The possibility of a potential Greek default has been
increasingly
in the news owing to its
broader economic impact to Europe (e.g., see
this chart) and the world at large. Given the series of financial crises
we've seen over decades, it's worth taking a moment to better understand the
conditions that might result in this type and scale of problem across the world.
Recent research points increasingly to the conditions that are created in
countries experiencing abnormal net capital inflows, large current account
deficits, and "sudden stops" to such inflows.
Countries Across the World
A good place to start is this 2008 piece "From
capital flow bonanza to financial crash" by Carmen Reinhart and Vincent
Reinhart. I'll excerpt some of their key findings (I've bolded certain
portions throughout this post for adding emphasis):
A pattern has often been repeated in the modern era of global finance.
Global investors turn with interest toward the latest “foreign” market.
Capital flows in volume into the “hot” financial market. The exchange rate
tends to appreciate, asset prices to rally, and local commodity prices to
boom. These favourable asset price movements improve national fiscal
indicators and encourage domestic credit expansion. These, in turn,
exacerbate structural weaknesses in the domestic banking sector even as
those local institutions are courted by global financial institutions
seeking entry into a hot market.
But tides also go out when the fancy of global investors shift and the
“new paradigm” looks shop worn. Flows reverse or suddenly stop à la Calvo [1]
and asset prices give back their gains, often forcing a painful adjustment
on the economy.
...and...
For each of 181 countries, we defined a capital flow bonanza as an
episode in which there are larger-than-normal net inflows...
[...]
For each of the 64 countries, this implies four unconditional crisis
probabilities, that of: default (or restructuring) on external sovereign
debt, a currency crash, and a banking crisis. [4]
We also constructed the probability of each type of crisis within a window
of three years before and after the bonanza year or years, this we refer to
as the conditional probability of a crisis. If capital flow bonanzas make
countries more crises prone, the conditional probability should be greater
than the unconditional probability of a crisis.
We summarise the main results and then provide illustrative
examples. For the full sample, the probability of any of the three
varieties of crises conditional on a capital flow bonanza is significantly
higher than the unconditional probability. Put differently, the incidence of
a financial crisis is higher around a capital inflow bonanza.
However, separating the high income countries from the rest qualifies the
general result. As for the high income group, there are no systematic
differences between the conditional and unconditional probabilities in the
aggregate, although there are numerous country cases where the crisis
probabilities increase markedly around a capital flow bonanza episode.
Also, to provide an indication of how commonplace is it across countries
to see bonanzas associated with a more crisis-prone environment, we also
calculate what share of countries show a higher likelihood of crisis (of
each type) around bonanza episodes. For sovereign defaults, less than half
the countries (42%) record an increase in default probabilities around
capital flow bonanzas. (Here, it is important to recall that about one-third
of the countries in the sample are high income.) In two-thirds of the
countries the likelihood of a currency crash is significantly higher around
capital flow bonanzas in about 61% of the countries the probability of a
banking crises is higher around capital flow bonanzas.
Beyond these general results, Figures 2 to 4 for debt, currency, and
banking crises, respectively, present a comparison of conditional and
unconditional probabilities for individual countries, where the differences
in crisis probabilities were greatest. (Hence, the country list varies from
one figure to the next).
For external sovereign default (Figure2), it is hardly surprising that
there are no high income country examples, as advanced economy governments
do not default on their sovereign debts during the sample in question. The
same cannot be said of Figures 3 and 4. While the advanced economies
register much lower (conditional and unconditional) crisis probabilities
than their lower income counterparts, the likelihood of crisis is higher
around bonanza episodes in several instances. Notably, Finland and
Norway record a higher probability of a banking crisis around the capital
flow bonanza of the late 1980s. Recalibrating this exercise in light of the
banking crises in Iceland, Ireland, UK, Spain and US on the wake of their
capital flow bonanza of recent years would, no doubt, add new high income
entries to Figure 4, which graphs conditional and unconditional
probabilities for banking crises.
I recommend clicking through to the
Reinhart &
Reinhart article to view all of their data and charts. Their ominous
conclusion:
Most emerging market economies have thus far been relatively
immune to the slowdown in the US. Many are basking in the economic warmth
provided by high commodity prices and low borrowing costs. If the pattern
of the past few decades holds true, however, those countries may be facing a
darkening future.
There's a lot more in the 2008 paper "This
Time is Different: A Panoramic View of Eight Centuries of Financial Crises"
by Carmen Reinhart and Kenneth Rogoff, as well as in their Dec 2008 paper
"The
Aftermath of Financial Crises". Another report worth a look is this one from
McKinsey Global Institute (2010) - "Debt
and deleveraging: The global credit bubble and its economic consequences".
With that backdrop, let's look at whether capital flow bonanzas have
something to do with the recent financial crises in European countries.
