Financial Globalization Opportunities and Challenges for

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					Latest Generation of Systemic Crises:
―I don’t think we are in Kansas anymore‖
Augusto de la Torre The World Bank

Finance Forum
June 20-22, 2002

Key facts on recent financial crises
Increasing frequency of severe twin crises
Twice as disruptive as currency crisis, adding 15% to cumulative output loss (Bordo et al. 2001)

Sudden stops
Current account deficits are not new
 Large & sustained deficits/surpluses during gold standard era

What is new: speed of major current account reversals

Linked somehow to financial globalization
Sudden stops have exogenous components and international capital markets are imperfect
 Russian contagion, ―globalization hazard‖ (Calvo 2002), weak framework of international institutions

Key facts on recent financial crises (2)
…but not explained by globalizatin per se
Gold standard era—greater financial globalization… …with less frequent currency and twin crises

With isolationism per se not preventing crises
Frequent currency crises in Bretton Woods, despite domestic financial repression and capital controls

Emergence of new, disturbing varieties
Triple (currency, banking, and public debt) crises Widespread breakdown of contracts/property rights

Crises have become more frequent…
14.00 Banking Crises 12.00 10.00 8.00 6.00 4.00 2.00 0.00 1880-1913 1919-1939 1945-1971 1973-1997 (21 countries) 1973-1997 (56 countries) Currency Crises Twin Crises All Crises
Frequency (annual % probability)

Source: Bordo et al. 2001

…but not more severe, on average…
All countries 1880-1913 Currency Crisis Banking Crises Twin Crises All Crises Currency Crisis Banking Crises Twin Crises All Crises 2.6 2.3 2.2 2.4 8.3 8.4 14.5 9.8 1973-1997 21-nations 1973-1997 56-nations 2.1 2.6 3.8 2.5 5.9 6.2 18.6 8.3

1919-1939 1945-1971 Average duration of crises in years 1.9 1.8 1.9 a 2.4 3.1 2.7 1.0 3.7 2.4 1.8 2.6 Average crisis depth (cumulative GDP loss in %) 14.2 5.2 3.8 a 10.5 7.0 15.8 1.7 15.7 13.4 5.2 7.8

Notes: a indicates no crises

Source: Bordo et al. 2001

Anguish zones under financial globalization
Contagion Risk (Runs)
Multiple equilibria
Current account / fiscal deficits  Overvalued currency Highly indebted government Wretched Trinity: Weak currency Fear of floating Weak institutions

II
Low currency & maturity mismatches

IV

Currency mismatches

I
Blessed Trinity: International currency Flexible exchange rate Sound institutions

III

Weak institutions

Incentive Distortions

Anguish zones under financial globalization
Contagion Risk (Runs)
Multiple equilibria
Current account / fiscal deficits  Highly indebted government Run on the currency Depositor run on system

II
Low currency & maturity mismatches

IV

Currency mismatches Run by foreign portfolio investors

I

III
Depositor flight to quality

Incentive Distortions

Type IV crises: Management and resolution issues
Containment Loss allocation Restructuring Regeneration International financial architecture

Type IV crises – containment issues
Contract-abiding containment proves insufficient
Defenses of currency (int’l reserves, interest rate hikes) and of banks (LOLR)—inconsistent and break down Full deposit guarantee (to retain depositors at home while facilitating bank closures) lacks credibility

Huge coordination/discernment problems Forcible containment—through contract violation
Deposit freeze (―corralito‖) and deposit securitization Stock pesification cum float Generalized internal and external defaults

Alternative to consider
Stock dollarization cum pesification at the margin

Type IV crises – loss allocation issues
Allocation through administrative measures or negotiation (not via hyperinflation) Pressures on government to ―compensate‖ agents for the effects of extreme policies
Not independent of nature of forcible containment

Huge coordination/discernment problems Dominance of political economy dynamics
Process depends significantly on quality of governance and power of traditional oligarchies

Burden sharing takes on new meaning

Type IV crises –restructuring issues
Fear of bank closures in midst of runs Post-freeze securitization could help restructuring
By shrinking banks’ balance sheets But asset management/disposal still a major issue

Special problems for bond-based recapitalization
How to value debt issued by government in default? Bank nationalizations Can recapitalization debt be made senior without violating negative pledge and other clauses?

Innovative corporate restructuring frameworks

Type IV crises – regeneration issues
Growth regeneration depends on…
Confidence and capital reflows Degree of openness in trade structure Speed/effectiveness of loss allocation and restructuring

…but its sustainability requires regeneration of financial intermediation…
Establishment of currency as ―store of value‖ Questions on new industrial organization of sector (narrow banks, offshores, etc.) Segmentation of access

…and institutional regeneration
Contractual and regulatory environment Democratic governance

Type IV crises – int’l architecture issues
Imperfections of int’l financial markets
Contagion (Calvo’s EMF) Defaults (int’l bankruptcy, exit consents, UDROPs, floor to debt to facilitate agreement on haircuts) Potential role of IFIs in peso debt markets development Externalities of fluctuations in international currencies

Fixing them would benefit EMs the most… …but incentives for industrial countries are weak Multilateral & regional institutions have a major responsibility