Managing Financial Crises : Recent Experience and Lessons for Latin America

G. Kincaid, and Charles Collyns

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2003
• eBook ISBN: 9781589062085

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Contents

Foreword

Preface

Abbreviations

I Overview

Charles Collyns and G. Russell Kincaid

The Argentine Context

Contagion and the Macroeconomic Implications of Regime Change

Reestablishing a Credible Nominal Anchor

Dealing with Banking Systems Under Pressure

Fiscal Policy and Economic Crisis

Debt Restructuring

References

II Assessing Crisis Vulnerabilities in Latin America

Javier Hamann, Kalpana Kochhar, Timothy Lane, Guy Meredith, Jürgen Odenius, David Ordoobadi, Hélène Poirson, and David Robinson

Elements of Vulnerability to Crises

Balance Sheet Fragilities

Early Warning Systems

Crisis Cost Models

Policy Paralysis

Economic Constraints

Political Factors

Contagion

Channels of Contagion

Policy Spillovers

Concluding Remarks

Appendix 2.1. Assessing the Scope for Emerging Market Contagion

References

III Macroeconomic Consequences of a Financial Crisis

Kalpana Kochhar, Timothy Lane, and Miguel Savastano

Crisis Experience in the 1990s

Growth and Current Account Adjustment

Exchange Rate Depreciation and Inflation Pass-Through

The Tablita Episodes

Implications for Argentina

Mitigating Factors

Aggravating Factors

References

IV Reestablishing a Credible Nominal Anchor After a Financial Crisis

Andrew Berg, Sean Hagan, Christopher Jarvis, Bernhard Steinki, Mark Stone, and Alessandro Zanello

Prerequisites for a Credible Nominal Anchor

Experience with Post-Crisis Exchange Rate Regimes

The Stance of Monetary Policy in a Post-Crisis Float

The Framework for Monetary Policy in a Floating Regime

Institutional Reforms to Promote Monetary Policy Credibility

Concluding Remarks

Appendix 4.1. Frameworks of Monetary Policy in Crisis Countries

Appendix 4.2. Institutional Reform for Monetary Policy Credibility in Selected Crisis Cases

References

V Dealing with Banking Crises in Dollarized Economies

Anne-Marie Gulde, David Hoelscher, Alain Ize, Alfredo Leone, David Marston, and Marina Moretti

Addressing Bank Runs in a Dollarized Economy

Background and General Policies to Stop Bank Runs

Bank Runs in Highly Dollarized Economies

Crisis Resolution and Reintermediation Under Dollarization

Reversing the Causes of the Crisis

Unwinding Emergency and Administrative Measures

Adapting Bank Restructuring and Prudential Arrangements

Reviewing the Role of Foreign Banks

Asset Reintermediation

Concluding Remarks

Reference

VI Public Debt Dynamics and Fiscal Adjustment

Richard Hemming and Teresa Ter-Minassian

Debt Sustainability

The IMF’s New Debt Sustainability Framework

Priorities for Future Work

Fiscal Adjustment in Crisis Countries

Why Fiscal Adjustment?

Fiscal Adjustment Experience

The Demand Impact of Fiscal Tightening

The Quality of Fiscal Adjustment

Institutional Reforms

Fiscal Policy Formulation and Implementation

Intergovernmental Fiscal Relations

Debt Management

Concluding Remarks

Appendix 6.1. The Output Gap and Fiscal Policy: A Case Study of Argentina

References

VII Corporate Debt Restructuring in the Wake of Economic Crisis

Sean Hagan, Eliot Kalter, and Rhoda Weeks-Brown

Linkages Across Sectors and Burden Sharing

The Framework for Corporate Restructuring

Alternative Approaches to Corporate Restructuring

Classification of Corporates

Workout Mechanisms

Legal and Regulatory Systems and the Institutional Infrastructure

International Experience

The Direct-Government, Across-the-Board Approach

The Market-Based, Case-by-Case Approach

The Hybrid Approach

Implications of the International Experience for Latin American Countries

Concluding Remarks

Appendix 7.1. Summary of Key Issues in Designing Orderly and Effective Corporate Insolvency Procedures

References

VIII Applying the Prague Framework in Crisis Resolution

Cheng Hoon Lim and Carlos Medeiros

Complementing the Catalytic Approach

Debt Restructuring

Objectives of Debt Restructuring

Road Map to Debt Restructuring

What Next?

Collective Action Clauses

Sovereign Debt Restructuring Mechanism

Concluding Remarks

References

Task Force Members

Boxes

2.1. Standard Models of External Crises

2.2. Models of Ratings, Spreads, and Crisis Costs

5.1. Currency Reform to End Partial Dollarization

5.2. Bank Runs in Dollarized Economies: Lessons from Experience

6.1. Tax and Expenditure Policies in Crisis Countries

6.2. Social Safety Nets

6.3. Fiscal Policy Formulation and Implementation

6.4. Intergovernmental Fiscal Relations

6.5. Debt Management

8.1. The IMF’s Policy of Lending into Sovereign Arrears

Tables

2.1. Selected Asian Countries: Key Vulnerability Indicators Based on Country (Credit Risk) Models

2.2. Selected Latin American Countries: Key Vulnerability Indicators Based on Country (Credit Risk) Models

2.3. Sovereign Debt Issuance, 1998–2002

2.4. Latin America: Foreign Banks’ Share of the Top Ten Banks’ Assets

2.5. Selected Asian Countries: Change in Export Volume Growth versus Different Measures of Competitiveness

2.6. Selected Latin American Countries: Change in Export Volume Growth versus Different Measures of Competitiveness

2.7. Selected Asian and Latin American Countries: Trade Shares

2.8. Selected Emerging Markets: BIS Lending and Common Creditor Index

3.1. Real GDP Growth

3.2. Contributions to Real GDP Growth

3.3. Current Account Adjustment

3.4. Pass-Through from Exchange Rates to Prices

3.5. GDP Growth in Tablita Episodes

3.6. Pass-Through Coefficients in Tablita Episodes

3.7. Forced Conversions of U.S. Dollar Deposits and Bank Intermediation

4.1. Crisis Countries: Indicators of Recovery and Stabilization

4.2. Monetary Policy Frameworks in Crisis Countries

5.1. Country Experiences with Bank Runs

6.1. Overall Balances, Primary Balances, and Public Debt

6.2. Changes in Primary Balances

6.3. Argentina: Measures of the Output Gap, 2002

6.4. Argentina: Fiscal Policy Indicators, 1996–2002

6.5. Argentina: Sensitivity of Fiscal Policy Indicators, 2002

7.1. Corporate and Household Distress-Resolution Schemes: Main Features

7.2. Corporate and Household Debt Resolution: Key Features

8.1. Use of Voluntary and Intermediate Tools in Crisis Prevention and Resolution

8.2. Recent Cases of Debt Restructuring

Figures

2.1. Common Creditor Index versus Ratio of Foreign Reserves to Short-Term Debt, 2001

2.2. Trade Competition Index versus Current Account, 2001

2.3. Dollarization in Selected Emerging Markets, End–2001

3.1. Real Effective Exchange Rate (REER) Depreciation and Pickup in Exports

4.1. Putting Together the Package

4.2. Floaters and Fixers

4.3. Short-Term Dynamics of Monetary Policy

6.1. Debt Sustainability Analysis

6.2. Primary Balances, Growth, and Interest Rates

6.3. Argentina: Potential Output and Output Gap

6.4. Argentina: Output Gap According to Okun’s Law

6.5. Argentina: Fiscal Impulse and Discretionary Fiscal Policy, 1996–2002

The following symbols have been used throughout this paper:

… to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist;

– between years or months (e.g., 2000–01 or January–June) to indicate the years or months covered, including the beginning and ending years or months;

/ between years (e.g., 2000/01) to indicate a fiscal (financial) year.

“Billion” means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

The term “country,” as used in this paper, does not in all cases refer to a territorial entity that is a state as understood by international law and practice; the term also covers some territorial entities that are not states, but for which statistical data are maintained and provided internationally on a separate and independent basis.

Balance Sheet Fragilities

A key element in most previous financial crises was the vulnerability of balance sheets in the public sector, banks, or corporations. In some instances (such as Mexico and Korea), there were inadequate cushions of liquidity in relation to short-term debt or foreign currency deposits. In other cases, the structure of public and/or private debt made these debts susceptible to interest rate and/or exchange rate movements (Brazil, Turkey). A particularly salient factor in many crises was the prevalence of un-hedged foreign currency borrowing by corporations (Indonesia, Korea), banks (Mexico), or government (Brazil, Russia). Maturity mismatches in the public or private sector (Thailand, Korea) made these balance sheets susceptible to the large changes in domestic interest rates that frequently characterize a crisis. Preexisting nonperforming loans (Korea, Thailand) were an important factor in some cases. Often the full magnitude of these problem loans did not become apparent until the crisis broke, and revelations further contributed to the downturn of market sentiment. In some cases (notably Russia), off-balance-sheet operations of the banking sector were also a source of vulnerability.

In many crises, a perceived lack of medium-term sustainability was critical. In some cases—Brazil, Russia, Turkey, Argentina—concerns were primarily over the public finances. In others—notably Thailand—it was private sector behavior that was most important in generating an unsustainable overall balance of payments. Table 2.1 highlights some elements of financial vulnerability in selected Asian countries just before the Asian crisis. Table 2.2 shows how this picture looked in Latin America at the end of 2001. In particular, the ratio of reserves to short-term debt was very low in Argentina, Brazil, and Uruguay, relative to the comparator sample.

Table 2.1. Selected Asian Countries: Key Vulnerability Indicators Based on Country (Credit Risk) Models

(In percent unless otherwise noted)

Sources: IMF, International Financial Statistics (IFS), World Economic Outlook, and IMF staff estimates; World Bank, Global Development Finance (GDF); and Bank for International Settlements (BIS).

¹ A sample of 41 countries was chosen as comparators for the Latin American countries. In light of the diversity within the Latin American group, the comparator group also included most important emerging markets as well as Hong Kong SAR, Hungary, Iceland, Ireland, Israel, India, Indonesia, Jordan, Korea, Lebanon, Malaysia, Mexico, New Zealand, Pakistan, Peru, Philippines, Poland, Portugal, Russia, Singapore, Slovak Republic, South Africa, Sweden, Thailand, Turkey, Uruguay, and Venezuela.

² By remaining maturity.

³ From GDF (only available for developing countries).

⁴ From BIS (refers to loans from banks and debt securities issued abroad; since credits from official sources are not included, these data tend to under-state the indebtedness of developing countries especially).

Table 2.2. Selected Latin American Countries: Key Vulnerability Indicators Based on Country (Credit Risk) Models

(In percent unless otherwise noted)

Sources: IMF, International Financial Statistics (IFS), World Economic Outlook, and IMF staff estimates; World Bank, Global Development Finance (GDF); and Bank for International Settlements (BIS).

¹ A sample of 41 countries was chosen as comparators for the Latin American countries. In light of the diversity within the Latin American group, the comparator group also included most important emerging markets as well as Hong Kong SAR, Hungary, Iceland, Ireland, Israel, India, Indonesia, Jordan, Korea, Lebanon, Malaysia, Mexico, New Zealand, Pakistan, Peru, Philippines, Poland, Portugal, Russia, Singapore, Slovak Republic, South Africa, Sweden, Thailand, Turkey, Uruguay, and Venezuela.

² By remaining maturity.

³ From GDF (only available for developing countries).

⁴ From BIS (refers to loans from banks and debt securities issued abroad; since credits from official sources are not included, these data tend to under-state the indebtedness of developing countries especially).

Given the importance of these balance sheet weaknesses in determining overall vulnerability, a number of systematic approaches have been developed to examine these weaknesses and their relationship to the incidence of crises. In particular, balance sheet weaknesses are a prominent aspect of early warning and country risk models. These models and their implications for Latin America are briefly reviewed below.²

Early Warning Systems

Early warning system (EWS) models, as well as models of country (credit) risk and so-called crisis cost models, provide a formal framework for examining vulnerability to crisis. EWS models focus on ascertaining the probability of a currency crisis, whereas models of country (credit) risk capture the likelihood of an external debt or funding crisis. Crisis cost models predict the likely impact of a crisis on output and growth, if it were to occur.

The different models have consistently highlighted a few key indicators of vulnerability. EWS models emphasize several external indicators: competitiveness (size of the current account deficit and exchange rate overvaluation); debt burden (external debt as a ratio to GDP or to exports, and default history); growth prospects (export growth, GDP growth, and investment); liquidity (the ratio of short-term debt to reserves, as well as import cover and the ratio of reserves to broad money)³ and financing requirements (Box 2.1). Most EWS models also identify domestic credit conditions as a financial indicator of vulnerability. Some EWS models (such as the Credit Suisse First Boston [CSFB] regional Latin America model) and most spreads and ratings models also highlight the budget deficit as a critical fiscal indicator (Box 2.2). More recently, some EWS models have highlighted corporate sector weaknesses as relevant warning signals of crisis. The main vulnerability areas according to these models are financial leverage (debt-to-equity ratios),⁴ liquidity (short-term debt over working capital), and corporate governance (proxied by a shareholder-rights index).

Box 2.1. Standard Models of External Crises

In first-generation models, the underlying causes of crisis are fundamental macroeconomic problems, although the proximate triggers of the crisis may be contagion effects or imprudently low levels of foreign exchange reserves. Fundamental causes of crisis include traditional macroeconomic imbalances such as unsustainable current account deficits, overvalued exchange rates, unsustainable fiscal positions, or excessive rates of credit expansion.¹

Second-generation models, in contrast, analyze crises as essentially avoidable financial panics—self-fulfilling attacks against otherwise viable economies. The models are characterized by multiple equilibria, where sudden shifts in market expectations and confidence can lead to collapse. Countries with low liquidity ratios are more vulnerable to such self-fulfilling panic. Another factor contributing to vulnerability is policymakers’ trade-offs between conflicting objectives, such as employment and exchange rate stability. Investors’ bets that the authorities will compromise on the latter rather than the former become self-fulfilling as an attack is launched on the currency.²

Interestingly, a number of second-generation models imply that a country is vulnerable to a self-fulfilling attack only over a range of values for the economic fundamentals. Hence, even in this approach, only countries with weak fundamentals will be vulnerable to panic.³ Although this blurs somewhat the mapping between variables and models, first-and second-generation models clearly have different empirical implications: in the first-generation approach, the probability of a crisis increases steadily in the run-up to a crisis, whereas second-generation models do not imply any particular trend in the probability of crisis prior to the crisis itself.

The Asian crisis seemed to tilt the consensus toward the second-generation models as more representative of recent crises. However, this was not unanimous, and third-generation models emerged in the post-crisis literature. These models acknowledged that second-generation models captured some aspects of the Asian crisis (notably the existence of multiple equilibria) but noted that other factors were also at play— namely, corporate and financial weaknesses.⁴ These models highlighted the flawed incentive structures under which the corporate and financial sectors operated in the Asian crises countries. These structures were characterized by regulatory inadequacy and close links between public and private institutions— including a long tradition of public guarantees to private sector projects—which caused an overreliance of firms on debt and foreign financing. Excessive foreign borrowing was also encouraged by exchange rate policies aimed at stabilizing the value of the domestic currency in terms of the U.S. dollar (thus lowering the risk premium on dollar-denominated debt) and international banks’ apparent neglect of the standards for sound risk assessment. Excessive risk taking and over-investment were reflected in persistent current account deficits and a highly vulnerable corporate financing structure.

More recently, a micro-based branch of this literature has examined the microeconomic and institutional factors underlying the corporate sector problems, such as ownership structure (characterized by links and cross-ownership between the corporate and banking sectors and between the government and both sectors) and flawed corporate go...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Foreword
• Preface
• Abbreviations
• I Overview
• II Assessing Crisis Vulnerabilities in Latin America
• III Macroeconomic Consequences of a Financial Crisis
• IV Reestablishing a Credible Nominal Anchor After a Financial Crisis
• V Dealing with Banking Crises in Dollarized Economies
• VI Public Debt Dynamics and Fiscal Adjustment
• VII Corporate Debt Restructuring in the Wake of Economic Crisis
• VIII Applying the Prague Framework in Crisis Resolution
• Boxes
• Footnotes