Tackling the Vulnerability to Economic Crisis

Financial crisis
Macroeconomics - Economic growth - Monetary Policy
Poverty - Inequality - Aid Effectiveness

This article was previously published in the Ideas Matters Blog, on June 9, 2017.

For Latin Americans, there are few memories as nightmarish as the “lost decade” of the 1980s, with its flagging growth and soaring levels of foreign debt, inflation and unemployment. Today, those days are gone. Dictatorships are no longer the norm. In most of the region, governing institutions have improved, and economic policymaking is generally more responsible, with stricter and better fiscal and monetary policies.

But how secure is the region today? How much less vulnerable and more resilient are countries to the currency and GDP crises that battered them more than three decades ago?

These were among key questions asked at the IDB’s Board of Directors meeting in the fall of 2015.

In an empirical study of the issue, I examined the short- and long-term correlations of key domestic and exogenous (external) determinants of both “currency” and “GDP” crisis episodes utilizing a novel database for 111 emerging and developing countries to track the evolution of the estimated probabilities of each crisis from 1982 to 2016.

For both types of crises, I observed a decline in vulnerability over time. During the last 35 years, Latin America and the Caribbean has generally shown higher levels of vulnerability than, for example, Developing and Emerging Asia. But, while starting from a higher position of vulnerability than that part of the world, it has made the greatest progress of any region, apart from Eastern Europe and Central Asia.

More specifically, comparing the periods 2003-2016 with 1982-2002, it has experienced a reduction of approximately 13 percentage points in its average estimated probability of experiencing a currency crisis. And it has experienced an 8-percentage-point reduction in the estimated probability of a GDP crisis. All but 4 countries in the region have reduced their economic vulnerability to currency and GDP crises. On average, the southern cone followed by the Andean countries have made the biggest progress in reducing vulnerability to currency crises.

These improvements have not come out of the blue. They have much to do with enhanced institutions, political consensus and, as a result, economic management. During the last 35 years, several countries have introduced reforms that have allowed them to shift from procyclical to countercyclical fiscal policy stances. Moreover, macroprudential policies, such as regulatory mechanisms that control capital and liquidity to counteract global and domestic threats to countries’ financial systems, have been increasingly implemented since the 1990s. Finally, with better institutional quality, there has also been a more technocratic and effective approach to monetary policy, including independent central banking and inflation targeting measures.

Graphically we can see this in the steady decline in vulnerability to GDP crises, which starts declining dramatically from the mid-1980s to the early 1990s, followed by a rise during the mid-1990s as countries became more financially integrated with the world economy and external shocks elevated the risk of external crises. Notable examples of these spikes in regional vulnerability began with the Tequila Crisis of 1994, followed by the contagion effects of the Asian and Russian Crises of 1997 and 1998, which continued with the Brazilian Currency Crisis of 1998 and the Argentine Economic Crisis (1999-2002). Higher growth and demand from emerging markets eventually led to the commodity boom, which caused another significant reduction in vulnerability levels during 2003-2008.

In 2009, the world financial crisis led to a massive spike in vulnerability levels primarily under the GDP measure, but countries’ reduction of foreign-denominated external debt, larger buffers of international reserves, as well as more stable macroeconomic policies and higher growth during the pre-world financial crisis period allowed most of the region and other emerging and developing regions to quickly recover in 2010. Since then, lower commodity prices, anemic growth in advanced economies, uncertainty regarding China’s sustainable growth prospects, and emerging geopolitical risks have created a challenging environment for Latin America and the Caribbean. Nevertheless, countries are now more able to quickly recover from severe external economic conditions. Critically, vulnerability to both currency and GDP crises on average remains significantly lower than it was in the 1980s and 1990s.

How do I document this? Defining broad measures of crisis for emerging and developing countries was the first step. For this, I turned to Frankel and Rose (1996), who define currency crises/crashes as a nominal depreciation of at least 25%, conditional on at least a 10% depreciation the previous year, and work by Ghosh and Ghosh (2003), which defines a GDP crisis as a contraction in real GDP of at least 2%.

While Frankel and Saravelos (2012), do a meta-analysis of domestic fundamentals of a financial crisis, with specific reference to the 2008-2009 crisis, my study utilizes a probabilistic approach that exploits a rich database of vulnerability indicators to explore short- and long-term effects. It also incorporates exogenous elements, such as growth rates of advanced economies (G7) and China; commodity prices; proxies of global liquidity, as well as global volatility and crisis persistence measures.

With enhanced institutions and policies, the region has become more able to recover quickly from external pressures. In fact, emerging and developing economies began to recover faster than advanced economies after the last financial crisis. Moreover, since 1997 the typical Latin American country has experienced better reserve adequacy levels, and it has maintained relatively low levels of vulnerability to both GDP and currency crises even during the last turbulent 9 years.

Of course, the region is highly heterogeneous, and policymakers still have much more work to do. Nonetheless, because of significant policymaking and institutional improvements during the last 35 years, it has made remarkable progress in reducing its vulnerability levels from the nightmarish times of the lost decade.

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