Pro-Cyclicality of Financial Systems and the Crisis: Should Emerging Markets (EMkts) Be Bold or Extra-Cautious in their Policy Responses?

Some macro-financial pro-cyclicality is inherent to financial systems, how should EMKts deal with it?

In last month’s piece, I suggested that risk-evaluation techniques played a perverse role in amplifying the financial accelerator in mature financial markets. That problem is part of a broad on-going re-assessment of the relationship between the financial sector’s regulations (especially those around Basel II[1]) and its inherent pro-cyclicality (see Taylor and Goodhart (2006)).  An emerging analytical work (see Borio (2008)), focusing on a “risk-taking” channel, could help to explain “persistence” in the transmission of monetary policy. It seems to indicate that minimum capital requirements can lead to an increase in pro-cyclicality, when higher risk-sensitivity of capital results in a lending pattern that amplifies booms and busts with real economy effects. The jury is still out to examine the combined results of theoretically stronger supervision and market disclosure rules (the other two pillars of the new Basel regulatory framework) [2]. Can supervision do its role well using inadequate risk-measurement tools? For example, perhaps if the (minuscule but not zero) probability of a single extreme event was computed in “through-the-cycle” ratings covering the true exposure of banks’ balance sheets, supervision and disclosure might have played their expected cycle-moderating role.

Macro-financial pro-cyclicality (partly linked to regulations, lax supervision, tools, etc.) can be observed, indeed, in the North. However, the IFIs’, BIS’s analysis so far is focusing essentially on mature economies and their financial services industry. What about EMkts? Well, they have identified a long time ago the main transmission mechanisms that amplify their own cycles: (a) external debt and equity flows subject to country-specific capital account rules and risk premium conditions; (b) usually weaker domestic regulations and supervision, one of the reasons why many were (before this crisis) on their way to implement Basel II. They also knew that the combination of large inflows and poor regulation/supervision led to busts (crises with sudden reversals of flows), especially when they held macro policies inconsistent with exchange rate regimes.

But here’s the paradox. EMkts have generally fixed their previous shortcomings of the 1990s.  They learned the lessons from their own crises. The current one did not originate in the South and EMkts’ banks were not generally exposed to “toxic assets” from the North. It is mainly greater interconnectedness with the global export and financial markets that is affecting EMkts.  The aggressive expansionary policy responses in the North depart dramatically from those recommended to EMkts in previous financial crises. So it is natural that EMkts, admittedly holding now stronger macro and financial fundamentals, ask themselves whether or not they should try to maintain the momentum of their previous credit and growth cycle, even when flows from the North are drying up.  How should EMKts deal with this particular crisis and should they be bold or extra-cautious in their policy responses?

EMkts Learned Painful Lessons from Previous “Cycles” with Large Capital Inflows

There is, of course, great diversity among EMkts.  There are structural “savers” and “consumers”, with different “flow structure” financing current accounts deficits, shades of “peggers” and “managed-floaters”, exporters of “commodities” versus “manufacturing” goods, with different sizes of domestic demand, countries with more or less “depth” and sophistication in their domestic financial markets, etc.  The literature (see Demirgüç-Kunt, A., and Detragiache, E. (1998)) has advocated a conventional wisdom sequenced path for capital account liberalization starting with strengthening domestic regulation and supervision before embarking on greater financial integration.  With the adequate framework, this literature/practice posited a “virtuous” relationship between financial deepening/integration, regulatory frameworks and “sound” financial systems and hence higher growth/welfare (see Caprio, G., and Klingebiel, D. (1996)). My sense is that there was less of a concern about “bubbles” in EMkts than about “missing opportunities” to increase financial integration.  And indeed, despite less developed and unevenly regulated/supervised local financial markets, most EMkts benefitted from credit booms in the North in congruence with their own relative risk and fundamentals.  Various issues of the Global Development Finance (see World Bank’s GDF (2008)) illustrated the key role of external capital in increasing leverage in EMkts’ banks for financing of trade, investment and local credit and equity markets.  A good illustration was the East-Asian boom in the 1990s and, in the early 2000s, Eastern Europe with cycle-amplifying debt inflows.  Available (but scarce) papers test and confirm the existence of pro-cyclicality in EMkts (see Craig S.R., Davis P., Garcia Pascual A. (2006) for Asia) and the role of external financing.

But at the same time, policy-makers learned that sudden and huge reversal of flows like the late 1990s currency/banking crises were possible and called for keeping macro-policies consistent with the chosen exchange rate regime (see Agénor and Montiel (2008)). For example, under the pre-Asian crisis (mostly) pegged exchange rate frameworks, large inflows led to pressure on the pegs, currency mismatches in banking sectors, short-term over-borrowing under insufficient levels of reserves. So the defensive framework evolved: (mostly) to floating (e.g., Brazil, Mexico, some East-Asians) and/or pegging with (much higher, e.g., China) levels of reserves (or some “implicit” guarantee, i.e. for EMkts closer to the Eurozone), and of course a restructuring and strengthening of local banking systems.  That included stronger supervision and prudential rules pointing to the direction of Basel.  In parallel, macro policies were also upgraded (e.g., on the fiscal and inflation targeting fronts) and there was a general feeling –validated by rating agencies– that EMkts ended up after their crises with stronger fundamentals and better banks. There was even talk of “decoupling”!

Surprise! What EMkts Got in 2008 Was Not What Was Promised….

Having learned their lessons from the 1990s and done (most) of their homework, EMkts looked at the 2000s’ cycle as a much more promising way to grow and prosper.  From a typical EMkt’s perspective, everything was going all right and as promised (greater financial integration was supposed to improve regulations, supervision and local financial stability, see Levine (1996)). The largest economy (the US) was growing fast and importing much; its major financing counterparts (Asia and oil producers) were also demanding more from the rest of the world, driving commodity prices and export volumes up.  Abundant liquidity was cheaper, less “home-biased” and also flowing South. And for structural or just temporary “savers”, it was logical to continue building reserves and hence financing the US current account deficit. Global growth was not balanced? Sure, but corrections were under way, with a gradual depreciation of the dollar even helping in controlling global inflationary pressures. It was not in the TORs of EMkts policy-makers to start getting worried (although some did) about the lower credit quality, excessive leverage of the financial sector industry in the North (and especially in the US) and the risks associated with its creative financial engineering. We know now the end of this movie.

So the crisis triggered a legitimate sense of frustration. Most EMkts are facing now problems they feel they don’t “deserve”: (1) External financing has “suddenly stopped” and in any event, has become more expensive, with EMBI spreads rising; worse, some “good, investment grade” EMkts face significant capital outflows –the most benign form being simply profit-taking–; their corporates and banks have greater funding problems in international markets under flight to safety (US Treasuries) mode; that is compounded by problems in rolling over existing international borrowing, forcing firms and banks to rush for assets to liquidate[3].  (2) The significant decline in demand for exports, which affects most EMkts, and the collapse of commodity prices seem far from having reached its bottom. And (3), most importantly, their domestic production is adjusting to new expectations of a protracted crisis far beyond the foreseeable external contraction.

Ironical but logically, EMkts that got financially interconnected the most (e.g., those surrounding the Eurozone and the anglo-saxon banking sectors) and relied more on external (volatile) debt financing are now the worse off.  In other cases (e.g., Latin America) shallow financial systems, higher domestic interest rates (due to past higher inflation, higher debt and lower macro credibility), poorer governance/business practices, idiosyncratic local political economy and tax factors, all contributed to somehow slow down financial integration[4]. But I guess the most puzzling aspect of this crisis for many EMkts’ policy-makers has been the path taken by industrial countries in stimulating their domestic demand through (announced but only in the making) large fiscal packages and aggressive monetary policies, together with intervening through ad hoc changes to rules and regulations[5], something that was “anathema” previously.

EMkts‘ Reponses to the Crisis: How Deep is Your Pocket?

So with a lot of annoyance and bewilderment, EMkts’ are finding themselves into two types of situations in this crisis.  The first is the well-known forced adjustment through a balance-of-payments crisis, usually under an IMF-managed program (e.g., many Eastern European EMkts). The second is less usual: many EMkts are hit but not like in previous crises. So there is the temptation of maintaining activity at (roughly) previous levels using the public sector’s “deeper pockets”, i.e., transferring to the government’s balance sheet part of the weaknesses observed in the private sector’s balance sheet.  Faced with a collapse in demand, a “logical” policy response is to do pretty much what the industrial countries are doing, with large liquidity injections, relaxing fiscal and monetary stances, using reserves, guarantees and other instruments to prop up credit markets, etc. An irony is that those EMkts that resisted the pressure to privatize extensively their domestic banking sectors have now, through their local public sector financial entities, more discrete usable instruments to extend direct credit to the real economy (a preceding lender of last resort before their central banks). There is obviously a need for active policies, but policy makers in EMkts need to evaluate carefully their response to cushion the downturn, its timing and magnitude, in order to better adjust to a (still unknown) new global macro financial reality.

A number of good reasons can be listed allowing EMkts more “latitude” this time. Their homework has largely been done; they have a much stronger reserve position; they enjoy the theoretical backing and blessing of the Bretton-Woods IFIs, calling for a “global coordinated fiscal stimulus” while making new financing facilities available[6]; they can rely on a new constructive role for the G20 to push for greater EMkts’ voice in the forthcoming international financial architecture reform; and finally, it is obvious that expansionary policies tend to raise local political economy enthusiasm. If the crisis is short-lived, they might be just right. But what if this crisis becomes pro-tracted, is deeper and lasts longer than currently expected[7]? EMkts’ public sector “balance sheet” is by nature weaker than that of mature economies. EMkts have less credibility and less ability to raise revenues for long periods of time. In other words, compensating the lack of private credit (domestic and external) by using the public sector, either directly or indirectly, affects the public sector’s long-term solvency. That will be much more scrutinized than that of mature economies and hence, EMkts’ public sector balance sheet might become over-stretched sooner than later (see Allen M., Rosenberg C., Keller C., Setser B., and Roubini N. (2002)).

So the questions might be more subtle and difficult: how much of one country’s balance sheet should be used? What should be the magnitude of a counter-cyclical impulse and at what timing and pace? Under a possible global recession, how should one manage the private sector’s expectations? Many EMkts policy-makers, having lived through past –but more benign—crises, can also list a number of good reasons suggesting “extra-caution” given the apparent unique severity, depth and magnitude of this crisis. Excessively pro-active policies might create future contingent fiscal liabilities while private expectations remain unaffected (or even worsen). Front-loaded interventions, before the effects of fiscal packages in the North start being felt, might exhaust too soon their fiscal space and leave EMkts, in a weaker position, hostage of the (well-documented) pro-cyclicality of rating agencies later on. Apart the (expected) bold political rhetoric, the pragmatic policy-maker is, I am sure, calculating how much counter-cyclicality the country can afford on a sustainable basis for a worst-case scenario. That scenario should include the possibility of delays in the recovery of the North and a nasty round of trade and “financial” protectionism. The “composition” of counter-cyclical packages will need also careful attention to maximize the effect on long-term productivity (e.g., infrastructure?) while minimizing additional permanent fiscal burden (e.g., use PPPs?). Finally, given their weaker automatic stabilizers and greater income inequality, EMkts have also to factor in their additional needs for social protection, especially since the crisis is likely to disrupt their political equilibria with seriously damaged local labor markets.

Eventually, in the medium-long term policy-makers in EMkts will have to re-assess the cost-benefit of the components of their own financial pro-cyclicality, i.e. their degree of capital account openness and their own domestic financial regulations. They will have to look at Basel II with new eyes and the sober diagnostic about what exactly went wrong in the North. They will have to quantify their specific trade-off between their own growth/consumption objectives vis-à-vis the risks of higher capital mobility and re-design their best regulations to control leverage and promote greater financial stability. They will have to resist the temptation of swinging the pendulum back to some form of “financial protectionism” that blocks innovation and/or an “over-regulated” environment that could prevent even long-term less volatile FDI to flow in. They will have, finally, to work in all the fora (the IFIs, the FSF, the G20) that will address the issues of reforming the international financial architecture. It is a tall agenda for the next decade.


Agénor, Pierre-Richard, and Peter Montiel, Development Macroeconomics, 3rd ed., Princeton University Press (Princeton, New Jersey: 2008).

Allen, Mark, Rosenberg C., Keller C., Setser B., and Roubini N., A Balance Sheet Approach to Financial Crisis, IMF Working Paper 02/210, IMF, December 2002.

Borio Claudio and Zhu H., “Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?” BIS Working Papers, No 268, 2008.

Caprio, G., and Klingebiel, D., “Dealing with Bank Insolvencies: Cross Country Experience”, Policy Research Working Paper no. 1620, The World Bank, Washington, D.C. 1996.

Craig S.R., Davis P., Garcia Pascual A., Sources of procyclicality in East-Asian Financial Systems, in Procyclicality of Financial Systems in Asia, ed. By Gerlach S. and Gruenwald P., Palgrave, 2006.

Demirgüç-Kunt, A., and Detragiache, E., Financial liberalization and financial fragility, Policy Research Working Paper, No. 917, The World Bank, 1998.

Levine, Ross, Foreign Banks, Financial Development and Economic Growth in International Financial Markets, ed. Bt Claude Barfield, American Entreprise Institute, Washington DC, 2006.

Taylor A. and Goodhart C., Procyclicality and Volatility in the Financial System: the Implementation of Basel II and IAS39, in Procyclicality of Financial Systems in Asia, ed. By Gerlach S. and Gruenwald P., Palgrave, (2006).

The World Bank, Global Development Finance, The Role of International Banking, The World Bank, (2008).

[1] Basel II has a “three pillars” framework – (1) minimum capital requirements (two-tier fixed ratio of equity vis-à-vis risk-weighted assets), (2) supervisory review and (3) market discipline – aiming at promoting greater “stability” in the financial system. The first pillar requires maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk (usually relying on external ratings agencies), operational risk and market risk (VaR approach). The second pillar provides regulators with more “teeth” and improved “tools” over their own domestic system. The third pillar greatly increases the disclosures that the bank must make including vis-à-vis market participants (in a sort of “self-regulatory” more transparent process).
[2] Is the problem in the design or implementation, in particular comparing intentions and results of the International Accounting Standard (IAS) 39 rule? The observed excessive pro-cyclicality of “fair accounting” or mark-to-market practices is obvious (ex-post) when used in a “bottom-less” free fall environment for asset prices.
[3] In addition, in some EMkts (e.g., Brazil, Mexico, South Korea), corporates and banks thought they could compensate their exchange rate appreciation during the boom by taking positions in derivative markets (through very asymmetric bets). The flight for quality and sudden USD appreciation is making their balance sheets now suffer from considerable losses.
[4] For many LA countries, some of the difficulties in negotiating the Financial Services component of the Doha Round resided in their “reluctance” to accept greater presence of foreign banks and more mobility for capital flows.
[5] Those include blanket guarantees on deposits and loans, suspension of mark-to-market rules, re-allocation of capital from the public to the private financial sector, new rules for securities transactions, closer supervision/monitoring of OTC derivatives transactions, temporary capital controls on specific flows, etc.
[6] But the headroom for IFI’s counter-cyclical financing is very small compared to the foreseeable contraction of private sector flows. If that is so, the crisis will result in greater correction of EMkts current accounts through falls of domestic consumption and investment.
[7] There are, unfortunately, many events pointing to a worsening of the crisis as of February 2009: rising protectionism in the North and the South; uncertainty about the timing and effectiveness of the new US policy package; difficulties in re-pricing the infamous “toxic assets” i.e. not “bottom” in sight for financial stocks; doubts about the G7’s ability to engineer timely macro-financial counter-cyclical coordination; the “global” nature of the recession, disabling export-led recoveries out of this crisis; etc.