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1The f i rs t vers ion of th is paper w as presented at the Paci f ic Rim Economic

Conference, Bei j ing, June 2001. The cur rent vers ion w as presented at the ANEC

Conference on Global izat ion and Development , Havana, February 2004, and w i l l be

presented at the Westmin i s ter Development Conference, London, June 2004. This

research w as suppor ted by the E. Morr is Cox endow ment . Research ass is tanc e was

prov ided by Hui Tong.

1

HOT MONEY AN D COLD COMFORTHOT MONEY AN D COLD COMFORTHOT MONEY AN D COLD COMFORTHOT MONEY AN D COLD COMFORT GLOBAL CAPITA L MOVEMENT ANDGLOBAL CAPITAL MOVEMENT ANDGLOBAL CAPITA L MOVEMENT ANDGLOBAL CAPITAL MOVEMENT AND

FINA NCIA L CRISES IN EMERGING ECONOMIESFINA NCIA L CRISES IN EMERGING ECONOMIESFINA NCIA L CRISES IN EMERGING ECONOMIESFINA NCIA L CRISES IN EMERGING ECONOMIES

Danie l Mc Fadden, Univers i ty of Cal i forn ia, Berkeley 1

1. INTRODUCTION

In the 19 t h Century , w hen the Un i ted Sta tes w as a new nat ion , i t had an

unregu la ted f ree market sys tem for bank ing and c red i t . Any ind iv idua l w i t h

a reputa t ion fo r honesty among h is ne ighbors cou ld open a bank, acc ept

deposi ts , mak e loans, and issue sc r ip t that c ould be used as money . Thissys tem fue led innovat ion by c rea t ing market s i n w h ich resources c ou ld f low

to thei r most produc t ive use, and the U.S. ec onomy grew rapid ly . How ever ,

the sys tem w as in t r i ns ica l l y uns tab le . Any natura l event , l oan whose qua l i t y

was quest ioned, o r even rumor cou ld se t o f f a run o f w i thdrawals by

depos i to rs tha t t he bank had insu f f i c ien t l i qu id it y t o sa t i s f y , l ead ing the

bank to fa i l . Th is cou ld happen even in c i r cum stances where the

fundamenta ls o f the bank w ere sound, w i th so l i d p rospects fo r eventua l

recovery o f l oan pr inc ipa l and in te res t tha t wou ld cover a l l depos i t s .

Further , these panics and t he resul t ing bank fa i lures spread havoc, ru in ingdeposi tors and businesses w ho lost the i r l ines of credi t . The fa i lures of ten

casc aded in to na t iona l pan ics tha t fed v io len t bus iness cyc les w i th f requent

cont rac t ions . Not on ly d id these f i nanc ia l s tu t t e rs i n the sys tem s low the

pace o f economic growth , bu t they p laced a heavy to l l on the l i ves o f

ind iv iduals .

The eventua l po l i cy response in the Un i ted Sta tes to th i s s i tua t ion w as

to in t roduce cent ra l bank ing , reserve requ i rements , bank regu la t ion ,

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deposi tor insurance, and bankrupt c y law . Over the past 50 years, these

ins t i tu t i ons , fo r the m ost par t care fu l l y admin is te red , have in the Un i ted

Sta tes la rgely e l im ina ted bank ing c r i ses and t he severe bus iness cyc les

these c r i ses can genera te .

The system is not per fect . In the 1980's , the U.S. re laxed some of thest r ingent regulat ions govern ing the loan por t fo l ios of a c lass of f inancia l

inst i t u t ions cal led Savings and Loan Assoc iat ions. These organizat ions

w ere in many cases not su f f i c ien t l y w e l l cap i ta l i zed and managed to surv ive

in an open ly com pet i t i ve env i ronment , bu t by pursu ing increas ing ly r i sky

loan por t fo l ios, they postp oned fa i lure. Beca use deposi ts w ere insured by

the government , these r i sky s t ra teg ies d id no t cause them to lose

deposi tors. When fa i lure c ame, the governmen t had to bear the heavy cost

o f ba i l ing ou t the depos i to rs . Th is w as a case w here the sys tem o f

regu la t ion c rea ted un in tended incent i ves , encourag ing f i nanc ia l f i rms togamble w i th the government s money . I f t he i r gambles paid , then they

w ere so lvent ; i f no t , i t w as the government and u l t imate ly the tax payers tha t

had to tak e the loss . The lesson i s tha t an insurer o f las t resor t faces a

severe mora l hazard , an incent i ve s t ruc ture t han encourages the insured t o

assume add i t i ona l r i sks , unless t he insurance ar rangement a l so cont a ins

suf f ic ien t p rudent ia l superv is ion and cont ro l t o b lun t t hese incent i ves .

2. CURRENCY CRISES2. CURRENCY CRISES2. CURRENCY CRISES2. CURRENCY CRISES

The reason fo r reca l l i ng th i s h i s to ry i s tha t the in te rna t iona l cap i ta l

market today resembles in many respect s the U.S. c red it m arke t 150 years

ago, w i th v i r tua l l y unregu la ted f ree f l ow o f cap i ta l ac ross borders tha t fue ls

innovat ion and economic growt h , bu t a l so c rea tes vo la t i l i t y and f i nanc ia l

pan ics tha t h inder economic deve lopment and damage peop le s l i ves. The

pat t ern is now fami l iar . Opening the borders of an emerging economy and

l ibera l iz ing or deregulat ing i ts f inancia l inst i tu t ions, combined wi th

insuf f ic ient ly developed f inancia l regulat ion, aggressive promot ion ofeconom ic deve lopment , o r l oose government f i sca l po l i cy , l eads to heavy

in ternat iona l bor rowing, w i th l oans denominated in do l l a rs o r o ther

indust r ia l i zed coun t ry cur renc ies. Much of the bor row ing is for h ighly

product i ve and innovat i ve inves tm ents , bu t easy acc ess to c red i t and w eak

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f inanc ia l i n te rmed iar ies may a lso induce unw ise inves tm ents or bor rowing

to finance cur rent governm ent spending. Then, some t r igger ing event

occurs, perhaps the insolvency of one or more large banks, a run by

deposi tors, a drop in expor t dem and, or sudden and tum ul tuous pressure on

a f i xed or c raw l ing peg exchange ra te , and a cur rency c r i s i s s ta r t s . Hotcap i ta l f l ow s out o f the c ount ry , l oans f rom fore ign ins t i t u t i ons are no t ro l led

over , and i f the cur rent ly is not re leased to f loat f ree ly , i t comes under

specu la t i ve a t tac k . Th is p rec ip i ta tes a fu l l -f l edged f i nanc ia l c r i s i s i n w h ich

f inanc ia l i ns t i t u t i ons may fa i l , and the count ry exper iences economic ,

pol i t i c a l , and socia l turm oi l , inc luding increased c ost of bor row ing or loss

of access to i n te rna t iona l cap i ta l marke t s . Fi sca l aus ter it y fo l l ow s, o f ten

as the pr i ce o f IMF in te rvent ion to s tab i l i ze the s i t ua t ion , economic growt h

is s tunt ed, many businesses fa i l because t hey do not have sources of dol lar

revenue to serv ic e thei r suddenly very expensive dol lar -denominat ed debtand do not have sec ure c red i t l i nes , and w orkers are damaged by the fa l l i n

economic ac t i v i t y and employment .

We a l l k now about the As ian c ur rency c r i s i s i n 1997, the Russ ian c r i s is

in 1998, and the Argent inean cr is is in 2002, but these are only the most

v is ib le of an epidemic of problems. The IMF repor ts that of i ts 180 mem ber

nat ions, 130 had ser ious banking problems between 1980 and 1995, and

there were 211 ep isodes o f bank ing or cur rency c r i ses in th i s per iod .

Fur ther , the economic cos ts o f these c r i ses were subs tant ia l . Typ ica l t ime

to recovery to t rend fo ll ow ing a cur rency c r i s i s was 18 m onths , and t yp ica lto ta l l os t ou tpu t w as 4 .3 percent o f annua l GDP. Bank ing c r i ses w ere more

severe, typ ic a l ly last ing 3.1 years and resul t ing in to ta l lost output of 11.6

percent of annual GDP. The worst c r ises ca n be t ru ly devastat ing. In the

1997 c ur rency c r is is in Asia, South Korea lost more than hal f -a-year s GDP

in potent ia l output , and the ongoing c r is is in Argent ina is even w orse.

One o f t he fea tures o f cur rency c r i ses is tha t they o f ten sp i l l beyond a

nat ion s borders. Thus, the Asian cr is is in 1997 spread f rom Thai land to

Indonesia, Malays ia, the Phi l ipp ines and Korea. The prox im ate c ause of the

Argent inean c r is is in 2002 wa s a large burden of dol lar -denominat ed loans,a f i xed exc hange rate t ha t w as unsusta inab le g iven domest i c i n f l a t i on and

i t s impact on t rade, and rap id f l ows o f Argent inean cap i ta l ou t o f the

count ry . How ever , a cont r ibu t ing cause was a un i late ra l Brazi l i an

deva lua t ion a year ear l i e r tha t had a subs tant ia l adverse impact on

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Argent inean expor ts . I w i l l spend some t ime today ta l k ing about fi sca l

po l i cy i n the Un i ted Sta tes , and the r i sk tha t i t w i l l i gn i te a f i nanc ia l s to rm

that cou ld sweep across the en t i re i n te rna t iona l marke t sys tem and do

great damage to unw ary emerg ing economies .

There are f i ve s ign i fi can t r i sks assoc ia ted w i th fo re ign borrowing:

Exc hange ra te r i sk domest i c cur rency deprec ia tes re la t i ve to fo re ign

cur rency denominat ion o f l oans

Matur i t y r i sk too m uch shor t -te rm debt o r ho t m oney rela t i ve t o payof f

per iods fo r i nves tment s

In terest rate r isk in ternat ional (e.g., L IBOR) rate vo lat i l i t y

Serv ice r i sk domest i c cont rac t ions , expor t vo la t i l i t y , o r inves tment

pro ject fa i lures increase burden of debt serv ice

Panic/Speculat ive r isk events t r igger speculat ion against t he domest iccur rency and f l i ght o f ho t cap i ta l

What c hanges cou ld be made in emerg ing economies and in i n te rna t iona l

cap i ta l marke ts tha t wou ld reduce these r i sks , and the f requency and

severi t y o f f i nanc ia l c r i ses? I w i l l fi r s t d i scuss w hat emerg ing na t ions can

do fo r them se lves to reduce t he probab il i t y o f o r ig ina t ing or be ing in fec t ed

by c r i ses , and to min im ize the ir e f fec t s w hen they do occur . A f te r tha t , I w i l l

d i scuss w hat the com muni ty o f na t ions might do to reduce vo la t i l it y and

prov ide a sa fe ty ne t fo r i t s cons t i tuent mem bers .An in i t i a l ques t ion i s whether emerg ing economies shou ld embrace

global izat ion of economic ac t iv i t y and bor row ing, or res is t i t . I f par t ic ipat ing

in the g loba l economy ent a i l s such r i sks , m ight a count ry be be t te r o f f by

c los ing i ts borders, l imi t ing t rade, making i ts cur rency non-conver t ib le ,

rest r ic t ing capi t a l f lows, in the model of the o ld Soviet Union? While there

is some m er i t to Benjam in Frankl in s adage Nei ther a bor row er nor a lender

be , the answ er today seems to be no. The gains from par t i c ipa t ion in

in te rnat iona l t rade fo r goods and serv i ces br ing economic benef i t s tha t

subs tant ia l l y ou tw e igh the ri sks assoc ia ted w i th g lobal i za t ion . Count r iestha t have sought au tarchy , such as Nor th K orea, have fa red less w e l l t han

cou nt r ies suc h as South K orea and China that ha ve aggressive ly pursued

g loba l market s . There are cases w here t ime ly i n te r fe rence w i th

in te rnat iona l cap i ta l movements seems to have worked to modera te the

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domest i c impact o f c r i ses , fo r example the impos i t i on o f cap i ta l f l ow

rest r ic t ions in Malays ia in 1998 and 1999, and the re lat ive ly tough

barga in ing s tand tha t Argent ina appears to be us ing w i th some suc cess to

emerge f rom i t s w rench ing c r i s is i n 2002. How ever , these are emergency

responses to cr ises in progress, not presc r ip t ions for f inancia l manageme ntunder normal c ond i t i ons.

In a ta lk at the Nat ional Academ y of Scienc es in 2002, the U.S. Sec retary

o f S ta te Co l in Powel l s ta ted what I cons ider to be a sound pos i t i on on

global izat ion; I paraphrase h is s tatem ent : There is no point in being fo r

global izat ion or against global izat ion. L ike the w eather , i t i s just there. We

shou ld concent ra te on how to l i ve w i th i t , max imize i t s benef i t s , and

min imize i t s c os ts .

What can emerg ing economies do to take advantage o f i n te rna t iona l

t rade and g loba l ized cap i ta l marke t s to s t imu la te ec onomic grow th , w i thoutgreat ly increasing the risk of cur renc y cr ises? What in ternal pol ic ies and

reforms are sel f -protec t ive? I wi l l d iscuss three broad areas, prudent ia l

superv is ion of f inancia l in termediar ies, responsib le f i scal po l icy, and

ins t i tu t i ons to a l l ow poo l ing o f r i sks w i th in and across borders .

3. PRUDENTI AL SUPERVISION

Prudent ia l superv is ion of f inanc ia l in term ediar ies is essent ia l i f lendersand depos i to rs a re to have conf idence tha t they are sound and we l l

manage d. Prudent ia l superv is ion a lso prov ides the in format ion tha t

governments need to de tec t p rob lems and a t tac k t hem before they grow

into cr ises. Prudent ia l superv is ion requi res that banking regulators be

independent , s t rong, and of unquest ioned in tegr i ty . I t requi res banking law s

that p revent i n te r lock ing re la t i onsh ips be tw een bus inesses and encourage

t ransparent , arms-length t ransac t ions . One o f the most impor tan t e f fec t s

o f e f fec t i ve prudent ia l superv i s ion i s deve lopment o f hea l thy domest i c

f i nanc ia l marke t s tha t k eep domest i c c ap i ta l a t home and reduce the needfor fo re ign borrow ing for deve lopment p ro jec ts . Key e lements o f p rudent ia l

superv is ion are

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! Transparent and uni formly appl ied law s and proper ty r ights regard ing

cont rac t en forcem ent , bankruptcy , and repossess ion

! Ef fec t i ve ins t i t u t i ons fo r overs igh t and regu la t ion , and cons is ten t ,

s t r i ngent bank aud i t s

! Adher ence t o I n t e r na t i ona l Acc oun t i ng Standar ds and pub l icin format ion on per formanc e, acc ount ing, and d isc losure standa rds

! Ear l y w arn ing sys tems fo r p rob lem bor rowers and ac t i ve m anagement

of non-per forming loans

! Separat ion of f inancia l managem ent f rom indust ry and governmen t , no

connect ed lend ing

! Coordinat ion of regulat ing agenc ies across jur isd ic t ions, w i th overs ight

of to t a l f inancia l f i rm operat ions, and t ight con t ro l o f o f f -shore operat ions

Governments c an p lay an impor tan t par t i n suppor t i ng and encourag ingdeve lopments tha t p rov ide jobs , fue l economic growth , and a l l ev ia te

pover ty . How ever , i t ra re ly w orks w e l l fo r governments to assume t he dua l

ro le o f regu la tor and cus tomer o f t he bank ing sec t or . For example , the 1997

cur rency cr is is in South Korea, whi le induced by volat i l i t y spread f rom

Thai land, was great l y deepened by prob lems in the bank ing sec tor tha t

came f rom government i n te rvent ion to suppor t charbo ls tha t were

ine f fi c ien t l y managed and eventua l ly unsus ta inable . The anemic ec onomic

per fo rmance o f Japan over the pas t decade i s subs tant ia l l y due to an

unw i l l ingness of i ts governm ent t o undertak e comprehensive banking reformthat m akes c ap i ta l ava ilab le to i nnovat i ve pro jec ts . Un less there i s a c lear

lega l separa t ion o f bank ing and government , w i th the government s t i ck ing

s t r i c t l y to supervi s ion, the r i sks o f c ompromised regu la t ion are h igh .

Whi le the recent Parmala t scanda l i n I ta l y w as, as i t s c ore , a s imp le

f raud, the balk anizat ion of bank ing regulat ion w i th in Europe, and betw een

Europe, the Uni ted States, and the Car ibbean a l low ed the f raud t o spread

undetec ted and cause a great deal of co l la t era l damage. The ear lier Enron

scanda l i n the Un i ted Sta tes w as a lso abet t ed by lax i t y i n superv i s ion o f o f f -

shore banking operat ions. Whi le these scandals both occ ur red in developedcount r ies, s imi lar problems on a smal ler scale are a lso happening in

emerg ing economies , and the g loba l i za t ion o f bank ing w i thout a

cor responding g lobal izat ion of superv is ion is increasing the r isk of

imprudent conduct o r f raud.

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Acc ountab i l i t y o f regu la tors and t ransparency o f opera t ions are most

eas i l y ach ieved when f i nanc ia l i ns t i t u t i ons are c lear l y separa ted f rom

indust r ia l ownership and management , and c lear ly separated f rom

government . Otherw ise, the b lur r ing of l ines betw een bor row ers and

lenders, and betw een f inancia l f i rms and thei r regulators, creat es incent ivesfor imprudent behav ior tha t c an lead to r i sky loan por t fo li os and undermine

depos i to r conf idence. Today, there are a number o f count r ies where

bank ing is in t rouble, and g lobal izat ion of bank ing promises more t rouble.

For example, in China, the state-owned banks are saddled wi th large

por t fo l ios of non-per forming loans, most a hang-over f rom the t ime when

both bank ing and manufac tur ing were under government management .

Today, many of these banks are wel l -managed, and g iven a level p lay ing

f ie ld could com pete ef fect ive ly in g lobal market s. Never theless, there is no

w ay they c an surv ive w hen Ch ina fu ll y opens i t s bank ing market to fo re ignf i rms in 2007 unless the st ate assum es thei r legacy of pension obl igat ions

and bad paper . In many other count r ies, such as I ta ly and Indonesia,

c rony ism has led many banks to m ake unw ise loans , and the resu lt i ng drag

on those economies has been an imped iment to g row th .

When f inancia l inst i t u t ions are g lobal , they have st rong inc ent ives t o use

in ternat iona l t ransac t ions and cap i ta l movement s to c i r cumvent regu la t ion

and d isguise weak ness. There is a need for regulatory bodies that are

commensura te l y g loba l i n scope and can main ta in overs igh t o f the fu l l

spec t rum o f f i rm opera t ions . For example , the c rea t ion o f the euro cur rencyunion makes nat ional regulat ion of EU-wide and in ternat ional banks very

di f f i cu l t . A great deal of s t rengthening of banking regulat ion at t he EU level

is needed i f a casc ade of fu ture scandals l i ke Parmalat is to be avoided.

4. GOVERNMENT FISCAL RESPONSIBI LIT Y4. GOVERNMENT FISCAL RESPONSIBI LIT Y4. GOVERNMENT FISCAL RESPONSIBI LIT Y4. GOVERNMENT FISCAL RESPONSIBI LIT Y

Government f i sca l m ismanagement i s a second m ajor source o f cur rency

cr i ses . When w eak tax sys tems conf l i c t w i th s t rong spend ing pr io r i t i es ,po l i t i c ians may choose d i sgu ised tax a t ion th rough the i ssuance o f debt to

f i nance spend ing . When government debt s t im u la tes an economy tha t i s

opera t ing be low capac i t y , o r when i t i s used to f i nance product i ve

inves tments , say in in f rast ruc t ure , then i t mak es econom ic sense, i n the

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same w ay tha t debt f i nanc ing o f new capac i t y i n a pro f itab le indus t ry makes

sense i f t he re turn from the inves tm ent exc eeds it s cos t . How ever , w hen

a government uses debt ra ther than tax es to f i nance cur ren t consum pt ion

and redis t r ibut ion programs, even those w i th laudable object ives, th is is a

s ign of w eakness and f iscal i r responsib i l it y . Fur ther , i ts cost s are h igh.There is the d i rec t c os t t ha t fu tu re genera t ions must bear o f serv i c ing the

debt , and the fu tu re oppor tun i t i es c row ded out by debt serv ice . Incent i ves

for p ri va te inves tm ent a re d is to r ted . I f t he debt i s f i nanced by bor row ing

f rom abroad, in dol lar -denominated loans, th is makes the economy more

vu lnerab le to exchange ra te r i sk , and to the predat ions o f specu la tors .

F inal ly , i f acc umulat ing government debt does t r igger a cur renc y cr is is , then

the ent i re economy i s d i s rup ted, w i th major economic cos ts .

I have been asked, rhetor ica l ly , how I can cal l for f i scal responsib i l i t y

w hen chi ldren are dy ing every day. I agree that prot ect ing the l i ves, heal th,and wel fare of i ts c i t i zens should be a government s h ighest pr ior i ty .

How ever , f i nanc ing these needs th rough unsusta inab le ex t erna l bor rowing

that l eads to cur rency c r i ses and economic co l l apse compounds the

prob lem and i s no t a so lu t ion . I be l ieve tha t t he on ly rea l l y ef fec t i ve w ay to

dea l w i th a soc ie ty s major soc ia l p rob lems i s th rough a Scand inav ian

consensus tha t a l l c i t i zens w i l l ga in from a jus t soc ie ty tha t t axes i t se l f t o

address these problems.

The leaders of the indust r ia l i zed nat ions somet imes use the depreciat ory

te rm banana repub l ic to re fe r to a count ry w hose government i s too w eakor i r responsib le to manage i ts f i sc al operat ions proper ly . The problem is in

fact w or ld wide, inc luding both indust r ia l i zed and developing nat ions, and

inc lud ing a number o f count r ies a t var ious t imes in La t in Amer i ca . Today,

the b iggest banana repub l i c , and the one most l i ke l y to t r i gger a g lobal

f i nanc ia l s to rm, i s the Un i ted Sta tes . I am go ing to make some ra ther

ex tended remarks on f i sca l and t rade po l i cy i n the Un i ted Sta tes , and

exp la in w hy in my v iew i t i s a l ooming th rea t to the in te rna t iona l f inanc ia l

sys tem.

Figure 1 g ives U.S. Government budget pro ject ions prepared by theConcord Coal i t ion, a non-governmenta l organizat ion that is re lat ive ly

conserva t i ve on budget mat te rs , and more rea l i s t i c than the o f f i c ia l

p ro jec t ions o f the Congress iona l Budget Of f i ce about ex tens ion o f tax cu t s

and fu tu re spend ing pat t e rns . They show the c ur ren t budget de f i c i t o f $523

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bi l l ion, or 4.5 percent of GDP, cont inu ing in the range of 400 t o 600 b i l l ion

per year over the com ing dec ade, or around 3.5 perce nt of GDP. As a

benchmark , no te tha t the EU requ i res tha t member na t ions keep the i r

budget def ic i ts below 3 percent of GDP, and there is cur rent ly a quar re l

because Germany and France are above tha t t a rge t . Government de f i c i t sin indust r ia l i zed nat ions in the range of 3 t o 5 percent of GDP have am ple

precedent , a l though they have been rare in the U.S. except dur ing major

w ars, as F igure 2 i l lust rate s.

Source :Source :Source :Source: The Concord Coal i t ion, The Comm it t ee for Econom ic Development , and the

Center for Budget and Pol icy Pr ior i t ies , The Developing Cr is is : Def ic i t s Matt er , 20

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Source :Source :Source :Source: The Concord Coal i t ion, The Comm it t ee for Economic Developm ent , and theCenter for Budget and Pol icy Pr ior i t ies , The Developing Cr is is : Def ic i t s Matt er , 2003.

Such def i c i t s a re in fl a t i onary w hen an economy i s near capac i t y , may

crowd out i nves tment , and lead to accumula t ing debt serv i ce cos ts tha t

squeeze cu r rent expendi tures for governmen t goods and serv ices. When

government de f i c i t s a re f i nanced ex t erna ll y , they increase t he exposure o f

the count ry to r i sk f rom vo la t i l i t y i n i n te rna t iona l cap i ta l marke ts , and

increase the prospect of t r igger ing a f inancia l cr is is . The cur rent U.S.

def i c i t i s a conc ern for f i sca l conservat i ves and many ec onomis ts because

i t p romises to pers is t t h rough the nex t expans ion , add ing to i n f l a t i onary

pressure and p inch ing government spend ing on educat ion and the

envi ronment . How ever , there are other fac tors in the U.S. f i scal p ic ture th at

are much m ore a la rming tha t today s de f i c i t .

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-$500,000

-$400,000

-$300,000

-$200,000

-$100,000

$0

$100,000

Annual(millions)

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

U.S. Balance of Payments

Figure 3Figure 3Figure 3Figure 3

Source: U.S. Depar tment of Comm erce

Firs t , because savings rat es in the Uni t ed Stat es are re lat ive ly low , U.S.

government bor row ing i s assoc ia ted w i th bor rowing f rom fore igners , and i s

ref lect ed in the balance of paymen ts for goods and serv ices. F igure 3

show s a sharp decl ine in the U.S. t rade balanc e s ince 1997. This impl ies a

cor responding inc rease in U.S. paper held abroad. F igure 4 show s that t he

U.S. exc hange rate against t he basket of major cur renc ies has dropped by

about 30 percent i n t he pas t tw o years , i nd ica t ing increas ing res is tence to

ac qui r ing th is U.S. paper . This is despi te the fac t t hat China, a major t rad ing

par tner w i t h w hom t he U.S. has a la rge b i l ate ra l t rade def i c i t , has kept t he

yen pegged to the do l la r and cont inues to rap idl y acc umula te do l la rs .

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80

90

100

110

120

130

140

1970 1975 1980 1985 1990 1995 2000 2005

U.S. Exchange RateIndex against Major Currencies

Figure 4Figure 4Figure 4Figure 4

Source: Federal Reserve Board

Do the tw in de f i c i t s i n t he U.S., in the government budget and in the

balance of paym ents, threat en a g lobal f inancia l cr is is? Aside f rom the

re lat ive s izes of the t w o econ omies, is the s i tuat ion in the U.S. today t hat

muc h d i ffe rent than the s i tua t ion in Argent ina in 2000? Both count r ies

faced sharp ly inc reasing debt serv ic e requi rement s, but t he U.S. has one

major advantage in tha t i t s fo re ign bor rowing i s most l y denominated in i t s

ow n cur rency. In genera l , i f I bor row f rom you and the loan is denominated

in your cur rency , then I bear the exc hange ra te r i sk , but i f i t i s denominated

in my cur renc y, then you bear the exc hange rate risk. Thus, China cannot

eas i ly reduce i t s exposure in do l l a r -denominated paper w i thout dam aging

i t s ow n do l la r reserves , and hence i t i s m ot i va ted to m ain ta in the exc hange

rate. Then, i f the prospect w ere s imply a cont inuat ion of U.S. government

def ic i t s of 3 .5 to 4.5 percent of GDP, i t i s l i ke ly t hat t he major holders of

do l lars wou ld ac t i ve ly res is t specu la t i ve pressure on the do l la r . What w e

w ould l i ke l y see ins tead i s a cont inued s l i de in the exc hange ra te , a r i se in

long-term int erest rates, and stabi l i zat ion of the t rade def ic i t . Such a

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0

5000

10000

15000

20000

25000

N

umberin5-yearCohort('000)

Census Low Population Projections

Age (5 year increments)5-year Increments, 1980-2050

gradual ad jus tment w ou ld re lease pressure and avo id pan ics , bu t i t w ou ld

not be pain less. The resul t ing shi f ts in term s of t rade w ould d isadvantage

some emerg ing economies who are us ing expor ts to fue l economic

deve lopment . For example , a w eaker do l l ar w ou ld have a negat i ve impact

on U.S. tour ism abroad, and on impor ts of agr ic u l tura l produc ts.

F igure 5Figure 5Figure 5Figure 5

A muc h m ore ser ious i ssue in examin ing the im pact o f U .S. pol i cy on t he

internat ional f inancia l system is the long term v iabi l i t y of U.S. government

po l i cy . The Un ited Sta tes faces a demograph ic t i da l w ave beg inn ing about

8 years in the future, as the large populat ion cohor t s born af ter Wor ld WarI I begin to ret i re and qual i fy for Socia l Sec ur i ty and Medica re. F igure 5 in

wh ich t ime i s i nc reas ing back to f ron t f rom 1980 to 2050, and age i s

increas ing from le f t t o r i gh t , show s the ag ing over t im e o f the baby boom

generat ion , and o f the i r ch i l d ren w ho fo rm a sec ond, smal le r w aveon the

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5%

10%

15%

20%

25%

30%

35%

40%

19501960

1970

1980

1990

2000

2010

2020

2030

2040

le f t . The source of th is f igure is U.S. Census populat ion pro ject ions,

augmented by t he au thor s c a lcu la t ions .

The ag ing o f the baby boomers imp l ies tha t t he ra t io o f re t i red persons

to those work ing wi l l begin to r ise sharp ly af ter 2012, near ly doubl ing by

2040, as show n in Figure 6. This gray ing of the U.S. w i l l p lace heavydemands on hea l th and re t i rement p rograms.

One fea ture o f these demograph ic fo recas ts , and economic pro jec t ionsbu i l t upon them, i s tha t t hey are re la t i ve l y uncer ta in . Government po l i cy

needs to no t on ly deal w i th the m ed ian impac t o f these demograph ic sh i f t s

on government budgets , bu t a l so needs to be su f f ic ien t l y robus t t o respond

ef fec t l y to c i r cum stances tha t c ou ld tu rn subs tant ia l ly worse .

Soc ia l secur i t y and Med icare are pay as you go en t i t l ement p rograms

in the U.S., w i th the c ost of benef i ts t o the c ur rent e lder ly bourne by cur rent

w orkers . The demograph ic t rans i t i on imp l ies a doub ling o f the burden on

w orkers i f i t w ere to be funded so le l y f rom payro l l t axes , wh ic h has te r r i b le

economic incent i ve e f fec ts and i s p robab ly po li t i ca l l y unsusta inab le . As aconsequence, the fund ing o f these government ob l i gat ions i s l i ke l y t o fa l l

substant ia l l y on genera l government revenues, and produce major

government de f i c i t s .

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-5%

0%

5%

10%

PercentofGDP

1970 1980 1990 2000 2010 2020 2030 2040

Social SecurityIncome, Expenditure, and Surplus

Income

Expenditure

Surplus

-5%

0%

5%

10%

15%

PercentofGDP

1970 1980 1990 2000 2010 2020 2030 2040

MedicareIncome, Expenditure, and Surplus

Income

Expenditure

Surplus

Figure 7Figure 7Figure 7Figure 7

Figure 7 pro jects soc ia l

s e c u r i t y i n c o m e a n d

expend i tu res by assuming tha t

the rat io of benef i ts per ret i reeto GDP per capi t a and the rat io

o f payro l l t axes per w orker to

GDP per c api ta rem ain at 2002

levels . Thus, in the absenc e of

increased payro l l t axes or

reduced benef i t s , the assets o f

the soc ia l secur i t y t rus t fund

wi l l beg in to dec l i ne around

2020, level ing out at a def ic i t o fabout tw o percent o f GDP.

Figure 8Figure 8Figure 8Figure 8

The Medicare program

prov ides hea l th care fo r the

elder ly. Cut ler and Sheiner

p r oj ec t t ha t t he t o t a l cos t o f

Med icare w i l l inc rease f rom i t s

cur rent level o f about 2.5percent of GDP to 6 perc ent of

GDP in 2040. In t his sam e

per iod , to ta l hea l th cos ts i n

the U.S. wi l l r i se f rom thei r

cur ren t l eve l o f 15 percent o f

GDP to m ore than 20 percent ,

and by some es t imates as

high as 40 percent of GDP.

F igure 8 g i ves my ownest im ates of Medicare incom e and expendi tu res, based on regressions of

the grow th rate of dol lars per e l ig ib le person on the grow th rat e of GDP per

cap i ta and a t rend. These regressions show the program go ing in to cur ren t

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2000 2010 2020 2030 2040-25

-20

-15

-10

-5

0

5

acc ount de f i c i t i n 2012, and the de f i c i t w iden ing to m ore than 4 percent o f

GDP by 2040 .

Figure 9Figure 9Figure 9Figure 9

Figure 9 is a summary c har t

f rom the Concord Coal i t ion,

thei r F igure 10, that pro jects

ent i t l ement p rograms fo r the

elder ly , the Socia l Secur i ty

and Med icare programs we

have just d iscussed, and

Med i ca i d , wh i ch p r ov i des

medica l c are fo r the ind igent .The i r s imu la t ions ind ica te

tha t these programs w i l l

expand f rom 8 percent to

more t han 17 percent of GDP

as the baby boomers ret i re . As the prev ious deta i led f igures show, cur rent

tax ra tes on the re la t i ve l y smal l numbers o f fu tu re w orkers w i l l f al l f a r shor t

o f c over ing these government ob l i ga t ions .

The combined e f fec t o f the

pro jec ted def i c i t s i n Soc ia lSecur i ty and Medic are, added

to the on-budget de f i c i t w h ich

h a s l i t t l e p r o s p e c t o f

i m p r o v i n g f r o m i t s

in termediate- term range of 3

to 5 percent of GDP, imply

fu ture government budget

def i c i t s tha t a re c lear l y no t

susta inable. S imulat ions bythe Concord Coal i t ion, show n

in f i gu r e 10 , p r o j ec t a

government de f i c i t r i s ing to

10 percent of GDP by 2025,

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and cont inu ing to exp lode thereaf te r . These pro jec t ions must be over -

s ta ted in t he long te rm, as major c hanges in government f i sca l po l i cy , i n tax

ra tes , and in these ent i t l ement p rograms to ac com modate t he demograph ic

t ide are inev i tab le. The cur rent adminis t rat ion in Washington is mak ing no

ser ious e f fo rt t o dea l w i th the looming fa il u re o f these ent i t l ement p rograms,or to m in im ize the d i s rup t ions to i t s own economy and those o f o ther

nat ions . There i s a high ri sk tha t soc ia l and f inanc ia l tu rmoi l w i l l r esul t ,

th rea ten ing the c ont inued prosper it y o f t he Un i ted Sta tes economy, and the

s tab i l i t y of the g loba l i zed mark ets i n wh ich i t i s a key p layer. Every

emerg ing economy shou ld cons ider care fu l l y i t s pos i t i on ing in g loba l

market s , it s ex posure to r i sk f rom do l la r vola t i l i t y , and i t s dependence on

expor ts to t he Un ited Sta tes , fo r p ro tec t ion f rom the t usumi tha t c ou ld come

f rom a major upheava l i n the U.S. economy in the nex t twenty years .

Fur ther , these ac t ions shou ld be s ta r ted now , because even though themost ser ious prob lems in t he U.S. economy are s t i l l more than a dec ade

aw ay, f i nanc ia l marke t s a re l i ke l y to t r i gger a c r i s is a t t he f i r st ev idence

that t he prob lems w i l l no t be w orked out domest i ca l l y .

The cur rent m anageme nt of the U.S. econo my, and fa i lure to p lan for the

looming generat ional cr is is , prov ide a case study for every developing

nat ion . Th is is how not to opera te your economy i f you seek t he benefi t s o f

g loba li za t ion w h i le l im i t i ng the r i sks o f f i nanc ia l c r i ses and the resu lt i ng

turmoi l .

5. RISK MANA GEMENT5. RISK MANA GEMENT5. RISK MANA GEMENT5. RISK MANA GEMENT

The th i rd b road area in w h ich emerg ing economies can tak e ac t ions tha t

prov ide pro tec t ion f rom f inanc ia l c r i ses is r i sk m anagement . There need to

be e f fec t i ve ins t i t u t i ons to a l l ow poo l ing o f r i sks , bo th w i th in and across

borders . These might tak e the form o f pr i va te or government i nsurance

programs, des igned w i th adequate c ont ro l s to m in im ize m ora l hazard , tax

po l i c ies tha t make specu la t i ve cap i ta l movements cos t l y , o r reg iona lcoopera t i ve agreements on s t ab i l iza t ion and exc hange ra te coord ina t ion .

Some o f t he th ings tha t c an be done to reduce ex change ra te r i sk a re to

requi re dol lar -denominat ed loans to be l ink ed to dol lar revenue sourc es, to

requi re a d ivers i f ied por t fo l io of fore ign-denominat ed debt , to mat ch debt

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mat ur i t ies to revenues for incom e-producing pro jec ts , and to requi re fore ign

lenders to assume some ex change-ra te r i sk . The in te rnat iona l marke t fo r

f inance wi l l not of fer these opt ions for f ree, but a reasoned pol icy for an

emerg ing economy i s to pass up the c heapest and most r i sky f i nanc ing in

favor o f a lte rna t i ves w i th sa feguards tha t l ower t he r i sk o f fu tu re f i nanc ia lc r i ses .

An impor tan t aspect o f modern f i nance i s the use o f var ious f inanc ia l

inst rum ents, inc luding derivat ives, to pool and hedge r isks. Employment of

these ins t ruments i s no t fo r the unw ary , bu t w i th due d i l i gence, they prov ide

w ays to p r i ce ou t and poo l ri sks . An example in the U.S. i s the prac t i c e by

Fannie Mae and Freddy Mac, two government -char tered companies, of

aggregat ing and resel l ing d ivers i f ied por t fo l ios of mor tgages w i th spec i f ied

r i sk a t t r i bu tes . Th is has great l y fac i l i t a ted m anagement o f de fau lt r i sk i n

mor tgage loans , and great l y expanded the s i ze and reach o f the m arket fo row ner -occ up ied homes. The opera t ions o f these com pan ies are a mode l fo r

how a government c an des ign an Independent Debt Agency t ha t has w e l l -

def ined per formance standards and prov ides qual i f i cat ion and moni tor ing

of bor rowers , r i sk poo l ing and d ivers i f i ca t ion to manage cur rency and

mat ur i t y r i sk , and concent ra t ion o f resources and exper t i se in dea l ing w i th

fore ign lenders. An exam ple is I re lands Nat ional Treasury Management

Agency .

I t i s a lso possib le for governme nts t o prov ide or organize the prov is ion of

more conv ent ional insurance, suc h as deposi t insurance . Carefu l design isneeded to avo id tw o p i t fa l l s, the mora l hazard a t tac hed to be ing and insurer

o f l as t resor t , w hen the insured may use the she l te r o f depos i t i nsurance t o

engage in r isky lend ing , w i thout d r i v ing away depos i to rs w ho are pro tec t ed

by the insurance, and the ex posure prob lem tha t the insurer o f las t resor t

has unl imi ted l iab i l i t y .

Fina l ly , it i s poss ible fo r a government t o use t ax po l i cy and d i rec t cap i ta l

regu lat ion and c ont ro l to manage t he r i sk iness o f fo re ign loan por t fo l i os .

Prior approval may be requi red for some forms of fore ign bor row ing, wi t h

qua l if i ca t ion o f l enders as w e l l as bor row ers , and res t r i c t i ons on m atur i t yand denominat ion of loans. Malays ia and the Phi l ipp ines are econom ies that

have used such cont ro l s . Taxes can be used to d iscourage shor t -te rm

cap i ta l movem ents. Chi le is an examp le. Capi ta l cont ro ls have a dow n s ide,

w h ich i s tha t t hey may reduce lender in te res t and in te r fe re w i th e f f i c ien t

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and t ime ly inves tment . For a cap i ta l cont ro l o r debt m anagement board to

work most e f fec t i ve ly , i t needs to func t ion as an agent fo r bor rowers ,

independent o f government cont ro l ex cept fo r w e l l -de f ined per fo rmanc e

standards fo r the r i sk c harac ter i s t i cs o f the loan por t fo l i o i t superv i ses .

6. IMPROVING INT ERNATI ONAL CREDIT ARRANGEMENTS6. IMPROVING INT ERNATIONA L CREDIT ARRANGEMENTS6. IMPROVING INT ERNATI ONAL CREDIT ARRANGEMENTS6. IMPROVING INT ERNATIONA L CREDIT ARRANGEMENTS

I have now d iscussed a var ie ty o f s teps an emerg ing economy can t ake

in i t i a te on i t s ow n to p ro tec t i t se l f aga inst som e o f the increased r i sks tha t

g lobal izat ion br ings. In addi t ion, there are pol ic ies that count r ies can

pursue jo int ly . F i rs t , major t rad ing par tners need to coord inat e ex cha nge

ra te po l i cy , coopera t ing to res i s t specu la t i ve a t tacks and pro tec t the

reserve posi t ions of the ind iv idual c ount r ies, avoid ing uni la tera l or duel ingdevaluat ions or in t erest rat e adjustm ents, and avoid ing uni la tera l imposi t ion

of t rade quotas or tar i f fs . In shor t , there needs to be a greater sp i r i t o f

coopera t ion be tw een government on t rade mat te rs . I t i s t rue tha t t rade i s

com pet i t i ve , and everyone has the i r ow n in te res ts . I t i s a l so t rue tha t t here

is g rea t mut ua l benef i t f rom comm erc ia l harmony.

Second, i t i s use fu l fo r count r ies to m on i to r i n te rna t iona l cap i ta l f l ows

and u t i l i ze ear l y warn ing sys tems to de tec t po ten t ia l f i nanc ia l p rob lems

before they steamrol l . The in ternat ional com muni t y should requi re the same

k ind o f t ransparency , cons is tency , and t ime l iness in pub l i c re lease o fna t iona l account and bank ing in format ion tha t i t does in the opera t ion o f it s

s toc k exc hanges. Such ru les do not work per fec t l y , and s tock m arket

scanda ls occ ur . How ever , they are e f fec t i ve in d iscourag ing many abuses,

and fo rc ing o thers in to s ight w here they can be cor rec ted .

Thi rd, co unt r ies should be sel f -protec t ive in the i r exc hange rate pol icy,

avo id tak ing r i sky pos i t i ons fo r temporary advantage, and pos i t i on

themse lves to w eather specu la t i ve a t tac ks . Managed f l oa ts i nv i te

spec ulat ive in terest . Super-f ixed exc hange rates (dol lar izat ion or c ur rency

un ions) across d i spara te count r ies are r i sky w i thout s t rong author i t y a t thecur rency un ion leve l to modu la te cyc l i ca l f luc t ua t ions . For example , i f t he

Uni ted Stat es had suppor ted t he Argent inean peso in 2000 -2001, as it d id

the Mex ic an peso in 1998, i t i s j us t poss ib le tha t specu la t i ve cap i ta l f l ows

cou ld have been de layed long enough fo r the c ount ry to ge t i t s f i sca l po l i cy

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under cont ro l w i thout the huge c r i s i s it has encountered. Comm i t t i ng to a

f ree f l oat o f one s c ur rency , ma in ta in ing t i gh t m oney to keep in f l a t i on under

cont ro l , and main ta in ing adequate reserves to d i scourage tes ts o f the

commi tment , has the bes t t rack record in te rms o f avo id ing specu la t i ve

at tac ks and c r i ses . The smal l cu t s and exc hange ra te r i sks assoc ia ted w i tha f l oa t ing exchange ra te seem to be a reasonab le pri ce to pay t o avo id

major c r i ses .

7. CONCLUSIONS7. CONCLUSIONS7. CONCLUSIONS7. CONCLUSIONS

I have now com ple ted my l i st o f po l ic ies tha t em erg ing economies can

tak e, ind iv idual ly , or w i th m ajor t rad ing partners, to prot ect them selves f rom

r isk o f f i nanc ia l c r i ses wh i le tak ing advantage o f the benef i t s o fg lobal izat ion, inc luding t rade promot ion and l ibera l izat ion of i ts f inancia l

market s . Inev itab ly , even w i th many pro tec t ions in p lace , poor management

or bad luck are go ing to somet imes get c ount r ies in to t roub le . My c los ing

comments are on what the communi ty o f na t ions , and the in te rna t iona l

ins t i t u t i ons they have es tab l i shed, can and shou ld do t o he lp ou t count r ies

in t rouble . The quest ion is how to w ork ou t p rob lems w i th the leas t damage

possib le to econom ies in cr is is . Current ly , in ternat ional lenders t reat c r is is

count r ies harsh ly , mak ing them exam ples to d i scourage futu re de fau l t s , and

pay ing scant a t t en t ion to the p l igh t o f the i r c i t i zens . Of ten , the mostin t ras igent l ender can b lock res t ruc tur ings tha t o f fe r these economies

reasonable w orkout s. The suppor t prov ided by the IMF is of ten cold

com for t , imposing crushing auster i ty as the pr ice of a bai lout . There seem s

to be som e consensus tha t ma jor c hanges in the prac t i ces o f i ndust r i a l i zed

count r ies and in ternat ional organizat ions might be desi rable, but are

un l i ke ly to happen w i thout concer ted and cont inu ing pressure f rom the

emerg ing economies . These inc lude cond i t i ons on the loan por t fo l i os o f

pr i va te lenders requ i r ing them to assume som e exc hange ra te r i sk , acc ept

buy in prov is ions, and d ivers i ty fore ign loans by matur i t y and cur renc y asw el l as des t ina t ion . They a lso inc lude re forms to in t roduce in te rnat ional

deposi tor insurance, an in ternat ional lender of last resor t , or a g lobal

bank r up t cy cou r t .

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There need to be more w ays than t he IMF cur rent l y p rov ides fo r count r ies

to w ork the i r w ay out o f c r i ses . IMF po l i c ies are too much in f l uenced by the

Uni ted Sta tes government and the in te res ts o f the la rge in te rna t iona l banks ,

and too l i t t l e i n f l uenced by the co l l ec t i ve in te res ts o f the emerg ing

eco nomies. The IMF should be reformed, and new inst i t u t ions designed tohelp c ount r ies manage cr ises should be c onsidered. I favor more open

evaluat ion and forecast ing of f inancia l problems by in ternat ional agencies,

and due d i l igence requi rement s for pr ivate lenders. Bet t er d iagnost ic s may

increase the number o f p rob lems detec t ed , bu t fo rce t hem t o be cor rec ted

w hen they are st i l l smal l . Regions such as Asia and Lat in Amer ic a should

cons ider fo rming the i r own ins t i tu t i ons to coopera t i ve ly i nsure the i r

mem bers. In the design of such inst i tu t ions, e i ther a revamped IMF or a new

regional organizat ion suc h as a Lat in Am er ican Monet ary Fund, the issue of

mora l hazard shou ld be a major cons idera t ion . I t i s c r i t i ca l tha t theex is tence o f i nsurance not be used to p romote more r i sky inves tment

programs, and th is requi res that any such organizat ion par t ic ipate

ef fect ive ly in prudent ia l superv is ion of the f inanc ia l inst i tu t ions i t insures.

In conc lus ion , I w ou ld po in t ou t tha t the des ign o f resource a l l oca t ion

mec han isms a lways c rea tes a tens ion be tw een fu ll decent ra l i za t ion tha t

puts t he incent ives for product ive behavior square ly on the par t ic ipants, and

mark et regulat ion t o manage r isk, cont ro l oppor tunis t ic behavior , and insure

adequate ou tc omes fo r a l l par t i c ipants . In te rna t iona l cap i ta l mark e ts

cur ren t l y exh ib i t some o f the adverse consequences o f i nsu f f i c ien tregulat ion, and i t i s in the in terest of a l l nat ions, indust r ia l i zed and

emerging, to redress the balance.

ReferencesReferencesReferencesReferences

A. Auerbach and R. Lee (eds) Demographic Change and Fiscal Pol icy,

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