Wednesday, April 2, 2008

From the 1990s IMF Bailouts to the 2008 US Federal Reserve: Any Similarities?

The US financial crisis resembles the 1990s emerging markets crisis for at least two reasons. First, the Federal Reserve (FED) through the term auction facility (TAF) is bailing out the commercial banking system. In brief, the banks are now entitled to give any type of collateral for the FED. So let’s say that the banks give the FED their ‘junk (or CDOs) collaterals’. In exchange the banks receive from the Federal Reserve an amount that is part of the ‘borrowed required reserves’ as a way to offset their losses from the CDOs. The whole process has been proved to be efficient because the total amount of required reserves has not changed since the first auction promoted by the FED, and hence the monetary base has been kept constant. According to the Federal Reserve, the TAF is permanent, suggesting that the banking bailout will continue as long as the financial system is at risk. It is a bailout because the collaterals offered by commercial banks (CDOs?) have been posting significant losses. The Federal Reserve is basically transferring - through the TAF - the future losses that commercial banks would have to report in their balance sheets to the lender of last resort, the Central Bank of the United States. Second, the financial contagion experimented during the 1990s emerging markets crisis is also present in the current scenario. In turn, countries that did not carry CDOs, or had small exposure to the US financial system, are also being affected.

What can developed countries learn from this episode? First, that before lecturing developing countries on what they should do to avoid financial crisis, they should test their recipe at home and do their homework. The absence of significant regulation on the synthetics as well as on the ‘monolines’ companies that started to provide insurance for these synthetics made the whole process prone to deep financial crisis. Second, that financial crisis stemming from bad regulation is possibly worse than the 2001 Argentina ‘default’.

While some analysts are concerned about the inefficiency arguing that the decrease in interest rates in the US will not help because it may lead the whole economy to the Japanese liquidity trap problem of the 1990s, others are more concerned with the impact of the US recession emerging The US financial crisis resembles the 1990s emerging markets crisis for at least two reasons. First, the Federal Reserve (FED) through the term auction facility (TAF) is bailing out the commercial banking system. In brief, the banks are now entitled to give any type of collateral for the FED. So let’s say that the banks give the FED their ‘junk (or CDOs) collaterals’. In exchange the banks receive from the Federal Reserve an amount that is part of the ‘borrowed required reserves’ as a way to offset their losses from the CDOs. The whole process has been proved to be efficient because the total amount of required reserves has not changed since the first auction promoted by the FED, and hence the monetary base has been kept constant. According to the Federal Reserve, the TAF is permanent, suggesting that the banking bailout will continue as long as the financial system is at risk. It is a bailout because the collaterals offered by commercial banks (CDOs?) have been posting significant losses. The Federal Reserve is basically transferring - through the TAF - the future losses that commercial banks would have to report in their balance sheets to the lender of last resort, the Central Bank of the United States. Second, the financial contagion experimented during the 1990s emerging markets crisis is also present in the current scenario. In turn, countries that did not carry CDOs, or had small exposure to the US financial system, are also being affected.
What can developed countries learn from this episode? First, that before lecturing developing countries on what they should do to avoid financial crisis, they should test their recipe at home and do their homework. The absence of significant regulation on the synthetics as well as on the ‘monolines’ companies that started to provide insurance for these synthetics made the whole process prone to deep financial crisis. Second, that financial crisis stemming from bad regulation is possibly worse than the 2001 Argentina ‘default’.
While some analysts are concerned about the inefficiency arguing that the decrease in interest rates in the US will not help because it may lead the whole economy to the Japanese liquidity trap problem of the 1990s, others are more concerned with the impact of the US recession emerging economies.
The impact of a global slowdown on Latin America tends to be negative. In different degrees, growth in all countries tends to be revised downwards. The decrease in commodity prices (driven by a decrease in global demand) tends to reduce Latin exports and income. A decrease in interest rates by developed economies (the US and Europe) without positive impact in financial markets suggests that economies with open capital account (Brazil and Colombia) should expect a capital outflow, depreciation of their currencies against the USD, decrease in international reserves and possibly an increase in inflation. We then expect a decrease in global liquidity which tends to decrease the amount of FDI in Brazil. With an expected current account deficit of 2% of GDP, it is possible that the Brazilian Central Bank (in case of capital outflows) raise domestic interest rates as a way to prevent further capital flight.
The imbalances displayed by the United States twin deficits are not new. Few were those that argued that China could finance such system forever. The so-called Bretton Woods II may now come to an end. The question is what do emerging markets learn from it? Will the global financial system remain the same? What are the necessary changes to be implemented to avoid a new crisis?

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