Mostly Economics

Joshua Aizenman of UCSD has written a useful paper on Korean economy’s experience in this crisis. 

In this paper we explore lessons from the current global liquidity crisis pertaining to the prudential supervision role of central bank in an open economy. The crisis validates the need for external debt management policy in emerging markets. Hoarding international reserves (IR) is a potent self-insurance mechanism. However, it is associated with relatively high costs and is also less efficient in absence of assertive external debt management policies. In the presence of firesale externalities associated with deleveraging, optimal external borrowing-tax-cum-IRhoarding-subsidy reduces the cost as well as the scale of hoarding IR.

 In nut shell he says despite having large forex reserves, Korean economy could not prevent exchange rate pressures. Why? Because it had large short term external debt.

Less than ten years after the 1997-8 East Asian crisis, Korea’s IR/GDP ratio seemed more than adequate by conventional yardsticks. Indeed, observers have been raising questions about the growing costs of stockpiling these reserves. It was asserted that the level of IR in EMs, including Korea, potentially exceed the social optimum [see Jeanne and Ranciere (2005)].

 Having said this, the sense of blissful abundance of IR in Korea evaporated following the sizable increase in Korea’s external debt during 2005-2008. The Korean external short term debt/GDP ratio increased from 7.5% in 2004 to 20% in 2008, while the overall external debt/GDP ratio increased during that period from 23% to 50%, without any significant change in IR/GDP. ‘

 This drastic increase has been attributed to several factors, including exposure to short term inflows of Less than ten years after the 1997-8 East Asian crisis, Korea’s IR/GDP ratio seemed more than adequate by conventional yardsticks. Indeed, observers have been raising questions about the growing costs of stockpiling these reserves. It was asserted that the level of IR in EMs, including Korea, potentially exceed the social optimum [see Jeanne and Ranciere (2005)].

 The forex reserves which were seen as insurance mechanism were considered inadequate. Moreover, emerging economies central banks were scared not to let the reserves slip below a certain %. They were afraid that markets would take that as a negative signal and lead to further speculation. In Korea’s case till swap line with Fed was not set., things looked bad.

Interesting lessons for emerging economies. You need to watch everything and be on toes. The external debt indicators should always be looked at.

Thorvaldur Gylfason. Professor of Economics at University of Iceland has summarised 11 lessons to be learnt from Iceland.

A number of economists have discussed the consequences of Iceland’s troubles and suggested solutions (Buiter and Sibert 2008, Danielsson 2010), but a key question remains: How could this happen?

To make a long story short (for the longer story, see Gylfason et al. 2010), the absence of checks and balances that had led to an unbalanced division of power between the strong executive branch and the much weaker legislative and judicial branches came to haunt the country when unscrupulous politicians put the new banks in the hands of reckless owners who then found themselves in a position to expand their balance sheets as if there were no tomorrow – and no supervision. Politicians who privatise banks by delivering them on a silver plate to their friends are not very likely to subject the banks to stringent supervision or other such inconveniences.

Iceland’s predicament raises old questions about collective guilt and responsibility. Many wonder how taxpayers can be held responsible for the failures of private bankers. But taxpayers are also voters – many of them voted for the politicians who sided with the bankers, having abstained or voted for the opposition is clearly not a valid excuse. Guilty or not, many feel responsible as taxpayers, but not all.

Read the whole thing.