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WEALTH MANAGEMENT


The belief that financial crises and negative outcomes happen to other people in other countries at other times is firmly rooted in financial markets.


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armen M Rienhart and Kenneth Rogoff dubbed this the “this time is different” syndrome. It might be largely explained by the conviction that we are doing things better,


we are smarter and have learned from past mistakes. After a financial crisis has struck, blaming others for its cause can strengthen this hubris. Depending on the type of crisis, the politicians will blame the bankers, the bankers will blame the regulators, and the regulators will blame a supranational institution (such as the IMF). With it comes the perennial cry for reform, which invariably consists of getting the IMF to do more and to do it better; or improving cross-border cooperation during times of financial crises, or even to get into the nitty-gritty of market operations to neutralize all future toxic waste from financial weapons of mass destruction. Invariably, we learn nothing from all of this, the next financial crisis strikes in some region of the world, and the whole sorry cycle starts all over again. Economists and economic historians have


undertaken a lot of work examining financial crises across time and space. Because we have a better understanding of past financial crises, can we predict where and when they are going to occur?


New crises, new models First the bad news. Each time a currency crises has occurred over the past thirty years, economists have developed new models to explain them – but after the event. Paul Krugman’s classic first-generation model of currency crises – which showed that that if the authorities are following economic policies inconsistent with a fixed exchange rate regime, there comes a point at which the peg is abandoned – was perfect at explaining the Mexican peso in 1976 and 1982, but it was not very good at explaining why currency crises spread to other countries and how crises can occur in the absence of deterioration in the macroeconomic fundamentals. Following the ERM crisis in the early 1990s, which could not be explained by Krugman’s model, economists


spent much time and effort on developing models that showed how speculative attacks occur without a deterioration in the macroeconomic fundamentals. However, these models did not predict the Asian crisis, so a third-generation model was developed – which showed how the combination of increasing debt, low foreign exchange reserves, declining government revenue and rising expectations of devaluation causes a currency crisis. The collapse of the currency is only part of a wider problem with the financial system, which can include “crony capitalism” and moral hazard. Hence, in Asia, the macroeconomic fundamentals were strong but the banking sector was characterized by bad loans and unhedged short-term borrowing from foreign banks. Turning to banking crises, it is instructive to note


that despite the publicity surrounding one or two doomsters who correctly called the sub-prime crises, the record of economists predicting bank crisis is not good.


Some indicators work Now for the good news. Contrary to popular belief, currency and banking crises usually do not appear out of the blue. Over the past 40 years, a high proportion have been anticipated by the better performing leading indicators, with only around 15 per cent of crises occurring with one third or fewer of the indicators flashing a danger signal. There is a problem, however, of too many “false alarms” (on the order of one false alarm for every two to five true signals even in the case of the better leading indicators). There is also little evidence that “market views”, or analysts’ views, as expressed in spreads, ratings and surveys, are reliable crisis predictors, important as they may be in determining market access. For banking crises, the best of the monthly


“Preventing future financial crises requires more than technical adjustments; it requires changing human nature, which is far harder”


indicators are an appreciation of the real exchange rate, a decline in stock prices, a rise in the money multiplier, a recession, a fall in exports and a rise in the real interest rate. Among the annual leading indicators of banking crises, a high ratio of short- term capital inflows to GDP came out on top. Micro indicators include the level of bank capitalization, changes in banks’ capitalization, shifts in the structure of banks’ balance sheets and rapid change in the maturity structure of banks’ assets and liabilities. The problem with the micro data – and this is especially true for emerging economies – is that it is not always available or it may be of poor quality, either because the institutional arrangements are not in place to produce reliable data even in the best of circumstances or because bankers and their borrowers have a strong incentive to present a rosy picture of their situation (especially when that situation is deteriorating). For currency crises, the best of the 15 monthly


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