- Despite strong efforts to turn sentiment in the Greek bond markets, all attempts so far have failed. The crisis dynamics we are seeing at the moment are following a concerning pattern that we have seen during other financial crises which got out of hand. The situation should therefore be taken very seriously.
- In this paper we look at the ‘standard crisis dynamics’ and use the pattern during the Asian crisis as an illustrative example of how a small regional crisis can end up with far larger effects for the global economy than initially thought possible.
- The Asian crisis was triggered by problems in the country in the worst state of affairs (Thailand) but quickly spread to other countries with similar problems and which shared the same story. Even South Korea – which was in a clearly better state – got sucked into the crisis through the negative spiral that ensued. This was a major surprise for policymakers at the time.
- Ultimately the Asian crisis spread to Russia and Brazil through complicated links in the global financial and economic system.
- A key lesson from the Asian crisis is thus that even countries that have decent fundamentals to begin with can get hit once the crisis dynamics set in.
- The danger of contagion is that panic can become self-fulfilling and very hard to turn once it gets beyond a certain point. In the current crisis, countries that look much better than Greece – such as Spain or Italy – could suddenly be in a crisis if bond yields rose to Greek levels. Given the size of these countries, it could become very critical and call for an unprecedented large-scale IMF rescue.
When falling prices lead to falling demand
The contagion we are seeing at the moment to other Euroland countries should be taken very seriously. We start to see the dangerous crisis dynamics in which falling prices do not lead to rising demand but rather the opposite. This can create a toxic negative spiral in which the decline in bond prices scares more people and leads them to see less value in holding the bonds rather than more value even though the bond as such has become cheaper. A bank-run mentality of „better safe than sorry‟ is leading to selling in markets which, in a normal situation, would cope well but in the current environment could get hit. Evaluating bonds from a rational or fundamental perspective is dangerous in this environment as fear takes over and „irrational selling‟ becomes the main driver.
As we will see below, it can be very difficult to stop a crisis once contagion sets in and the potential for damage is often underestimated. Contagion can spread to markets that you might not imagine would be affected. As long as the crisis is local in nature, it is normally fairly harmless on the rest of the global economy. But often the links to countries not directly involved goes through more indirect channels. If a regional crisis cascades through to erode confidence in equity markets and credit markets, it could impair investment behaviour and slow global growth at a vulnerable time when there is little fiscal ammunition left to get it back on track if it slips.
It is critical that policymakers take the dynamics of contagion very serious. It is imperative not to get behind the curve again, but to show massive financial force before confidence erodes further. We should look for all high-level policymakers across G7 countries to express concern and will to take decisive action. The speed of action is important now and could for example involve raising the IMF reserves to calm investor nerves over whether some countries are too big to be rescued if needed.
Case study: The Asian crisis
The Asian crisis is probably the best example of how contagion can have a huge impact and is often underestimated. It started off with a devaluation in a small and, on a global economic scale, insignificant country – Thailand (in July 1997) – but spread quickly to the rest of Asia. Ultimately, the impact on global growth and subsequent decline in oil prices played a role in the Russian default in August 1998 which led to the collapse of the Long Term Capital Management hedge fund. It also created the environment which led to the crisis in Brazil in late 1998.
A very short version of the crisis runs as follows:
- In the years ahead of the crisis, Asian countries had seen massive capital inflows from foreign investors wanting to get a share of the strong Asian economic performance. This led to large-scale imbalances best witnessed by huge current account deficits. These were initially explained away but were the most clear symptom of excesses building up in the region which also included a real estate boom largely funded through finance companies getting funding from short-term USD loans. On top of domestic overheating, the current account deficit was also under pressure from a weakening of the JPY, which meant that countries with fixed exchange rates to the dollar saw their competitiveness decline. A devaluation in China in 1994 had also put exports under pressure.
- On 2 July 1997, the Thai government devalued the Thai Baht after a long time of considerable pressure on the currency. Realising the major imbalances, investors started to flee the country. As a result, FX reserves were quickly eroded and Thailand eventually had to let the Baht go. A lot of debt was in USD and had a short maturity. The devaluation led to an explosion in USD payments and the short-term funding possibilities quickly evaporated, leading to a debt crisis.
- The crisis quickly spread from Thailand to other Asian economies sharing the same story. Indonesia, Malaysia and the Philippines devalued their currencies shortly after Thailand. Investors had invested in the Asian story rather than out of knowledge of the individual countries. This was no problem when the investments performed well. But when investments turn sour, investors pull their money from countries they do not understand or have detailed knowledge of. Forced liquidation in Emerging Market funds due to investment losses also played a role and this led to selling in Asian countries as a whole.
- Despite this worrying development, few expected South Korea to get into trouble. In his book An uncertain world, the US treasury secretary at that time, Robert Rubin, writes that “We hadn‟t thought of South Korea as a country where trouble would develop.” That may seem a bit odd when looking at things in the rear view mirror. But there was a good reason for this expectation. First, the currency was stable to begin with while other countries saw a massive decline. Second, when looking at the fundamentals of South Korea, they looked much stronger. Current account deficits had been very small prior to the crisis so South Korea‟s economy was more balanced and the dependency on foreign capital was much smaller. Nevertheless, South Korea got hit through the ripple effects from the economic slowdown, leading to souring loans in Korea as well. Contagion took out even a strong country like South Korea which saw the equity market slide by 35% and the currency weaken by 50% against the USD! Of great importance was also that Korean FX reserves turned out to be much smaller than they had been recorded officially. This revelation shook the financial world and added to the massive loss of confidence
- A wide range of IMF packages led to harsh tightening measures which reduced economic activity substantially in the whole region. The IMF package to Korea was of USD55bn and was the largest financial rescue ever.
- The contagion to the rest of the world happened through both financial and economic links. The response in US equity markets was limited but global growth got hit from the direct economic links to Asia.
- Commodity exporters were hit especially hard as oil prices declined substantially during 1998 to around USD10/bbl. This played a major role in the Russian default in August 1998 leading to the problems in Long Term Capital Management hedge fund. The decline in commodity prices and decline in risk appetite towards Emerging Markets ultimately contributed to the crisis in Brazil in late 1998 and early 1999. Both Russia and Brazil were vulnerable to begin with.
The crisis in Asia as such ultimately calmed down during spring 1998 as currencies and equity markets stabilised, production bottomed in South Korea over the summer and confidence slowly returned to the region on the back of the IMF package and harsh policy measures. But, as seen above, the crisis had spread to other regions by then but this ultimately had a limited impact on OECD production which started to recover by the end of 1998 as monetary policy was eased and confidence returned to global stock markets in late 1998.
Lessons of the Asian crisis
There are clearly differences between the current crisis and the Asian crisis. For example, the Asian crisis was a very typical currency crisis whereas the current crisis is a debt crisis. Short-term USD funding was a major factor in the vulnerability of the Asian countries.
However, there are still lessons to be learned from the way the „crisis dynamics‟ work and how the contagion spreads through the system:
1.
Expect the unexpected: One striking feature of the Asian crisis is the complicated links through which the contagion works and the very unpredictable nature of the crisis. Psychology and confidence takes over from rational analysis of what is fair and not fair and this psychology is almost impossible to predict. This is a very classical crisis dynamic.
2
. Shared story determines vulnerability: The Asian crisis also indicates which countries we should look for to see where vulnerability is the highest. Initially we tend to look at the countries that are the most similar to the first country hit – countries that have a shared story. In this case, it is obviously countries which have experienced the same kind of imbalances with high budget deficits, high current account deficits and housing bubbles.
3. There are panics and there are panics: Another key lesson is that countries that initially looks sound can get sucked into the crisis as the panic becomes self-fulfilling – but these countries are normally the last to be hit. In his book The return of Depression Economics, Paul Krugman provides a brilliant description of this behaviour. As Krugman describes, there are panics and there are panics. One kind of panic is the kind where it pays to keep a cool head and bet on the panic to reverse quickly. Those who panic initially will lose. The other – and more serious kind – is the panic that becomes self-fulfilling. In this kind of crisis, the investors that panic first win out while those that bet on the panic to disappear lose badly. In the current crisis, this could happen if yields on Spanish or Italian bonds were to suddenly rise to 8% or higher. In this case, what looks like a sustainable debt situation to begin with could quickly change to an unsustainable situation – and thus suddenly validate the high yield level. Another way of expressing this is that there are multiple equilibriums. One at a low yield level and one at a high yield level.
4. Unpleasant revelations are poison for confidence: During the Asian crisis, both Thailand and South Korea revealed unpleasant surprises to the markets after pressure had started. FX reserves in Thailand turned out to be much less than expected because they had made forward agreements so the reserves had to be delivered at a future date. In Korea, FX reserves were also smaller than believed because it turned out they had been deposited with local banks in trouble. This proved detrimental to confidence and worsened the pressure on the countries substantially. This bears a clear resemblance to the difficulty in Greece to win back confidence after the revelation that budget deficits were substantially understated. It is extremely important that we do not see more of these negative surprises from Greece – and from other countries under pressure.
5. It takes substantial effort to turn confidence once it slides: A key feature in all crises is the exponential way in which they move. It is like a virus spreading which becomes more and more difficult to control. This means it is imperative that the policy response is very strong to begin with in order to avoid contagion. It is not enough to merely put out the fire in the house in front of you. You have to prevent the next fire from starting by building a shield to the next house. This is probably the most worrying thing at the moment: policymakers are again falling behind the curve and underestimating this dynamic. The further the fire spreads, the stronger the policy response has to be and the more money needs to be spent.
6.
Expect policymakers globally to get involved: During the Asian crisis, US policymakers played a vital role in finding solutions and putting together the rescue packages. It may not take long before this crisis goes from an EU level to a global level with involvement from the US and possibly Asia as this is a threat to the global financial system. Interestingly, US Treasury Secretary Tim Geithner and economic adviser to the Obama administration Lawrence Summers were both part of the team of advisors working during the Asian crisis.
A matter of restoring investor confidence!
Ultimately turning a crisis is about turning investor confidence. You can only live so long on financial assistance, so you need to have a credible plan for restoring sustainability for investor confidence to come back.
In order to achieve this, we believe as a minimum we need the following: (a) a very strong and clear commitment from all vulnerable countries to do whatever it takes to get fiscal balances on a sustainable path with support in the population, and (b) that EU/IMF shows massive financial force to stand by the countries that could be in trouble.
Ireland succeeded in winning confidence earlier in the crisis by only doing the first point. But there is a risk it could get sucked back in due to the problems in other countries.
To sum up, we are quite concerned about the current development and fear that politicians will again fall behind the curve meaning that the ultimate bill for stopping this gets bigger. There is a clear risk that spreads in Portugal, Spain and Ireland will go wider as investors may run for the door because they fear the panic is the kind that becomes self-fulfilling. Ultimately even a fiscally „sound‟ country like Italy could be hit – as happened to South Korea during the Asian crisis.
What to watch
Whether we see a real economy impact will depend on how risk markets perform. If equity markets start to drop significantly and credit spreads widen, it could erode business and consumer confidence and put a brake on investment and consumption decisions. It is far too early to say anything specific about this and fortunately we currently see a strong momentum in global growth which all else equal is more difficult to break. However, it is important to keep an eye on how risky assets perform as too much damage here could risk pushing the economic recovery off track and add to the systemic risk.
A positive is that direct trade link to the vulnerable countries is negligible for the global economy as a whole – unless of course the crisis would spread to US. But we believe the US would limit the effect on bond yields through potentially adding to the quantitative easing programme. It is harder to see an early forced tightening in the US as the authorities there are very focused on not damaging growth and would be more willing to use the so-called nuclear option and print more money to hold down bond yields. This could potentially also be an option in Euroland but it is very uncertain how this could be done within the Treaty and the political process would probably take longer. But it cannot be ruled out as a policy option.
The continued development in bond market contagion will also be important to track – not least if we were to see yields in the UK or Japan start to rise. So far, that has not been the case. A further rise in Spanish or Italian spreads could also become critical as these are countries with high nominal debt levels – and thus much more tricky to bail out if needed. Also keep an eye on CDS spreads.
It will also be important to watch the situation in European banks – especially in Southern Europe. A rise in losses could increase the system risk.
Contagion to Eastern Europe currencies and bonds should also be watched closely. We already see some signs that the markets here are feeling the pressure.
Finally business and consumer confidence should be watched but we do not think we will see an effect in the short term. Should the crisis develop further, though, it will be key to keep an eye on whether it is doing damage to companies and consumers confidence.
