, and prudence dictated that they try to cover their positions. The result was a rush to buy dollars, and therefore an acceleration of the depreciation. From then on it was all downhill.

This was the time at which, to avoid the Thai crisis turning regional, it would have been necessary to take a different tack. The IMF would have needed to be in sufficiently

9 Similarly, if the government wanted to discourage the public holding claims denominated in foreign currency, it could impose a tax surcharge on interest income received on claims denominated in foreign currency.




close touch with Indonesia's authorities to be able to offer a deal similar to that given to Brazil almost exactly five years later, in which Indonesia too would have been offered a loan of something like $30 billion condition- al only on the country continuing with its good policies, including in this case main- taining the crawling band for its exchange rate. That would surely have required the Fund to hold its nose and would doubtless have had some undesirable consequences, like delaying the arrival of democracy in Indonesia. But since Indonesian income is now between a quarter and a third lower than it would have been on the pre-crisis growth path (depending on exactly how this is calculated), one wonders how many Indonesians would prefer what actually hap- pened. If Malaysia had been offered a similar deal and the U.S. Congress had not impeded a proper U.S. contribution to the Thai support fund, just conceivably that would have contained the crisis.

Once the rupiah was allowed to float, the options were closed. To suggest "a la Feldstein (or Sachs) that altered IMF rhetoric would have made a dramatic difference in the depth of the crisis strikes me as a hallucination.

The issue of whether the IMF erred in urging higher interest rates on the crisis countries has never been definitively resolved in the way the fiscal issue was, where the IMF itself admitted it had made a mistake in initially pushing for a tightening (as Stan Fischer acknowledged in the NBER volume). Every textbook on international economics, including mine, says that a higher interest rate will strengthen a currency. Against that, Stiglitz (see, for example, Furman and Stiglitz 1998) made two points. First, he asked why an increase in expected yield of a mere xy, where x is the weekly interest rate and y is the number of weeks that the interest rate is expected to stay up, should have much effect on a currency's strength. Second, he argued that what inter- ests investors is not the nominal yield x but px, where p is the probability of the firm to

which they have lent being able to pay interest, and that a higher interest rate would tip some debtor firms into bankruptcy both by increasing debt service costs and by cutting growth, and thus reduce p. I think the first point does have an answer. A high interest rate strategy is not just a promise to raise interest rates for y weeks, but to hold them up until the currency stabilizes or recovers, which means that the expected yield when that strategy is announced (or when it com- mands confidence) is much more than xy. But the second argument does draw attention to a consideration that had not previously been factored into analysis, and the only satisfactory resolution of it will be empirical. Although the evidence so far is mixed, my impression is that the bulk of it is against the Stiglitz conjecture (see, for example, the first two chapters in Michael Dooley and Jeffrey Frankel 2003).

The question of whether banks should be closed in the middle of a crisis also remains in dispute. The argument in favor of closure is that allowing an insolvent institution to continue functioning invites gambling for resurrection. Herbert Baer and Daniela Klingebiel (1995) show that in five important cases they study (United States 1933, Japan 1946, Malaysia 1986, Argentina 1989, and Estonia 1992), a policy of imposing losses on creditors was rewarded by the financial system coming back to life, without precipitating a major economic decline. The important point is to make sure that there is public confidence that all the bad financial institutions have been dealt with, so that there is no reason for a new run on the banks that remain open. In the absence of that cer- tainty, the government can give a guarantee, but the danger of this is that it invites gambling for resurrection by bad banks that remain open. This was the dilemma that the Fund faced in Thailand and even more in Indonesia. The Fund has admitted that it should not have closed sixteen Indonesian banks and left the impression that this was merely a first step; the Baer/Klingebiel study




suggests that it should have been more will- ing to see depositors' assets written down to a realistic level and then allowed banks to remain open.

Then, of course, there is the issue of whether, and if so how, debts should be reconstructed. The guidelines offered by Cline that were alluded to earlier seem as sensible as any: have the IMF judge early on where the crisis lies on the spectrum from illiquidity to insolvency, and then make large, temporary, high-interest loans in cases of illiquidity while keeping any private-sector involvement as close to voluntary as possible, while in cases of insolvency accept the inevitability of debt relief by the private sector. We will need at least one more round of crises to decide whether that can be accom- plished efficiently under existing institution- al arrangements, or whether it will be necessary to give the IMF the power to decree, and also prohibit, standstills. The contention advanced above, that the IMF erred in not offering a Brazil-like deal to Indonesia to ward off the float that ignited the implosion of the Indonesian economy, suggests that there are still circumstances in which large IMF loans could play a critical role in avoiding disaster.

4. Concluding Remarks

The East Asian crisis was the most profes- sionally disconcerting event in the experience of many who had come to regard the region as something of a model that we urged other developing countries to emu- late. (Those of us in this category do not all believe industrial policy to have been the key to their success: some of us recognize that Hong Kong belongs in East Asia.) The NBER performed a signal service to the pro- fession in promptly launching a study of that crisis and the near-contemporaneous crises elsewhere.

I hope that I have persuaded readers of this article: * that the fifth East Asian crisis country was

Hong Kong rather than the Philippines; * that the Thai crisis had a rather orthodox

cause, those in Southeast Asia resulted from contagion, and exchange-rate and fiscal policy were at fault in most of the others;

* that the channel of transmission from Thailand to Southeast Asia was through the psychology of investors, who asked themselves what would happen if other investors asked themselves the same question that they suddenly started asking themselves;

* that capital controls are likely to have an important role to play in avoiding similar crises for a long time yet, and

* that the best chance of avoiding the contagion that turned the Thai crisis into a regional crisis would have involved a pre- emptive IMF move to help Indonesia avoid floating its exchange rate at the wrong time.

REFERENCES

Asian Development Bank. 1997. Emerging Asia: Changes and Challenges. Manila: Asian Development Bank.

Baer, Her ert and Daniela Klingebiel. 1995. "Systemic Risk When Depositors Bear Losses: Five Case Studies," in Banking, Financial Markets, and Systemic Risk. George Kaufman, ed. Greenwich, CT: JAI Press.

Blustein, Paul. 2001. The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF. NY: Public Affairs.

Calvo, Guillermo A. 1999. "Contagion in Emerging Markets: When Wall Street Is a Carrier," work. pap. U. Maryland.

Dooley, Michael P. and Jeffrey A. Frankel. 2003. Managing Currency Crises in Emerging Markets. Chicago: U. Chicago Press for NBER.

Financial Stability Forum. 2000. "Report of the Market Dynamics Study Group of the Working Group on Highly Leveraged Institutions," Basel: Financial Stability Forum.

Fratzscher, Marcel. 2000. "On Currency Crises and Contagion," work. paper 00-9, Institute Int. Econ. Washington.

Furman, Jason and Joseph E. Stiglitz. 1998. "Economic Crises: Evidence and Insights from East Asia," Brookings Pap. Econ. Act. 2, pp.1-114.

Goldstein, Morris. 1998. The Asian Financial Crisis: Causes, Cures, and Systemic Implications. Washington DC: Institute Int. Econ.

Goldstein, Morris and Philip Turner. 2004. Controlling Currency Mismatches in Emerging Economies.




Washington DC: Institute Int. Econ. Kamin, Steven B. 2002. "Identifying the Role of Moral

Hazard in International Financial Markets," Board Governors Fed. Reserve System, Int. Finance Discus. Paper 736.

Kaminsky, Graciela L. and Carmen M. Reinhart. 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," Amer Econ. Rev. 89:3, pp. 473-500.

Kaminsky, Graciela L.; Carmen M. Reinhart and Carlos A. Vegh. 2003. "The Unholy Trinity of Financial Contagion," J. Econ. Perspect. 17:4, pp. 51-74.

Masson, Paul. 1998. "Contagion: Monsoonal Effects, Spillovers, and Jumps between Multiple Equilibria," work. pap. IMF.

Persaud, Avinash. 2003. Liquidity Black Holes: Understanding, Quantifying and Managing Financial Liquidity Risk. London: Risk Books.

Radelet, Steven and Jeffrey D. Sachs. 1998. "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects," Brookings Papers Econ. Act. 1, pp.1-74.

Rajan, Ramkishen and Reza Siregar. 2002. "Choice of Exchange Rate Regime: Currency Board (Hong Kong) or Monitoring Band (Singapore)," Austral. Econ. Pap. 41:4, pp. 538-56.

Stein, Jerome L. and Guay C. Lim. 2003. "Asian Crises: Theory, Evidence, Warning Signals," forthcoming Singapore Econ. Rev. Invited Eminent Paper Series.

World Bank. Global Development Finance. http://www.worldbank.org/prospects/gdf2003/index. html.

. World Development Indicators. http:// www.worldbank.org/data/onlinedatabases/online databases.html.

Zhang, Xiaoming Alan. 1999. "Testing for 'Moral Hazard' in Emerging Markets Lending," Institute Int. Finance Research Pap. 99-1.



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The Years of Emerging Market Crises: A Review of Feldstein

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