Academic journal article Journal of Money, Credit & Banking

Can Miracles Lead to Crises? the Role of Optimism in Emerging Markets Crises

Academic journal article Journal of Money, Credit & Banking

Can Miracles Lead to Crises? the Role of Optimism in Emerging Markets Crises

Article excerpt

"That this region [East Asia] might become embroiled in one of the worst financial crises in the postwar period was hardly ever considered--within or outside the region--a realistic possibility. What went wrong? Part of the answer seems to be that these countries became victims of their own success. This success had led domestic and foreign investors to underestimate the countries' economic weaknesses. It had also, partly because of the large scale financial inflows that it encouraged, increased the demands on policies and institutions, especially but not only in the financial sector; and policies and institutions had not kept pace. The fundamental policy shortcomings and their ramifications were fully revealed only as the crisis deepened" (International Monetary Fund World Economic Outlook, May 1998).

THE EXPERIENCE OF the last decade suggests that emerging capital markets are vulnerable to significant shifts in investors' confidence in both upward and downward directions. Downward shifts in confidence and financial market collapses are abrupt and often take place unexpectedly after a large boom. Table 1 documents the magnitude of these booms for several precrisis episodes: Argentina and Mexico in 1994, Korea in 1997, and Turkey in 2000. Taking Turkey as an example, the year before its financial crisis in 2001, the country boasted an average quarterly current account-to-GDP ratio of -5.1%, consumption growth of 4.5%, an increase in equity prices of 57%, and GDP growth of 3%. (1)

It is widely agreed that overconfidence and informational problems are at least partially responsible for recent crisis episodes, as the above opening quote by International Monetary Fund (IMF) on the Asian crisis suggests. Whether these frictions in international capital markets can be large enough to explain precrisis periods of bonanza and the depth of the crises remains an open question.

In this paper, we aim to answer this question by studying the quantitative predictions of a model in which optimism, due to investors' underestimation of the weaknesses of emerging economies, acts as the driving force behind both the precrisis booms and the vulnerability that paves the way to financial turmoil and deep recessions. In the model, the precrisis bonanza is driven by a sequence of positive signals that investors interpret as an improvement in the true fundamentals of the economy. The crisis occurs as a sudden downward adjustment in investors' expectations of the true fundamentals is triggered and their optimism suddenly fades. The magnitude of this downward adjustment increases with the level of optimism attained prior to the crisis.

The informational frictions that are the key ingredient of the model are likely to be prevalent in emerging markets for several reasons. One is the lack of transparency in policymaking and data reporting, which manifests itself in the form of inaccurate or misleading data. (2)

A second reason informational frictions pose particular challenges for emerging economies is the existence of high fixed costs associated with obtaining country-specific information and keeping up with the developments in emerging economies, as suggested by Calvo (1999). Such costs could arise due to idiosyncrasies affecting financial markets in these countries, for example, each country's unique institutions, policies, political environment, and legal structure. From international investors' perspective, it might be optimal not to "buy" this information. Calvo and Mendoza (2000) provide two arguments for why this can be the case. First, if short-selling positions are limited, the benefit of paying for costly information declines as the number of emerging economies in which to invest becomes sufficiently large. Second, if punishment for poor performance is high, managers of investment funds may choose to mimic each other's behavior instead of paying for costly information.

The model in this paper features two types of investors, domestic and foreign, both of whom trade a single emerging market asset. …

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