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

By Michael Pettis | Go to book overview

2
Market Structure Issues

Illiquidity versus Insolvency

Before going on to discuss how changes in global liquidity conditions affect LDC borrowers, there are a few market structure issues worth discussing. First of all, we should make the standard distinction between liquidity crises and solvency crises. A liquidity crisis is analogous to a bank run, in which the bank may well be solvent—and even very profitable—before the onset of the crisis. However, because it normally mismatches its long-term assets and short-term liabilities, when depositors come clamoring for their money the bank may be forced to liquidate illiquid but healthy assets in order to meet the cash needs of depositors. A liquidity crisis, then, is one in which although the value of assets may exceed the value of liabilities when the crisis begins, the liabilities cannot be repaid as they come due by the normal cashflows generated by the assets. If the assets cannot be monetized— or converted into cash—quickly enough to meet liabilities as they come due, the borrower faces a liquidity crisis.

A solvency crisis is different from a liquidity crisis. It occurs when investors realize that the borrower is already in a position in which both the value of his assets is not enough to cover his liabilities and the amount of his current earnings is not enough to cover immediate debt servicing costs. In this case borrowers may refuse to lend or to roll over existing maturities, and the borrower is forced to meet debtservicing requirements out of insufficient assets and revenues. Liquidity crises can be converted into solvency crises, and there are two ways in which this can occur. If the rate of withdrawal is fast enough

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