WHILE THE SKIES ARE STILL BLUE
APPENDIX 4.1: Painting the Picture of a Financial Crisis
It is crucial for managers to understand what to expect when a financial crisis hits, what actually happens in the first hundred days, and what are the typical next phases. Management teams that improvise solutions not grounded on a thorough understanding of financial crises are more likely to stumble in their efforts, and may even do more harm than good. Companies that survive crises do so because management clearly understands the risks and deploys resources in a timely manner where they will have the greatest impact.
To give executives a sense of rhythm and timing, we have found that financial crises can be broken down into four phases that have different themes: managing the initial liquidity crisis, returning to financial stability, restructuring the economy, and reentering the global marketplace. We first developed this framework while summarizing the Scandinavian financial crises of the early 1990s for our Korean clients in 1998, and have since applied it to other crises as well. We describe each phase briefly below, to give executives a sense of how badly a financial crisis can affect the economy.
Unfortunately, some countries do not make it through all of these four phases, become stuck in one of the early phases, and subsequently often go back into crisis.
One caveat that we have found: Good macroeconomic policies rarely emerge before there is political consensus and stability. Countries such as Indonesia, Japan, Russia, and Argentina demonstrate that financial crises can take a long while to resolve when the political situation is uncertain.
Phase 1—Managing the Initial Liquidity Crisis The first phase is usually several months long and very acute. Most of the time, its first manifestation is a sudden currency depreciation accompanied by a liquidity crisis. The central bank raises real interest rates to stabilize and reverse currency flows as well as to lower inflation expectations. It may also choose to restrict the money supply further by selling bonds or increasing reserve requirements. Many financial institutions cut back credit lines and stop rolling over debt. Short- term interest rates skyrocket.
The implementation of a restrictive monetary policy has a significant impact on businesses in the short term. As interest rates rise, so do com- panies’ existing debt burdens. In addition, higher interest rates limit compa-
nies’ access to capital since it becomes unaffordable and banks may create a credit crunch because of the effects on their profits and losses. Managers need to either limit spending or find alternative sources of capital to offset the impact of increased interest rates on their businesses. Cash is short for everyone, bankruptcy tremors are rampant, and assets are repriced almost overnight to new, depressed-market prices while the cost of liabilities soars.
Under these conditions, there is also a crisis of confidence. Rumors and uncertainty abound, and the financial crisis crowds out all other news on the front page. Every dinner party discussion turns into an exchange of anec- dotes that illustrates both the extent to which the economy is suffering and the almost obsessive but understandable involvement that every business- person must have with respect to current crisis events.
Phase 2—Returning to Financial Stability After the first few months, the second phase starts in motion. By this time, the most vulnerable surviving companies are beginning to negotiate with creditors, and business operations have slowed down, sometimes quite significantly, in response to consumers adapt- ing to the new environment by curtailing purchases and simply making do with less. Usually, this financial crunch can last anywhere from six to twenty- four months. Liquidity problems persist and sometimes increase (e.g., Argentina, Turkey), and bankruptcies continue. Payment systems are often deeply affected and adopt new channels and sometimes even new currencies, while banks are reorganized or taken over, awaiting resolutions that can take months or even years. Asset prices continue to head south, albeit less steeply than at the beginning of the crisis, and by now even the optimists acknowledge that recession has set in.
Figure A4.1A shows just how hard a financial crisis can hit an economy, but even these numbers do not give the full picture. Overshooting—prices moving past their long-term equilibrium level—is very common during the early months of crisis. Interest rates soar, in part due to monetary restric- tions imposed by the central bank, but also as a reflection of the lack of con- fidence in the economy. Exchange rates plunge, and with this change come many dramatic effects. Overnight, companies that are significantly depen- dent on foreign trade blossom, as they export their way out of their prob- lems—or die, if they rely significantly on foreign inputs or if overseas credit lines are pulled. The prices of shares in the stock exchange also gyrate wildly as investors reassess the circumstances of companies, for better and worse.
Paradoxically, some companies even experience windfall profits from the repricing of accounts receivable, cash balances, or inventories.
How long these conditions last depends on many factors, some of them political. Figure A4.1B shows how various countries have restored eco- nomic activity over time, with some obviously faring better than others.
Korea and Mexico stand out for their comparatively rapid recovery in the
90 100 110 120
GDP in real term Index, base year = 100
Commercial banks credit
$, index, base year = 100
2 years before crisis
3 years after crisis Crisis starts
Total investment*
$, index, base year = 100
0 50 100 150
2 years before crisis
3 years after crisis Crisis starts
0 50 100 150
2 years before crisis
3 years after crisis Crisis starts
Foreign investment
$, index, base year = 100
2 years before crisis
Crisis starts 3 years after crisis
Indonesia Malaysia Thailand S Korea Mexico
× FIGURE _A4-1b
RECOVERY _ FROM _FINANCIAL_ CRISES
400 800
0
*Data source for Malaysia only covers total investment for manufacturing industry
Source: National Statistic Offices; BKPM; BI; Bank of Thailand; Bank of Korea; Bank Negara Malaysia; EIU
Korea
Malaysia Indonesia Thailand
Singapore
CREDIT CRUNCHES FOLLOWING FINANCIAL CRISES
Taiwan 3.9
1.3 1.6
4.4 3.5
6.2 1.6
-3.8 0.7 0.7 1.3 -13.4
-10.0
8.0 Credit crunch period
Real interest rates (average)
Real private sector credit growth Asian example
Percent, 1999 to 2000
Philippines
Source: IMF; EIU; central banks
FIGURE A4.1A Credit crunches following financial crises.
FIGURE A4.1B Recovery from financial crises.
near term, although both countries still face lingering issues at the time of this writing. Much of this relative advantage is due to the collective response in Korea to its crisis, compared especially to other countries in Asia, and Mexico’s unique trade relationship with the United States and Canada.
Phase 3—Restructuring the Economy The third phase, which can last several years, is the beginning of the real long-term turnaround, with a restructur- ing of not just the financial system but the entire economy. The government focuses on establishing a sustainable foreign exchange regime, concluding negotiations with bank creditors, and establishing principles for long-term economic liberalization. In the private sector, businesses consolidate, indus- try structures shift and realign, and assets that pass through a restructuring agency are slowly redeployed into the real economy.
Setting an appropriate foreign exchange rate, given a country’s eco- nomic context, is one of the most important policy decisions that a govern- ment will make after a financial crisis. It fosters economic stability by setting sustainable currency levels to help avert crises—to make sure that the gov- ernment does not run out of money trying to prop up the currency—and limits inflation expectations. It also creates the conditions for growth by providing a stable environment for trade and investment.
BOX A4.1: METHODS TO STABILIZE THE EXCHANGE RATE
There are several policy methods a government can use to stabilize the exchange rate, and the chosen method may change over the short versus long term (for example, using a fixed currency peg in the short term to create complete exchange rate stability, and—two to three years later—
floating the currency once stability has been achieved). These methods are briefly defined below.
1. Fixed or floating currency peg. Under a currency peg, the central bank commits to buying or selling the necessary amount of foreign cur- rency to maintain the exchange rate level at which the currency is
“pegged.” Policymakers implement pegs because they achieve the dual objective of creating both real and perceived stability and allowing policy- makers to retain some control over currency policy (as compared to adopting a third party’s currency).
2. Similarly, under a floating peg, the central bank commits to sup- porting the currency within a predetermined band within which it is allowed to float against a chosen currency or a basket of currencies.
Central banks deploy two strategies to support both fixed and floating
(continued)
In addition to setting foreign exchange policy, policymakers focus on concluding negotiations to restructure bank debt. Prompt renegotiation of existing debt plays an important role in stabilizing the economy by lessening burdensome interest payments on the government to free up resources for other uses, and restoring the credibility and confidence of lenders, thereby increasing access to future capital. The process of restructuring debt follow- ing a crisis essentially allocates losses among the following key parties:
creditor banks, international and domestic investors, bondholders, and the government. Because it is a zero-sum game, each party must fight aggres- sively to preserve its interests.
After addressing the critical issues of monetary and foreign exchange rate policy, governments focus on implementing needed fiscal discipline.
Sound fiscal policy depends on crafting a government budget, which can be financed over time on a sustained basis. The budget allows government to meet obligations to international and domestic creditors as well as public stakeholders (e.g., pensioners) while decreasing its debt level. As a result, government often must either raise revenue or reduce spending accordingly.
pegs. Either they buy or sell their own currency to support the peg or they use interest rate policy to stimulate private currency traders to do so.
3. Floating exchange rate. Under a floating exchange rate, a cen- tral bank does not commit to maintaining the currency at a given exchange rate. Instead, it lets markets set the exchange rate through daily buying and selling. Because of their frequency, these adjustments are typically small and therefore not economically disruptive after an approximate equilibrium is reached. Before that point, currency values tend to gyrate wildly.
4. Currency board. Adopting a currency board has similar impli- cations to a fixed exchange rate, if not more extreme. It sends a signal of even more binding commitment to prudent and austere macroeconomic policies because it more rigidly supports a given exchange rate. Govern- ments choose to adopt currency boards because they provide the most short-term stability following a crisis. In the long term, however, they can be difficult to sustain and are therefore ultimately problematic.
5. Adopting the currency of another country. This is by far the most far-reaching example of the final foreign exchange mechanism and perhaps the most difficult to implement. The best example of this is dol- larization; the adoption of the euro by European countries in January 2002 is another.
Given the difficulty of balancing the budget during crises, governments often turn to supplementary mechanisms, such as privatization, to increase revenues. It is difficult to gain political support for these structural reforms in prosperous times, but it becomes more compelling during a crisis. While the sale of government assets in times of crisis yields lower prices, by the time they are actually sold few alternatives exist. As a result, privatizations under such circumstances are common. Other efforts to improve govern- ment finances through structural reforms include eliminating barriers to for- eign competition in certain sectors, opening formerly protected areas for resource exploration (e.g., oil), and increasing private sector involvement in the pension system.
Given limitations, particularly in consumer demand and government spending, growth becomes highly dependent on bank lending for capital investment. Yet banks are unable to provide the stimulus for growth. They lack the necessary access to capital on which to leverage a loan portfolio. In addition, during this time banks are focused on important internal objec- tives, such as collecting nonperforming loans and internal restructuring.
Finally, having just survived a financial crisis, banks are hesitant to risk lending to companies that are in the process of restructuring, as most are at this time. Bank managers are often shell-shocked and strongly risk-averse after a financial crisis. Their inability or unwillingness to provide needed economic stimulus is referred to as the “credit-channeling problem.”
Managers experience the impact of this credit-channeling issue at the business level as they struggle to raise the necessary capital for their own businesses. Similar constraints affect their own suppliers and customers fac- ing similar challenges. In addition, they have to demonstrate significant restructuring efforts to convince debtors to continue debt rollovers.
In many post-crisis countries, private sector credit fails to grow despite low real interest rates. As described above, this lack of available credit results from weak and poorly capitalized banking sectors, a scarcity of viable lending candidates, and high risk aversion. One solution to this situa- tion is to have the government implement a credit guarantee program, as was done in Korea. Such programs have risks, however, which include the potential for moral hazard, delayed restructuring, and high fiscal costs.
Because these risks have the potential to limit long-term economic stability, managers must ensure that they are effectively addressed by policymakers in the design phase.1
As these public reforms occur, bank lending resumes and more long-term capital becomes available, including an influx of new foreign capital looking for enhanced opportunities in a post-crisis, restructured economy. Compa- nies build up operational excellence and revamp the internal performance ethic, and an active market for corporate control appears, along with more visible M&A activity.
Phase 4—Reentering the Global Marketplace Finally, the crisis enters a fourth phase, marked by a renewed emphasis on harmonizing the economy in line with global market demands and standards. Managers now face lower infla- tion, less currency risk, and increased access to credit. They feel that busi- ness is finally “coming back” even if it has not returned to pre-crisis levels.
GDP growth resumes, banking systems are rebuilt, and capital markets develop better linkages to global financial hubs. Manufacturing moves toward world-class standards, a growing service sector emerges, small and medium-sized businesses develop and change the competitive landscape, and foreign competitors increase the level of competitive intensity as well.
Now, government officials shift their focus from stability to growth.
While the macroeconomic policies outlined above are critical to creating the underlying stability needed for economic growth, they alone are not sufficient to stimulate it. Growth depends on policies that focus on the business sector, including policies that promote world-class corporate governance standards, a domestic capital market that is linked efficiently to the global financial mar- kets, a strong financial service supervisory regime, and improvements to the legal framework that usually results in the aftermath of a financial storm.2