It is fashionable to blame the International Monetary Fund for the wave of financial turmoil that has swept emerging markets since Mexico's ``Tequila crisis'' of 1994. By bailing out countries in trouble time and again, the IMF allegedly encouraged investors to take unwarranted risks, plowing money into countries without properly assessing whether they could ever pay it back. According to IMF critics, bailouts allowed leaders from Brazil to Turkey to avoid painful but necessary reforms, with the perverse effect of making crises inevitable.
This argument - an example of what economists call ``moral hazard'' - is easy on the mind, but it has feet of clay. In fact, foreign investment in emerging markets already started to subside after 1995, then plummeted with the Asian crisis of 1997, and has remained low ever since - even as the IMF orchestrated many of the bailouts that allegedly distorted investor behavior in the first place!
Moreover, foreign investment in emerging markets shifted after 1994 to factories, real estate, service industries, and so forth. Unlike foreign bondholders, who could cut and run after the IMF guaranteed that they would be paid, these direct investors suffered major losses when crisis struck--and thus can hardly be said to have benefited from bailouts.
Ever since the beginning of the 1990s, when private credit to emerging markets soared to roughly ten times its annual average in 1970-89, the main source of financial contagion has not been moral hazard, but what might best be called globalization hazard. The hazard struck after 1996, when foreign private investors fled emerging markets even faster than they had flooded them. For example, in 1997-98 Thailand suffered an outflow of foreign capital equivalent to 26% of GDP, despite a solid record of sustained economic growth.
Why were even relatively well-run economies pulled under so suddenly? The most likely scenario is that investors attributed the steep initial rise in credit flows after 1989 to sound policies in emerging markets. Throughout much of the 1990s, the ``Washington establishment'' reinforced this belief, encouraging an overly optimistic belief in the permanence of large credit flows.
Ultimately, however, each crisis multiplied the worries of investors about emerging-market risk. Worse still, their mood reversal was swift owing to the lack of a long and reliable track record for emerging-market debt. This drove up interest rates for emerging-market debt as an asset class . As borrowing costs rose in all emerging markets - regardless of their fundamental economic health - so did the probability of recurrent crises, forming a vicious circle.
At a time of escalating global turmoil, there is an urgent need for incisive, informed analysis of the issues and questions driving the news – just what PS has always provided.
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If this were the whole story, then what lay at the root of financial contagion in emerging markets would be of secondary importance. Whether moral hazard or globalization hazard, more careful credit rationing by investors could be expected to reduce the recurrence of financial crises.
But only up to a point. For while the moral hazard argument emphasizes the orthodox commandment ``Thou shall not intervene,'' the crucial feature of globalization hazard is market failure . Unlike moral hazard, market failure highlights circumstances in which government intervention is both socially desirable and economically defensible. That the failure of international capital markets led to sudden and devastating capital outflows after 1996 is only one such episode.
Consider other devastating events that are uninsured (and often uninsurable) in the private sector. In the US, for example, floods, hurricanes, earthquakes, and tornadoes trigger immediate Federal assistance. Similarly, the cost of the public's aversion to air travel following the September 11 th terrorist attacks would have been much higher for the economy as a whole if the airline industry had been allowed to collapse.
Unfortunately, many emerging markets have weak governments that cannot define credible policies for financing intervention in such circumstances. A typical case is a country whose terms of trade abruptly deteriorate - for example, Nicaragua after the recent collapse of coffee prices caused by Vietnam's bumper crop. When this happens in a country with few other economic sectors that can compete internationally and so take up the slack, the result is similar to a natural disaster. The government, faced with lower budget revenues, is likely to issue new debt, but without being able to specify how it will be repaid.
So, who will pay the bill eventually? The moment official intervention is required, everyone runs for cover. Investment decisions are postponed, implying slower growth and an even more precarious fiscal position. In an open economy, fears of higher taxes may spur capital flight and a run against the domestic banks, requiring even bigger government transfers. Weak governments grow weaker by the day.
But even weak governments are not entirely helpless. They can lengthen their debt maturities by imposing controls on capital inflows, as Chile and Colombia have done. They also can conclude trade agreements with more advanced economies. The North American Free Trade Agreement, for example, probably contributed to Mexico's strong and lasting recovery from the Tequila crisis.
The Tequila crisis demonstrates that rapid multilateral action - in this case, a $50 billion package to refinance short-term debts at below-market rates - can also be effective in preventing the spread of contagion. Such packages provide the breathing space that governments need in a crisis in order to launch longer-term reforms. This was true of Thailand and South Korea, when both moved fast to strengthen their banking sectors after receiving IMF bailouts.
IMF assistance is, of course, no universal panacea. Emerging markets are inherently fragile markets. Precisely for this reason, the problem has been too little multilateral intervention, not too much.
Although Donald Trump got off to a good start, with equity prices hitting all-time highs in anticipation of pro-growth policies, investor confidence has vanished, tanking the stock market. With the president deliberately undermining the foundations of US prosperity, one must ask why he is doing it, and what could stop him.
offers three explanations for a set of policies that have sent investor confidence into a tailspin.
The US administration’s plan to impose “reciprocal” import tariffs could severely curtail key Indian exports, including chemicals, metals, auto parts, and pharmaceuticals, leading to job losses and undermining fiscal stability. India has little choice but to lower its own tariffs while negotiating improved access to the US market.
urges policymakers to brace for the impact – known and unknown – of the US administration’s trade policies.
Less than two months into his second presidency, Donald Trump has imposed sweeping tariffs on America’s three largest trading partners, with much more to come. This strategy not only lacks any credible theoretical foundations; it is putting the US on a path toward irrevocable economic and geopolitical decline.
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It is fashionable to blame the International Monetary Fund for the wave of financial turmoil that has swept emerging markets since Mexico's ``Tequila crisis'' of 1994. By bailing out countries in trouble time and again, the IMF allegedly encouraged investors to take unwarranted risks, plowing money into countries without properly assessing whether they could ever pay it back. According to IMF critics, bailouts allowed leaders from Brazil to Turkey to avoid painful but necessary reforms, with the perverse effect of making crises inevitable.
This argument - an example of what economists call ``moral hazard'' - is easy on the mind, but it has feet of clay. In fact, foreign investment in emerging markets already started to subside after 1995, then plummeted with the Asian crisis of 1997, and has remained low ever since - even as the IMF orchestrated many of the bailouts that allegedly distorted investor behavior in the first place!
Moreover, foreign investment in emerging markets shifted after 1994 to factories, real estate, service industries, and so forth. Unlike foreign bondholders, who could cut and run after the IMF guaranteed that they would be paid, these direct investors suffered major losses when crisis struck--and thus can hardly be said to have benefited from bailouts.
Ever since the beginning of the 1990s, when private credit to emerging markets soared to roughly ten times its annual average in 1970-89, the main source of financial contagion has not been moral hazard, but what might best be called globalization hazard. The hazard struck after 1996, when foreign private investors fled emerging markets even faster than they had flooded them. For example, in 1997-98 Thailand suffered an outflow of foreign capital equivalent to 26% of GDP, despite a solid record of sustained economic growth.
Why were even relatively well-run economies pulled under so suddenly? The most likely scenario is that investors attributed the steep initial rise in credit flows after 1989 to sound policies in emerging markets. Throughout much of the 1990s, the ``Washington establishment'' reinforced this belief, encouraging an overly optimistic belief in the permanence of large credit flows.
Ultimately, however, each crisis multiplied the worries of investors about emerging-market risk. Worse still, their mood reversal was swift owing to the lack of a long and reliable track record for emerging-market debt. This drove up interest rates for emerging-market debt as an asset class . As borrowing costs rose in all emerging markets - regardless of their fundamental economic health - so did the probability of recurrent crises, forming a vicious circle.
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At a time of escalating global turmoil, there is an urgent need for incisive, informed analysis of the issues and questions driving the news – just what PS has always provided.
Subscribe to Digital or Digital Plus now to secure your discount.
Subscribe Now
If this were the whole story, then what lay at the root of financial contagion in emerging markets would be of secondary importance. Whether moral hazard or globalization hazard, more careful credit rationing by investors could be expected to reduce the recurrence of financial crises.
But only up to a point. For while the moral hazard argument emphasizes the orthodox commandment ``Thou shall not intervene,'' the crucial feature of globalization hazard is market failure . Unlike moral hazard, market failure highlights circumstances in which government intervention is both socially desirable and economically defensible. That the failure of international capital markets led to sudden and devastating capital outflows after 1996 is only one such episode.
Consider other devastating events that are uninsured (and often uninsurable) in the private sector. In the US, for example, floods, hurricanes, earthquakes, and tornadoes trigger immediate Federal assistance. Similarly, the cost of the public's aversion to air travel following the September 11 th terrorist attacks would have been much higher for the economy as a whole if the airline industry had been allowed to collapse.
Unfortunately, many emerging markets have weak governments that cannot define credible policies for financing intervention in such circumstances. A typical case is a country whose terms of trade abruptly deteriorate - for example, Nicaragua after the recent collapse of coffee prices caused by Vietnam's bumper crop. When this happens in a country with few other economic sectors that can compete internationally and so take up the slack, the result is similar to a natural disaster. The government, faced with lower budget revenues, is likely to issue new debt, but without being able to specify how it will be repaid.
So, who will pay the bill eventually? The moment official intervention is required, everyone runs for cover. Investment decisions are postponed, implying slower growth and an even more precarious fiscal position. In an open economy, fears of higher taxes may spur capital flight and a run against the domestic banks, requiring even bigger government transfers. Weak governments grow weaker by the day.
But even weak governments are not entirely helpless. They can lengthen their debt maturities by imposing controls on capital inflows, as Chile and Colombia have done. They also can conclude trade agreements with more advanced economies. The North American Free Trade Agreement, for example, probably contributed to Mexico's strong and lasting recovery from the Tequila crisis.
The Tequila crisis demonstrates that rapid multilateral action - in this case, a $50 billion package to refinance short-term debts at below-market rates - can also be effective in preventing the spread of contagion. Such packages provide the breathing space that governments need in a crisis in order to launch longer-term reforms. This was true of Thailand and South Korea, when both moved fast to strengthen their banking sectors after receiving IMF bailouts.
IMF assistance is, of course, no universal panacea. Emerging markets are inherently fragile markets. Precisely for this reason, the problem has been too little multilateral intervention, not too much.