The Financial Crisis in Emerging Markets: Lessons for Global and Not-So-Global

Financial Architecture

Conference “Preventing the Next Financial Crisis”Columbia University, December 11, 2008

Erik BerglofChief Economist

European Bank of Reconstruction and Development*

Remarks are in personal capacity and need not reflect the views of the EBRD

The crisis is now global

Recession in all major industrial regions

World trade and global capital flows falling

Emerging markets facing ”sudden stop”

Emerging Europe is particularly threatened

But even China severely affected

”Global Financial Architecture” discussion is (once again) in full swing

How much “global financial architecture”reform do we need?

Objective of this talk: to convince you of three points.

1. The real news not the lack of decoupling of emerging markets but rather their extraordinary resilience

2. The cause of this crisis not found in the “international financial architecture” but in national (and regional)architectures in the face of excess global savings

3. But deficiencies in the international financial architecture an important impediment in containing the crisis. This is where progress is urgently needed.

Claim 1With respect to emerging markets, the real news in this crisis is extraordinary resilience

(yes, so emerging markets have finally been hit. But it took a nuclear explosion in the centre of the system to get to this

point—not, as in the past, “the drop of a pin”)

Until September 2008, emerging markets had largely “decoupled”

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Emerging markets much more resilient than in earlier crisesAverage response of EMBI to daily changes in the VIX during periods of financial volatility in the United States

Jan-Mar 91 1/ Jul 97-Feb 98 Jul 98-May03 Jul 07-Sep 08 Sep-Dec 080

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Note: Based on regression of daily changes in EMBI spreads on changes in the VIX in periods during w hich the VIX consistently exceeded 20 points. 1/ Constrained by data availability. Turbulence period started in July 1990.

Average VIX around 60!

Average VIX around 25 in all four episodes

What explains the resilience of emerging markets–until now?

Not: Better “international financial architecture”. Since 1998 much talk, no action.

Rather: improvements in emerging market fundamentals: policies and institutions.

In most countries: lower public debt, better fiscal policies; better monetary frameworks; more stable external capital structures

In some countries (but not in transition economies): lower foreign currency external debt

Public debt ratios have declined – and are especially low in Eastern Europe

Public debt over GDP

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Liquidity ratios improved in many emerging markets, not in Eastern Europe

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Unlike other emerging markets, current account deficits large in Eastern Europe

FDI and CA balance (% GDP, in 2007)

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FDI comparator countriesCA balance comparator countries

FDI EBRD countriesCA balance EBRD countries

…though they have largely been financed by FDI

What sets aside Eastern Europe is the huge increase in private external debt …

Private debt over GDP

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Syndicated lending is sharply down, but parent bank financing has held up so far

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Total net bank lending: still high ... in spite of declining wholesale lending

Source: BIS Source: Dealogic

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Claim 2Deficiencies in the “international financial

architecture” cannot be blamed for the current crisis (and more generally, so far do not matter a whole lot in crisis prevention)

(omnipotent, perfect international institutions could prevent crises –but so could omnipotent, perfect national institutions)

The list of potential crisis culprits is long ...

Too high global savings chasing too few assets

Liquidity fueled by lax monetary policy

Distortions caused by the GSE model in the U.S.

Failures to regulate subprime lending in the U.S.

Failure to regulate exposures to structured products across the globe

Failures of financial institutions and rating agencies to recognize dangers associated with structured products

Allowing Lehmann to collapse...

... but global financial architecture is not on the list

Problem was not collective action at the international level, or lack of global institutions

Global institutions would only have helped if they had been both more powerful and wiser than national institutions – a tall order

More generally, lack of global coordination is rarely the bottleneck in crisis prevention

Domestic policy failures and spillovers across countries together produce international crises

But lack of cross-country coordination rarely explain why policymakers fail to prevent crises

So far, if policymakers had always taken the right crisis prevention steps from a purely national perspective, they would also have gotten it right from an international perspective

...but failure of EU architecture made Eastern Europe highly vulnerable

Eastern European banking system controlled (80 per cent) by international banking groups

EU members (and candidates) deregulated their capital accounts

Regulation and supervision through home-host country coordination failed

Lack of centralized financial regulation and supervision at the EU level

Claim 3In contrast to crisis prevention, the

international dimension is hugely important in crisis resolution

(and this is where the beef is right now)

Two international dimensions to crisis resolution

Once a crisis hits, emerging markets are (almost by definition) in need of external funding

In a crisis, countries often tempted to take actions that are individually rational (in the national interest) but make everyone worse off collectively. True in the Great Depression - and in the current crisis.

The current crisis response fails along both dimensions

Problem 1: Underfunded international crisis lending

IMF quotas have not been revised since 1998. The IMF is ill-equipped to deal with the current crisis

European Commission funds are even smaller

If rescues with high private rollover rates a gamble during the Asian crisis – with ample international liquidity – they are an even bigger gamble today

In the short run, the IMF should use ad-hoc liquidity promises (Japan) to scale up its financial support. In the longer run, significant quota increase needed

Problem 2: Adverse spillovers from national rescue packages

In a financially integrated system, national rescues can have adverse external effects

Passively: by drawing deposits and capital flows away from countries with weaker government support and distorting competition

Actively: by limiting international banking groups’ability to support subsidiaries across borders

Reinforced the crisis in Eastern Europe, and worsen as the capitalization of banking groups deteriorates

Needed: a coordinated resolution of financial sector problems in East and West

Government banking support should focus on the group, not just the parent or just the subsidiary

Requires close home-host country coordination

Governments should not get in the way of parent bank support for subsidiaries

International institutions can help, either at parent bank level (EIB) or at subsidiary level (EBRD, IFC)

Conclusion

The international financial architecture a non-issue both with respect to the causes of the crisis, and in explaining the resilience of emerging markets (weak EU architecture made Eastern Europe vulnerable)But a huge issue in the crisis going forward.Eastern Europe immediately needs a plan involving both home and host countries, and international banking groups and international lendersIn the longer run, the global architecture needs a not-so-global (regional) intervention mechanism that mirrors the integration at the bank group level

The crisis is now globalHow much “global financial architecture” reform do we need?Until September 2008, emerging markets had largely “decoupled”Emerging markets much more resilient than in earlier crisesWhat explains the resilience of emerging markets–until now?Public debt ratios have declined – and are especially low in Eastern EuropeLiquidity ratios improved in many emerging markets, not in Eastern EuropeUnlike other emerging markets, current account deficits large in Eastern EuropeWhat sets aside Eastern Europe is the huge increase in private external debt …Syndicated lending is sharply down, but parent bank financing has held up so farThe list of potential crisis culprits is long ...... but global financial architecture is not on the listMore generally, lack of global coordination is rarely the bottleneck in crisis prevention...but failure of EU architecture made Eastern Europe highly vulnerableTwo international dimensions to crisis resolutionProblem 1: Underfunded international crisis lendingProblem 2: Adverse spillovers from national rescue packagesNeeded: a coordinated resolution of financial sector problems in East and WestConclusion