As we said earlier, the unstable atmospheric conditions underlying a financial storm are composed typically of inefficiencies in the real economy, financial sector instability, and ineffective regulatory supervision. Now, macroeco- nomic policies—particularly surrounding exchange rates—increase the insta- bility of the system and ultimately cause the storm to intensify. They also
can play a significant role in determining how long the resulting storm will last, and what the severity and the duration of the crisis will be. Since exchange rates are perhaps the most immediate triggers, we will focus on their implications first.
Impact of Exchange Rate Policies
Managed well, exchange rate policies help control inflation, enable domes- tic industries to develop and build an international presence, and attract for- eign capital. Managed poorly, they can quickly increase prices, putting companies and whole sectors out of business by making them noncompeti- tive, and setting off crises in both the financial and real sectors. The truth is that virtually any “managed” exchange rate is by definition a distortion of the “market price” for a currency. Over time, the existence of a peg leads to increasing distortions. Between countries and within them, these distortions can affect the allocation of resources.
Managed rates also lead to the danger of sudden repricing, should pres- sure from investors and creditors ultimately overwhelm the ability of govern- ment to maintain a pegged rate. Every country we have studied employed fixed or crawling-peg exchange rates to control inflation, reduce the cost of capital, and improve terms of trade. In every case these currencies were sus- pected of being overvalued in the period leading up to crisis (Figure 3.11).17 Overvaluation helps to cause currency attacks, forces interest rate policies that negatively affect banking system profits, and reduces banks’ ability to manage the unfolding crisis and the negative impact of exogenous shocks.
Figure 3 11
OVERVALUED EXCHANGE RATES OFTEN PRECEDE CRISES Percent
Country Exchange rate overvaluation*
Mexico
ILLUSTRATIVE
37.0
35.0
32.0
25.0
K 1 8 Thailand Ecuador
Turkey
*Overvaluation calculated by using PPP methodology, represents overvaluation on eve of crisis Source: IFS; World Bank; McKinsey analysis
FIGURE 3.11 Overvalued exchange rates often precede crises.
Pegged Exchange Rates and Overvaluation For fixed exchange rate regimes to work, they—and the monetary and fiscal policies that underpin them—
must be both believable and sustainable. Domestic investors want to know that the value of their investments will not drop in real-dollar terms. Foreign investors want to ensure that currency risk will not eat away at their returns.
Domestic borrowers in foreign currency—including banks in the countries we examined—pray for stable currency, but they also hedge positions and take precautions to ensure that they are not too exposed to sudden depreci- ation. Lenders want to avoid increases in defaults due to increased debt servicing among their borrowers. Virtually every actor in the economy, therefore, closely watches exchange rates for the first sign of weakness. For this reason, the government tries to guard its stability fiercely.
Thus, the choice to peg exchange rates requires a heavy economic man- agement and public relations burden for policymakers. They have to ensure not only that key product, factor, and financial market conditions are being met, but also that nervous investors and creditors expect them to be and to continue to be met.
Unfortunately, the relatively weak real economies of many countries cannot keep pace with the demands of the currency regime—and their cur- rencies gradually become overvalued, the traded goods sector becomes uncompetitive, and the currency to which exchange rates are pegged (e.g., the U.S. dollar) goes out of alignment. In reality, it is the productivity of the U.S. economy and other countries that compete in traded goods that helps to influence the demands of the currency regime. The longer these policies are maintained, therefore, the deeper the distortion of supply and demand for the currency becomes. This danger only increases the government’s com- mitment to a fixed-rate regime. However, most governments lead with a defense that first begins with interest rates and then with reserves.
Interest Rate Defense of Exchange Rates In defending failing exchange rates, most governments begin by tightening interest rates. While this move tends to increase demand for the currency and thus props up its valuation, it has a number of negative effects as well. Government interest rate hikes increase the real rates paid by corporations, individuals, and government entities them- selves, and quickly reduce aggregate economic activity as investment declines.
This decline affects banks in three painful ways. First, a slowed econ- omy reduces the total demand for bank credit. Banks therefore see their book of new loans shrink. Second, weakened corporate and individual returns increase the number of NPLs, and banks see their profitability drop on out- standing loans. Third, rising money market rates ensure that the net spread on loans falls, further reducing bank profitability. Few policymakers appear to fully understand this tight linkage between interest rates and bank perfor- mance, and many others are caught unaware as their banks begin to lose
ground. More sophisticated investors and creditors perceive this weakness, undermining the confidence that the government is trying so hard to engender.
Figure 3.12, drawn from our analysis of the Colombian crisis, displays the tight link between interest and fixed or pegged exchange rates. Prolonged periods of high interest rates weaken corporate sectors and financial interme- diaries. Even if high rates are successful in holding off exchange rate deprecia- tion, they nevertheless have secondary effects that can be equally devastating.
Currency Attacks Even more devastating than the impact of increased inter- est rates is the unsustainability of an overvalued exchange rate. When a currency is perceived as being overvalued, and as expectations of devalu- ation build, market participants rush to save their investments before the currency collapses. Meanwhile, opportunists and speculators arrive to cap- ture profit opportunities. These are the “currency attacks” that often trigger dangerous dynamics in both the real and financial sectors. In the real sector, devaluation drops real income and further weakens corporations’ and indi- viduals’ ability to repay loans. The financial sector is then hit by a rapid increase in NPLs, as well as by increasing payment requirements as foreign- denominated loans become vastly more expensive.18
To make matters worse, at the first sign of devaluation in many emerg- ing markets, the foreign interbank loan flows that historically have been so
0 500 1,000 1,500 2,000 2,500
1997 1998 1999 2000
0 10 20 30 40 50 60 70 80 90 100 Exchange rate
Pesos/US$
Money market rates Percent
Figure 3-12
RISING RATES CAUSE BANKING PROBLEMS Exchange rate Peg floor and ceiling Money market rate
Buildup to crisis Crisis
Source: Bloomberg; Banco de la República; McKinsey analysis
FIGURE 3.12 Rising rates fuel Colombian banking problems.
critical to financial solvency are typically the first to reverse and withdraw from an economy.19The result is a series of banks under increasing duress, faced with a liquidity crisis that can set off a broader financial crisis. Since governments will often burn up their reserves in an unsuccessful bid to stem the tide of this process, market forces will lead inevitably to a depletion of reserves, devaluation, or both—as Argentina’s case and those of other coun- tries have painfully shown.
Unfortunately, crawling pegs and mini-devaluation systems are bound by similar conditions as fixed exchange rates, and provide little relief from the dangers of overvaluation. As the currency becomes overvalued, the mar- ket tends to push governments through crawling peg triggers, forcing an accelerating series of controlled devaluations that merely inject political fanfare—and a loss of credible government promises—into the inevitable process of devaluation. Past experiences with these middle-of-the-road regimes prove these policies to be functionally the same as fixed rates. In fact, they may be even worse, as they tie themselves to a predetermined amount of devaluation, restricting the ability of policymakers to react to currency attacks.
The Role of Exogenous Shocks The final process of disintegration often begins with exogenous shocks in the relevant country. Political events (the assassi- nation of Mexican presidential candidate Luis Donaldo Colosio in March 1994 and the revival of the Chiapas crisis later that year), weather systems (the impact of El Niủo in Ecuador), wars (the civil war in Colombia), and financial crises in other countries (the impact on Korea of the financial crisis in Thailand) all serve to undermine confidence in shaky exchange rates, weak real economies, and financial systems. In many of the cases we exam- ined, the final push, in fact, was provided by an unexpected event that had nothing to do with the domestic financial system, but that nevertheless undermined confidence in the fragile economic status quo.
The Role of Internal Shocks Finally, there are internal shocks. The most com- mon internal shock is the rapid loss of investor or depositor confidence fol- lowing the closure of one or more failed banks. The first sign may be when depositors rush en masse to their bank branches to withdraw their life sav- ings. Unless sufficient liquidity—cash—is provided to stop the runs, a bank holiday may occur, further eroding already fragile consumer confidence.
Left unmanaged, the bank holiday becomes a rout on the entire financial system and worsens the crisis, as was the case in Ecuador in 1998 or Argentina in early 2002.20
Effects of Other Macroeconomic Policies
Other macroeconomic conditions have a bearing on the health of the econ- omy and the banking system. An especially important link exists between fiscal deficits and interest rates charged in money markets. Tracing the effects of fiscal deficits to banks’ profits only requires remembering that the hikes in interest rates caused by fiscal crowding out have similar effects on corporate sector portfolios as do increases made to protect exchange rates, which lead to higher NPLs and lower bank profits. However, another interesting effect arises, because the crowding out of private borrowers leads to a change in bank portfolios. Generally, governments are thought to be better risks than private borrowers; however, governments also can default, but not before funding to the private sector dries up and causes financial distress.21
Figure 3.13 shows that during the period 1998–2001, Argentina’s government crowded out private corporate borrowers from the bank mar- ket at higher and higher interest rates. Hence, during this period, banks’
loan portfolios became more tied to the destiny of the government. When the government defaulted in early 2002, it pulled the banking system down with it.
We believe that crises like those of Argentina and Russia are relatively rare. In both of these cases, the route to crisis was defined almost exclusively by government behavior. However, there were some significant weaknesses and warning signs in the private corporate sector and state-owned banks.
The other crises we have seen had both the private corporate sector and banks as the key instigators. Governments played a role, to be sure, but
23.5
28.2 28.8 30.3
CORPORATE BORROWERS
47.0 45.1 41.3
36.2 CAGR -10%
CAGR 7.5%
1998 1999 2000 June
2001
Bank credit to companies
1998 1999 2000 June
2001
Government debt bank holdings
$ Billions
Source: Banco Central de la República Argentina; McKinsey analysis
FIGURE 3.13 Argentina’s government crowds out private corporate borrowers before crisis.
their role was to trigger the crisis events, generally through mismanagement of macroeconomic policies rather than through their direct involvement in the conditions leading to crisis.
The Role of International Money and Capital Markets
In Chapter 2, we underscored the role of international money and capital markets in enabling the conditions that cause the buildup and triggering of crises. Since this subject has been amply covered previously, we only under- score key conclusions in this section.
We believe that in most crises foreign funding sources have roles more as catalysts than as prime movers. The institutions and investors that con- trol foreign funding resources are clearly pursuing arbitrage opportunities in crisis-bound economies. While a few of these investors are large, generally the resources of any one player deployed against any particular situation will be a relatively small part of the total, both for reasons of risk diversifi- cation and other opportunities available. While George Soros is correctly perceived to have taken on the Bank of England and won, for instance, this type of incident is rare—though useful to politicians, investors, and bankers anxious to find scapegoats for problems of their own making.
Arbitrageurs play on the cutting edge of markets. As players on the margin who seek to take advantage of opportunities for trading currencies and financial instruments, their reactions to specific opportunities help to moderate price fluctuations. Their role is to seek price anomalies and to exploit them until they are exhausted. They run large risks in doing so, for if the anomaly outlasts them, then they lose a portion of the principal that they put at risk. For this reason, if they feel that a price in the market is sus- tainable they go elsewhere with their money. Their very nature makes them ephemeral participants in markets, always one trade away from being alto- gether gone from any market. Hence, their role is to take anomalous condi- tions and to exploit them for what they are worth. They are professional skeptics, always looking for signs of weakness.
In recent financial storms, international commercial banks—seeking to earn the higher returns available in emerging markets—have taken on a role as arbitrageurs. In this way, they have served as catalysts that cause sudden surges of funding to enter countries, only to reverse course and leave, caus- ing a funding drought that eventually triggers a crisis. In every case, though, they are reacting to others’ leads, and primarily to the signs of extreme opti- mism and distress that are displayed by economies on their way to crisis.
In the highly interrelated global economy, foreign funding will surge on good news, thus reinforcing the good news, and sputter with bad news, sometimes spiraling an economy into crisis as the bad news feeds more fund withdrawals, which lead to a steeper downward spiral. Knowing this, we
believe that governments and companies should adopt strategies that allow the overshooting to be absorbed and countered.
In many emerging markets, however, there is an ingrained resistance against allowing the development of markets where risk positions can be traded, reflecting contending points of view about the sustainability of eco- nomic growth and the policies on which such growth is based. Thus, there are too few instruments with which to hedge risks and too few opportunities to take and express contrarian positions. As a consequence, doubts about the sustainability of a growth model turn into currency runs that are both more damaging and abrupt than is justified. As the world becomes more tightly linked, the points at which emerging economies interconnect with the rest of the world will need to develop further—until there is a rich vari- ety of instruments with which to buffer and protect an economy from bouts of skepticism and concern about the sustainability of a growth path. In other words, many small corrections following a trend are much better for emerging markets than large, abrupt swings. This fact is as true during the initial period of growth as it is later when only downside risks are apparent.
The Impact of Asset Bubbles
Asset bubbles are present in several of the crises analyzed in this book.22In none of the cases that we have examined do they alone account for the cri- sis, although in several cases—including Sweden and Thailand—they were strong contributors to crisis conditions.
Bubbles are relatively rare and happen most frequently in nontradable goods, such as commercial and residential real estate, where supply grows slowly. They also happen in stock exchanges, generally due to exuberant feelings of optimism that are usually dissipated as information about the sustainability of a price run-up is made available.
Figure 3.14 shows the price bubbles in real estate and the stock exchange of the Thai economy. The Thai bubble was especially harmful because real estate developers used expectations about the effect of price increases on the value of their property portfolios to obtain financing. These pyramid-like schemes could not withstand the pressure that eventually was placed on them, and they collapsed when financiers became reluctant to provide addi- tional resources to fund development.
Bubbles tend to be just as exaggerated on the way down as they are on the way up. In Jamaica, the bubble’s burst caused the government workout agency to be the largest owner of commercial and residential real estate. The government had to slowly liquidate the portfolio or run the risk of having big blocks of real estate on the market, further depressing the value of its hold- ings. Consequently, real estate bubbles can take an especially long period to work out. This is also true of nonperishable assets whose technologies are
not rapidly evolving. The bubble that burst in the U.S. data and telecom market in 2001 is a good example. How long the effects of this event will last is dependent upon the pace of technological change. If these assets become obsolete rapidly, then new investments will start up in the industry soon, otherwise the amount of equipment—servers, switches, and comput- ers—sitting around will depress the recovery of the sector.
■ ■ ■
In sum, financial crises are the result of the complex interaction of power- ful forces at both the macro- and microeconomic levels. Our work suggests that the microeconomic foundations of financial crises have been seriously underestimated and understated as a primary explanation of financial crises.
Underperforming corporations and inadequate banking practices create the conditions for crisis. Rapid increases in international money and capital flows, government policies, asset bubbles, and other exogenous and endoge- nous triggers usually act as catalysts.