Crises Increased by Excessive Short-Term Debt

Countries set themselves up for trouble because they had far more short-term debt than they did the resources or 'reserves' to rapidly repay skittish creditors.

Perhaps it seemed like a trivial issue at the time: the country's economy was booming; foreign investors were eager to get in on the action; and, given the pace of things, no one really gave much thought to the fact that the new money flowing across the border often came in the form of short-term loans. Maybe short-term debt seemed cheaper than long-term debt, or perhaps there was some quirk in the local tax or regulatory structure that made short-term loans the preferred investment instrument. Whatever the rationale, NBER Research Associates Dani Rodrik and Andrés Velasco argue that a country that "binged" on short-term investments in the 1990s often discovered that what seemed to be so effective at keeping the good times rolling quickly flipped into its opposite and became a major show-stopper.

In Short Term Capital Flows (NBER Working Paper No. 7364),they look at financial crises of the past few years and find that in almost every situation--particularly the East Asia meltdowns--countries set themselves up for trouble because they had far more short-term debt than they did the resources or "reserves" to rapidly repay skittish creditors. "Countries with short-term liabilities to foreign banks that exceed reserves are three times more likely to experience a sudden and massive reversal in capital flows," state Rodrik and Velasco. "Furthermore, greater short-term exposure is associated with more severe crises when capital flows reverse."

The authors note that in the international lending boom of the 1990s, debt extended to emerging countries more than doubled, rising, at one point, from $1 trillion in 1988 to $2 trillion in 1997, with short-term debt rising "particularly rapidly." This left those countries vulnerable to what Rodrik and Velasco refer to as a "self-fulfilling confidence crisis." The imbalance itself made investors nervous and more likely to call in their debts, resulting in the so-called "capital flight" that saw once-booming economies suddenly starved for cash.

For example, in late 1997, as the financial crisis in Thailand began to spread across the region, investors looked at Korea and what they saw was a country holding short-term debt equal to 300 percent of its reserves and around 15 percent of GDP. Foreign creditors began demanding payment and almost overnight a nation that was often cited as a sterling example of the new Asian economic powerhouses was flirting with default.

These economic horror stories aside, the authors do not intend to convey that short-term debt is a bad thing. They note that in many instances, it's a prudent form of investment. But they believe that "one has to keep an alert eye on the ratio of short-term liabilities to available liquid assets." Interestingly, it's countries that are currently doing relatively well that might want to watch this particular meter. Rodrik and Velasco point out that "as economies get richer and financial markets become deeper, the external debt profile gets tilted towards short-term liabilities." In other words, corrective action to bring things into balance is required when countries are booming, a time when they may be least inclined to do something that might be perceived as slowing growth.

But is that perception equal to the reality? Must growth be sacrificed to achieve some equilibrium in the debt portfolio? Turning to this issue, Rodrik and Velasco examine the controversial area of capital controls--policies intended to discourage wild swings in investment flows but with restrictions that frequently prove irritable to both international and domestic entrepreneurs.

The authors contend that an effort in the 1990s by Chile to discourage high-levels of short-term investment---for which it was roundly criticized in some quarters--was a success in reducing dependence on short-term capital. They note that, by 1997, the country's short-term debt was only 7.6 percent of total debt.

They also assert that while Malaysia's brief attempt in 1994 to limit short-term investments from abroad "did not prevent Malaysia from getting into trouble a few years later," at the time the policy was "remarkably effective," reducing short-term debts in 1994 to 26 percent of total debt compared to 37 percent in 1993. (The authors believe one possible explanation for why 1994 policy did not protect Malaysia from having problems in 1997 is that "the controls were lifted too soon.")

Perhaps most importantly, according to Rodrik and Velasco, these proactive efforts to discourage short-term debt did not appear to affect economic growth. In fact, they may have been responsible for good fiscal health. "Chile is a success case of the 1990s, in no small part because it has managed to avoid the destabilizing influence of short-term capital flows," the authors conclude. "Even in Malaysia, where the imposition of restrictions in January of 1994 resulted in a massive turnaround in capital flows, growth was unaffected. In fact, the Malaysian economy grew faster in 1994 and 1995 than in 1993."

-- Matthew Davis