Pierre Cailleteau and Aurelien Mali of Moody's Investors Service -

Introduction

Ten years after the outbreak of the Asian crisis, what caused such a virulent bout of financial and economic disruption, which has still not been entirely overcome, and the lessons that can be drawn have been widely commented. Indeed, rarely have contemporary economic phenomena engendered so many debates and studies. Nevertheless, this profusion of research has also blurred the operational conclusions. Ten years on, what are the key lessons that ought to be kept in mind in order to understand today's risks?

The difficulty is that even as the understanding of the causes of the crisis improved, the system itself, the global economy and global finance, has become considerably more complicated. This calls for a modest approach to the lessons we can draw from past experience. In fact, after 10 years of deliberations, alongside the things that we do know about the Asian kind of financial crises, there are many things that we only believe we know, as well as things that we simply do not know, including those that are probably not knowable with any precision.

What We Know

Among the key lessons of the Asian crisis, three are robust and relevant to today's world:

--liquidity is of primary importance;

--risk management improvements pay off;

--economic integration enhances resiliency

A key conclusion drawn by Moody's at the time of the crisis is that liquidity matters a lot. Although apparently uncontroversial, this conclusion stands in contrast to the .shopping list of factors that range from weak governance to insufficient transparency or inadequate banking supervision. What is meant here by liquidity risk is the extent to which countries are exposed to the risk of sudden and prolonged stoppages in external finance. A crisis of confidence that leads to an interruption or, worse, a reversal of capital inflows makes the central bank's foreign exchange reserves the external liquidity of last resort. As these reserves are limited, the central bank cannot print money in foreign currency, a private sector balance sheet crisis can contaminate the public sector's own balance sheet.

In a way, vulnerability to a prolonged shortage of funds is what distinguishes emerging market economies (EMEs) from mature economies (such as Iceland or New Zealand, let alone the US). The latter may experience imbalances but are extremely unlikely to face disruptions in external finance. Since the end of the 1990s, most EMEs, but chiefly those in Asia and commodity-exporting countries, have taken steps to inoculate themselves against liquidity risk. This has been done in two ways:

--A considerable domestic demand compression and the intensification of global trade integration have led to current account surpluses, reducing the need for external finance;

--A massive accumulation of foreign exchange reserves – an insurance policy against external financial shocks and unpopular calls on IMF resources. This accumulation has reached unprecedented, and to a large extent unimaginable, levels in countries such as China. As a matter of comparison, during the European Monetary System crisis in the early 1990s, the Bank of France had about $30bn available as against almost a trillion dollars now for the People's Bank of China.

Note that, while foreign exchange policies have differed, they have generally supported this strategy: flexible exchange rates policies, which have become much more prevalent, have considerably reduced the risk of a disruptive external payment crisis; stable exchange rate policies, which still dominate in part of Asia and in the Gulf countries have even amplified the rate of foreign reserve accumulation. Even though buying an insurance policy against liquidity risk does not make the "inconsistent Trinity", the key lesson of the 1990’s that fixed exchange rate policy, autonomous monetary policy and free capital flows cannot coexist for long less inconsistent, it clearly reduces the risk of an external crisis.

In conclusion, a diminished exposure to liquidity risk has considerably enhanced countries' shock absorption capacity. Ironically, this new global state where EMEs are net providers of capital to the rest of the world has created other problems, including potential asset price bubbles. However, from a global credit perspective, it is positive

In the aftermath of the Asian crisis, risk management imperatives came to the fore. As a result of deep reflection on the risks of global financial liberalisation and integration, risk management practices have improved, broadened and converged across the financial industry and the public sector. The economic policy field in the last ten years has indeed been very much influenced by the emphasis on risk management, inspired from practices at sophisticated financial firms, which had themselves influenced the concomitant revamping of the Basel I framework. Note that this convergence between public authorities and the financial industry in terms of risk sensibility reduces in itself the threat of a meltdown. Four key improvements have taken place in the last 10 years from a crisis prevention stand-point: 

--A focus on countries' balance sheets and therefore stock and flow considerations as compared to a focus on flows only, as in traditional balance of payment risk analysis. In other words, from a situation where the analysis concentrated on the risk that a currency crisis poses to the ability of a country to remain current on its debt, the analysis has moved to a situation where balance sheet exchange and interest-rate mismatches are taken into account to assess the potential severity of the shock. On the liability side, a notable effort to manage actively the public debt: debt reduction, substitution of foreign currency bonds by local currency debt, lengthening of debt maturities and shift to fixed interest rates etc;

--A focus on governments' off-balance sheet liabilities, such as those arising from banking systems distress or even government related corporate entities failures;

--A focus on probabilistic outcomes and stress-testing. Many EMEs have started to build crisis scenarios to help them develop contingency measures.

A recent illustration of this emphasis on risk management has been the unusual development of asset-liability management (ALM) by governments which have to manage external wealth as well as external debt.

A strong export sector coupled with a depreciated exchange rate has played an important role in explaining the difference often observed between the post-crisis economic rebound in Asia and in Latin America. In fact, the intensity of trade integration plays a positive role both in terms of crisis probability and crisis severity even though, admittedly, the concomitant slump in Asian economies compounded the problems before offering a way out. An important development in this regard is the trade opening of many Latin American economies, which used to be more open financially than economically. This is also naturally a key factor for those European economies that have been through the EU integration process.

What We Think We Know

Among the lessons that have been drawn and that are plausibly, but not assuredly, reliable, three stand out as important

--Not all current account imbalances are alike;

--Periods of boisterous financial liberalisation often end in tears;

--Local currency debt is better than foreign currency debt

A first source of analytical uncertainty surrounds the assessment of current account imbalances. At this stage in the development of the world economy, where most EMEs are running often massive current account surpluses, the situation of those countries that are in deficit can easily be seen as alarming. Interestingly, this is largely a pan-European phenomenon for EMEs (from Turkey to Hungary and the Baltic countries). One desperately banal lesson from the Asian crisis was that current account deficits do indeed matter, especially when they reflect excessive capital accumulation, asset price bubbles and credit overextension. That said, while intellectually comforting, it would probably be wrong to always equate current account deficits and dangerous - in other words it is unclear why a surplus should always be superior. Indeed, in the last decade, the analysis of current account imbalances has become more detailed and subtle.

Also, the relative importance of the current account as compared to the financial account financing flows has shifted, while the standard analysis continues to focus on the top of the balance of payment (trade and services). For the USA, admittedly well ahead of most countries in terms of financial depth but probably setting the trend, the sum of the imports and exports of goods and services equalled $2.1 trillion in 1998, as compared to $18 trillion of gross equity and bond cross-border flows. In 2005, imports and exports equalled $3.2 trillion, as compared to about $40 trillion of capital flows.

Besides the concept of sustainability, which determines the tolerable increase in external indebtedness, the concept of vulnerability has emerged, revolving around the issue of "financeability". Vulnerability depends on the nature of the financing needs - private sector rather than public sector, investment rather than consumption, and the nature of the financing - FDI rather than portfolio flows, cross-border banking etc. In fact, a deficit may be unsustainable in the long run but may not raise major vulnerability issues, as is the case for mature market economies such as Spain, Australia and the USA.

The idea therefore is that current account deficits are always a source of concern, especially when the country is subject to liquidity risk. However, when the liquidity constraint is less binding i.e. when the country boasts important foreign reserves and/or the country benefits from stable sources of financing, the question of how efficient the recourse to external finance is becomes more important than the simple question of the deficit.

The Asian crisis - following the 1995 Mexican crisis - was a 21st century type of crisis in the sense that it took place in an environment of largely free capital flows. This is why this crisis was as much a capital account crisis as a current account crisis. Also, the interaction between external vulnerabilities and weak domestic financial systems proved very damaging. Although rapid credit growth, especially when combined with episodes of financial liberalisation, is always to be watched carefully, it is also true that some situations require a more nuanced perspective. For instance, credit growth in new European Union countries - the Baltics, Romania, Bulgaria etc - has been very rapid. At the same time, this is taking place in an environment marked by: (i) low levels of financial depth (credit growth is high but credit/GDP ratios are low), (ii) reasonable expectations of real-income convergence (that validate some leveraging) and (iii) a high level of cross-border banking integration within the EU area (which provide some degree of stability to the system, given the credit standing of the banks in question and the reputational as well as institutional risks of walking away from their commitments in another EU country).

The conclusion is that high credit growth remains a good predictor of financial stress, but that some regional characteristics may be stabilising enough to prevent the stress in question from degenerating beyond bad loans and depressed domestic demand into a fully-fletched financial crisis.

A third lesson that is a little less straightforward than it sounds is that, for a government, borrowing in its own currency is better than borrowing in a foreign currency. For many years, most EMEs had been able to borrow only in dollars because they suffered some sort original sin. This meant that international investors were not prepared to take the foreign currency risk. Governments, in light of the often limited amount of available saving in the economy, had to resign themselves to tapping the international market, at its conditions.

A major development since the Asian crisis has been the creation of local currency debt markets where international investors have been active. This is a positive trend from a credit standpoint as it reduces foreign currency balance sheet mismatches: the exchange rate risk is borne by investors, which means that a depreciation of the exchange rate does not have to put the government's balance sheet under stress.

Yet, while positive, the impact on credit risk is more nuanced than it seems. As a large part of EME public debt remains foreign-currency denominated, it will take some time before a devaluation (or sharp depreciation) becomes entirely neutral for the debt burden. More generally, financial integration - authorised by full convertibility - creates linkages between domestic and foreign liabilities. This is why Moody's local currency and foreign currency government bond ratings have tended to converge over time.

The conclusion is that, while clearly positive, this trend does not fully insulate countries from external financial turbulence.

What We Do Not Know

Ten years after the Asian crisis, there are at least four key issues on which we still do not know enough. Understanding of these issues has improved, but not to the point of providing full comfort in terms of risk assessment: 

--Disentangling structural from cyclical factors;

--Contagion dynamics remain largely undecipherable;

--Crisis resolution remains hazardous Political risk is hard to anticipate;

--Disentangling structural from cyclical factors.

Probably the most critical issue is the difficulty of disentangling structural from cyclical factors. This stems from the fact that the world economy is undergoing a dramatic change, probably one of the most important in its history.

The integration of goods and services markets has accelerated since the early 1990s, with the increased participation of former command economies such as China and Russia and the greater acceptance of market principles across the developing world in countries such as India. The atomisation of production processes across borders, the supply chains, and the increasing tradability of services through outsourcing have helped leverage comparative advantages, disseminate technology and bolster price competition.

In this fast-changing environment, the mean-reversal assumption that implicitly underlies any kind of risk assessment - what goes up must come down - is somewhat challenged: what is the "mean" for an economy like China that has grown steadily - by about 10% a year - over the past 15 years? After an exceptional period of sustained growth - the longest since the 1970s - is Latin America doomed to revert to its "bad habits", or has the combination of steadier macroeconomic policies, more outward-looking approaches and more participative political regimes broken the traditional cycle? Has wealth accumulation in the Gulf countries reached a point where credit risk concerns should be structurally mitigated? Has the EU anchor generated an irreversible change for macroeconomic policies and the microeconomic environment of accession countries?

Sorting out what in the recent decade is cyclical and what is structural is a most complex question on which a lot of investments - through the evolution of the risk-adjusted return – depend.

An illustration of this difficulty also comes from the fact that cyclical strengths can transform into structural ones. For instance, an increase in foreign exchange reserves has always a cyclical component that can reverse, especially with pegged exchange rates. Yet, beyond a point, it is simply not plausible that a central bank could lose $200bn or more in foreign exchange interventions to support the national currency. This means that, past a certain level of reserve accumulation, one form of liquidity risk has effectively disappeared. Contagion dynamics remain largely undecipherable.

Contagion has been a prominent feature of the Asian crisis, with much written about it. This is an issue that interests investors, because of potentially unexpected portfolio correlations, as much as policymakers, who have realised that the danger may come from unsuspected sources. In a way, the reflection on contagion prompted a look at the demand side of the capital market - who finances what and on which basis - in addition to the more traditional approach based on the supply side, ie. the issuers of financial claims, such as governments.

Nonetheless, even though familiarity with this question has increased, there is no widely agreed analytical framework for approaching this question. In the meantime, the intricacy of financial spill-overs has probably increased with the multiplication of actors and financial innovation. Contagion is understood ex-post; it is rarely predicted with accuracy.

The Argentinean crisis, for instance, created few spill-over effects. Contagion is based on the existence of a multiplicity of actors whose individual action may, or may not, have the effect of creating linkages between, or within, asset classes. In fact, not only are contagion dynamics not well known, but it is possible to conjecture that they are not .knowable, ex-ante with any degree of precision. Absent a reliable contagion model, investors and policymakers have to rely on stress-testing and scenario-analysis.

The Argentinean crisis has brought to the fore the complication of sovereign debt restructuring in a market-based financial environment. While the resolution of the crises of the 1980.s had relied on some sort of "relationship" crisis management because the official sector was able to convene in the same room both the debtor and the creditors - large international banks on which some degree of persuasiveness or even moral suasion could be exerted - the crisis of the late 1990s and of tomorrow can no longer be managed in the same way. The atomicity of the creditor base and the diversity of incentives are such that the "relationship" model of crisis resolution has become obsolete.

This problem is by no means limited to the world of sovereign lending - the corporate world is exhibiting increasingly complex capital structures as well - and is a consequence of the expansion of market-based finance.

A final lesson from the crises of the last decade is that we do not know how to anticipate political crises. More precisely, while the risk of political turbulence can be foreseen, the unfolding scenario of a political crisis is generally unpredictable.

An element of complexity in country/sovereign crises is that the crisis dynamics can take unusual forms, with shattering implications in terms of losses for investors. Interestingly, this is not a new point and it has not become more or less complex than in the past. The impact of the 1917 Russian Revolution for bondholders was presumably difficult to predict. Therefore, this is a field where expertise can improve, but full knowledge is out of reach.

The conclusion is that political risk must be factored into risk evaluation, and must be underpinned by rigorous and updated scenario analyses. However, it constitutes a defuse "risk halo" rather than a distinct shock whose unfolding can easily be fathomed.

Conclusion

Ten years on, considerable progress has been made in understanding what happened in Asia - and in Mexico earlier or Argentina later. Yet, in the meantime, the system has become also more complex, and it is unlikely that all the lessons drawn yesterday are relevant today.

A case in point is that the world economy has since then embarked in a major, probably historical change. This is why some of the lessons might have become obsolete, and why it is as important to be truthful about what we know as well as what we do not know.

A rather firm and somewhat trivial conclusion is that the purchase by countries of liquidity insurance in the form of massive foreign exchange reserves - even though it betrays some degree of mistrust for multilateral support mechanisms such as the IMF - is credit-positive. Another conclusion is that risk management has moved from a binary model - crisis/not crisis - to a stochastic model - generating a distribution of probability of crisis in which very low probability but high severity events should increasingly focus the minds.

Pierre Cailleteau is Senior Vice President, International Policy Analysis, and Aurelien Mali is Associate Analyst, International Policy Analysis.

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