Implications for Trade and Financial Policies

A first policy lesson is that a strategy of export-led growth entails greater risks than appreciated previously. The point is not just that global demand is volatile; it is that trade appears to be more elastic with respect to the cycle and more vulnerable in downturns than previously thought. The decline of exports in emerging Asia in late 2008 and early 2009 was nothing short of catastrophic, with volumes down by as much as 40% year on year. The consequences for GDP were dramatic. In Singapore, an extreme case, GDP fell at an annual rate of 13% in the first quarter of 2009.⁹ Unbalanced growth emphasizing exports creates vulnerabilities just like excessive dependence on foreign finance. Evidently, trade as well as finance can exhibit sudden stops.

The destabilizing macroeconomic impact is even greater to the extent that a growing share of investment in emerging markets is export linked. In the PRC, investment in gross fixed capital in the tradable sectors increased from 28 per cent of total investment in the first half of the 1990s to 36% in 2003–2007. In Brazil the comparable increase was from 19 to 56%.¹⁰ Falling export demand therefore means falling domestic demand at the same time.¹¹ Some shift from the excessive inward orientation of investment in countries like Brazil was clearly desirable. The question is whether, given what we have now learned about the volatility of export demand, the shift has gone too far.

Determining the appropriate policy response requires first identifying the causes of the recent collapse of trade. This is an important topic for investigation since the root causes remain obscure. It could be that the collapse reflected despair about future demand leading to an exceptional drawdown of inventories for traded goods. With evidence now that governments are prepared to intervene to stabilize demand, equally violent inventory corrections may be unlikely. It could be that trade was hammered by disruptions to the supply of trade credit. To the extent that this is the explanation, then enhancing the public provision of emergency trade finance is an alternative to altering the composition of production and investment. Or it could be that production fragmentation and the elaboration of global supply chains, for the manufactured products in which emerging Asia specializes in particular, have somehow increased the sensitivity of trade with respect to the cycle, in which case more far-reaching policy adjustments may be called for.¹²

Second, the crisis serves as a reminder, if one was needed, of the risks of excessive dependence on foreign finance. Countries with large current account deficits and external financing requirements were disproportionately hit by the crisis as foreign investors deleveraged and capital flows dried up. Emerging Asian and Latin American countries have managed their current accounts and external financing requirements more carefully in light of prior experience. But the same can not be said of Central and Eastern Europe. With benefit of hindsight it is hard to conceive how the Latvian authorities, to take the most glaring example, could have permitted the country's current account deficit to soar to some 25% of GDP. It, as well as other countries in a less extreme version of this same position, saw domestic demand compressed violently when foreign finance for their deficits dried up. Latvian GDP is forecast (as of midyear) to contract by an astonishing 18% in 2009—this despite a rescue package jointly financed by the International Monetary Fund (IMF or Fund) and European Union equivalent to 34% of national income.

East Asia and Latin America may have avoided large current account deficits but they did not avoid currency and maturity mismatches. The Republic of Korea's (hereafter Korea) problem as I read it was essentially a maturity mismatch: banks that lent long-term to shipbuilders who had receivables in US dollars (which would accrue when the boats were floated) squared their currency books by borrowing short, offshore, in dollars. When the crisis hit, their short-term US dollar funding dried up, setting off alarms. In Mexico and Brazil, in contrast, the problem was essentially a currency mismatch. While on-balance sheet foreign currency mismatches had been reduced, corporations in both countries had increased their off-balance sheet foreign currency exposure through derivative positions. These corporations bet against depreciation of the local currency by selling foreign exchange options in the offshore market and were smashed when those currencies depreciated by more than 30% following the failure of Lehman Brothers.¹³ These are arguments for why regulators should require banks to more closely match the maturity of their assets and liabilities when operating in foreign currency and why they should regulate firms' positions in forward and options markets.

The crisis also sheds new light on earlier arguments about foreign bank presence. Contrary to worries that foreign banks would cut and run at the first sign of trouble, foreign banks maintained support for their subsidiaries in emerging markets to a remarkable degree.¹⁴ Cross-border lending fell less in countries with significant foreign bank presence than in emerging markets where foreign bank ownership was not dominant, other things equal. If anything, domestic banks with shallower pockets were more likely to cut back in the crisis.¹⁵ Here is one place where Asian countries that have been reluctant to open to foreign banks might take a cue from Central and Eastern Europe. Of course, whether home countries will now be as permissive in encouraging banks' foreign operations, given the difficulties of multinational supervision, remains to be seen.

Other positive aspects notwithstanding, foreign bank presence also appears to be associated with currency mismatches. In Central and Eastern Europe foreign banks were the vehicles for extending euro- and Swiss franc-denominated corporate, home, and car loans to firms and households with incomes in local currency—something that added to corporate and household financial distress when local currencies depreciated. Austrian, Italian, and Swiss regulators, seeing their banks with assets and liabilities both in their own currencies, happily looked the other way. The implication is that emerging markets, while encouraging foreign bank entry, should at the same time strictly regulate their local lending practices.

These banking-sector controversies bring us back to the argument for local bond markets. Bond markets provide an alternative to bank intermediation. There is evidence that countries with better developed bond markets experienced less negative fallout from the crisis as large firms in particular retained access to nonbank sources of finance.¹⁶ Opening those markets to foreign investors, on the other hand, appears to have been a mixed blessing. Korea, the East Asian country with the largest share of its security market capitalization held by foreign investors, also experienced the sharpest price and exchange rate corrections as those foreign investors, forced to deleverage, desperately repatriated their funds. Encouraging foreign investor participation is a quick way of jump starting local bond market activity. But recent experience suggests that quickest is not necessarily best.

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