I came across and interesting article by Feldstein on different global economic levers.  On reading the article I was left thinking what do we pay all these political leaders, and bureaucrats for. What’s Needed is Liquidity

Feldstein’s views the absence of a global leader that could provide a source of liquidity.  His illustration shows that the IMF is not the answer to liquidity because of insufficient funds and bureaucracy.  The IMF 1998 loan to Brazil for example was too slow, and trickled through which forced them to devalue their currency two months later and then compounded the impact of the recession…sound familiar!  The IMF’s bureaucratic procedures make loans available to pre-approved countries.  However, most of the emerging economies in Asia would not meet these pre tests.  The alternative solution is private assured funds, but this is not possible to insure liquidity, due to the fear of being locked into risky loans.  The answer to liquidity he suggests does not lie in establishing new world lending architecture, but new ways of increasing liquidity.

Fixing Currency Can Lead to Speculation

The next critique is of the fixing of exchange rates to the dollar, in order to get low cost credit and inflation.  The results of his analysis highlight the vulnerability to short trading of currency that is borrowed, which can destabilise a currency or indeed a company.  The speculation by traders can devalue a currency….again sound familiar!  An example of the disadvantages of a fixed exchange rate is the Thai Bhat at 25 Baht to the Dollar in 1987 right into the mid 1990’s.  A sharp drop in the currency caused significant damage.   The relative value of the foreign debt in this case doubled.  The overvaluation caused a trade deficit plus net interest due in foreign loans amounted to the equivalent of 8% of their GDP.  The promise of a fixed baht to dollar rate meant that people borrowed against a guaranteed dollar rate, which further devalued the Baht.  Eventually fear set in and foreign banks no longer wanted to lend.  The lesson was that a  fixed exchange rate set too high inevitably caused the ballooning in trade deficit , an attack on the  currency , a loss of foreign exchange reserves and resulted in the corrective fall in the exchange rate. There were some questions not posed.  Does this make the fall worse than it would have been? The professor comments that in fact many countries employ this fixed rate tactic and hope that the deficit will fix itself if domestic prices fall or the dollar falls, the case in point given is Argentina.  However, what is interesting is that Argentina has since defaulted on it’s Bonds and Switzerland currently employ this tactic against the Euro.  The writer concedes that this tactic can temporarily keep the currency in check, so one would have to question if it is a valid solution, but with a time limit on its effectiveness to relieve a financial crisis.

4 Root Causes to a Financial Crisis

Feldstein finds 4 root causes to a financial crisis:  an unsustainable current account deficit, a balance sheet crisis, a banking implosion, and irrational “contagion” turbulence.  To which the solution provided is enhanced liquidity.  If a country has sufficient liquidity in the form of large amounts of foreign currency they can try to sustain a high value of their currency by buying it.  The so-called speculation of a currency is expensive because of the interest rates on the currency being sold are higher than the dollar and the yen.  The speculators have a lot to loose so they bet only on vulnerable currencies.   Feldstein points out that a currency with a floating exchange rate can still come under attack if the short-term debt exceeds the foreign currency reserves.  The lack of immediate funds to meet obligations can affect the state of mind of investors.  The on set of fear is evidenced in the 1997 fate of South Korea, who were solvent but illiquid.  Nervous depositors can make a country ‘s currency crisis worse.  A possible way to relieve the angst is to move funds from home banks to local banks backed by overseas banks.  The example cited is Argentina.  Theoretically banks could be advised or prevented from favouring particular industries and tightening their supervision.  However this would be counter to the national development strategies, and hard to implement.    So the pragmatic solution comes back to liquidity.

Measures to Protect the Countries Economy

The article outlines measures that a country can take to protect oneself:  to reduce the short-term foreign debt, accumulate liquid reserves and organise a collateralised credit facility.  These simple measures make the reader question why governments are not taking these precautions.  Chile is provided as an example for governments intervening to discourage short-term foreign loans, where a higher deposit is required for short-term foreign loans.  This policy allowed capital inflow to Chile, but encouraged investors to shift funds to less volatile assets.  The cost of this policy was that it raised the cost of capital for Chile’s private borrowers, but it reduced the risk of a currency crisis.   China is cited as they have accumulated $140 billion plus in reserves, which gives a strong signal that they would not be forced to devalue their Yaun.  Countries with floating exchange rates accumulate reserves to reduce the risk of a currency crisis.  However, reserves are costly.  If you accumulate reserves by having exports exceed imports it requires a cut in domestic consumption and investment.   Secondly if a government buys foreign currency from exporters and issues domestic bonds in exchange, they do this at a higher rate of interest.  Finally, this policy of accumulation of foreign reserves by running a trade deficit takes time, and storing up export earnings is at an opportunity cost because this capital cannot be invested.  To reduce the costs of such a policy, a country can accumulate reserves more quickly by borrowing abroad with long-term maturities and investing the funds in liquid international securities.  China and Mexico have adopted this approach, but this strategy is also expensive, for example, Mexico pay a 11% interest rate on their 20 year bond, 6% more than investing in the US dollar, which is a potential cost of $1.8 billion a year nearly half its GDP!  China pays a lower rate of 7%, and a country could lower the costs by investment in liquid assets with higher yields than short-term US treasury bills.  The writer admits the price is high but not when you offset this against the cost of a currency crisis.

Pragmatic Solution to Liquidity

A final pragmatic option is offered to create a collateral loan facility.  The ability to borrow large amounts of foreign currency as needed would be as valuable as physically accumulating the currency.  However, there is the challenge of finding such a credit line.  The IMF as he previously critiqued has less than a $200 billion capacity to lend, which is not large enough a facility for a global credit line.  A private credit line would be concerned over the exposure to such large loans.  The writer suggests creating a collateralised credit facility to overcome this challenge, where private lenders would have secured loans against liquid assets.  This collateralised credit facility is cheaper than accumulating currency as long as it is never put into action.  However, once the facility has to be activated it would incur significant administrative costs.

Feldstein analyses the extreme policy of economic isolation, currency boards and the dollar and yen zone.   The results are the impracticalities of such tactics.  Malaysia employs economic isolation; this policy is a solution but involves the control of both the inflow and outflow of capital.  Malaysia discourages foreign firms from making direct investments.  Feldstein sees this tactic as an unconvincing argument that isolation allows a country to stimulate its economy through lower interest rates.  He proposes that the same result could be achieved by targeted tax incentives, which offset the cost of higher interest rates.  The second tactic of currency boards is employed by Argentina and Hong Kong.  This means that they hold 1 dollar for every unit of their own currency as a reserve.  Everyone has the right to exchange, however, a drop in foreign exchange reserves causes the bank to reduce the money supply and raise interest rates.  The increase of the interest rates until the investors stop selling, and is a deterrent to discourage currency speculation. The success of this market lever is the confidence that the government will let the interest rate rise regardless of the cost.  As such a currency board cannot prevent a financial crisis.  The final economic lever to pull is the Dollar and Yen zone, so to change the local currency for the dollar or yen, much like the Euro.  However, Feldstein points out the woes of Italy and Portugal.  There is not enough flexibility for the central bank to provide enough currency that depositors need locally, or to make local adjustments.

The Need to Break the Cycle – New Strategy and Not Old Tactics

Countries need to kick their bad habits, which in the past have led to the root causes of a financial crisis identified.  Feldstein points out that there is no substitute for sound economic policies to moderate trade deficits, low short-term foreign debts, and a strong banking system.  He does however; indicate how even strong policies are exposed to factors such as market contagion, which affects the mind-set of investors and depositors.   The flaws identified in international institutions like the IMF require emerging markets to protect themselves through increased liquidity through reducing short-term capital flows, increasing foreign exchange reserves and establishing collateralised credit facilities.  These options are recognised as costly, but nothing in comparison to an economic crisis.  Emerging markets can help themselves and determine their own fate in an economic crisis.  Established economies who are now struggling can apply these lessons and appracoh this economic crisis with a different strategy.

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