Dealing with an international credit crunch is no easy task, as any policymaker in the world would tell you today! Credit flows are the blood of the world’s economic system. When a human artery becomes clogged and the blood flow is interrupted, the consequences can be dire unless the flow is restored promptly. Similarly, a sudden stop in capital flows that blocks the normal supply of international credit to countries can inflict serious damage on the affected economies unless decisive action is taken. But if you’re not a government like the United States, a safe haven for global savings that can provide billions of dollars to pump into a stimulus package, what’s a country to do?
This short note looks at this question from the Latin American point of view. Drawing from research that explored the region’s experience with the sudden stops in capital flows of the 1990s, it reviews lessons learned that may be of use in the present. To begin with, countries must realize that it’s not necessarily their fault. A defining characteristic of systemic sudden stops is that they originate in shortcomings in international capital markets −i.e. international capital supply shocks− rather than in domestic policy failings. However, while the cause may come from abroad, the solutions must often be home grown and if sudden stops are not handled adequately, then output collapse can be severe and recovery more painful.
In designing a strategy to confront sudden stops and avoid output collapse, several questions come to mind: Can emerging countries afford expansive monetary and fiscal policies in times of crisis? Should they instead restore credibility by tightening monetary and fiscal policy, or will these policies only make matters worse? To what extent are weak initial macroeconomic conditions an important constraint leading to disaster? Do they put a country on an irreversible path? Are they destiny, or can their impact be mitigated during a crisis? Should financial shocks be viewed as temporary or persistent, and what policy options are available? And further down the road, what implications does the latent risk of sudden stops have for economic policies during periods of bonanza?
This note draws from a new IDB book, “Dealing with an International Credit Crunch: Policy Responses to Sudden Stops in Latin America,” which addresses these questions from different angles, bringing in both lessons from country studies as well as cross-country analysis. The book, made in collaboration with an excellent team of researchers, documents policy responses to sudden stop episodes of the late 1990s for eight Latin American countries. But it also takes a more systematic approach by analyzing the impact of policies on output behavior for a wider range of emerging markets. Using both sets of information, and distinguishing between successful and unsuccessful cases, it extracts policy recommendations for countries that might face a sudden stop in the future. As the world teeters on the brink of a major global financial crisis with potentially severe consequences for emerging economies, the issues addressed in this volume come back to the forefront of the policy debate.
The book presents the following main conclusions:
- Expansionary fiscal and monetary policy that does not affect credibility or solvency can reduce output collapse in the aftermath of a sudden stop. Countries that were able to adopt more flexible fiscal and monetary policies in the aftermath of a financial crisis had a loss in output of less than 5%, while nations with much less flexibility had output contractions above 10%. However–and this is really crucial–countries need to be able to afford these policies
- Initial conditions matter: the same shock can have different consequences in countries with different levels of preparedness and may seriously limit policy options. There are no good substitutes for reducing vulnerabilities during good times to confront the possibility of bad times in the future. For example, successful anti-cyclical policies during financial crises work when governments are prepared to boost spending in a sustainable way –for which you need to have saved before— and conduct looser monetary policy that does not fuel inflation or lead to balance-sheet problems in either the public or private sectors —for which you need to avoid the dollarization specter during the boom years—.
- Initial conditions are not destiny: even if they haven’t done all their homework, countries still have means at their disposal to weather the storm. A targeted use of international reserves during an international credit crunch–for example, supporting export credit lines– might be a more effective use of available resources than exchange rate market interventions.
- The persistence of the shock is important in determining whether liquidity issues become solvency problems. A short-lived crisis, such as the capital shortage experienced by Latin America in the aftermath of the Mexican 1995 crisis was much less dangerous than the long capital drought that followed the Russian crisis of 1998, where substantial real exchange rate corrections (needed to abruptly close current account gaps) put solvency in shambles. Early recognition of the nature of the crisis being faced proved to be very important.
- External financial packages are essential when initial conditions don’t help. This explains, for example, why Mexico recovered fairly quickly in the aftermath of the Tequila Crisis in 1994, while Argentina’s economy collapsed when the IMF withdrew support in November 2001. Argentina’s vulnerability made it clear that a protracted sudden stop requiring substantial real exchange rate depreciation almost inevitably called for debt restructuring given Argentina’s substantial liability dollarization. However, there is reason to believe that with international support, the restructuring process could have been much more orderly.
Perhaps the clearest lesson from the research is that countries that were able to conduct countercyclical policies were able to withstand crisis better. In turn, the lucky ones that earned the chance of conducting countercyclical policies were those that had previously resisted the temptation of taking comfort in favorable tailwinds and had prepared for a rainy day. While some basked in the sun of high global growth rates and soaring commodity prices, others remained wary of cycles in the international economy, commodity prices and world financial conditions. Those that did not use the boom years to lay the groundwork for countercyclical policies had much less scope for independent policy actions during the credit crunch. Any attempt to boost spending dramatically, for example, could erode confidence in the country’s ability to repay its debts in the future. Thus, the biggest lesson is that there is no substitute for taking advantage of periods of external bonanza to improve macroeconomic fundamentals at home.
This lesson will most likely be at work in the prevailing financial crisis, meaning that the availability of counter-cyclical policy options, as well as final outcomes, will to a large extent be determined by initial conditions. However, policy reactions will remain key especially in countries where initial conditions have not predetermined their destiny and there is some margin of maneuver. The multilateral system can help these governments by boosting their foreign currency reserves and providing financing for governments with a sustainable fiscal position. In other countries, seeking external financial assistance sooner rather than later might prove to be the least costly option.
Latin America and the Caribbean have improved their economic conditions since the Russian crisis, giving them some leeway, particularly regarding monetary policy, to implement measures to fight the crisis. Countries have built up US$ 400 billion in international reserves, and they have substantially reduced the level of dollar-denominated debts, particularly within the banking system. Lower levels of debt dollarization allowed Brazil, for example, to loosen monetary policy amid the credit crunch in ways that other countries were not able to do during the aftermath of Russian crisis. This time around, several Latin American countries swiftly depreciated their currencies without entering major financial turmoil.
Loose monetary policy typically leads to currency depreciation and an increase in exports that helps ease the economic slowdown. However, currency depreciation, which boosted exports as a way out of the crisis for several emerging markets in the past, may not fully work this time because of the ongoing global recession, particularly in rich nations.
On the fiscal front, the picture is less clear. Most of the region’s nations built up very little savings during the five-year commodity boom that ended last year, according to a 2008 IDB study titled “All that Glitters May Not Be Gold: Assessing Latin America’s Recent Macroeconomic Performance.” A simple average of the region’s seven biggest economies – Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela – shows that they spent 77 percent of the extra revenue from the commodity bonanza since 2002. Chile, in comparison, which set aside a considerable part of the increased tax collection into a special fund, spent only 34 percent, according to the 2008 study. Some nations in Latin America will be forced to cut spending in the face of the current crisis because of insufficient savings. For others, the most feasible policy will be to maintain the current level of government spending but only a few such as Chile are in a position to increase spending.
For multilaterals, the current crisis offers an opportunity for a different approach when compared with the policy options taken during the Russian crisis. The prevailing view in 1998 was that emerging nations needed to reassure creditors about the solvency of their economies. As a result, emerging countries around the globe were asked to cut spending and raise interest rates, which deepened the recession. The IDB study of successful policy responses during past crises suggests multilaterals should follow a selective approach that takes into account each country’s initial conditions in order to design tailor-made policies. Countries with their macroeconomic house in order need not enact strong adjustment policies to signal credibility. However, countries need to be particularly cautious regarding the duration of the current crisis, because large and/or sustained downturns in global economic trends could deem fiscal caution a necessary element of any policy-response package.
Note: An edited version of this note appeared previously in VoxEU.org under the title: Dealing with the crisis: Lessons from Latin America.