This is a slightly revised version of a presentation the author made at the Annual Meeting of the Institute for International Finance, held in Washington, DC, on October 20, 2007. The author is indebted to C. Fred Bergsten for helpful comments on an earlier draft and to Doug Dowson for excellent research assistance.
My task is to identify several of the key lessons that have been learned about financial crises in emerging markets over the past decade and to evaluate what those lessons suggest for emerging-market financial crises going forward. I plan to divide my remarks into two parts. The first part covers the good news, namely that some key determinants of currency and debt crises in emerging markets have changed rather dramatically for the better. The second part gives the bad news: It is premature to herald the end of emerging-market financial crises. There are some potential dangers looking forward, including the risks associated with very large capital inflows going to emerging Europe and the possibility of weaker than expected growth performance in the United States and China.
II. Currency and Debt Crises: Why Have Things Changed?
Over the past 13 years, the emerging-market crisis business has experienced a boom-bust cycle. Between 1994 and 2003, major financial crises were occurring with both high frequency and severity; since then, there have been practically none. Indeed, the drop-off in the frequency of such crises has been so marked that the institution charged with providing emergency funding for such crises-the International Monetary Fund-has recently had to reconsider its income model, since it is no longer earning much from crisis lending.1
When thinking about emerging-market financial crises, it is useful to divide them into their three main varieties-that is, currency crises, debt crises, and banking crises. Because of time constraints, I will speak this morning only about currency and debt crises.
One of main lessons from earlier currency crises is that vulnerability is high when you have three underlying conditions: a large currency mismatch, an overvalued real exchange rate, and large net inflows of portfolio capital paired with a weak banking system.
By a currency mismatch, I mean a situation where the difference in the currency denomination of assets and liabilities is such that a change in the exchange rate has sizeable effects on an entity's net worth or net income. In plain language, it's a mismatch when your net worth and/or your net income is not well hedged against a change in the exchange rate.
Why do I put such emphasis on currency mismatch? There are three reasons.2 To begin with, serious currency mismatch has been a feature of every major emerging-market currency crisis of the past dozen years. It was there in Mexico in 1994-95, in the Asian crisis countries in 1997-98, in Russia in 1998, in Brazil in 1998-99 and 2001-02, in Turkey in 2001-02, and in Argentina in 2001-02. Second, currency mismatch provides the best explanation we have for why large exchange rate depreciations in emerging economies have had such costly growth effects. When financial liabilities are mostly denominated in dollars or in other reserve currencies while assets and revenues are mainly denominated in local currency, then a large depreciation of the local currency will result in balance sheet problems that ultimately cause economic growth to nosedive. Third, when an emerging economy is a net debtor in its foreign exchange position and has a large currency mismatch, it will be very reluctant to allow the exchange rate to depreciate significantly, thereby losing the shock-absorbing advantages that go with exchange rate flexibility.3
The degree of real exchange rate overvaluation is important because the more overvalued the exchange rate, the higher the probability that the currency will suffer a sharp decline that will activate currency mismatches.4 A recent history of large net inflows of portfolio capital matters, because portfolio flows are more likely than inflows of foreign direct investment to reverse direction if there is a sharp deterioration in the borrower's prospects (IMF 2006). And a weak banking system makes it less likely that the credit expansion that often goes with large capital inflows will go to the right borrowers.
We have seen all too often how these three factors interact during the buildup and ignition of a currency crisis. In many cases, the capital inflow is predominantly denominated in foreign currency and is of relatively short maturity; it is being used to finance either longer-term projects and/or consumption; and many recipients of this external financing and bank lending are in businesses, like real estate, that don't generate much foreign exchange revenue. When the good economic news that attracted the inflow turns sour, capital flows out, the overvalued local currency plunges, net foreign liabilities soar, bankruptcies multiply, the banking system comes under strain, aggregate demand crashes, and economic growth falls.
All this implies that if we are seeing a big decline in the frequency and severity of currency crises, it ought to because some of these key factors driving crises have improved relative to earlier periods. And this is what we in fact observe.
Consider currency mismatch. One popular measure of aggregate mismatch that combines currency and liquidity elements is the ratio of short-term external debt to foreign exchange reserves. For the four Asian crisis economies-Thailand, Indonesia, Korea, and Malaysia-that ratio was in the range of 80 to 330 percent at the onset of the crisis; it is now in the 20-55 percent range.5 In none of 22 emerging economies today is the ratio of short-term external debt to reserves higher than one, and in almost two-thirds of them, that ratio is lower today than it was in 2002. Philip Turner of the Bank for International Settlements (BIS) and I have also produced a measure of aggregate currency mismatch for 21 emerging economies that is much more comprehensive than the short-term debt to reserves ratio (Goldstein and Turner 2004). That measure too shows very large reductions in aggregate currency mismatch for most emerging economies; increasingly, those economies also now have net creditor-not net debtor-positions in foreign exchange. For net creditors, a depreciation of the local currency vis-à-vis the major reserve currencies actually improves their net worth.
Operating in a similar direction, today's resurging net capital inflows to emerging economies have a higher share of net foreign direct investment flows than in the inflows of the 1990s (IMF 2007a). More recipients of large capital inflows also are running current account surpluses-not deficits. There remain some cases of highly overvalued real exchange rates but fewer in economies with large currency mismatches. And with much, much larger stocks of international reserves than before, the temptation to engage in pro-cyclical monetary and fiscal policy responses to a decline in reserves is much attenuated.6
There are many factors behind this reduced vulnerability to currency crises. Suffice to say that-in addition to the benign global environment of high growth and abundant international liquidity-part of the improved picture reflects a shift toward greater reliance on domestic bond markets (BIS 2007a), which tend to be denominated in local currency to a much greater extent than international bond markets, and better disciplined monetary and fiscal policies, which have made both domestic and foreign investors more willing to hold such local-currency-denominated debt.7
One can tell a similar story about debt crises in emerging economies. There have been many severe debt problems during the past dozen years (Pakistan, Ukraine, Uruguay, Thailand, Indonesia, Ecuador, Russia, and Argentina) but not much in the last several years.8
Debt crises occur when investors conclude that the debt ratio has become unsustainable. The traditional framework for analyzing debt sustainability is to call the debt "sustainable" if the ratio of public or external debt GDP is constant or falling and to label it as "unsustainable" if that ratio is increasing. To make a projection for what the public debt ratio will be next year, one makes year-ahead projections for the economy's real GDP growth rate, the real interest rate on the debt, and the primary surplus in the government budget. Because analysis of public debt ratios ignores the economy's ability to generate foreign exchange revenues, most analysts supplement the exercise for public debt with an analogous one for external debt-the only difference being that for external debt, the economy's trade surplus replaces the government's primary surplus (Goldstein 2003).
The good news here has been that after rising steadily over the 1997 to 2001 period, the ratio of public debt to GDP for emerging economies has fallen by roughly 4 percentage points over the 2002-06 period.9 Institute for International Finance (IIF) data (IIF 2007b) reveal that annual economic growth in emerging economies averaged almost 7 percent over the 2004-07 period-much above the 4.7 percent pace of the 2000-2003 period. The EMBIG (Emerging Markets Bond Index Global) interest rate spread over US Treasuries is currently running about 200 basis points-roughly one-fourth the level recorded in the more turbulent summer and fall of 2002 (Kato 2007). According to the IMF (2006), this recent large improvement in the relationship between real GDP growth and the real interest rate on debt was the main factor in turning around the worrisome trend in public debt for emerging economies. Average overall fiscal deficits of emerging economies have also declined, and there has also been a modest improvement in the average primary surplus. Whereas in 2002 or 2003, one could be skeptical about the ability of some emerging economies to deliver a 3 percent or higher primary surplus over an extended period, the fiscal performance of Brazil, Turkey, and some others over the past four years had made it easier to believe that debt ratios can sometimes be reduced significantly without debt restructurings.10
Developments on the external debt front have been even more favorable. While external debt ratios for emerging economies have been falling since the mid-1990s, it is noteworthy that relative to exports of goods and services, both external debt and external debt service payments are now less than half as high as they were as recently as 2000 (IMF 2007b). In addition to the growth and interest rate trends mentioned earlier, 2007 will be the eighth year in a row that emerging economies as a group have run current account surpluses.
To sum up, while there are many factors that have contributed to the much improved recent scorecard on emerging-market currency and debt crises-including more buoyant industrial-country growth and easy global credit conditions-an important part of the reduced crisis vulnerability is the progress made by emerging economies in reducing currency mismatches and in improving debt sustainability. I think that progress also explains in part why emerging economies have at least so far suffered relatively little in the recent bout of financial turbulence initiated by the subprime crisis in the United States.
III. Are Emerging-Market Crises Obsolete? Two Worries Going Forward
If crisis vulnerability in emerging economies has been going down, can't we go further and foresee soon the end of such crises? I think that such a conclusion would be going too far: Reduced vulnerability does not mean no vulnerability, improvements have not been made evenly across the emerging-market world, and new threats continue to surface. Let me be more specific about two current concerns.
The main concern involves the management of very large capital inflows into emerging Europe. Both gross and net capital inflows in 2006 and 2007 are larger than those that went to Asian emerging economies in the run-up to the Asian financial crises (IMF 2007a). Yes, growth in emerging Europe remains high; yes, there are good investment opportunities; yes, foreign exchange reserves exceed short-term debt; yes, the institutional links with the European Union have provided a most helpful framework for spurring the transition to market economies (Åslund 2007); and yes, foreign ownership (by European banks) in these banking systems is very high (Maechler et al 2007). Still, there are warning signs.
Emerging Europe is the only region among emerging economies that runs an aggregate current account deficit-equal to over 7 percent of GDP-and such deficits are likely to exceed 13 percent of GDP this year for Estonia, Latvia, Lithuania, Bulgaria, and Romania (and 5 percent of GDP or more in Hungary, the Slovak Republic, and Croatia) (IMF 2007a). This region also has the largest external gross borrowing requirement; for Hungary, Romania, and Turkey, Deutsche Bank estimates this borrowing requirement at 10 percent or more of GDP in 2008 (Deutsche Bank 2007). Among large emerging economies, Hungary is one of the few to have a larger aggregate currency mismatch in 2006 than it had in 2000.11 Goldman-Sachs' (Goldman-Sachs 2007) measure of real exchange rate misalignment places the Turkish lira as the most overvalued among currencies of larger emerging economies, and the currencies of Hungary and Poland also show double-digit overvaluation.12 Increasingly, the region's capital inflows are of the more volatile non-FDI type, with significant inflows of foreign-currency denominated bank loans, and with much of it used to fund consumption and rapid bank credit growth. In 2006, Estonia, Latvia, Albania, and Romania each experienced private sector credit growth of 50 percent or more, and credit growth in Slovenia, the Slovak Republic, and Lithuania topped 20 percent; growth of external financing also rose in 2006 by 20 percent or more in Bulgaria, Croatia, Cyprus, Estonia, Hungary, Kazakhstan, Latvia, Romania, Russia, South Africa, and the Ukraine.13 Private loan placements-which often carry less extensive disclosure requirements than public listings-were at a much higher level and grew at more rapid rates in 2005-07 in emerging Europe than in either emerging Asia or in Latin America.14 Housing prices in the Baltic countries and in Bulgaria are more than 200 percent above their 2003 level. External borrowing by banks in Russia and Turkey in 2004-06 was more than five times greater than their external borrowing during the 1995-97 surge (World Bank 2007). Banking systems in Bulgaria, Hungary, Turkey, Estonia, and the Slovak Republic all get a "D" rating on Fitch's Stand-Alone Bank Soundness ratings, and equity market-based credit risk indicators suggest that default risk in 2007 is considerably higher for banks in emerging Europe than for those in either Latin America or emerging Asia (IMF 2007c). Companies from emerging Europe now account for 39 percent of total foreign borrowing by developing-country firms-up from 19 percent in 1996-2003 (World Bank 2007). In its latest issue of Global Development Finance (World Bank 2007, xii), the World Bank issues the following caution: "Concerns are growing that several countries in emerging Europe and Central Asia are experiencing a credit boom engendered by cross-border borrowing by banks of untested health and stamina. Some of these banks have increased their foreign exchange exposure to worrisome levels, a concern that warrants special attention from national policymakers."
To summarize, we are seeing troubling echoes of some of the key vulnerabilities of the Asian financial crisis now playing out in emerging Europe and in some of its neighbors in the Commonwealth of Independent States (CIS). I am not saying that a financial crisis in emerging Europe is imminent, nor I am denying that vulnerabilities differ significantly across economies in that region. But I am suggesting that if there is a bout of serious risk aversion in international financial markets, the fallout in emerging Europe is not apt to be a pretty one.
A second concern is that we could get weaker than expected economic growth in both United States and China in 2008-with adverse consequences for emerging economies.
The October 2007 Blue Chip consensus forecast for the United States is for about 2 percent growth in 2007 and about 2 1/2 percent in 2008. For China, the corresponding consensus forecast is for 11 percent growth in 2007 and for 10 percent in 2008. In both countries, however, there are plausible scenarios in which growth would fall short of those numbers.
In the United States, the most likely culprit for a growth shortfall (along with much higher world oil prices) would be greater than expected weakness in the housing market, compounded by a correction in the equity market. The factors contributing to a pessimistic outlook for housing have been laid out recently by Desmond Lachman (Lachman 2007) of the American Enterprise Institute, with emphasis on, inter alia, the increasing reset rate for adjustable mortgages, the dramatic tightening of mortgage lending standards, the greatly reduced rate of home equity withdrawal, and the forecast from (Case-Shiller) future house price contracts, suggesting a double-digit decline in housing prices over the next two years. A correction in the equity market-spurred perhaps by lower earnings-is relevant because stock price gains over the past 18 months have so far more than offset the loss in housing wealth on personal-sector net worth. If US equity prices fell in 2008 while the housing decline accelerated, it would be difficult to sustain consumer spending at forecast rates.
In China, the long-running rise in the investment share of GDP seems finally to have reached a plateau, yet economic growth has accelerated. The main reason for this outcome is China's mushrooming global trade surplus. Net exports jumped from 2 ½ percent of GDP in 2004 to 7.3 percent of GDP in 2006, and it is anticipated that they will reach 10.6 percent of GDP this year (Goldstein and Lardy 2007). Whereas net exports accounted for an average of less than 5 percent of growth in 2001-04, they accounted for more than a fifth of growth in 2005-06 and probably more than that in 2007 (Goldstein and Lardy 2007). But trees don't grow to the sky. At some point, the rate of expansion of China's net exports will have to slow-because the domestic and foreign pressures for external adjustment will become irresistible. When that happens-and it could be as early as 2008-the contribution of net exports to growth will diminish significantly, domestic demand growth could also slow a little, and China's overall economic growth could decline-perhaps on the order of two to three percentage points.15
If economic growth in the United States and China slows at roughly the same time, global growth will get less of a push from two of its main locomotives, and those emerging economies that have either relatively large trade links with them, or relatively high export openness or relatively high dependence on commodity exports, will suffer the most (Goldstein 2005).
Exports to the United States and China account for a relatively high share of GDP in Hong Kong, Singapore, Malaysia, Venezuela, and Mexico (see Goldstein  and Deutsche Bank ). Emerging economies in Europe would be much less affected, since they are much more dependent on the European Union as an export destination. On the primary commodity side and abstracting from major oil exporters in the Middle East, Latin America is the region most vulnerable to a commodity shock.16 Here, Venezuela, Peru, Colombia, Ecuador, Argentina, and Chile each have half or more of their exports concentrated in primary commodities (Deutsche Bank 2007).
Again, I don't want to suggest that a joint US-China growth slowdown would necessarily initiate a set of emerging-market crises. But it would increase significantly the vulnerability of emerging markets and would make the external environment facing them much less benign than it has been in recent years.
Thank you very much.
Åslund, Anders, 2007. How Capitalism Was Built: The Transformation of Central and Eastern Europe, Russia, and Central Asia. Cambridge University Press, United Kingdom.
Bank for International Settlements, Committee on the Global Financial System, 2007a. "Financial Stability and Local Currency Bond Markets." CGFS Paper No. 28, Bank for International Settlements, Basle, Switzerland, June.
Bank for International Settlements, Committee on the Global Financial System, 2007b. 77 th Annual Report. Bank for International Settlements, Basle, Switzerland, June.
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Calvo, Guillermo and Carmen Reinhart, 2000. "Fear of Floating." NBER Working Paper No. 7993. National Bureau of Economic Research, Cambridge, Massachusetts.
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Goldstein, Morris, 2002. Managed Floating Plus. Policy Analyses in International Economics No. 66, Institute for International Economics, Washington, March.
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1. See the Final Report of the Committee to Study Long-Term Financing of the IMF-now commonly referred to as the Crockett Report (Crockett 2007)-after the name of the Chairman of that committee.
3. Calvo and Reinhart (2000) refer to this as "fear of floating."
4. Goldstein, Kaminsky, and Reinhart (2000) document that overvaluation of the real effective exchange rate is one of the best performing leading indicators of currency crises in emerging markets.
6. The World Bank (2007) reports that international reserves held by all developing countries jumped from less than 10 percent to almost 25 percent of their GDP over the past 10 years.
7. According to World Bank (2007) figures for the 28 largest emerging-market economies, the domestic portion of the outstanding stock of public debt rose from a little more than half in 1998 to roughly three-quarters in 2006. Goldstein (2002) argues that exchange rate flexibility, a credible monetary policy framework of inflation targeting, and measures to discourage currency mismatching-a regime I call "managed floating plus"-reinforce one another.
9. See IMF (2006), along with preliminary data for 2006. The Bank for International Settlements (BIS 2007b) reaches a similar qualitative conclusion using median values for the ratio of public debt to GDP.
10. According to data provided by JP Morgan (2007), Brazil has run a primary fiscal surplus of 3 percent of GDP or more continually since 2000, while Turkey has run a surplus of at least 4 percent of GDP continually since 2000; that same publication also indicated that Brazil's ratio of public-sector debt to GDP has fallen from 79 percent in 2002 to 68 percent in 2007; the corresponding calculation for Turkey shows a decline in the public-sector debt ratio from 96 percent in 2002 to 59 percent in 2007.
12. In terms of deviation of real effective exchange rates from the 1990-2007 average, emerging Europe is also the region with the largest appreciation.
13. Maechler et al (2007) and IMF (2007c). Kato (2007) also documents very high rates of domestic credit growth in emerging European economies using a different metric, namely, the change in domestic credit as a share of GDP over the 2004-06 period. The World Bank (2007) reports that between 2001-05, both private-sector growth and external borrowing by banks rose by more than 50 percent in Estonia, Hungary, Kazakhstan, Latvia, Lithuania, Romania, Russia, and the Ukraine; also, banks' foreign liabilities now exceed their foreign assets in those economies.
14. IMF (2007c). Those same default indicators also show that default probabilities were lower in 2007 than in 2006 for all three geographic groups of emerging-market banks.
15. The impact of a declining net export surplus on China's overall growth depends in part on what policy measures the government adopts; see Goldstein and Lardy (2007).