Sizing Up the Debt Dilemma: Lessons from
Sovereign Debt Crises in Emerging
Markets
LILIANA ROJAS-SUAREZ
Bretton Woods Committee
May 2012
•
A lesson learned the hard
way in Emerging Markets is
that a vicious circle between
sovereign debt crisis and
banking crises can easily be
formed.
•
Over the last thirty years,
there have been abundant
examples of concurrent
sovereign debt and banking
crises in Emerging Markets.
•
This combination resulted in
very large output losses.
Banking Crises and External Debt Defaults in
Emerging Markets -Selected Examples
Year of
default or
restructuring
Argentina
1980-1982
1982
2001-2004
2001
Bulgaria
1995-1997
1990
Chile
1976
1972
1981-1986
1983
Ecuador
early 1980s
1984
1998-2000
2000
Egypt
early 1980s
1984
Jordan
1989-1990
1989
Mexico
1981-1991
1982
Morocco
early 1980s
1983
Peru
1983-1990
1984
Russian Federation
1998-1999
1998
Trinidad and Tobago
1982-1993
1989
Uruguay
1981-1984
1983
Venezuela
late 1970s-1980
1982
Year of
Banking Crises
Sources: Caprio and Klingebiel (2003) and Reinhart and Rogoff (2009)
• Experience shows that the interrelationships between
external debt and banking crises might start with
problems in either the banks or the public sector.
1: Large external (mostly short-term) private debt
 unsustainable credit growth credit boom that ends in a
bust  banking crisis  resolution involving large fiscal
costs. Ex: East Asian crises
2: Large fiscal deficits and sovereign external debt problems
 incentives or forceful allocation of government paper
in banks’ balance sheets  banking crisis following
sovereign defaults.
Indonesia is a good
example of the first
pattern…
…while Russia
exemplifies the
second pattern
Mispricing of Risks: The Key Factor for Amplifying the
Interrelation between sovereign Debt and Banking
Problems
Example 1: A good example has been role of Basel-based capital
requirements
• Zero or low-risk weights attached to government debt have led to
increased banks’ holding of government paper, especially at times
of economic slowdown, reducing credit to the private sector and
further exacerbating recessions and banking difficulties.
• This is evident in pre-banking crisis periods, such as those in
Argentina and Turkey.
Mispricing Risks
The Basel-based capital requirements
Banks increased their holdings of government paper, even though
perceptions of sovereign creditworthiness deteriorated!
Mispricing Risks
• As perceptions of country creditworthiness
deteriorate, government liabilities may become
as risky as or even riskier than certain private
sector liabilities.
Lack of recognition of this factor in Basel I, II and III leads
to “contagion” from sovereign debt problems to banks
Mispricing Risks
Example 2: Implicit and underpriced government
guarantees lead to excessive banks’ risk-taking
AN EXAMPLE OF AN UNDERPRICED GUARANTEE:
1. Fixed exchange rates (not sustained with appropriate fiscal policies -including adequate levels of sovereign debt).
- Induces banks’ overlending to the non-tradable sector (such as the housing
sector)
- If a devaluation occurs, the banking sector might collapse
- But a devaluation might be unavoidable if high levels of debt leads to a sharp
reduction in confidence in the currency
A lesson from Emerging Markets: exchange rate risk can easily transform into credit risk
• Examples: East Asian crises (1997-1998); Eastern European Crisis (2007)
• In advanced Europe: Eurozone implicit guarantee
From Vicious to Virtuous: Four Pillars to Latin
America’s and Asia’s Financial Stability and Growth
1)
AMPLE AVAILABILITY OF EXTERNAL LIQUIDITY
If a country does not have the capacity to issue “hard currency”
(internationally tradable currencies), its best insurance against
volatile capital markets is the accumulation of liquidity:
− International reserves (central banks)
− High liquidity ratios (financial institutions)
− Agreed lines of credit with the IMF (like the FCL)
•
•
•
Only countries with full access to a lender of last resource in hard currency can
afford to avoid self-accumulation of liquidity.
Uncertainties about a credible lender of last resort have exacerbated problems
in Europe.
Discussion on “fiscal solvency” lose meaning when countries face a liquidity
constraint.
From Vicious to Virtuous: Four Pillars to Latin
America’s and Asia’s Financial Stability and Growth
2). INCREASED FLEXIBILITY OF EXCHANGE RATES (NOT “PURE”
FLOATING)
Allowing the exchange rate to depreciate at times of increased
turbulence in international capital markets avoids the conflict
between:
− increase interest rates to defend the value of the currency
− lower interest rates to promote growth and prevent banking sector
weaknesses
•
•
•
During the global financial crisis, many Latin American and Asian countries
were able to lower interest rates –countercyclical monetary policies –without
generating a “one side-bet” against the currency.
Interest rates have gone back to normal levels now in many EMs, allowing
space for action if a new adverse external shock materializes.
In contrast, advanced economies don’t have too much room for countercyclical
monetary policies.
From Vicious to Virtuous: Four Pillars to Latin
America’s and Asia’s Financial Stability and Growth
3). ADEQUATE FISCAL MANAGEMENT LEADING TO SUSTAINABLE PUBLIC
DEBT RATIOS THROUGH:
− Implementation of fiscal responsibility laws: creation of
“fiscal space” for countercyclical policies.
− Establishment of an adequate maturity structure of
government debt.
A key Lesson: There is no magical debt/GDP ratio that guarantees fiscal
sustainability. A country with low debt/GDP ratio can become over-indebted if a
sudden shock drastically reduces its access (and increases the cost) to the
international capital market. ASSESSING ACCESS TO LIQUIDITY SHOULD
GUIDE PUBLIC LEVEL OF INDEBTEDNESS
From Vicious to Virtuous: Four Pillars to Latin
America’s and Asia’s Financial Stability and Growth
4). WELL REGULATED AND SUPERVISED FINANCIAL SYSTEMS
− Conservative supervision pays-off – especially when the role
of high liquidity is recognized.
− It’s a myth that conservative supervision leads to less credit
and reduced access of the population to financial services.
Loose supervision is a culprit for lack of access.
Key Lessons:
•
•
Enforcement of existing regulations is central to minimize banking problems.
This was a problem in the recent US crisis.
Distorting regulations (Basel I, II and liquidity requirements in Basel III) can
give a false sense of security, while exacerbating problems in bad times.
Sizing Up the Debt Dilemma: Lessons from
Sovereign Debt Crises in Emerging
Markets
LILIANA ROJAS-SUAREZ
Bretton Woods Committee
May 2012