Reinhart examines theory and practice in addressing financial crises

• Pages: 187-189

Page 187

In May, as part of its in-house training program, the IMF Institute presented an internal course on financial crises. Carmen Reinhart, Professor of Economics at the University of Maryland, organized the course, which consisted of papers presented by Reinhart and colleagues, each addressing different aspects of financial crises, their causes, and possible approaches to dealing with them. Reinhart spoke with the IMF Survey about the causes and prevention of crises.

IMF SURVEY:What are the important issues involved in addressing financial crises?

REINHART: That is a long list. It should begin with better monitoring of risk and the likelihood of financial distress, be it a currency crisis, a banking crisis, or a combination of the two. One lesson that has been learned is that it's fine to continue to monitor all the traditional macroeconomic variables, but monitoring at the micro level is equally important; the benign neglect of financial data and balance sheet data is no longer possible if one wants to assess vulnerability.

Where I see big challenges is in tracking the corporate sector. There is no easy way of collecting and processing data on the state of health of the corporate sector. It's usually only after a crisis that you find out how much debt the corporations had accumulated.

IMF SURVEY:What do you see as the major exchange rate regime issues? Is there any general trend toward one or the other? What is the best choice of exchange regime for emerging markets?

REINHART: The trend right now, at least in policy advice, is that countries should stay away from soft pegs and move toward more flexibility, although what exactly is meant by "soft pegs" is not at all clear.None of the Asian crisis countries-Korea,Malaysia, or Thailand- had a categorically soft peg before the crisis hit. They were all classified as managed floats or, in the case of the Philippines, freely floating. Thailand was the only country that had a more explicit peg-and it was to a basket.And, yet, now we're calling them soft pegs.

So the advice seems to be to introduce more exchange rate flexibility, often paired with inflation targets. But I have some doubts about whether we will actually see this in practice. There are a variety of reasons why emerging market countries are concerned about the exchange rate moving too much-what we call "fear of floating." Saying that you have an inflation target isn't going to do away with the problem of fear of floating, especially if there is an issue of high passthrough from the exchange rate to prices, which is particularly problematic for countries with a history of high inflation.

For the Asian economies, the fear of floating stems from their high dependence on trade, which is invoiced in dollars, not in their own currencies.

Hedging is costly, so exchange rate volatility definitely does have implications for them.

I think the common ground for fear of floating in emerging markets is that no matter where they are, they tend to have foreign currency debt, a lot of which is denominated in dollars. One can say, well, you can remedy the problem if the government stops borrowing in foreign currency and bites the bullet and issues only domestic currency-denominated debt...