Similarity between 1997 crisis and 2007 crisis

The recent IMF Finance and Development issue is a must read for all interested in developments in economics and finance. I have pointed before no crisis is different and we see a lot of commentary comparing the same ( Sweden’s 90 crisis, 1987 crisis, Rogoff/ Reinhart and Bordo in seperate papers saying all crisis are different)

This article by Khor Hoe Ee and Kee Rui Xiong in F&D is pretty engaging. They point to the similarities between South East Asian crisis and subprime crisis. Similarities are as follows:

• A common backdrop to both crises was abundant liquidity and excessive, imprudent credit expansion
• There was also a search for yield by lenders, and the abundance of liquidity tended to lead to lax credit standards
• Another sign of trouble prior to both crises was the rapid increases in property asset prices
• Another sign of trouble prior to both crises was the rapid increases in property asset prices
• There were also classic cases of moral hazard, because lenders and borrowers faced little if any risk from their activities

However, despite the similarities the policy responses weer different:

In the subprime crisis, major central banks have intervened aggressively to provide liquidity to contain disruptions and contagion in financial markets. At the same time, the U.S. Federal Reserve has cut interest rates substantially to ease monetary conditions, and the U.S. Congress has approved a fiscal stimulus package.

In the Asian crisis, monetary and fiscal policies were initially tightened to support exchange rates because of massive capital outflows and a run on foreign reserves, which contributed to a downward spiral in the real economy. Only after exchange rates had stabilized at a lower level did governments adopt more expansionary fiscal policies to support the real economies.

Even recapitalisation of banks has been different:

During the Asian crisis, many governments took over nonperforming loans and injected new capital into the banks, while the IMF topped up the depleted foreign reserves of the central banks. Only at a later stage were there substantial injections of private capital in the form of foreign buyouts of local banks.

In the current crisis, the main recapitalization of banks has come through direct placements or through capital injections by sovereign wealth funds. Two notable exceptions were Northern Rock…..and the Bear Stearns rescue

Further the article points out the lessons developed countries should learn from Asia.

The first is the reduction of leverage for the class of borrowers whose problems were painfully exposed by the crisis. In the Asian crisis, those borrowers were the corporate entities and banks that were both overleveraged and overreliant on foreign debt. The subprime equivalents are the U.S. household sector, the banks that had engaged in off-balance-sheet investments, the investment banks and  the hedge funds and other investment companies

Interestingly, subprime equivalents are virtually everybody!!

The article also discusses sub-prime lessons for Asia:

First, Asia should watch for the common early warning signs: abundant liquidity, rapid credit growth, and sustained asset price inflation.

Second, Asia needs to find the right balance between progress and prudence, innovation, and caution. An overemphasis on progress over prudence might have been one of the contributing factors to the subprime crisis.

A third lesson is that economic fundamentals are essential.

The article points that we must look at financial innovation with caution:

A case in point was the rapid collapse of Bear Stearns and Northern Rock. The former was at the forefront of financial innovation in securities markets, and the latter was lauded for its innovative funding strategy. Asia should be careful to ensure that any move away from traditional banking practices toward more innovative techniques is accompanied by enhanced management of liquidity risk.

To be sure, Asia should continue to develop its capital markets and encourage the growth of its financial institutions as part of its broader economic and financial development. However, the subprime crisis has shown that financial innovations—whether new products, new structures, or new market players—do not come without risks. As Asian financial markets expand into new terrain, policymakers must put measures in place to deal with the risks posed by financial innovation.

So, again the onus is on policymakers.Not only should they expand these markets but ensure there are no excesses. I mean if emerging markets had the resources to do all this balancing they wouldn’t have been emerging markets after all.  It also offers some lessons on how we can achieve this but again it is those common wisdom which comes after every crisis-

Credit standards must be maintained at all times 
Transparency is critical for financial supervision and market discipline to be effective.
Financial linkages must be understood.

This note is a kind of an eye-opener on existing policy framework. Most assume US financial markets and macroeconomic policies to be the benchmark and push developing countries to emulate the same. This subprime crisis is a lesson for all .

Clearly not all is ok with this so called financial innovation and development. The high growth is followed by an equally sharp downfall. There are very few who understand these products (the LTCM case showed the fathers couldn’t understand it either !!!). But we just don’t seem to learn and still advocate derivatives markets in emerging markets (see this recent article from IMF’s South Asia Division economists and my take on modern finance.)

No one disputes that derivatives are not useful, unfortunately there are very few who understand them. There are hardly any policies and people simply ride on the spread in good times. And in times of stress we often see them increasing risks rather than mitigating it and latter is often said is the purpose of derivatives. Most don’t understand even basic derivative products but markets only keep getting complex. I really don’t know why. We need to fix a lot of things before we look at fully advanced derivative markets in emerging markets. They simply don’t have the cushion available in developed economies to recover if things go wrong. Somehow we miss the riskiness aspect of these modern financial markets.