What causes a financial collapse? Free-market economists argue that crises follow bad economic fundamentals, flawed policies, lack of transparency or crony capitalism.
By Deepak Gopinath
June 2001
Institutional Investor Magazine
What causes a financial collapse? Free-market economists argue that crises follow bad economic fundamentals, flawed policies, lack of transparency or crony capitalism. Those less smitten with liberal orthodoxy like to blame market psychology or unchecked capital flows. Michael Pettis says that the real culprit is none of the above.
A veteran emerging-markets bond trader who now heads Bear, Stearns & Co.'s liability management group, Pettis argues in The Volatility Machine: Emerging Economies and the Threat of Financial Collapse that crises occur when countries mismanage their sovereign balance sheets, or capital structures, in ways that exacerbate their vulnerabilities to external shocks. In the author’s view, badly designed capital structures act as “volatility machines,” making financial troubles far worse than they’d otherwise be.
In essence, the author applies the insights of traditional corporate finance to sovereign risk management. Just as companies routinely seek to reduce the volatility of their earnings or debt-service costs by hedging their exposure to external risks, such as interest rate fluctuations, so too should countries, Pettis concludes. Instead, he maintains, many developing nations focus almost exclusively on raising debt as cheaply as they can. They often rely on foreign currency debt or borrow short term, which may reduce their near-term cost but provides no good long-term solution. That’s because such capital structures - Pettis calls them inverted, because they set up an inverse relationship between revenues and costs - are ultimately doomed. Such structures, he writes, “lock borrowers and investors into self-reinforcing behavior in which small changes, good or bad, can force players to behave in ways that exacerbate the changes.”
An inverted funding structure typically uses short-term dollar debt; it might also include floating-rate local currency debt or short-term local currency debt. When an economy that uses short-term dollar debt is doing well, asset values and tax revenues increase, the local currency strengthens, and debt-service costs decline. But when global economic conditions deteriorate, debt costs increase, while revenues and asset values decline, making a bad situation worse.
The author’s solution: Countries should adopt “correlated” capital structures that minimize the effects of external forces. These would typically use fixed-rate local currency debt, causing debt service costs to decline when economies weaken.
Unfortunately, boom times often inspire developing country policymakers to adopt the more aggressive inverted capital structures. In the early 1990s, for example, when the Mexican economy was growing and inflation was falling, the government’s decision to rely heavily on short-term dollar borrowing seemed to make sense; interest rates and debt-service costs declined. But when the peso collapsed in 1994, debt-service costs increased, and government credibility was undermined.
Pettis also cites the case of Indonesia in the mid-1990s. During that period, private corporations took advantage of the economic boom to reduce their funding costs by borrowing in dollars. But after the currency crisis hit in July 1997, corporations found that their debt was much more expensive and rushed to hedge their exposure, inevitably triggering further declines in the rupiah.
The author observes that liquidity changes in developed countries, more than local growth prospects or economic fundamentals, drive capital flows to emerging markets. In his view, investors move into emerging markets when a “displacement” in developed country markets increases global liquidity. As liquidity improves, investors turn to hitherto-overlooked developing countries for higher returns. The capital flows into these small economies spur growth, which not only prompts rich country lenders to invest more but also encourages local policymakers to adopt economic policies that they believe will be conducive to growth.
Writing in a clear, accessible style, Pettis is skeptical of the free-market economic model and the oft-repeated contention that the Asian crisis was proof that the Asian development model failed. When there is a glut of global liquidity, most policies seem to work, he suggests, but they all fail when liquidity disappears. Pettis notes that the timing of capital flows to Argentina, Brazil, Chile and Mexico was roughly identical during the past 30 years, although the timing of their economic reforms was quite different.
The Volatility Machine provides a welcome departure from the sterile academic debate on the subject of financial crises. Economists may quibble with the author’s single-minded focus on capital structures, but they would be wise not to ignore his insights into how they exacerbate external risks.
