PORTFOLIO FLOWS AND CAPITAL ACCOUNT CRISES: 1990S

The global financial system of the 1990s was dramatically different from the one that existed at the start of the debt crisis in 1982. Although big commercial banks had been the primary driver behind the expansion of global finance in the 1970s and early 1980s, it was global portfolio investment that exploded in the 1990s. Between 1990 and 1994, roughly $670 billion of foreign capital flowed into countries in Asia and Latin America as investors around the world began putting their money into emerging market economies’ stock and bond markets.[1] Governments in these capital receiving countries, once dependent on commercial banks, began to rely more on the issuance of debt securities (bonds) in international credit markets. To illustrate this trend, Figure 4.4 presents net portfolio investment in three emerging market economies from 1982 until 1999.[2]

This is not to say that foreign lending by US commercial banks was insignificant during the 1990s. However, it was now only a fraction of global financial flows. Figure 4.5 presents total cross-border lending by US banks from 1982 to 1998 and points to two trends.[3] First, there was considerable retrenchment in US banks’ foreign lending throughout the 1980s as the debt crisis unfolded. Second, this trend began to reverse itself in the early 1990s as US banks once again began to expand their foreign portfolios. For added clarity, Figure 4.6 presents the volume of a variety

Figure 4.4

Net Portfolio Investment in Three Emerging Markets, 1982-1999

Figure 4.5

Total Cross-Border Claims of US Banks, 1982-1998

of financial flows from the United States to foreign markets in 1994 and 1997.35 in 1994, US residents’ foreign portfolio investments were nearly four times the size of US banks’ cross-border lending; by 1997, US foreign portfolio flows were more than six times foreign bank lending!

Just as the complexity of the global financial system was changing, the nature of financial crises also changed in the 1990s. In the previous 35 [4]

Figure 4.6

Total US Foreign Claims by Type, 1994 and 1997

decade, sovereign debt crises were the predominant variety. They centered on the reluctance of a relatively small group of large commercial banks to continue rolling over the debts of heavily indebted developing country governments. When sovereigns partially or wholly default on their debt obligations to their creditors, they directly impose losses on financial firms with large foreign balance sheets. Although the threat of sovereign default did not disappear in the 1990s, financial crises in that decade tended to be of a different breed. They developed in a country’s capital account as a result of short-term capital flows.36 The prevalence of these "capital account crises” was exacerbated by the entrance of investment funds and individual investors participating alongside the big banks. These new entrants in financial markets were far more prone to what some observers dubbed "herd” behavior. A few pieces of bad information about a national economy could spark a group of investors to pull their money out. Other investors witness this and assume that things must be bad and the race is on for the exit. Moreover, improvements in technology now meant that these investments could be pulled out of a country "with little more than the flick of a computer key.”37

In these situations, spooked investors looking to get off of a sinking ship before it is too late exchange the local currency for dollars, or other hard currencies. This, in turn, forces the emerging market central bank to spend down its foreign exchange reserves. Meanwhile, speculators [5] [6]

looking to make a quick profit added to the mounting pressure by placing bets against the monetary authority’s ability to maintain the fixed exchange rate. If the herd is large enough, it can force a significant and painful devaluation of the currency. Such "currency crashes” increase the likelihood that governments and firms will default on foreign debts. A major devaluation in a currency’s exchange rate can inhibit a borrower’s ability to pay back external debts if they are denominated in a foreign currency, as is typically the case with developing and emerging market economies.[7]

  • [1] Calvo, Leiderman, and Reinhart 1996, p. 123; Prasad et al. 2003; Truman 1996, p. 201.
  • [2] Data were collected by the author from the IMF balance of payments statistics viaData-Planet. Unfortunately, time-series data on US-only flows to these countries areunavailable for these years.
  • [3] Adjusted foreign claims data were collected by the author from relevant CELS reportsvia the Federal Reserve archive, available at http://fraser.stlouisfed.org/publication/?pid=333.
  • [4] Securities and equities data were collected by the author from the US Treasury’sAnnual Cross-US Border Portfolio Holdings data, available at http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/fpis.aspx. Unfortunately, the US Treasurydid not begin the annual collection and reporting of data on US residents’ holdings of foreign debt securities and equities until 2000. Consequently, data for years prior to 1994, aswell as 1995 and 1996, are unavailable. Banking data are from CELS reports.
  • [5] Calvo (1998) referred to the crises that developed in the 1990s as "capital accountcrises” to distinguish them from current account crises, which were the dominant varietyin previous decades.
  • [6] Calvo, Leiderman, and Reinhart 1996, p. 127.
  • [7] Economists call this "original sin”: If a country is forced to devalue its currency andits liabilities are predominantly denominated in a foreign currency, debts become moredifficult to service, which can lead to a crisis, see Eichengreen and Hausmann 1999, 2005.Existing empirical research supports the original sin argument as a recent study found thatas the ratio of foreign currency debt to total debt increases, the likelihood that a country willexperience a debt crisis also increases: see Bordo et al. 20010.
 
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