Lessons from Systemic Financial Crises Guillermo Calvo Columbia University India Policy Forum Sponsored by NCAER and The Brookings Institution. New Delhi, July 14-15, 2009

Sudden Stop, SS Definition: Large and largely unexpected cutback in credit flows to a country or large sector (e.g., real estate). NB: It does not require a fall in credit stock. India is likely going through a SS episode, but total credit stock continues to increase. –However, portfolio credit stock has recently started to fall.

Why is SS dangerous? If SS is provoked by an exogenous shock, it brings about unplanned contraction in the affected country/sector’s demand for goods and services, –unless the country/sector has enough liquid assets to offset the SS (international reserves) The fall in demand may cause a major change in relative prices (e.g., real estate prices, real exchange rate).

Changes in relative prices are largely unexpected Thus, if country/sector borrowed to buy assets which prices sharply declined, this could cause severe stress for lenders (e.g., local banks). If banks suffer liquidity crunch, they will be forced to cut credit across the board, causing contagion. Therefore, the credit crisis might spread to the rest of the economy.

Aggravating Factors Government and large firms may replace the sudden cutback in external loans by borrowing from domestic banks. This crowds out firms with limited access to external financing –typically, small and medium-sized firms who utilize labor-intensive techniques, putting strong downward pressure on employment and real wages.

Fortunately, India has momentarily cushioned the blow by injecting liquidity through a decline in International Reserves.

(% of GDP, last 4 quarters, last value 2008-IV) India. Net Capital Flows Note: “Other” Flows include Loans, Banking Capital, Rupee Debt Service and other unclassified flows. Source: Reserve Bank of India.

India. International Reserves Source: EIU and IFS. (quarterly data, % of GDP)

Capital Controls and SS If capital inflows are positive, as in India, one cannot prevent SS by imposing controls on capital outflows. Because for SS to happen it is enough that the rate of capital inflows falls, as it is actually happening in India –capital flow reversal need not take place!

Controls on capital inflows cannot prevent SS, unless inflows are zero, and capital outflows are forbidden This is especially difficult to implement when multinational firms are involved. Controls on capital outflows may dampen incentives for Foreign Direct Investment because it makes profitability harder to assess ex ante. This shows why capital controls could have deleterious effects on growth or simply be ineffective in preventing SS.

Bank Regulation While controls on capital flows are highly debatable, this does not rule out bank regulation, which sometimes is akin to controls on capital flows. Banks should be tightly regulated because their failure brings about systemic shocks. In some cases bank failure paralyzes the payments system (e.g., Argentina 2002). Keep an eye on banks’ short-term foreign- exchange liabilities –both on and off-balance-sheet

India and Emerging Markets: Then and Now For India, the present external front is not very different from that in 1997/1998 Asian/Russian crisis. But for Emerging Markets 1997/1998 represented a major blow Interest rates skyrocketed and Current Accounts suffered a major adjustment.

(Current Account Balance as % of GDP, Terms of Trade 2005=100) India. Current Account & Terms of Trade Note: e = estimate Source: EIU. Current Account Terms of Trade At 2005 prices

EMs Then

(EMBI sovereign spread & Current Account Balance in EMs, millions of USD, last four quarters) External Financial Conditions for EMs Note: Includes Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Slovak Republic, South Africa, Thailand, Turkey and Venezuela.

LAC 7: INVESTMENT (LAC-7, s.a. Investment, 1998.II=100)

LAC 7: GROWTH (LAC-7, s.a. GDP, 1998.II=100)

EMs Now much better from BOP view point

Greenspan’s “conundrum” testimony External Financial Conditions for EMs (daily data, EMBI+, bps, last value 04/07/09) Source: Bloomberg. Pre-Asian Crisis Spread Pre-Asian Crisis Yield ENRON Effect Spreads Yields Beginning of improvement in international financial conditions Fears of FED tightening  =+54%  =-12% Lehman Brothers files for bankruptcy Basis points

US Junk & EM Bonds (yields in %, last value ) (yields in %, last value 04/07/09 ) Note: (1) EM Corporate = Credit Suisse Corporate Bond. (2) EM Sovereign = JP Morgan EMBI+ Sovereign. (3) US Junk= MSCI High Yield Bonds. Source: Bloomberg. EM Sovereign US Junk EM Corporate

EMBI+ Yield & Terms of Trade in LAC (quarterly data, Terms of Trade Index 1997-I = 100, EMBI+ Yield) Note: Terms of trade series include Argentina, Brazil, Chile, Colombia, Mexico and Peru. Simple average. Source: IADB and Bloomberg.

Implications Capital markets for Emerging Markets have not been a source of major disturbance Except for countries that exposed themselves to vulnerabilities clearly identified by research (e.g., Eastern Europe), namely, –High Current Account Deficit –Liability Dollarization (foreign-exchange denominated debt) This is an important lesson looking forward.

Estimated Sudden Stop Probabilities (Based on Calvo, Izquierdo and Mejia, NBER Working Paper 14026, 2007) Notes: Simple country averages. LAC7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. CAC5 includes Costa Rica, Guatemala, Honduras, Nicaragua and Dominican Republic. Eastern Europe includes Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Turkey.

India: Financial Strengths Liability dollarization is not a major issue – although one must keep track of trade credit as economy opens up to trade. Recall Korea, Thailand in 1997 and Brazil in Reserves cover a good share of M2 A large share of International Reserves has been acquired with seigniorage (money printing) –associated with an increase in the demand for money triggered by high output growth. –This source of reserve accumulation will tend to dry up if growth declines.

India. International Reserves and Money Source: IFS.

India. International Reserves’ Accumulation and Seigniorage Note: Correlation coefficient statistically significant at 1% level. Source: IFS. (quarterly data, Billions of USD, q-o-q change, last value 2008-QI) Correlation = 0.8*

India. Bank Loans The level of international reserves is large with respect to M2. However, M2/GDP has increased very rapidly since mid 2000 and the proportion of loans to private sector with respect to public sector has more than doubled. This flashes a yellow warning light, because Sudden Stops are usually preceded by high growth in bank credit.

India. M2 as share of GDP Source: IFS

India. Ratio of Banks’ Claims on Private/Public Sector Source: IFS

- Bank Credit - GDP Bank Credit Credit GDP t-2t-1tt+1 t Collapses in EM Economies CollapseRecovery GDP Bank Credit Credit GDP US Great Depression CollapseRecovery EM Collapses & the US Great Depression: Similarities

(Average Credit to the Private to Credit to the Public Sector ratio*, trough (t)=100) Bank Credit during Systemic Collapses Note: Public sector includes only the Central Government. Source: Own estimates base of the IMF-IFS data. GDP All Episodes 90s

India: Fiscal, Inflation Risks Domestic debt is large and fiscal deficit is approaching 9-10% of GDP. Inflation could be contained by draining international reserves, but this would increase the chances of Sudden Stop. Therefore, there seems to be little room for fiscal stimulus. Further devaluation could help, but if global green shoots fade out, its effect will likely be minor.

(% GDP) Public Debt Note: e = estimate / f = forecast. Source: EIU.

(y-o-y % change) Inflation & Exchange Rate Source: IMF. Exchange Rate Inflation

(y-o-y % growth rate) GDP growth Source: EIU. India USA

Lessons from Systemic Financial Crises Guillermo Calvo Columbia University India Policy Forum Sponsored by NCAER and The Brookings Institution. New Delhi, July 14-15, 2009