Since 1982, emerging markets have been rocked by three major financial crises. How can they manage the risks associated with greater integration into the international financial system?
Since the Thai baht first came under attack in July 1997, currencies and asset prices have plunged throughout Asia, as capital has fled from countries once favored by investors. The Asian crisis, like the Latin American debt crisis of the 1980s and the Mexican crisis of 1994-95, has had a broad and devastating impact, not only on the economies of the affected countries but also on other developing countries believed to be "similarly situated." An examination of the similarities between the crises, as well as of their differences, sheds light on the Asian countries' sudden fall from favor and suggests actions that may enable them to weather such storms in the future.
In the months or years leading up to each of the crises, capital inflows to emerging markets surged (see chart). Able to get financing in the international markets on increasingly favorable terms, a number of developing countries built up massive sovereign and private debt denominated in foreign currencies-much of it unhedged.
Between the first oil crisis of 1973 and the outbreak of the debt crisis in 1982, net private capital flows to emerging markets amounted to $165 billion, or about 1 percent of emerging markets' GDP over that period. For most of the 1970s, borrowers in emerging markets were able to get syndicated international loans at low-and even negative-real interest rates; these loans were denominated in U.S. dollars and priced at spreads over LIBOR (the London interbank offered rate). Although the debts were hedged to some degree by holdings of U.S. dollar-denominated reserves, fewer hedging instruments were available in the 1970s than today, leaving borrowers with large exposures to interest rate and exchange rate movements.
Developing countries regained their access to international financial markets in the early 1990s. From 1990 to 1997, yield spreads on Brady bonds fell from an average of 1,100 basis points over U.S. treasury bonds with comparable maturities to 350 points. Between 1991 and 1996, the average maturity on new Eurobond issues grew from 4.4 years to 8 years. Net private capital flows to emerging market countries soared to $1.04 trillion during 1990-96 (about 3 percent of their total GDP).
Despite the explosive growth of global derivative products in the 1990s, unhedged currency and interest rate exposures also played a central role in the Mexican and Asian crises. Indeed, in some instances, governments and private entities increased their exchange rate exposures just before the crises. In 1994, the Mexican government shifted from issuing peso-denominated debt (mainly Cetes) to issuing short-term debt securities (Tesobonos) with debt-service payments indexed to the U.S. dollar. The foreign exchange exposure of nonfinancial corporations also played a key role in the Asian crisis. Domestic interest rates in countries with a fixed or pegged exchange rate were higher than foreign interest rates; as a result, many firms financed their operations through security issues and loans in foreign currency. They neglected to hedge these often large exposures because domestic derivatives markets were undeveloped and purchasing offshore hedging products would have raised the cost of borrowing abroad; moreover, their governments had made a credible commitment to an exchange rate peg or a preannounced crawl.
Another common feature in all three crises was the weak state of the financial systems and regulatory regimes of the affected countries. Both the controlled financial systems of the 1970s and...