EXPLAINING FINANCIAL CRISES IN EMERGING MARKETS – AND WHY THEY WILL HAPPEN AGAIN… What changed during the 1990s to account for the frequency and severity of financial crises in emerging markets? Will there be more crises in the future? Writing in the latest issue of the Economic Journal, Professor Michael Dooley provides a coherent explanation of the explosion of capital inflows into emerging markets in the 1990s and the timing and severity of the crises that followed. He argues that the underlying mechanism is the same for Mexico, Russia and Korea. Moreover, since nothing fundamental has changed, we should expect more crises in the future. The basic idea is that all private investors in emerging markets, including residents of these countries, understand that during a crisis, some or all of their financial claims will be transformed into claims on the government. Expected repayment therefore depends on the government's resources and the government's incentives to use those resources to pay creditors. Even investors that do not expect to benefit directly from government insurance benefit indirectly. If some investors are bailed out, those that remain - for example, equity investors - have a better chance of recovering their capital. The very high returns on equity positions leading up to crises suggests that investors knew these were uninsured and therefore relatively high-risk investments. Dooley calculates that following crises, insurance covered about two thirds of the net private capital inflow since 1990. Once a crisis is underway, the government is unable to borrow from private markets. So credible insurance must be backed by assets such as net international reserves that the government can sell or by access to loans from governments and international organisations. For insurance to be credible, the government must also have strong incentives to exhaust its reserves and lines of official credit after the crisis is under way. Finally, investors must be able to generate insured financial obligations. All three conditions must be in place to generate an inflow/crisis sequence. Crises are observed when the addition of a ‘missing ingredient’ sets off a capital inflow. Since the missing ingredient will vary from country to country, and even for a given country over time, crises will seem to be unrelated to fundamentals. A more careful look at recent crises suggests that insurance fundamentals are the common denominator for recent crises. For emerging markets in Latin America, the missing ingredient before 1990 was the resource to make insurance credible. The 1982 debt crisis left these governments with debt that far exceeded their liquid assets. A number of factors contributed toward building an exploitable insurance fund at the end of the 1980s. Debt restructuring under the Brady Plan and a dramatic decline in international interest rates reduced the market value of Latin American governments' debt. At the same time, economic reform and stabilisation programmes opened lines of credit with international organisations and wealthy governments. Finally, about half of the capital inflow that responded to the new insurance pool was salted away in reserves and this further augmented the insurance fund. Such a sequence ends in crisis when the insurance fund can no longer cover the expected claims on the government's liquid assets during the crisis. Emerging markets in Asia also benefited from the fall in international interest rates but the more important change in Asia was deregulation of financial markets. In these countries, insurance of financial markets was credible but was difficult to exploit. Financial liberalisation resulted in an explosion of domestic credits, much of which was fuelled by borrowing from non-residents. Asian emerging market countries were also committed to manage their exchange rates, making them an inviting target for a capital inflow/attack sequence. Governments in both Latin America and Asia were committed to defending their exchange rates. In practice, this meant that investors could be confident that all available reserves and lines of credit would be exhausted in defending the regime. But a fixed exchange rate is not a necessary condition for an inflow/crisis sequence. In Russia, investors believed that the government's domestic-currency debt would be insured by access to official credits. Investors were half right. The international institutions delivered the expected insurance cover, but the governments managed to divert the proceeds to their friends. Note for Editors: ‘A Model of Crisis in Emerging Markets’ by Michael Dooley is published in the January 2000 issue of the Economic Journal. Dooley is Professor of Economics at the University of California, Santa Cruz. For Further information: contact Michael Dooley on 001-831-459-3662 (email: firstname.lastname@example.org); or RES Media Assistant Niall Flynn on 0171-878-2919 (email: email@example.com).