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Op-ed

Why this Financial Crisis Could Have Been Worse

by Arvind Subramanian, Peterson Institute for International Economics

Op-ed in the Business Standard, New Delhi
January 29, 2009

© Business Standard


When the history of the impact of this global financial crisis on emerging markets is written, two questions that will have to be answered are whether residents in emerging market countries behaved differently from nonresidents and indeed differently from the way they behaved in the earlier emerging market crises of the 1990s; and if so, why?

The financial shock to emerging market countries in this episode was a "sudden stop" of capital flows. This shock was predominantly externally-triggered because nonresidents, for reasons related to developments in their home markets (US and Europe), needed liquidity. This so-called deleveraging process that emerging market countries witnessed entailed sharp reductions in stock prices and currency values. But as these asset prices declined, it appears—and there is still no hard evidence on this—that residents did not feed the asset-selling by foreigners.

This latter phenomenon is, of course, in stark contrast to the other emerging market crises of the 1990s (Mexico, Argentina, Brazil, and in the Asian countries later in the decade) when residents shed their holdings of domestic currency along with nonresidents. In fact, in the case of Mexico in 1994, there was suspicion that residents bolted before their foreign counterparts.

Or to put it differently, the earlier emerging market crisis was in fact a set of twin crises (involving a flight from the currency as well as a flight from the domestic banking system). The current one, at least on the face of it, and with notable exceptions in Russia and Eastern Europe, appears to have the mark more of a currency crisis.

If this basic hypothesis is true, it raises the question why. Three not mutually exclusive explanations suggest themselves. First, residents were unable to easily shed their domestic asset holdings because of capital controls (especially in a country like India). Second, residents had less incentive to shed domestic assets (and engage in arbitrage) because they took a different view of the domestic economy and currency than nonresidents did. Third, that residents' incentive to engage in arbitrage was shaped by central banks' holdings of reserves; that is, self-insurance by central banks worked in limiting residents' flight away from the domestic currency.

One piece of evidence suggestive of a difference in the behavior of residents between this crisis and the earlier crises relates to the policy response. In this crisis, many central banks were willing and able to infuse large amounts of liquidity and reduce interest rates during the crisis without apparent concern about the impact on the currency. In contrast, in the emerging market crises of the 1990s, the difficult policy question was whether and how much to raise interest rates, as they struggled to retain confidence in the currency by raising interest rates despite the consequences on the banking system and economic activity. Somehow, in this crisis, that trade-off did not seem to be as pressing a problem, probably because retaining confidence in the currency seemed less of an issue.

Turn now to the possible explanations. Some countries such as India do maintain controls on residents, but in the emerging markets as a whole such controls have been significantly liberalized since the Asian financial crisis, making capital controls a less likely explanation of the behavior of residents. Even in India, the argument is made that capital controls have become less binding because of the rapid increase in trade. Presumably, trade is available as a conduit for taking capital out as it is for bringing it in.

The most likely explanations for differential behavior seem to be a combination of differing assessments combined with the effects on residents of large central bank holdings of reserves. Unlike in the earlier emerging market crises, this time residents may have believed, perhaps with good reason, that the reasons for declining currency values and asset prices had little to do with the domestic economy and almost entirely to do with foreign investors' imperatives. In other words, the reason for the "sudden stop" was an external, not internal, reason (of course, the combination of external pull and internal push factors varied across countries in this crisis too, but as a whole it appears to have been different from the previous emerging market crisis).

This differential assessment of underlying factors may have been enough to convince residents that their holdings of domestic currency would remain attractive. But equally it may not. The risk of substantial currency declines may have remained. Holdings of reserves, which central banks such as India deployed to defend the currency, would then have helped reassure residents and dissuade them from rushing to exit. In the event, the strategy seemed to have worked and relative calm has returned to currency markets, including India's.

A recent paper by Obstfeld, Shambaugh, and Taylor presented at the American Economic Association meetings earlier this month provides evidence that in this recent crisis countries that had higher levels of reserves experienced, on average, smaller currency depreciations. A simple reading of this paper is that self-insurance in the form of reserve acquisition appears to work consistent with the argument made earlier. But more research is needed to shed light on the different responses of residents and foreigners in this crisis.

If this analysis is broadly correct, three possible conclusions emerge. First, residents and nonresidents can behave differently during a financial/currency crisis. Second, this differential behavior stems from the source of the shock, namely whether it is external to a country or internal to it. Third, foreign exchange reserves can play a role in affecting perceptions and hence limiting the extent to which a currency is affected during a crisis.

Perhaps the most important lesson might be the following. Being financially integrated in the world economy does entail costs; in this instance, emerging markets could reasonably claim to have been victims of serious failings elsewhere. But bad as this crisis is, and will be, the bigger threat to stability comes when the problems, and the causes of financial crises, are home-grown. Having the internal house in order is still the best insurance against financial crises.


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