Speech

Learning from Experience: Debt Defaults and Lessons from a Decade of Crises, Remarks by John Lipsky, First Deputy Managing Director, IMF

May 10, 2007

Federico Sturzenegger and Jeromin Zettelmeyer have put together a very useful compendium of the experience of sovereign debt crises (Debt Defaults and Lessons from a Decade of Crises, The MIT Press, 2006). I want to congratulate them on this achievement and to thank the participants in today's discussion of their important book.

Chapter 1 of the book notes that the first recorded sovereign debt default goes back at least to fourth century B.C. My statement, you'll be relieved to know, won't start out quite so far back in the past. To me, the story line for the set of issues tackled in this book begins around 1990 when the collapse of communism gave us the possibility of a truly global economy. But, unlike the Bretton Woods arrangement, this was a world of floating exchange rates, at least among the major industrialized nations, and relatively open capital markets.

It wasn't long before this new world went through a severe series of tests, starting with the Mexican crisis in 1994 and then, from 1997 onwards, the Asian crisis, the Russian default, Argentina-and so on. We've gotten a bit of a break from crises these last couple of years. That's good -- it's difficult to mend a bike while you're still riding it. So this pause is a good time to reflect on why we stumbled in the past and fix things so we don't do so in the future.

A salient development of the last few years is the increase in international investor interest in emerging markets -- and indeed even in developing countries, including in Africa. One can view this as either a moment of great danger or a moment of great opportunity. It is of course a bit of both.

But we can make it a moment of great opportunity, in part if we can avoid setbacks of the kind dealt by the financial crises of the mid-1990s. We cannot avoid crises -- capitalism without crisis is like religion without sin, as Allan Meltzer is fond of saying. But we can work to avoid some crises and to resolve better those that occur. The financial crises of the future are likely to be those involving private debt. But we all know that even if crises do not originate with the sovereign, they usually end up involving the sovereign sooner or later.

Against this background, I think the two policy chapters of this book are quite invaluable. They provide a great discussion of what has been achieved by domestic policymakers and through work on the international financial architecture to make the global financial world a safer place.

Though `much remains to be done' as the saying goes, I think we can take some satisfaction in what has been accomplished since the peak crisis years of 1997-98.

Reasonably well-developed capital markets are now in place in many emerging economies. Indeed, the stock of domestically issued bonds in emerging market countries amounts to about $3.9 trillion, making it an important global asset class. A striking sign of improvement, I think, is that international investors are increasingly purchasing securities denominated in local currency. Dedicated emerging market U.S. mutual funds have grown ten-fold since 2000 to about $230 billion as of mid-2006. The stock of domestic securities in emerging market economies has increased, by some estimates, from about 25% of GDP to about 40% between 1996 and 2006.

Thus, many emerging markets seem to have atoned, in investors' eyes, for what some experts had called their "original sin." This is an important development, even if its implications are not yet fully evident. Some see it as risky, arguing that it may reflect only an overly exuberant "search for yield" in an environment of low interest rates and ample liquidity.

My own view is that the growing internationalization of emerging market securities reflects important structural changes taking place in the global economy and in global markets. These include, notably, the growing integration and greater role of emerging market countries in the global economy, and the growing sophistication of financial markets and risk management.

The process has been helped by the fact that many emerging markets have substantially improved their macroeconomic and financial policies. They have also taken advantage of the generally favorable environment to build cushions against external shocks -- through such measures as improved debt structures, expanded regional reserve pooling arrangements (for example in Asia), and increased stockpiles of international reserves. In addition to these steps to prevent crises, countries have taken steps to improve the process of crisis resolution. For instance, the inclusion of collective action clauses in international sovereign bond contracts is welcome, though it's true that their ability to deliver has not been fully tested as yet.

Of course, the unexpectedly benign economic and financial environment of the past few years has helped. We've had the fastest five-year period of global growth in recent times. The more forthcoming stance by international investors signals an important vote of confidence in future economic and financial stability in the advanced economies. I think while individual emerging market countries are capable of generating a crisis in their own countries all by themselves, the kind of generalized crisis we saw in the mid-1990s is not self-generated but reflects developments in advanced economies. So it is critical for advanced economies to maintain the environment of macro stability by preserving the combination of steady growth and low inflation. Lowering current account balances in a steady and cooperative way over the medium-term will also help.

In the current relatively benign global environment, not many emerging market countries have needed to borrow from the Fund. This is good news. But the Fund still needs to be prepared for times when market access for emerging market borrowers could become constrained. On the basis of a review of past experience, Sturzenegger and Zettelmeyer say that IMF liquidity needs to be delivered "in a way that is faster, more effective and more incentives-friendly". I agree. Indeed, the thrust of our discussion with our emerging market members has been on how to design a financing instrument that provides sufficient predictability and flexibility to meet their potentially large needs.