Asia may be bouncing back. But apprehension was in the air when the IMF, the World Bank and the Asian Development Bank convened a conference in Washington to discuss financial contagion. Rudiger Dornbusch, MIT’s celebrated international economist, was one of the prime movers for this event. He talked to James Smalhout.
Would the official community have reacted any differently to the Asian crisis in July 1997 had we known then what we know now about financial contagion?
No, I think that the research shows two things of interest. First, every one of those economies had horrible balance sheets and with an accident you’re going to get a big fallout.
The fallout gets aggravated by lack of liquidity, by a lack of knowing what is happening next in politics, by a question of whether the government will choose to default rather than have a serious fiscal impact in the budget that is politically unpopular.
All of that, I think, is well documented and leaves the policy question of whether you should intervene or not. The answer always is: when it’s big, intervene. I think that will remain the answer. What is big is carefully not defined, neither for the Federal Reserve in relation to domestic banks – other than too large to fail – nor in the case of emerging markets. Everyone has been looking for a victim. Finally, they found Ecuador. It’s so small that it doesn’t make a difierence.
That’s to show that not everybody gets bailed out. So I don’t believe that the research has a direct feedback to our policy action.
But I think that research is important when we paint a picture of how a country is integrated in the world economy. One of the things to consider is the volatility correlations. A shock that happens anywhere happens everywhere. The more leverage there is in the system and the more balance sheets are problematic, anything that happens is big.
Those are important lessons that policy-makers now know and they lead to the next questions.
What are the key vulnerabilities? What’s a good exchange rate policy? What’s the minimum reserve in the banking system? What’s the regulation that avoids mismatching.
All of the right questions are being answered now and, one hopes, are being taken seriously.
Mexico collapses every sixth year. This is the sixth year and they say: “Check the shopping list. We’ll take you over it, one by one. We have a flexible rate. So, that’s our shock absorber. We have long maturities and that is a shock absorber. We have a good budget. That is a shock absorber. So, sure the exchange rate can depreciate, but collapse?” I think that’s pretty good, when a Finance minister understands that there is a shopping list and people check it off to ask whether they can have an accident.
What is your definition of contagion?
I think the right one is that you are standing innocently around and the next thing it hits you. Any participant in traffic knows that you can have an accident because someone runs into your car. That’s contagion. It wasn’t you. It was him. But it was totally stupid to say: “Gee, I didn’t realize this could happen.” That’s what we had in Asia. We were totally innocent. That wasn’t true because they had horrible balance sheets. And to say that it cannot happen is naive. So, I think this traffic analogy is really the right one because it catches them on their key vulnerability. Yes, something happened and it wasn’t caused in Indonesia by itself, but the fact that they were driving drunk really didn’t help.
Here, economists sound much more self-assured about their ability to analyze and predict crises using conventional methods. After Mexico, many economists said their models didn’t work. How do you explain the greater confidence today?
It’s 10,000 papers later, is one answer. And there’s a focus on the balance sheet. That’s really where it happened. And what is a vulnerable balance sheet? Nobody here says they can time it. They can tell you whether someone is exposed and they can use empirical work to say what some of the impact will be on Country X if it happens in Country Y, because there’s a lot of empirical work done on the correlations. So, I think that a huge amount has been done. But the key lesson is: don’t look at the trade balance, go to the balance sheet. If it’s big that’s where it happens. I think there is a hugely better understanding of how to make a crisis. Today, we know how to make one, right? Or, turn it around. They spend a lot more time not on the inflation rate and not on the trade balance, but looking at the maturity matching and how it can go wrong. The bad balance sheet has 10 ways of going wrong. Then, all you need is to ask how will this be triggered in the First place. If there is an election you can be sure that it’s right after.
Do you think foreign investors destabilize emerging markets?
I think when something goes wrong, finding the scapegoat is the First order of business. I think foreign investors are a wonderful influence, just as stockholders are for a company. They beat up management, get them to perform better. It’s a great civilizing influence.
During a crisis with contagion, market movements become more correlated. How can you design a well-diversified portfolio?
If you had invested in the stock market and said what happens in a downturn, you would be asking exactly the same question. You’d be saying that you really needed a lot of utilities. They tend to be less cyclical and what is the utility equivalent? You’d say I’d take three helpings of Singapore and Taiwan, because they have better balance sheets. They may be hit, but they won’t go down as much and maybe you should have less emerging markets.
You’ve seen that the correlations are very high in bad times. Having them spread out isn’t going to get you that far away from it.
They’re all the same. So, I’m saying invest strategically.
Which countries should be overweighted and which countries should be underweighted in view of contagion?
I think that you want to go to countries that have top-rated banks if you want to minimize the downside. That will turn out to be an extremely important factor. Just look at the average rating of banks in a country and say that I won’t go anywhere that has less than “B”. That basically means that you will not go to emerging markets, but you would go to Taiwan, Singapore and Hong Kong.
Over the past decades, do you think we have moved toward a financial system in which exchange rates reflect fundamentals more closely and promote growth for that reason or not?
I have never complained about exchange rates.
People look at the yen-dollar rate over the past three years. We have gone from a world where Japan was about to go totally dead to one where they’re back to life, not big life but some life. I’m not surprised that the exchange rate moves by a very substantial amount. I think the same is true for emerging markets. You come back three months after a crisis. Once the damage is known, the real exchange rate hasn’t moved that much. So I think they’re good. I don’t have much problem with real exchange rates.
If a museum burns down and you have to estimate the damage while the Flames are going up, it’s pretty hard. The Rembrandt might be all right or not. That’s what an emerging market crisis is like. So overshooting ex post reflects the total absence of a judgment about the damage as well as the policy response.
Will the country be friendly to foreign investors or will it be haircut time? I’m not surprised about large exchange rate moves.
