The Volatility Machine: Emerging Economies and the Threat of Financial Collapse

The Volatility Machine: Emerging Economies and the Threat of Financial Collapse

The Volatility Machine: Emerging Economies and the Threat of Financial Collapse

The Volatility Machine: Emerging Economies and the Threat of Financial Collapse

Synopsis

This book presents a radically different argument for what has caused, and likely will continue to cause, the collapse of emerging market economies. Pettis combines the insights of economic history, economic theory, and finance theory into a comprehensive model for understanding sovereign liability management and the causes of financial crises. He examines recent financial crises in emerging market countries along with the history of international lending since the 1820s to arguethat the process of international lending is driven primarily by external events and not by local politics and/or economic policies. He draws out the corporate finance implications of this approach to argue that most of the current analyses of the recent financial crises suffered by Latin America,Asia, and Russia have largely missed the point. He then develops a sovereign finance model, analogous to corporate finance, to understand the capital structure needs of emerging market countries. Using this model, he finally puts into perspective the recent crises, a new sovereign liability management theory, the implications of the model for sovereign debt restructurings, and the new financial architecture.Bridging the gap between finance specialists and traders, on the one hand, and economists and policy-makers on the other, The Volatility Machine is critical reading for anyone interested in where the international economy is going over the next several years.

Excerpt

In this book I will argue that certain types of financial crises—like the crises that have affected many Latin American and Asian countries in recent years—are problems of sovereign balance sheet mismanagement and not economic mismanagement. In contrast to much of the analysis that has appeared recently, I will argue that these crises do not occur because domestic economic policies are flawed, or because capital flows are excessive, or because international investors behave irrationally, or even because currency regimes are mismanaged. They occur instead for two other, related, reasons. First, emerging market borrowers and investors have consistently underestimated the source and magnitude of volatility in emerging financial markets. Second, perhaps as a consequence, borrowers and investors have permitted and even encouraged sovereigns to put into place capital structures that systematically exacerbate this volatility.

In the world of international finance there is a disconnect between the work of corporate finance specialists and economists. While the former typically attempt to evaluate and quantify the way market risks are absorbed into a company's capital structure, the latter try to understand the development and functioning of the long-term processes that drive an economy. But countries and even regions are subject to market-related risks and shocks that can disrupt their behavior, just as companies are, and these risks are transmitted in the same way: through their capital structures. In fact any economic entity's capital structure can be seen as a sort of volatility machine, one of whose main functions is precisely to manage the way external markets impact internal processes. This volatility machine converts the price . . .

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