Capital Flows and Crises in Emerging Markets

Michael P. Dooley [*] Private capital flows to developing countries have been characterized by surges of inflows followed by financial crises. Explanations for this volatility can be found in the behavior and expectations of investors. However, the challenge is to look for less obvious explanations. In particular, is there a framework that can inform us about the apparently very different events, such as the 1982 debt crisis in Latin America and the 1998 crisis in Russia, without appealing to destabilizing investor behavior? Only ten years ago most "academics" were convinced that crises could be explained by conflicts between exchange rate policies and fiscal policies of emerging market governments. This view has been demolished by the apparent absence of such conflicts preceding recent crises in Asia. My research strategy has been to propose alternative policy conflicts while retaining the assumption that private financial markets are inherently stable, The foundation of this approach is the well-known moral hazard problem. The idea is that the behavior of private debtors and creditors is influenced by the expectation that, in some circumstances, creditors will be able to sell their claims to a government on terms that are favorable relative to market prices at the time of the sale. The capital inflow/crisis sequence based on moral hazard can be summarized as follows: [1] the availability of free insurance raises the expected yield on a set of liabilities issued by residents for a predictable time period. The yield differential relative to international returns generates a private gross capital inflow (a sale of domestic liabilities to nonresidents) that continues until the day of attack. When the government's marketable assets are matched by its contingent insurance liabilities, the expected yield on domestic liabilities falls below international rates, and investors sell the insured assets to the government, exhausting its assets. The idea that moral hazard plays some role in recent financial crises is now widely accepted. However, the possibility that it has been the primary cause of crises remains controversial. My interpretation of the evidence is that the moral hazard approach provides a good basis for understanding and, to some extent, for predicting all of the financial crises that have overtaken developing countries during the past 30 years. Collateral and Capital Inflows Why do nonresidents lend to sovereign governments when the ability to collect is so much in doubt? I have suggested that creditor and debtor governments' willingness and ability to liquidate (not just to service) private debt is necessary for private capital inflows. Three "fundamentals" must be present in order to generate a capital inflow/crisis sequence. First, a government must have marketable assets and lines of credit available to support new debt. Collateral consists of assets it can sell (usually international reserve assets) or the right to borrow against future tax receipts at nonmarket rates. This will usually take the form of credit lines from creditor governments and international organizations. One important assumption is that, at the time of a crisis, the debtor government cannot borrow against future tax receipts from a subset of private creditors in order to liquidate the claims of other private creditors. I argue later in this article that private debt contracts are designed to make this "re solution" of a crisis impossible. Second, the government's commitment to exhaust these net reserves to pay off implicit or explicit insurance contracts must be credible. That is, it must be consistent with the government's incentives and ability to mobilize and exhaust its assets after the attack begins. Third, investors must have access to transactions that produce insured losses. That is, they must be able to appropriate the government's assets. For example, governments might instruct banks owned or controlled by the government to lend to firms that do not earn the competitive rate of interest in order to promote exports or employment or to subsidize constituents. …