Crisis Management Issues

With the possible exception of Turkey, where the underlying macroeconomic situation remains brittle, none of the countries in the emerging Europe region is a likely candidate for a possible financial crisis of the kind seen in the second half of the 1990s and which has engulfed the Latin American economies during the past twelve months. Russia’s strong fiscal and external accounts and rapidly falling levels of indebtedness have given it a thick protective barrier and the central and eastern European economies will continue to benefit fr om structural reforms implemented in the run up to EU enlargement. A recent article by George Soros highlights some aspects of crisis management in emerging markets which, the above notwithstanding, it is useful to examine, given the growing risk of contagion in a world of fully integrated capital markets. (See the Financial Times, 13 August 2002.)

By way of illustration, Mr Soros suggests that the crisis is Brazil has more to do with investor fright than with Brazilian fundamentals. The disappointing response of the market to the announcement of another IMF bailout is partly a reflection of investor concerns about the possibility of an “adverse” result in the forthcoming presidential elections (which itself raises basic questions about the interaction between the democratic process and financial markets), but mainly a reflection of risk aversion in the middle of a global slowdown. With Brazilian bond yields at historically high levels, the fiscal effort that would be necessary to bring the debt/GDP ratio to a sustainable path is so enormous as to be not politically credible. (In an article in the International Herald Tribune professor Stiglitz highlights the much better fundamentals in Brazil than in Argentina and suggests that if markets understood “the state of affairs in Brazil, interest rates and exchange rates should adjust” and “Brazil should have no difficulty meeting its commitments” - 15 August 2002).

In Mr Soros’ view the absence of a lender of last resort for the global economy creates a situation wh ere countries have to over-adjust because investors require extra insurance against the risk of default. He argues that “a modicum of moral hazard” is implicit in every economy with a lender of last resort. But whereas this has been understood by market participants in the context of national economies, the lesson has not yet been learned internationally. Rather than asking what is the level of the primary surplus that is necessary to stabilise debt ratios, Mr Soros suggests a different question: what is the level of interest rates that is consistent with “reasonable growth” and fiscal sustainability? Provided the authorities are judged to be making good faith efforts to implement appropriate policies, a combination of “international credit enhancements or guarantees” could be a much better way of giving confidence to investors that risks would be maintained within reasonable bounds. The alternative, a $30 billion package of loans with many strings attached, the overwhelming part of which is not even projected to be disbursed until 2003, is of limited use as a confidence-building mechanism.

There is a useful historical precedent (which Mr Soros does not mention) which  supports his main thesis. In 1990 the IMF, after much agonising and heated debate, introduced a sizable Stabilisation Fund for Poland, to defend the currency against speculative attacks at a time of radical economic transformation. The SF was enormously successful, even though not a single drawing was ever made! It permitted a lower level of interest rates than would have been otherwise necessary; it eased the programme’s fiscal adjustment, it therefore helped reduce the country’s risk premium, at virtually zero cost. We share Mr Soros’ implicit contention that, unless supported by some such institutional innovations, emerging market crisis will continue to plague the global economy. [1]

[1]  This and related issues will be addressed in a forthcoming Global Economics publication.