Address to CEDA, Sydney, 31 October 2002

I want to speak today about lessons to be learnt from the successive financial crises that have swept through individual economies, and in some cases the world, this past 50 years.

I will argue that crises are extremely hard to predict, because the next one is always inherently different from the last. This means that those concerned with trying to predict crisis - the IMF, World Bank, public policymakers, credit rating agencies, and people involved in trade, finance and investment - are somewhat like generals preparing to fight the last war. The next financial onslaught always catches us unawares and ill-prepared.

But difficult as the task may be, we have to try and anticipate where the next crisis might come from and how it might differ from the last one, because doing so can make such a big difference to our business bottom lines. Anticipating and preventing crisis can obviously also bring large national economic returns, considering that currency and banking crises in emerging economies can cause huge output losses, mounting on average to 8-12% of one year's GDP after they have run their course.

With this in mind, I will go on to suggest tentatively how twenty-first century crises might differ from 1990s ones.

Crisis prediction - a graveyard for reputations

But before I do, I'd like to go back and remind you what a graveyard for reputations the business of crisis prediction has been over the years. Time and again, the best brains in global finance have been totally blindsided by crises - sometimes on their very eve, or even after they have happened.

A notable case was the declaration by the former chairman of Citibank, Walter Wriston, that 'Countries do not go bankrupt'. He said this just after Mexico imposed a moratorium on its foreign debt payments in 1982. That moratorium, you will recall, ushered in the International Debt Crisis of the 1980s, and the so-called Lost Decade for Latin America, when living standards went backwards dramatically.

But it hasn't been just the practical bankers who have got things wrong. The World Bank, the IMF, the ratings agencies and the markets have too.

You might remember that the World Bank published a report in 1993 called 'The East Asian Miracle'. An apt title insofar as it described the remarkable post-war growth of Asia up to the time of writing. But I must say I see hardly a hint in that report of the troubles ahead.

Even as late as May 1997, just two months before the outbreak of the Asian crisis, the IMF was predicting that advanced economies in Asia would undergo only a 'mild cyclical correction' in 1997.

Meanwhile, the ratings agencies didn't notice much happening either - except perhaps Moody's, which downgraded Thailand's short-term government debt in September 1996 and put Thai government debt under review in February 1997. (The baht devalued in July 1997.) Otherwise, downgrades followed crisis, not anticipated it.

(Incidentally, we in EFIC downgraded Thailand in November 1995, and put Malaysia on watch for downgrade at the same time. I regret to say we saw no reason to sound alarms about either Korea or Indonesia.)

If the people paid to be alert were asleep on sentry duty, what about market players themselves – bondholders, portfolio managers, traders? Did they see anything suspicious and go on to demand a higher risk premium? I am afraid not. Spreads between foreign and domestic interest rates and between yields on emerging market bonds and US Treasuries did not widen in the approach to crisis.

Of course, after the crisis broke there was no end of pundits ready to explain what went wrong. But they remind me of the man in the cartoon below.

The Australian 16 October 2002.

Looking the wrong way

So why do we always seem to be looking the wrong way when crisis strikes?

I believe the main reason is: crises mutate continuously. This comes about as creditors, debtors and policymakers alike learn the lessons of crises past and adjust behaviour and institutions to prevent a recurrence.

They burnt their fingers in the 1980s on Latin American syndicated loans, so they pulled back from those for a while. Countries can go bankrupt after all.

But then everyone homed in on the East Asian Miracle. Governments can go broke, it was agreed, but here were governments that ran fiscal surpluses and had little public debt. Besides, it was the private sector that was seeking capital, and surely whole banking and corporate sectors couldn't go broke. So everyone piled into the Asian private sector. Unfortunately, the conventional wisdom proved wrong again. When the music stopped, there was indeed wholesale banking and corporate collapse . . . and again a pullback and a rethink.

But human nature being what it is, I strongly suspect that greed will sooner or later take over from fear again. New sure-fire things are bound to be discovered, even if they aren't Bangkok shopping malls or Korean shipyards. In fact, the markets already seem to have found a new darling; or perhaps it would be more accurate to say redoubled their love for an old sweetheart. For the glamorous place to be now is China rather than South East Asia or Korea – and the euphoria spans everything from semiconductor plants to residential mortgages.

An intriguing question is whether the current love affair will turn to revulsion in future.

Multiple equilibria - another element of unpredictability

Another reason crises can take us by surprise is perhaps a little more disturbing: not all of them are inevitable.

In the old days before financial markets became so globalised and capital flows so large, it was more or less accurate to say that countries got the crises they deserved. You ran unsound fiscal and monetary policies inconsistent with your fixed exchange rate, or you were hit with a setback such as a commodity price slump. That caused your trade and current account deficits to swell and your foreign currency reserves to drain away. If you failed to devalue and tighten monetary and fiscal policy to rebalance your economy, you would be faced with a cash crunch as your reserves dwindled to nothing. Unsound fundamentals plus lack of adjustment equalled trouble. Sound fundamentals plus adjustment equalled plain sailing.

But in the present era of globalised financial markets, all that has changed. Countries can be chugging along with more or less sound policies and buoyant overseas markets one day, only to find market sentiment suddenly shifting against them the next.

This is possible nowadays because both foreign and local investors can and do make large adjustments to their holdings of a country's assets and liabilities. And they are prepared to rebalance their portfolios significantly for even small reasons. When confidence has taken a hit, the resultant capital outflows can often completely swamp the trade and current account flows. And in the ensuing meltdown, share, bond and currency markets can all plunge. To make matters worse, there can be wholesale financial collapse if banks and companies have big currency or maturity mismatches on their balance sheets and P&Ls, because cash flow dries up and foreign currency obligations become unpayable from baht and rupiah revenues.

This is what Mexico, Thailand, Indonesia and Korea have all succumbed to in recent years, what Argentina is suffering now . . . and what Brazil is facing.

I don't want to give the impression that financial markets are completely capricious and that therefore any country, however sound its fundamentals, is at their mercy. There isn't much evidence that countries with unequivocally strong fundamentals are prone to speculative attack. At the other extreme, it remains valid that countries with weak fundamentals will inevitably end up in crisis unless they mend their ways.

It is the countries with in-between fundamentals where the doubts occur. Whether one of these falls into crisis doesn't just depend on fundamentals, but on whether the markets believe the economy is crisis-prone. If they think yes, they will dump assets, withdraw capital, and their expectations will prove self-fulfilling. If they think no, they will sit tight, and crisis won't happen.

Either outcome is possible. In the jargon of economists, there are multiple equilibria.

As I said, the implications of this are quite unsettling. Perhaps the pundits weren't so culpable for missing the Asian crisis after all. And countries with unfinished economic reform agendas or perhaps some political instability, which nonetheless find themselves the subject of 'buy' and 'overweight' recommendations, shouldn't feel too smug. After all, small setbacks can quickly unnerve markets. The focus then suddenly shifts from buying to selling points, and all the capital that flowed in can flow out again.

This is precisely what happened during the period of the East Asian Miracle. The region was praised for its sound public finances, its export orientation, its thrift, and its emphasis on investment and education. But when the crisis hit, all the talk turned to authoritarianism, national disunity, cronyism, related-party lending, implicit government guarantees, yawning current account deficits, overvalued currencies, currency and maturity mismatches, real estate and share bubbles, and glutted overseas markets.

As Dr Mahathir once remarked, 'When the river falls, the filth surfaces.' Markets have certainly been finding plenty of hitherto-invisible filth in Asia since mid-1997.

Twenty-first century crises

I now turn to what future financial crises might look like. As I have already hinted, I believe the clue to how crises will evolve lies in the reaction of creditors, debtors and policymakers to recent crises.

In official circles – at the IMF and among G7 finance ministers – there are two chief concerns about recent crises, such as East Asia, Russia and Argentina. One is that the emergency official credit provided to these economies has bailed out private creditors excessively, which has created moral hazard, which could in turn lead to undue risk-taking in future. The other concern is that not enough is being done to head off brewing crises. Creditors and debtors alike wait till meltdown happens with unnecessary cost for all concerned.

So we are seeing efforts to bail in private creditors during crises, rather than bail them out. In 1998, for instance, the IMF asked the Ukrainian government for assurances that it wouldn't use IMF funds to redeem maturing Euronotes. Ecuador defaulted on its foreign bonds in 1999 in an experiment to see if it could get bondholders to help bail it out. And also in 1999, the Paris Club, a group of official bilateral creditors, told Pakistan that it would reschedule interest payments only on condition that the government negotiated comparable arrangements with other creditors, including bondholders.

If there are any emerging market bondholders in the audience, I have some bad news for you. Whereas up till recently, you typically escaped debt rescheduling in the aftermaths of crises even as bankers and official creditors were taking haircuts, you will increasingly be asked to take one too. This will happen, because bond finance has now grown to be such a large fraction of emerging market debt that it needs to be restructured if countries with unsustainable debts are to get meaningful relief. Moody's went so far as to say of the Paris Club decision on Pakistan that it 'may signal the beginning of a new phase in the world financial system'.

An even more interesting development is the push now underway at the IMF to set up a Sovereign Debt Restructuring Mechanism (SDRM). The reasoning goes as follows. Under the present muddle-through approach, the international community is often confronted with the choice of accepting a disruptive and potentially contagious unilateral default as in Argentina this year or bailing out private creditors and creating moral hazard. What it needs instead is a mechanism to bail in creditors that at the same time preserves as much or their wealth as possible – and as much economic activity in the afflicted economy – by restructuring early before meltdown occurs. In other words, something that resembles national bankruptcy law.

The proposal the IMF and the G7 is promoting would empower a 'super-majority' of creditors (60-85%) to reach agreement with a troubled debtor country and make the terms of the restructuring legally binding on all creditors. The SDRM would be put into effect by amending the IMF's Articles of Agreement.

Views within the private sector about the SDRM are mixed. Bondholders seem more amenable and bankers less so, perhaps because they have been accustomed up till now to have control of the debt restructuring process.

One alternative to the SDRM suggested by the private sector is greater use of so-called collective action clauses (CACs) in bond contracts that limit the ability of dissident creditors to block a widely-supported debt restructuring. In response, the IMF has argued that CACs cover only one class of creditors, bondholders. In addition, it would take 10-15 years to bring a country's entire sovereign debt under the CAC umbrella, because most sovereign bonds have long maturities and therefore take a long time to be renewed.

Anyway, it looks likely that some rationalisation of sovereign debt restructuring will take place, perhaps even a statutory approach. For creditors, including bondholders, this will mean that they can expect to be bailed into debt restructurings more often, but if the new approach succeeds in preventing catastrophic crises such as the recent Argentine one, they can expect fewer deep writedowns.

Summary

The world has in some ways become a more dangerous financial place since the advent of financial globalisation. Large waves of capital can wash into economies to create a boom. But equally, they can wash out again, creating a crash. Moreover, it's not always clear beforehand who is crash-prone. This ambiguity applies especially to countries with mixed fundamentals. Bondholders who have up till now enjoyed more or less a free ride on other creditors in financially distressed economies won't get off so lightly in future. There is a growing conviction that we can do better at preventing crises. This conviction has translated into a push to get a SDRM underway. If one does get up, debt restructuring and debt relief for emerging markets are likely to become more frequent, but correspondingly, catastrophic crises less so.

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