Financial Crises: A Primer On Survival For Emerging Markets

Jeff Frankel of Harvard summarises the current thinking:

The 2008-09 Global Financial Crisis: Lessons for Country Vulnerability

After the currency crises of 1994-2001, and especially the East Asia crises of 1997-98, a lot of research investigated what countries could do to protect themselves against a future repeat. More importantly, policy makers in emerging markets took some serious measures. Some countries abandoned exchange rate targets and began to float. Many accumulated high levels of foreign exchange reserves. Many moved away from dollar-denominated debt, toward other kinds of capital inflow that would be less vulnerable to currency mismatch, such as domestic currency debt or Foreign Direct Investment. Some instituted Collective Action Clauses in their debt contracts to facilitate otherwise-messy restructuring of debt in the event of a severe negative shock. A few raised reserve requirements or otherwise tightened prudential banking regulations (clearly not enough, in retrospect). And so on.

When the Global Financial Crisis hit ten years later, it was bad news for everyone, except that it was good news for econometricians: we could observe which countries got hit badly by this common external shock in 2008-09 and which did not, and could try to draw inferences about which strategies helped countries withstand the shock better than others.

What follows after the above is a discussion of three topics (with references):

1. Does accumulating international reserves help? (Yes);
2. Does having capital controls and/or prudential measures help? (No for capital controls; Yes, significantly,  for FX related prudential measures);
3. Automatic restructuring of debt, with a couple of ideas – “sovereign cocos”, where the terms of the debt contract are automatically adjusted when macro-variables reach predefined criteria, and indexing of debt to commodity prices (for commodity exporters).

That last point is really interesting. Neither idea will be countercyclical, though that’s not the point (borrowing costs are likely to increase) – but it would reduce the need for post-crisis negotiation and bargaining between lenders and creditor, which is an enormous source of market uncertainty. That in itself should reduce volatility and hence vulnerability of countries to sudden stop liquidity crises.

As for the first two points, here’s hoping BNM continues dragging its feet over internationalisation of the Ringgit.