One of the most intriguing puzzles following the Lehman debacle is that, in spite of its global nature, the current crisis dealt a much smaller blow to emerging markets than its predecessor, the Russian/Long-Term Capital Management crisis of 1998 (Levy-Yeyati 2009, Walti 2009).
Any exogenous measure of risk vis-à-vis emerging markets would suggest that the current shock was much larger. For example, the US high-yield bond spreads that belong to the same asset class as emerging markets increased much more significantly following Lehman´s collapse than in the Russian/LTCM crisis (1200 bps trough to peak in the former, 300 bps in the latter). However, in contrast to the Russian/LTCM crisis, at no point in time following the Lehman crisis did Emerging Market Bond Index (EMBI) spreads cross the 1000 bps critical mark, usually considered by the markets as a threshold at which countries are rationed out of credit and priced at default levels (see Figure 1).
Figure 1. EMBI spreads reaction: Lehman crisis (2008) versus Russian/LTCM crisis (1998)
So what was different this time? Was it stronger fundamentals in emerging markets or the readiness of the international community to provide financial support to emerging markets? To address this question, we draw on formal empirical work that is part of an ongoing research agenda that will be part of IADB’s 2010 Macroeconomic Report to be presented at the Annual Meetings of the Board of Governors of the Inter-American Development Bank.
Competing explanations for differences in spread behaviour
A first explanation is that emerging markets had stronger fundamentals during the current crisis and thus were better positioned to resist the storm in international financial markets. In fact, if we take emerging market credit ratings as a proxy for fundamentals, we find that fundamentals were stronger. On the eve of the Lehman debacle emerging markets had an average rating of BB+ (closer to investment grade levels), whereas they scored an average rating of BB- on the eve of the Russian/LTCM crisis (thus lingering closer to the high-credit-risk category).1
To analyse the impact of improved fundamentals on spread changes, we look at changes in EMBI spreads in the 60-day window starting on 1 September, two weeks prior to the collapse of Lehman Brothers, all the way to the apex of US high-yield spreads by end-October 2009, i.e., the period of maximum uncertainty about the fate of the global crisis. We then constructed two groups, one including emerging market countries with pre-Lehman crisis average credit ratings and a second group of emerging market countries with pre-Russian/LTCM crisis average credit ratings.
Not only did we expect EMBI spreads of the second group to perform worse than the first – which was indeed the case – but we also expected EMBI spreads of this second group to perform worse than EMBI spreads in the Russian/LTCM crisis – something that didn’t happen (Figure 2). The maximum increase in EMBI spreads within the 60-day window of the Lehman crisis was 534 bps for countries in the first group and 702 bps for countries in the second group. However, they are both much lower than the increase of 1042 bps that took place in the equivalent window of the Russian/LTCM crisis.
Figure 2. The role of fundamentals in the Lehman crisis
1 Includes countries with pre-Lehman crisis BB+ or BBB- credit ratings (Brazil, Colombia, Egypt, El Salvador, Kazakhstan, Panama and Peru).
2 Includes countries with pre-Russian/LTCM crisis BB- or BB credit ratings (Indonesia, Philippines, Turkey, Uruguay and Venezuela).
In short, fundamentals were relevant and did make a difference, but they do not tell the whole story.
A second competing explanation for the differences in spread behaviour is related to the readiness of the international community to provide financial support to emerging markets facing liquidity problems.
Given the global nature of the current crisis and the perception that emerging market countries were innocent bystanders, the international financial community displayed early on a predisposition to act swiftly as international lender of last resort for emerging markets, providing timely, unconditional, preventive, and sizeable assistance. The earliest indication came in April 2008, when Japan announced liquidity swap lines for Indonesia (and for India two months later). Shortly after the Lehman downfall, the US Federal Reserve offered swap lines for systemically relevant countries such as Brazil, Korea, Mexico, and Singapore, and the IMF launched a short-term liquidity facility. In addition to official initiatives, academic circles and other fora were calling for emergency-lending facilities for emerging markets to deal with the global crisis.2 The icing on the cake came in April 2009, when the G20 decided to triple the resources of the IMF and the IMF launched its flexible credit line to assist – unconditionally and at longer maturities – countries with sound policies facing liquidity constraints. In contrast, during the Russian/LTCM crisis, support by the international community was slow-moving, conditional, curative rather than preventive, and of smaller magnitude.
To assess the impact of access to international lender of last resort facilities on emerging markets spreads, we once again constructed two groups of countries. The first group includes emerging markets that were not expected to have access to international lender of last resort facilities during the current crisis, namely Argentina, Venezuela, and Ecuador.3 To control for fundamentals, the second group includes countries with the same credit ratings but access to international lender of last resort facilities.
As expected, countries with no access to international lender of last resort facilities had much larger spread spikes than countries with access, even after controlling for fundamentals. EMBI spreads in no-access countries rose by a maximum of 1571 bps within the 60-day window of the Lehman crisis, compared to 830 bps in countries with the same credit ratings and access to international lender of last resort facilities (see Figure 3). But even more remarkable, EMBI spreads of no-access countries in the 60-day window of the Lehman crisis performed worse than EMBI spreads of EM countries with similar credit ratings during the Russian/LTCM crisis equivalent window – yet another control group. Thus when controlling for access to international lender of last resort facilities – which were essentially absent during the Russian/LTCM crisis – and fundamentals, the results turn out as expected, i.e., EMBI spreads performed worse during the current crisis.
Figure 3. The role of access to international lender of last resort facilities in the Lehman crisis
1 Includes Argentina, Ecuador and Venezuela.
2 Countries with access to ILOLR during the Lehman crisis with the same credit rating as countries without access during the Lehman crisis. Includes Belize, Dominican Republic, Ghana, Georgia, Indonesia, Jamaica, Pakistan, Philippines, Serbia, Sri Lanka, Turkey and Ukraine.
3 Countries that during the Russian/LTCM crisis had the same credit ratings as countries without access during the Lehman crisis. Includes Brazil, Lebanon, Russia, Turkey and Venezuela.
This evidence suggests that access to international lender of last resort facilities played a key role in preventing EMBI spreads from skyrocketing, which likely would have resulted financial distress and severe economic contractions.4 Thus, it has major implications for the design of a new international financial architecture and the future actions of the IMF and multilateral development banks.
The first order of business is the institutionalisation and improvement of the ad hoc international lender of last resort mechanisms used during the global crisis. However, it is not yet clear whether the resources and the instruments used during this crisis will be available when emerging markets face the next systemic financial crisis, particularly if it does not originate in the industrialised economies. The new financial architecture emerging from this crisis should address that uncertainty sooner rather than later.
Moreover, we should also ensure that international lender of last resort facilities possess the following characteristics:
- ex ante eligibility, based on the soundness of policy regimes in place,
- automatic (i.e., non-discretionary) liquidity assistance for eligible countries in financial distress,
- timely disbursements to prevent crises rather than cure their consequences,
- sizeable support, i.e., sufficient to meet short-term financial obligations and avoid a collapse in aggregate demand.
In order to gain eligibility to ex ante access to international lender of last resort facilities, countries would have to adopt a macroeconomic policy framework aimed at promoting stability. Such a framework would include for example, the adoption of (i) sound monetary and exchange rate policy regimes to control inflation and efficiently respond to shocks, (ii) counter-cyclical fiscal rules, (iii) fiscal targets consistent with convergence to prudent public debt levels, and (iv) frameworks for financial system stability.
These two initiatives could constitute the basis for an incentive-compatible “stability pact à la Maastricht for emerging markets”. In line with the IMF’s flexible credit line, the benefits of access to international lender of last resort facilities would only be enjoyed by those who pre-qualify, based on previous efforts to attain sound macroeconomic policy frameworks, thus preventing moral hazard. Within this pact, the IMF and multilateral development banks would play a complementary role, the former acting as international lender of last resort for emerging markets and the latter financing the macro-policy-framework reform agenda. Thus, the IMF and multilateral development banks should be endowed with adequate resources for the task.
Since the Mexican “Tequila” crisis in 1994 through the Asian Crisis in 1997, the Russian/LTCM crisis in 1998, the ENRON crisis in 2001-02, emerging markets with perfectly sound fundamentals were plagued by contagion, which inflicted unnecessary pain on otherwise healthy economies. Had there been an international lender of last resort to prevent the virus from spreading to healthy bodies, a lot of (economic and human) suffering could have been prevented. The readiness of the international community during the current global crisis to put both the resources and the instruments at the disposal of emerging markets and the effectiveness of this intervention have created the conditions for the institutionalisation of international lender of last resort facilities for emerging markets to prevent future crises. The international community should seize this opportunity. If so, the global crisis might well have been a blessing in disguise for emerging markets.
Acknowledgements: We want to thank very specially Santiago Levy for his insights and ideas. We also want to thank Ignacio Munyo and Diego Pérez for very useful comments.
1 Throughout this note, we work with a sample of thirty seven emerging markets included in J.P. Morgan’s EMBI Global Index.
2 See for example, CLAAF (2008) and Izquierdo and Talvi (2008). For an early proposal of international lender of last resort to prevent contagion in emerging markets see Calvo (2005).
3 For our purposes, countries with no access to international lender of last resort facilities are defined as those with no Article IV consultations with the IMF for the last two years, and/or in arrears with the IMF, and/or in default with bondholders.
4 For systematic evidence on the adverse impact of periods of international financial turmoil on emerging markets macroeconomic performance and the anatomy of the subsequent recovery, see Calvo, Izquierdo and Talvi (2006).
Calvo, G. (2005), Emerging Capital Markets in Turmoil: Bad Luck of Bad Policy?, Cambridge, MA: MIT Press, Chapter 18.
Calvo, G., Izquierdo, A. and Talvi, E. (2006), “Phoenix Miracles in Emerging Markets: Recovering without Credit form Systemic Financial Crises”, NBER Working Paper 12101.
Izquierdo, A. and E.Talvi, coords. (2008), “Policy Trade-offs for Unprecedented Times: Confronting the Global Crisis In Latin America”, IADB Research Department Report presented at the Annual Meetings of the Board of Governors of the Inter-American Development Bank held in Medellín, Colombia.
Latin-American Shadow Financial Regulatory Committee (CLAAF) (2008), “Latin America in the Midst of the Global Financial Meltdown: A Systemic Proposal”.
Levy-Yeyati, Eduardo (2009), "Decoupling and the future of emerging economies’ growth", VoxEU.org, 7 November.
Wälti, Sébastien (2009), “The myth of decoupling”, VoxEU.org, 27 July.