Fixing Financial Crises in the 21st Century

Sayantan Ghosal and Marcus Miller¹

Following Mexico's moratorium on its external debt payments in 1982, virtually all voluntary lending to emerging markets by commercial banks ceased (Buchheit 1999); and the 1980s came to be known as the "lost decade" in Latin America. When lending to these markets restarted in the 1990s as a result of the Brady Plan, lenders sought to avoid any repeat of the write-downs imposed on commercial banks by swapping loans for sovereign bonds. Unlike bank lending, however, Brady bonds issued under New York law cannot be restructured without unanimous consent. While this may be a useful check on debtor's "moral hazard", it means that emerging markets are exposed to financial crisis due to creditor panic or extraneous shocks to their debt service capacity. Nevertheless, for some years, capital kept flowing to emerging markets at modest rates of interest - underwritten in part by an IMF policy of (ever-increasing) bail-outs. Following Russia's partial foreign debt repudiation in August 1998, however, generous inflows to Latin America once again came to a standstill; and sovereign interest rate spreads rose to over 1,600 basis points on the EMBI+ index, remaining above 700 basis points for the next two years.

These developments - together with the collapsing currencies and soaring sovereign spreads facing many Latin American countries in 2001/2 - have put in question traditional explanations for financial crises, based on current account and fiscal deficits. They suggest the need to focus on the intrinsic behaviour of capital markets (Calvo et al. 2002). Why do sudden stops to the flows of finance occur? What are the economic consequences and the implications for institutional design?

In this chapter, we focus on how problems of creditor co-ordination interact with debtor's incentives to generate excessive crises. In the literature, these issues are typically treated separately. In explaining bank runs, for example, Diamond and Dybvig (1983) demonstrated the possibility of multiple equilibria in financial markets, taking as given the structure of demand deposit contracts (i.e. the right of depositors to withdraw on demand) and the choice of investments by the bank. To help select the

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