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It is difficult to predict the nature
of financial crises in the 21st century, but it is quite likely that they
will incorporate features from both the more distant past and the 1990s. |
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Financial
Crises of the Future |
The damaging financial crises of the
1990s—originating in Mexico in 1994, Asia in 1997, and Russia in 1998—spread
quickly across emerging markets, prompting calls for reform of the financial
architecture. That was a decade ago, however. The only major, full-blown
emerging market crisis of this century—in Argentina in 2001—led to little
spillover, or "contagion," except in neighboring Uruguay. In recent years,
commentary in the financial press and in publications by investment banks and
rating agencies has often emphasized an apparent decline in international
contagion risk.
That is not to say that investors are
not occasionally reminded of the issue of contagion: recent episodes of
financial market turbulence include the drop in equity prices in emerging
markets in May–June 2006, the global equity sell-off that began with an
unwinding of positions on the Chinese stock market in February–March 2007, and
the most recent woes that began in mid-2007, triggered by developments in the
subprime mortgage markets in the United States.
On the whole, however, over the past few
years emerging markets have enjoyed abundant liquidity, low bond spreads, and
surges in capital inflows. Moreover, a very long-term perspective suggests
that the contagious crises of the 1990s were not the norm but an unusual
phenomenon. During the last period of financial globalization—the half century
prior to World War I—the world witnessed several crises, but essentially no
contagion. Even the most famous financial collapse of the period, the Barings
crisis that originated in Argentina in 1890, did not have much impact outside
the borders of that nation.
Will future crises look more like those
of the 1990s or of the 1890s? Was the Argentine crisis of 2001 a harbinger of
a return to self-contained crises? And if international spillovers remain
possible, are there implications for global governance in the area of
financial markets? To shed light on these questions, it is useful to analyze
the historical record.
A Tale of Two
Eras: The
1870–1913 period of financial globalization—characterized by free trade,
nearly unrestricted migration, large international capital flows, and
sophisticated financial markets—resembles, and in some respects surpasses,
globalization as we know it today. The London market for bonds issued by the
"emerging economies" of the day was large (with an overall capitalization
amounting to more than half of Britain’s GDP), liquid (with bond spreads
fluctuating considerably and reported daily in the newspapers), and supported
by timely and reliable information (with political and economic news about
emerging economies widely available in the British press). The typical
portfolio of a British investor around the turn of the 20th century was
probably more internationally diversified, and included a far larger share of
emerging market securities, than that of his great-grandchild living at the
beginning of the 21st century.
This global integration came to an
abrupt end with the outbreak of World War I and the subsequent upheaval of the
Great Depression and World War II. International financial flows resumed in
the 1970s, but only in the final years of the 20th century did financial
globalization achieve a level and a form reminiscent of the pre-1914 period.
In particular, reliance on tradable emerging market bonds was jump-started by
the Brady deals of the early 1990s, which repackaged the defaulted bank debt
of the 1970s and early 1980s into bonds.
Despite these similarities in scale and
reliance on bond finance, a striking difference between the 1870–1913 era and
the 1990s relates to the extent that asset prices—specifically, sovereign bond
spreads—moved together. Sovereign bond spreads are defined, for the historical
period, as the yields on emerging market countries’ bonds issued in pounds
sterling on the London Stock Exchange, minus yields on British consols; and,
for the modern period, as the yields on emerging market countries’ bonds
issued in U.S. dollars, minus yields on long-term U.S. treasury bonds. Whereas
bond spreads followed country-specific trajectories during the pre-1914 era,
emerging market bond spreads tended to move in tandem to a much greater extent
in the 1990s. The message is similar when one focuses on comovement in times
of crisis: sharp increases in sovereign bond spreads (of, say, more than 200
basis points) often took place simultaneously in several emerging markets in
the 1990s, but they were typically restricted to one country in the pre-1914
period.
Changing
influences on asset prices:
What explains the observed
differences in the extent of co-movement of asset prices between the two
periods? The evidence (based on event studies and econometric analysis of data
on asset prices, macroeconomic variables, and contemporary newspaper articles)
shows that the determinants of asset prices were different. Bond spreads a
century ago were driven primarily by country-specific events such as droughts,
rebellions, wars, other changes in the political climate, and economic
fundamentals. In particular, episodes of politically motivated violence had
the most visible impact on bond spreads. By contrast, in the 1990s,
country-specific macroeconomic data and events, while still relevant, had more
limited power in explaining individual-country bond spreads, with developments
in the overall emerging market indices (and, especially, contagious emerging
market crises) playing a greater role.
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Changes in investor behavior and
the way in which international investment is organized and undertaken
also contribute to greater comovement of asset prices in modern times. |
To some extent, the greater degree of
comovement of emerging market bond spreads in modern times than in the past is
explained by greater similarity in the economic structures of emerging market
economies today. Before World War I, these economies tended to be very
specialized (for example, Argentina produced wheat and wool and Brazil
produced coffee and rubber). Now, they are better diversified and, as a
result, engage in more similar economic activities, so that their economic
fundamentals tend to move together to a greater extent than they did a century
ago. Nevertheless, the increased similarity in the economies of today’s
emerging markets cannot fully account for the rise in asset price co-movement
and shared crises.
Changes in investor behavior and the way
in which international investment is organized and undertaken also contribute
to greater comovement of asset prices in modern times. During the 1990s,
losses incurred at the outset of a crisis in a given country induced large
investment funds (including mutual funds and hedge funds) to sell assets in
(initially) unaffected countries to maintain certain liquidity and risk
profiles. For example, when open-end mutual funds foresaw future redemptions
after a shock in one country, they raised cash by selling assets they held in
other countries. Similarly, leveraged investors, such as banks and especially
hedge funds, faced regulatory requirements, internal provisioning practices,
or margin calls that led them to rebalance their portfolios by selling their
asset holdings in countries that were initially unscathed. By contrast,
investors in the past operated primarily as individuals at a time when trading
technologies were also slower. In times of impending crisis, investors may
have responded to trouble in one emerging market by buying assets in another,
thus shifting assets rather than selling them en masse.
The Strange Case
of Argentina: Why
was there a near absence of contagion in the case of the Argentine crisis of
late 2001 (only Uruguay was affected, mainly because of withdrawals by
Argentines who had deposits in its banking system)? Here too investor behavior
is the key. Whereas the crises of the 1990s took many investors by surprise,
the Argentine crisis was widely expected and market players had ample
opportunities to adjust their exposure. Data on international mutual funds
reveal a major decline in Argentine holdings throughout 2001. By the time the
Argentine currency board collapsed in December, such holdings were extremely
low. At a more technical level, a timely reduction of Argentina’s weight in
the Emerging Markets Bond Index tracked by many market participants may have
facilitated an orderly shift of investment positions out of Argentina into
other emerging markets.
Although there
are some who argue that the 2001 Argentine crisis indicates that contagion may
have permanently "vanished," the anticipated nature of this crisis casts doubt
on that view. On the contrary, the generalized surge of capital inflows into
emerging markets observed in recent years is consistent with the view that in
some cases investors fail to discriminate sufficiently among emerging markets,
based on fundamentals.
Trouble in the
Core and on the Periphery:
An additional factor determining
whether contagion occurs has to do with whether financial market players in
the "core" advanced countries are adversely affected by developments in the
country in which a crisis originates. Indeed, in many of the best-known
contagious emerging market crises, advanced-country financial institutions
played a role in transmitting the initial shock to countries on the
"periphery." For example, losses incurred by advanced-country banks and other
financial institutions were an important transmission channel of contagion
during the Asian crisis.
The debacle of
Long-Term Capital Management was a key factor in the spread of the Russian
crisis of August 1998 to other emerging market economies. And the most recent
woes that began with developments in the subprime market in the United States
caused concern, though not a full-blown crisis, in a number of emerging
markets. In fact, prompt liquidity provision by the central banks of the main
advanced countries—while obviously aimed squarely at restoring confidence
domestically—may also have reduced the likelihood of contagion to the emerging
markets. The importance of liquidity provision by central banks in the core
financial markets has not changed much since the previous era of financial
globalization. Prompt action by the Bank of England is often credited with
averting international contagion that might otherwise have emanated from the
collapse of the investment house of Barings in 1890.
The Future of
Contagion: The
likelihood of contagious financial crises and high co-movement across global
financial markets in the future is reinforced by the entry and increased
importance of new financial instruments and new players on international
financial markets:
Hedge funds
have grown tremendously in recent years and manage assets in excess of $1
trillion. As seen in the 1990s and in the recent crisis in subprime mortgages,
hedge funds’ operations have often added to asset price comovement. Some
commentators, however, have suggested that hedge funds may also occasionally
mitigate the severity of financial crises by trading "against" the market when
prices fall too low for investors with lower risk appetite.
Private equity funds
affect comovement and the nature of financial crises, but how they do so is
less clear. Private equity funds are typically long-term investors, so their
presence might mitigate crises and contribute to stability. But were they to
unwind a large position suddenly, the opposite would occur. Moreover, private
equity funds occasionally have shorter investment horizons, which lead them to
invest in fashionable sectors in several countries at the same time,
contributing to comovement across countries.
Sovereign wealth funds
are sparking new interest, although they have been investing sovereign
nations’ international reserves for years. The sudden interest has been
kindled by various factors: these funds have grown rapidly in the past decade,
attaining a vast scale; they have acquired large stakes in both emerging
market and advanced country corporations and financial institutions,
occasionally raising concerns about the perceived strategic importance of the
target companies; and several of them do not make their investments public. By
some estimates, sovereign funds manage assets well in excess of $1½ trillion,
with most of this amount accounted for by a handful of such funds. Although
most have used conservative and long-term investment strategies, in principle
they could play a destabilizing role if they reversed a position abruptly,
particularly one in a small emerging market country.
Beyond the emergence of new players, new
investment vehicles for individual investors also have the potential to
increase asset price comovement across countries. For example, the rise and
growing popularity of index-based investing—through index mutual funds and,
more recently, exchange-traded funds—leads to investment in aggregate country
or regional indices rather than in individual securities (or countries).
Exchange-traded funds are open-end mutual funds that typically seek to
replicate a well-established market index. Flows into and out of them may
cause all underlying securities to move together, with limited regard for
country-specific information. On the other hand, the introduction of new
financial instruments, such as exchange-traded funds, may help investors
diversify their portfolios and increase market liquidity, contributing to
investors’ willingness to invest in individual stocks and bonds. The growth in
cross-border banking has no doubt also played a role in increasing the
potential for international transmission of financial and other shocks.
Prepare for the
Future: It is
difficult to predict the nature of financial crises in the 21st century, but
it is quite likely that they will incorporate features from both the more
distant past and the 1990s. Financial crises in the pre–World War I era
occurred against the background of macroeconomic difficulties, but were
typically triggered by such events as wars or other episodes of politically
motivated violence, reflecting institutional deficiencies and political
instability. Macroeconomic policies have improved in many emerging markets.
But, in some, institutional weaknesses remain, so future crises may well also
be triggered by political upheaval. And today’s greater financial
linkages—including those generated by the activities of new players—may lead
to the rapid transmission of crises to other countries, much as happened in
the 1990s.
A prudent working assumption, then,
would be that contagion is likely to reemerge, suggesting the need to be
prepared at both the domestic and the international level. At the domestic
level, many countries have taken steps—including improved macroeconomic
policies and debt management—aimed at reducing their vulnerability and at
softening the blow in the event of a crisis. At the international level, to
the extent that market failures and externalities require global governance
and coordination, the debate has focused on the possible role of international
financial or other supranational institutions, for example, in establishing
mechanisms committed to providing liquidity in a crisis. Regional groups of
countries have arranged to pool their international reserves to provide a
backstop in case of a crisis.
Beyond increased stockpiles of official
sector liquidity—whether through self-insurance in the form of international
reserves, or international arrangements among countries or with international
institutions—are there additional implications for global governance in the
area of international financial flows? The debate is likely to concentrate on
whether the official sector should increase its scrutiny of private financial
market players. Although some observers have suggested forms of regulation of
international financial flows, attention will probably be focused on the
possible need for additional transparency and data provision, and refinements
to existing prudential regulations. This will include a discussion of whether
gaps were uncovered by the recent turmoil originating in the subprime market.
The implications of newly important
players, such as hedge funds, private equity funds, and sovereign wealth
funds, are not yet fully understood, and reasonable arguments can be made for
whether—on a net basis—each of these players is likely to foster stability or
volatility. Regardless, it is not difficult to imagine scenarios in which
these players would be a source of volatility and contagion; a careful
discussion of how to avoid such scenarios seems warranted. In particular, the
policy debate is likely to concentrate on whether these players should provide
additional information about their strategies and investments (that is,
greater transparency), and on the possibility that new (voluntary) codes of
conduct will be conceived for these new players. Progress in these areas will
require identifying exactly what information is needed to permit effective
prudential regulation and to facilitate informed decisions by investors
without unnecessarily hampering the operation of the financial system.
What seems clear is that both advanced
and emerging market countries will pay close attention to this debate.
Traditionally, the importance of good governance and transparency has been
emphasized with regard to avoiding hidden liabilities, and related
vulnerabilities, in crisis-prone emerging markets. The focus on transparency
in emerging markets has shifted to the asset side, with frequent calls for
greater transparency in the operations of emerging market sovereign wealth
funds. However, the financial turmoil that began during the summer of 2007 has
shined the spotlight on issues related to transparency of advanced-country
financial institutions and the importance of preserving stability in the core
financial markets—not only for the well-being of domestic investors, but also
to avoid harmful international contagion. The debate on these issues is likely
to become more prominent still in the years ahead. |
