Trip Wires and Speed Bumps: Managing Financial Risks and ... · Managing Financial Risks and Reducing the Potential for Financial Crises in Developing Economies Ilene Grabel No. 33,

UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT

G-24 Discussion Paper Series

UNITED NATIONS

Trip Wires and Speed Bumps:

Managing Financial Risks and Reducing the Potential for Financial Crises

in Developing Economies

Ilene Grabel

No. 33, November 2004

G-24 Discussion Paper Series

Research papers for the Intergovernmental Group of Twenty-Fouron International Monetary Affairs

UNITED NATIONSNew York and Geneva, November 2004

UNITED NATIONS CONFERENCEON TRADE AND DEVELOPMENT

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iiiManaging Financial Risks and Reducing the Potential for Financial Crises

PREFACE

The G-24 Discussion Paper Series is a collection of research papers preparedunder the UNCTAD Project of Technical Support to the Intergovernmental Group ofTwenty-Four on International Monetary Affairs (G-24). The G-24 was established in1971 with a view to increasing the analytical capacity and the negotiating strength ofthe developing countries in discussions and negotiations in the international financialinstitutions. The G-24 is the only formal developing-country grouping within the IMFand the World Bank. Its meetings are open to all developing countries.

The G-24 Project, which is administered by UNCTAD�s Division on Globalizationand Development Strategies, aims at enhancing the understanding of policy makers indeveloping countries of the complex issues in the international monetary and financialsystem, and at raising awareness outside developing countries of the need to introducea development dimension into the discussion of international financial and institutionalreform.

The research papers are discussed among experts and policy makers at the meetingsof the G-24 Technical Group, and provide inputs to the meetings of the G-24 Ministersand Deputies in their preparations for negotiations and discussions in the framework ofthe IMF�s International Monetary and Financial Committee (formerly Interim Committee)and the Joint IMF/IBRD Development Committee, as well as in other forums.

The Project of Technical Support to the G-24 receives generous financial supportfrom the International Development Research Centre of Canada and contributions fromthe countries participating in the meetings of the G-24.

TRIP WIRES AND SPEED BUMPS:MANAGING FINANCIAL RISKS AND REDUCING

THE POTENTIAL FOR FINANCIAL CRISES INDEVELOPING ECONOMIES

Ilene Grabel

Associate Professor of International FinanceGraduate School of International Studies

University of DenverDenver, Colorado, United States

G-24 Discussion Paper No. 33

November 2004

viiManaging Financial Risks and Reducing the Potential for Financial Crises

Abstract

This paper investigates the shortcomings of the �early warning systems� (EWS) that arecurrently being promoted with such vigour in the multilateral and academic community. It thenadvocates an integrated �trip wire-speed bump� regime to reduce financial risk and, as aconsequence, to reduce the frequency and depth of financial crises in developing countries.

Specifically, this paper achieves four objectives.

First, it demonstrates that efforts to develop EWS for banking, currency and generalizedfinancial crises in developing countries have largely failed. It argues that EWS have failedbecause they are based on faulty theoretical assumptions, not least that the mere provision ofinformation can reduce financial turbulence in developing countries.

Second, the paper advances an approach to managing financial risks through trip wires andspeed bumps. Trip wires are indicators of vulnerability that can illuminate the specific risks towhich developing economies are exposed. Among the most significant of these vulnerabilitiesare the risk of large-scale currency depreciations, the risk that domestic and foreign investorsand lenders may suddenly withdraw capital, the risk that locational and/or maturity mismatcheswill induce debt distress, the risk that non-transparent financial transactions will induce financialfragility, and the risk that a country will suffer the contagion effects of financial crises thatoriginate elsewhere in the world or within particular sectors of their own economies. It arguesthat trip wires must be linked to policy responses that alter the context in which investors operate.In this connection, policymakers should link specific speed bumps that change behaviours toeach type of trip wire.

Third, the paper argues that the proposal for a trip wire-speed bump regime is not intendedas a means to prevent all financial instability and crises in developing countries. Indeed, such agoal is fanciful. But insofar as developing countries remain highly vulnerable to financialinstability, it is critical that policymakers vigorously pursue avenues for reducing the financialrisks to which their economies are exposed and for curtailing the destabilizing effects ofunpredictable changes in international private capital flows.

Fourth, the paper responds to likely concerns about the response of investors, the IMF andpowerful governments to the trip wire-speed bump approach. The paper also considers the issueof technical/institutional capacity to pursue this approach to policy. The paper concludes byarguing that the obstacles confronting the trip wire-speed bump approach are not insurmountable.

ixManaging Financial Risks and Reducing the Potential for Financial Crises

Table of contents

Page

Preface .......................................................................................................................................................... iii

Abstract .......................................................................................................................................................... vii

1. Introduction ................................................................................................................................................. 1

2. A brief review of efforts to predict financial turbulence ........................................................................ 32.1. Intellectual pre-history of EWS models: etiological efforts from the 1970s

to the European currency crisis of 1992�1993 ................................................................................. 32.2. From etiology to crisis prediction: the Mexican crisis of 1994�1995

to the current EWS models ............................................................................................................... 3

3. A proposal for trip wires and speed bumps ............................................................................................. 83.1. Contrasting trip wires-speed bumps and EWS ................................................................................. 83.2. Trip wires ........................................................................................................................................... 93.3. Speed bumps .................................................................................................................................... 11

4. The feasibility of the trip wire-speed bump approach .......................................................................... 164.1. Concern #1. A trip wire-speed bump programme cannot reduce the unpredictability

and volatility of cross-border and/or cross-currency capital flows. Therefore theutility of this approach is questionable. .......................................................................................... 16

4.2. Concern #2. The activation of trip wires and speed bumps might ironicallytrigger the very instability that they are designed to prevent. ........................................................ 16

4.3. Concern #3. The trip wire-speed bump proposal is unnecessary becauseprivate investors and credit rating agencies can do a better job of identifyingfinancial vulnerabilities than can governments. ............................................................................. 17

4.4. Concern #4. Trip wires and speed bumps will not achieve their objectivesbecause economic actors will evade them. ..................................................................................... 17

4.5. Concern #5. Many developing countries do not have the technical policy-makingcapacity that is necessary for the success of trip wires and speed bumps. ..................................... 17

4.6. Concern #6. The negative reaction of the Bretton Woods institutions,the United States Government and/or international investors is an obstacleto the implementation of trip wires and speed bumps. ................................................................... 18

4.7. Concern #7. Countries that implement trip wires and speed bumps will faceincreased capital costs and lower rates of economic growth. ......................................................... 18

4.8. Summary .......................................................................................................................................... 19

Notes ......................................................................................................................................................... 19

References ......................................................................................................................................................... 20

Figure 1 The underlying, general economic logic of early warning systems ................................................. 4Figure 2 The indeterminant effect of early warning system models in the current environment

of liberalized, internationally integrated financial markets .............................................................. 8Table 1 Key financial risks confronting developing countries; and examples of associated

trip wires and speed bumps ............................................................................................................. 12

1. Introduction

This paper begins from the assumption that itis in the interest of developing countries to take stepsto curtail the financial risks to which they are ex-posed. This is because these risks so often culminatein costly and painful financial crises. Toward thisend, the paper proposes �trip wires and speed bumps�as means to curtail the types of financial risks towhich developing economies are exposed. I arguethat the trip wire-speed bump approach presentedhere has a far greater ability to curtail financial risks(including the potential of these risks to induce cri-ses) than do the �early warning systems� (hereafter,EWS) that are currently being promoted with suchvigor in the multilateral and academic community(e.g., Goldstein, Kaminsky and Reinhart, 2000; andsee below for further references).

The financial turbulence of the past three dec-ades has stimulated a great deal of research into both

the etiology and the prevention of financial crises.Unlike the situation of the 1970s and early 1980s,recent research has not been stimulated by the col-lapse of currency pegs or by efforts to predictexchange rate changes in wealthy countries. Thechief catalyst for recent research has been recurrent,severe, costly, and contagious financial crises in thedeveloping world.1 The first of these recent crisesoccurred in Mexico in 1994�1995 (with contagionin several countries in South America). Next camethe crisis in East Asia in 1997�1998. This crisis be-gan in Thailand in the summer of 1997 and ratherquickly engulfed the economies of the Philippines,Indonesia, and Malaysia. Within months the crisisspread to the Republic of Korea, the Russian Fed-eration and Brazil. Turkey experienced a financialcrisis in early 2001, and Argentina has experiencedseveral rounds of crisis since then. With only theexception of Malaysia during the East Asian crisis,these crises were followed by large bailouts fromthe IMF, painful programmes of economic reform,and severe economic and social dislocation.

* This paper was prepared with financial support of the International Development Research Centre (IDRC) of Canada. Theauthor is grateful to George DeMartino, Randall Dodd, Guillaume Arias, and K. Kanagasabapathy for critical reactions to an earlierversion of the paper, to Rob Parenteau and Jamie Galbraith for reactions to related work, and to Vladimir Zhapov for excellentresearch assistance.

TRIP WIRES AND SPEED BUMPS:

MANAGING FINANCIAL RISKS AND REDUCINGTHE POTENTIAL FOR FINANCIAL CRISES IN

DEVELOPING ECONOMIES

Ilene Grabel*

2 G-24 Discussion Paper Series, No. 33

In large measure, the financial crises mentionedabove are the result of the decision to liberalize ex-ternal and internal financial flows in the developingworld from the 1980s onward. For the purposes ofthis study, the link between financial crisis and fi-nancial liberalization in the developing world willbe assumed rather than demonstrated. This is becausethe link between financial liberalization and finan-cial crisis has been explored convincingly in numerousrecent works, such as Arestis and Demetriades (1997),Arestis and Glickman (2002), papers in Chang,Palma, and Whittaker (2001), Crotty and Lee (2001),Eatwell and Taylor (2000), Grabel (2003a, 2003b,2003e, 1996), Singh and Weisse (1998), Weller(2001), Williamson and Mahar (1998), Wyplosz(2001).2

The significant economic and social costs as-sociated with recurrent financial crises has stimulateda large volume of research (and associated policyadvocacy) into the matter of whether financial cri-ses in developing countries can be prevented ormitigated through models that predict currency,banking and generalized financial difficulties. Themost important of these efforts involves the devel-opment of EWS. The work of Goldstein, Kaminskyand Reinhart (2000) is the gold standard of such ef-forts (though see also Berg and Patillo, 1998; Edison,2000; Frankel and Rose, 1996; Goldstein, 1997a;Hardy and Pazarbasioglu, 1998; IMF 2001; Kaminand Babson, 1999; Kaminsky, Lizondo, Reinhart,1997; Kaminsky and Reinhart, 2000; Sachs, Tornell,Velasco, 1996).

The financial turbulence of the last decade hasalso reinvigorated study of certain types of capitalcontrols as a tool for reducing the likelihood of and/or mitigating the effect of financial crises on devel-oping economies (see Epstein, Grabel and JomoK.S., 2004, and references therein). In this connec-tion, recent discussions of capital controls in Chile,Colombia, Malaysia, China, India, Singapore, andTaiwan Province of China are quite relevant to thediscussion of trip wires and speed bumps.

This study has several objectives.

First, it will establish that efforts to developEWS for banking, currency and generalized finan-cial crises in developing countries have not met withsuccess. This failure mirrors the failure of similarefforts to predict currency turbulence in the 1970s and1980s. It will be argued that recent efforts to predict

crisis through EWS have failed because they are basedon faulty theoretical assumptions and on the incor-rect view that the mere provision of information canreduce financial turbulence in developing countries.

Second, against the current crop of proposalsfor EWS, the paper will advance an approach tomanaging financial risks (including the risk of fi-nancial crisis) through trip wires and speed bumps.The trip wire-speed bump approach is initially de-veloped in Grabel (1999, 2003a, 2003b), and iselaborated further in Chang and Grabel (2004: ch. 9).3In this paper, the approach is developed more fullythan in any of these works.

Trip wires are indicators of vulnerability thatcan illuminate the specific risks to which develop-ing economies are exposed. Among the mostsignificant of these vulnerabilities are the risk oflarge-scale currency depreciations, the risk that do-mestic and foreign investors and lenders maysuddenly withdraw capital, the risk that locationaland/or maturity mismatches will induce debt distress,the risk that non-transparent financial transactionswill induce financial fragility, and the risk that acountry will suffer the contagion effects of financialcrises that originate elsewhere in the world or withinparticular sectors of their own economies. It will beargued that trip wires are a necessary tool for ascer-taining the unique vulnerability (or combination ofvulnerabilities) that confront individual developingeconomies. It will be argued further that trip wiresmust be linked to policy responses that alter the con-text in which investors operate. In this connection,it will be argued that policymakers should link spe-cific speed bumps that change behaviours to eachtype of trip wire.

Third, it will be argued that the proposal for atrip wire-speed bump regime is not intended as ameans to prevent all financial instability and crisesin developing countries. Indeed, such a goal is fan-ciful at best. But insofar as developing countriesremain highly vulnerable to financial instability, itis critical that policymakers vigorously pursue av-enues for reducing the financial risks to which theireconomies are exposed and for curtailing thedestabilizing effects of unpredictable changes in in-ternational private capital flows. It is in this contextthat the trip wire�speed bump approach is presented.

Fourth and finally, the paper will respond tolikely concerns about the response of investors, the

3Managing Financial Risks and Reducing the Potential for Financial Crises

IMF and powerful governments (namely, that of theUnited States) to the trip wire-speed bump approach.The paper will also consider the issue of technical/institutional capacity to pursue this approach topolicy. The paper will conclude by arguing that theconcerns anticipated should not be seen as insur-mountable obstacles confronting the trip wire-speedbump approach.

2. A brief review of efforts to predictfinancial turbulence

The current project to predict financial crisesin developing countries through EWS has its rootsin two previous research agendas. These earlierprojects are etiological studies of the currencycrises that followed the collapse of the BrettonWoods-era pegged exchange rates and the crisis inEuropean currency markets in 1992. In what follows,we focus on the current EWS project. But beforemoving to the EWS models, we reflect briefly on itsintellectual antecedents.

2.1. Intellectual pre-history of EWS models:etiological efforts from the 1970s to theEuropean currency crisis of 1992�1993

Theoretical and empirical treatments of theetiology of currency crises is not a new area of re-search in macroeconomics. The starting point fortheoretical treatments of the subject is Krugman�sseminal 1979 paper on the circumstances that leadto the collapse of fixed/pegged exchange rate re-gimes. Krugman maintains that such regimescollapse under the pressure of weak fundamentals �to wit: excessively expansionary monetary and/orfiscal policies or persistent balance of payments defi-cits render fixed/pegged currencies untenable.Extensions of Krugman (1979) are legion; in theseelaborations, weak fundamentals play a central rolein triggering currency crises. The earliest extensionsof Krugman (termed first generation models) focuson the role of monetary and/or fiscal imbalances inspeculative attacks against a multiplicity of exchangerate regimes; later extensions (termed second gen-eration models) centre on the possibility for multipleequilibria and self-fulfilling attacks on a currencyfollowing the deterioration of fundamentals.4

The European currency crisis of 1992 reinvig-orated efforts to understand the causes of currencycrises; important works in this regard includeEichengreen and Wyplosz (1993), Eichengreen, Rose,Wyplosz (1995); and Rose and Svensson (1994).Neither the work in the post-Krugman tradition northe work of the Europeanists attempted to developexplicit predictors of financial crisis.

2.2. From etiology to crisis prediction:the Mexican crisis of 1994�1995 tothe current EWS models

It was not until the Mexican crisis of 1994�1995that orthodox economists moved beyond the projectof uncovering the causes of crisis and began to elabo-rate predictors of financial crisis in developingeconomies. Official efforts to understand the Mexi-can crisis were very much guided by the view thatcrises could be prevented through the provision ofaccurate and timely information about conditions indeveloping economies. The central role of informa-tion in crisis prevention was indeed the main messageof the June 1995 Group of Seven Summit held inHalifax in the wake of the Mexican crisis. At Hali-fax, the IMF was urged to encourage the promptpublication of economic and financial statistics andto identify regularly countries that did not complywith the institution�s new information standards(standards that eventually became the IMF�s Spe-cial Data Dissemination Standard).5 The currentproject by orthodox economists to develop EWSbuilds directly on the IMF�s failed efforts to preventcrises in East Asia through the provision of infor-mation through the Special Data DisseminationStandard.

2.2.1.The underlying, general logic of EWS

The underlying, general logic of EWS is ratherstraightforward. Crisis prevention requires twothings: good predictors (embodied in EWS) that fillinformation gaps; and an open, liberalized regimein which agents are free to reallocate or liquidatetheir portfolios in response to problems made ap-parent by EWS. Hence, the self-regulating actionsthat rational agents take in response to EWS willprevent the predicted event from coming to fruition(or at least will mitigate its severity). The underly-ing logic of the EWS is summarized in figure 1.


The EWS approach assumes that once a dan-gerous economic tendency is revealed, rationalprivate economic actors will change their behavioursin a manner that ultimately stabilizes markets.

2.2.2.Brief review of EWS models

Economists that develop predictors of crisispropose two broad types of predictors � the �regres-sion� or �probit� approach associated with Frankeland Rose (1996) and the more frequently discussedEWS (often termed the �signal extraction�) approachassociated with Goldstein, Kaminsky and Reinhart(2000).6

The regression approach estimates the probabil-ity of a currency or a banking crisis and identifiesthe variables that are statistically correlated withcrisis. Econometric work by Frankel and Rose (1996)exemplifies this approach to crisis prediction (Sachs,Tornell and Velasco, 1996). For example, Frankeland Rose (1996) conclude that currency crashes oc-cur when foreign direct investment dries up, whencurrency reserves are low and falling, when domes-tic credit growth is high, when Northern nominalinterest rates rise, and when the real exchange rateis overvalued by 10 per cent.

The EWS approach compares the behaviour ofa variable before a crisis with its behaviour during

normal times. A variable is then taken to be useful ifit displays anomalous behaviour before a crisis butdoes not provide false signals of an impending cri-sis in normal times. When a variable exceeds or fallsbelow a certain threshold, it is said to issue a signalthat a crisis may occur.

Goldstein, Kaminsky and Reinhart (2000) is thepoint of departure for all efforts to develop EWS(reviews and extensions appear in Abiad, 2003; Bergand Patillo, 1998, 2000; Edison, 2000; Hardy andPazarbasiouglu, 1998; Hardy, 1998; Hawkins andKlau, 2000; IMF, 1998: ch. 4; Kamin and Babson,1999).7 Goldstein, Kaminsky and Reinhart (2000)find that there is a systemic pattern of empiricalabnormalities leading up to most currency and bank-ing crises in developing economies over a sampleperiod ranging from 1970�1995. For currency cri-ses, they find that the best predictors using monthlydata are appreciation of the real exchange rate (rela-tive to trend), a banking crisis, a decline in stockprices, a fall in exports, a high ratio of broad money(M2) to international reserves, and a recession.Among the annual predictors of currency crises, thetwo most reliable predictors are a large current ac-count deficit relative to both GDP and investment.For banking crises, they find that using monthly datathe most reliable predictors of crisis (in descendingorder of importance) are appreciation of the realexchange rate (relative to trend), a decline in stockprices, a rise in the M2 money multiplier, a decline

Figure 1

THE UNDERLYING, GENERAL ECONOMIC LOGIC OF EARLY WARNING SYSTEMS (EWS)

Stabilizing effects on the economy

Behavioural change by investor/lender

EWS identifies a destabilizing

economic tendency

1

23

Stabilizing effects on the economy

Behavioural change by investor/lender

EWS identifies a destabilizing

economic tendency

1

23


in real output, a fall in exports, and a rise in the realinterest rate.8 Among the annual predictors of bank-ing crises, the most reliable are a high ratio ofshort-term capital inflows to GDP and a large cur-rent account deficit relative to investment. They findthat in most banking and currency crises, a high pro-portion of the monthly leading indicators � on theorder of 50�75 per cent � reach their signallingthreshold. In other words, when a developingeconomy is moving toward a financial crisis, manyof the leading indicators signal a crisis.

Goldstein, Kaminsky and Reinhart (2000) showthat there is a wide divergence in the performanceacross leading indicators; warnings usually appearten to eighteen months prior to the onset of crisis.The authors remain firm in their view that the EWScan make apparent an economy�s vulnerability tocrisis. They do make clear, however, that the systemdoes not speak to the timing of a crisis.

At present, the Bank for International Settle-ments utilizes an EWS model. The IMF employs twoEWS models, and also monitors the EWS utilizedby numerous private firms (such as the Credit SuisseFirst Boston Emerging Markets Risk Indicator,Deutsche Bank Alarm Clock, and Goldman SachsGS-Watch) (IMF, 2001). Much mention is madein the business press of the Damocles model de-veloped by economists at Lehman Brothers-Asia(Subbaraman, Jones and Shiraishi, 2003). TheDamocles model relies on ten predictors of finan-cial crises (many of which figure into the Goldstein,Kaminsky and Reinhart model). Indeed, all of thenew EWS are very close cousins of the model de-veloped by Goldstein, Kaminsky and Reinhart(2000).

2.2.3.The empirical performance of EWS(and other predictive) models

The empirical performance of crisis predictors(both of the EWS and the less frequently discussedregression/probit models) is rather dismal. Numer-ous empirical tests (many indeed conducted byproponents) conclude that predictive models wouldnot have provided ex-ante signals of the events inMexico or East Asia.

For example, Flood and Marion (1999),Hawkins and Klau (2000), and the IMF (1998: ch. 4)conclude that all predictive models have a mixed

record of success. Goldfajn and Valdes (1997) andHardy and Pazarbasioglu (1998) are less ambigu-ous: the former study concludes that exchange ratecrises are largely unpredictable events, a result theydemonstrate in the case of the currency crises inMexico and Thailand; the latter study concludes thatthe East Asian banking crises would not have beenpredicted by the usual macroeconomic predictors.Eichengreen�s (1999) survey of predictive modelsconcludes that they have remarkably poor power (seealso IMF, 2001; Eichengreen, Rose and Wyplosz,1995). His assessment is worth quoting at length:�If investors, with so much at stake, cannot reliablyforecast crises, then it is hard to see why bureau-crats should do better�Their (predictors) trackrecord is not good. Models built to explain the 1992�1993 ERM crisis did not predict the 1994�1995Mexican crisis. Models built to explain the Mexi-can crisis did not predict the Asian crisis� (p. 84).

Several studies test a comprehensive battery ofcrisis predictors; these studies, too, fail to offer em-pirical support to the predictors project. In a test ofnearly all existing predictors (both of the regressionand the EWS variety), Berg and Patillo (1998) findthat some models perform better than guesswork inpredicting the East Asian crisis. But they find thatnone of these models reliably predicts the timing ofthe crisis (that is, whether there would be a crisis in1997). This is because false alarms, in almost allcases, always outnumber appropriate warnings.Edison (2000) also concludes that predictive mod-els issue many false alarms and miss important crises.Sharma�s (1999) review of the empirical perform-ance of predictive models concludes that they wouldnot have predicted the events in East Asia (a conclu-sion echoed by Corbett and Vines (1998)). Sharma sumsup the matter definitively: �the holy grail of crisisprediction may be intrinsically unattainable� (p. 42).

The most prominent advocates of predictorsremain unshaken by the weight of discouragingempirical evidence. Goldstein (1997a), for example,concludes that preliminary tests of the predictors hedevelops indicate that they would have predicted theThai crisis. Goldstein, Kaminsky and Reinhart(2000) conclude that their EWS model performsquite well, not only in tracking currency and bankingcrises in developing economies over the 1970�1995sample period, but also in anticipating most of thecountries affected by the East Asian crisis (particu-larly as regards currency crises in the region).9 Totheir credit, the authors clearly acknowledge that


their EWS is prone to many false alarms and wouldhave missed some important crises: the best indica-tors send a significant share of false alarms on theorder of one false alarm for every 2�5 true signals(chapter 5).

As regards the recent difficulties of Argentina,there is no evidence that EWS models would havepredicted the collapse of the currency peg. Indeed,the general bullishness of the international invest-ment and policy community on the Argentineeconomy from the inception of its currency board in1991 and up until a few months before its collapsein 2002 suggests that EWS were not providing indi-cations that the country was heading toward crisis.10

The empirical shortcomings of the EWS projectare clear, even to some of its most ardent partici-pants. What is not clear is why efforts to refineexisting predictors and to develop new ones proceedsdespite the resounding empirical failure of this en-terprise. This failing suggests the need to developother strategies for reducing financial risks in gen-eral, and for reducing the risk of financial crisis inparticular. Section 3 below presents one such ap-proach.

2.2.4.Why have existing predictive models failed toachieve their principal objective of curtailingthe risk of financial crises by predictingthem?

I argue that the failings of existing predictivemodels stem from the fact that they are based on sixmisguided initial assumptions. Recall that the gen-eral economic logic of EWS models begins from thepresumption that the provision of accurate and timelyinformation about an economy�s vulnerability is ul-timately market stabilizing, provided that investorsare able to adopt appropriate defensive postures inresponse to this information (figure 1). In my view,this view is indefensible on several grounds.

2.2.4.i.) The informational prerequisites for EWS aresimply unreasonable in the developing economy con-text.

The success of EWS depends very much onthe accuracy and availability of information about arange of economic conditions. But these informa-tional prerequisites cannot be accommodated in the

developing economy context. Problems of data in-accuracy are to be expected. Indeed, identificationof precisely this problem motivated the IMF�s crea-tion of the Special Data Dissemination Standard. Butidentification of the problem has not solved it.

False and missed alarms are likely as long asthe integrity of data are compromised. And falsealarms are obviously no small matter insofar as theycan trigger real crises by causing an investor panic.Moreover, governments have a strong �incentive todeceive� (i.e., to mis-report data) once an EWS is inplace, and this incentive deepens as a country enterscrisis territory. Paradoxically, then, the introductionof predictors is likely to reduce the quality of re-ported data.11

We know that the quality of economic data isfar from ideal, even in wealthy countries like theUnited States. The Federal Reserve and various de-partments of the United States Government issueex-post adjustments of data as a matter of course.For example, the dating of business cycles is alwayssubject to ex-post adjustment; the accuracy of dataon United States productivity has been the subjectof much discussion over the last few years. The needfor ex-post revision (and/or disputes about method-ology) may cause little problem when the matter atstake is the dating of recessions (or calculating pro-ductivity growth), since this news is unlikely to affectbehaviours in consequential ways. But inaccuratedata reporting in the context of predicting crisis isanother matter entirely. In this context, inaccuraciesare not benign.

2.2.4.ii.) The interpretation of predictors is endog-enous to the economic environment.

The EWS model presumes that the interpreta-tion of predictors is a science rather than an art. Theformer implies that the determination as to whatconstitutes a �dangerous reading� is independent ofthe economic climate and the state of expectations.In contrast, I argue that the interpretation of predic-tors is far more art than science. The determinationas to what constitutes a dangerous level for some setof predictive variables is endogenous to the economicenvironment. The interpretation of the consequencesof a rising current account deficit is an example ofthe endogeneity of the interpretation of crisis pre-dictors. A rising current account deficit may be takenas a sign of an impending crisis and a reflection ofunderlying economic fragility, or may be taken as a


reflection of a country�s strength and desirability toinvestors.

2.2.4.iii.) EWS models are predicated on the falsenotion that crises in developing countries have thesame etiology.

This is simply not the case. The etiology ofevery crisis is at least slightly different. Thus, wehave no reason to expect that a standard EWS modelbased on a static set of crisis predictors would beappropriate for the job. For example, the root causesof the European, Mexican, East Asian, and Argentineancrises remain distinct. Therefore, it comes as no sur-prise that predictors developed after each crisis failedto predict the next one (Corbett and Vines, 1998).

2.2.4.iv.) Refining existing EWS models will not endthe pattern of recurrent crisis in developing econo-mies. The problem lies with the creation of highlyliberalized, internationally integrated financial mar-kets that render developing countries particularlyvulnerable to crises.

The refinement of EWS models assumes thatcrises are a consequence of informational inadequacyrather than a fundamental, structural feature of theliberalized financial and regulatory environment thathas been promoted in developing countries over thelast two decades. Economies with internationally in-tegrated, liquid, liberalized financial systems areinherently crisis prone, as recent events have wellshown. Several empirical studies show that finan-cial liberalization in developing countries is a strong(and, in some cases, the best) predictor of banking,currency and/or generalized financial crises (Corbettand Vines (quoting Wyplosz), 1998; Demirgüc-Kuntand Detragiache, 1998; Weller, 2001). Empirical evi-dence that links financial liberalization and financialcrisis is also reviewed in Arestis and Demetriades(1997), Arestis and Glickman (2002), Brownbridgeand Kirkpatrick (2000), papers in Chang, Palma, andWhittaker (2001), Crotty and Lee (2001), Grabel(2003a, 2003e), Palma (1998), Singh and Weisse(1998), and Williamson and Mahar, 1998.12

2.2.4.v.) Economists have never succeeded in pre-dicting economic turning points.

Finally, it bears mentioning that efforts at di-vining market swings have never met with much

success. The spectacular failure of the hedge fund,Long Term Capital Management, a fund managedby Nobel Laureates and other distinguished econo-mists, demonstrates that even pioneers of elaboraterisk management models cannot anticipate marketshifts with great accuracy.13 Developing economiessimply cannot afford to bear the costs of failed effortsat crisis prediction through EWS (namely, false sig-nals that trigger investor panics, or missed signals).

2.2.4.vi.) We know that investors can respond to newinformation in a manner that is either market stabi-lizing or market destabilizing.

By making agents aware of fragilities in theeconomy, predictors of crisis may induce market-stabilizing or destabilizing changes in behaviour.Given the herd-like behaviour of investors and theinherent instability of liquid, liberalized, internation-ally integrated financial markets, rational economicactors are just as likely to engage in destabilizingbehaviour in response to information on problemsin the economy as they are to engage in market-sta-bilizing behaviour. In the game of musical chairs,no one wants to be the last one left standing, as JohnMaynard Keynes noted long ago. We simply cannotpredict with certainty whether agents will respondto the information provided by predictors in a mar-ket-destabilizing or stabilizing manner. Indeed,investor panic seems a likely response to warningsof dire circumstances ahead.

The general, underlying logic of this criticalview of predictive efforts is summarized in figure 2.

At best, predictors of crisis have indeterminateeffects on macroeconomic stability in the context ofthe current environment of liberalized, internation-ally integrated financial markets in which investorsare free to take defensive actions in response to newinformation (changes in market sentiment, etc.).

Ironically, there is reason to expect that the pres-ence of an EWS might promote higher levels offinancial instability in developing countries. Thismay be termed the �predictor credibility paradox�.The paradox may be introduced if the presence ofan EWS induces a heightened level of confidenceamong economic actors, such that they may be aptto engage in riskier financial arrangements, providedthat the EWS does not provide an indication of loom-ing difficulties.


3. A proposal for trip wires andspeed bumps

This paper responds to the failure of current ef-forts to reduce the likelihood of financial crises bypredicting them through EWS. I maintain that the tripwire-speed bump approach has the potential to reducethe specific financial risks that national policymakersdeem most important to their own economies.

3.1. Contrasting trip wires-speed bumpsand EWS

The trip wire speed-speed bump approach dif-fers from EWS in several critical ways.

3.1.1.Trip wires are diagnostic tools only.

In contrast to the EWS approach, the informa-tion provided by trip wires is understood to have arather narrow value as a diagnostic tool. Thus, un-like predictors in the EWS models, trip wiresthemselves are not expected to curtail financial risksand stabilize markets. Trip wires are necessary � butnot sufficient � to the task of curtailing financial risks.

3.1.2.The trip wire-speed bump approach rests onthe idea that specific, targeted changes inpolicy and/or behaviour are necessary tocurtail particular financial risks as soon asthey are identified.

In contrast to the EWS, trip wires and speedbumps do not rest on the assumption that the self-correcting actions of private actors or private ratingagencies will prevent identified financial risks fromculminating in a financial crisis. Indeed, the trip wire-speed bump approach begins from the assumptionthat the actions of private actors in response to in-formation about financial vulnerabilities can triggeradditional financial instability (for instance, as in-vestors run for the exits at the first sign of trouble;see figure 2).

The trip wire-speed bump approach calls uponregulators to activate gradual speed bumps at the firstsigns of vulnerability. It is these behavioural and/orregulatory changes that can reduce financial risksand prevent them from culminating in financial cri-ses. Thus, and unlike the EWS, the warning signalledby a trip wire does not itself carry the full weight ofcrisis prevention. Instead, it triggers a series of regu-latory actions that alter investor behaviour in waysthat avert crisis.

Figure 2

THE INDETERMINANT EFFECT OF EARLY WARNING SYSTEM MODELS IN THE CURRENTENVIRONMENT OF LIBERALIZED, INTERNATIONALLY INTEGRATED FINANCIAL MARKETS

Destabilizing economic tendency

EWS provides information to invest./lenders

Stabilizing effects on

the economy

1

2

3

2OR

Destabilizing economic tendency

EWS provides information to invest./lenders

Stabilizing effects on

the economy

1

2

3

2OR


Note that there is precedent for the trip wire-speed bump approach in United States stock marketsand futures exchanges. Within these markets, auto-matic circuit breakers and price limits are used todampen market volatility and stabilize extrememarket swings. Regulatory authorities also havediscretionary authority to stop trading or temporar-ily close an exchange or the trading in one particularsecurity or derivative.14 We return to this point insection 4.6.

3.1.3.Problems of informational inadequacy arenot nearly as damaging to the success of tripwires and speed bumps as they are to EWS.

The adequacy of the information used in tripwires is quite obviously an important matter. But itis not nearly as significant a concern as it is for EWS.This is because the goal of a trip wire is not to �pre-dict crisis�, but to identify a risk of looming difficultythat warrants regulatory response. In this approach,the regulatory response bears the principal weightof ensuring stability, while under the EWS approach,information must do the full job.

In a trip wire-speed bump approach, regulatorsmonitor trip wires constantly. So close to the ground,regulators are well positioned to monitor the qualityof the information they gather � indeed, they are in afar better position to do so than distant market ac-tors or rating agencies (who must rely in part on thereporting of these regulators � see section 4.3 be-low). Moreover, the gradual, early activation ofspeed bumps can reduce the cost of regulatory errorassociated with incorrect information. Under thisapproach, it is true that incorrect information mayinduce over- or under-regulation; but under the EWS,incorrect information is apt to induce sudden, dra-matic reactions of private actors that inaugurateeconomic instability and crisis.

A government�s incentive to deceive under anEWS (see section 2.2.4.i.) above) evaporates undera trip wire-speed bump approach. Under the EWS,the government has an incentive to misreport thevalue of important economic variables, and to exag-gerate the quality of the government�s data collection(so as to achieve and maintain credibility). Underthe trip wire-speed bump approach, the officials whomonitor the trip wires have no such incentive, sincethey are themselves the agents who will use the in-formation they produce. Moreover, they now have

an incentive to assess carefully the quality of thedata they report, and to take account of this qualitywhen activating and calibrating speed bumps. Forinstance, where data quality is known (or suspected)to be poor speed bumps would be imposed earlierthan otherwise.

3.2. Trip wires

It is possible to envision a variety of trip wiresthat measure the types of financial risks that con-front individual economies. Before proceeding,I note two caveats about the trip wires presented be-low.

First, the trip wires proposed here are illustra-tive, only. They are neither exhaustive nor definitive.It is hoped that this paper will stimulate discussionof how these trip wires can be refined by national orregional policymakers or by the G-24.

Second, the financial risks identified below areof differential relevance to particular developingcountries. National policymakers are in the best po-sition to design specific trip wires that speak to theirown economy�s unique vulnerabilities. For instance,many developing countries do not confront the riskof portfolio investment flight because they receivevery little or no international portfolio investment.Indeed, over the last 13 years, eight middle-incomecountries have accounted for 84 per cent of total netflows of portfolio investment to the developingworld; and ten large, middle-income countries re-ceived 70 per cent of the FDI flows that went to thedeveloping world in 2002 (World Bank, 2003). Butthe risk of flight is highly consequential for the smallnumber of developing countries that receive themajority of these flows. Other developing countriesare far more vulnerable to sudden, significant de-clines in inflows of bi- or multi-lateral loans orprivate remittances. These risks require a differentset of trip wires.

In what follows, I suggest trip wires that focuson particular financial risks. Among the most sig-nificant of these risks are the risk of large-scalecurrency depreciations, the risk that investors andlenders may suddenly withdraw capital, the risk thatlocational and/or maturity mismatches will inducedebt distress, the risk that non-transparent financialtransactions and other financing strategies will in-


duce financial fragility and inter-sectoral contagion,and the risk that a country will experience cross-border contagion.

3.2.1.Trip wires for currency risk

Currency risk refers to the possibility that acountry�s currency may experience a sudden, sig-nificant depreciation.15 Currency risk can beevidenced by the ratio of official reserves to totalshort-term external obligations (the sum of accumu-lated foreign portfolio investment and short-termhard-currency denominated foreign borrowing); andthe ratio of official reserves to the current accountdeficit.

3.2.2.Trip wires for fragility risk

Fragility risk refers to the vulnerability of aneconomy�s private and public borrowers to internalor external shocks that jeopardize their ability to meetcurrent obligations. Fragility risk arises in a numberof ways. Borrowers finance long-term obligationswith short-term credit, causing maturity mismatch.This leaves borrowers vulnerable to changes in thesupply of credit, and thereby exacerbates the ambi-ent risk level in the economy. A proxy for maturitymismatch could be given by the ratio of short-termdebt to long-term debt (with foreign-currency de-nominated obligations receiving a greater weight inthe calculation).

Fragility risk also arises when borrowers con-tract debts that are repayable in foreign currency,causing locational mismatch. This leaves borrowersvulnerable to currency depreciation/devaluation thatmay frustrate debt repayment. Locational mismatchthat induces fragility risk could be evidenced by theratio of foreign-currency denominated debt (withshort-term obligations receiving a greater weight inthe calculation) to domestic-currency denominateddebt. In general, we might think of the dangerousinteractions between currency and debt market con-ditions as introducing the possibility of inter-sectoralcontagion risk.

Fragility risk is also introduced whenever eco-nomic actors finance private investment with capitalthat is either highly subject to reversal, is highlyvulnerable to changes in the price at which addi-tional funds are forthcoming, or is highly vulnerable

to changes in the value of the underlying collateralthat supports the investment. For instance, commer-cial real estate often serves as collateral for bankloans. A decline in real estate prices can then under-mine bank balance sheets. This type of fragility riskraises the specter of inter-sectoral contagion. Tripwires that illuminate the fragility risk associated withparticular financing strategies are discussed belowin the context of flight risk.

Finally, fragility risk is introduced whenevereconomic actors finance their projects with highlyrisky, non-transparent financial instruments, such asderivatives or off-balance sheet activities, more gen-erally. For example, in the case of derivatives thesudden necessity to meet collateral requirementsoften requires the selling of some other securities(often not in an area yet hit by turmoil).16 This forcedselling spreads turmoil to other sectors of the finan-cial system, and ultimately can inaugurate difficultiesin the economy as a whole.

The risk that arises from off-balance sheet ac-tivities such as derivatives is not amenable to tripwires precisely because data on these activities arenot readily available. For this reason, it is my viewthat these activities have no place in developingeconomies because they introduce far too much fi-nancial risk (e.g., foreign exchange exposure) tofinancial systems that are already quite vulnerable.Indeed, research on the East Asian crisis illuminatesthe important role that off-balance sheet activitiesplayed in the crisis (Dodd, 2001; Neftci, 1998;Kregel, 1998). Thus, financial regulators in devel-oping countries might consider banning the use ofthese activities altogether. An alternative directionfor policy towards derivatives is to mandate theirtransparency, such that these transactions appear onfirm balance sheets. See Dodd (2002) for discus-sion of transparency and other aspects of prudentialfinancial regulation vis-à-vis derivatives in devel-oping economies. With transparency it would bereasonable to think about the development of appro-priate trip wires (and speed bumps) for derivatives.

3.2.3.Trip wires for flight risk

Lender flight risk refers to the possibility thatprivate, bi-, or multi-lateral lenders will call loansor cease making new loans in the face of perceiveddifficulty. An indicator of lender flight risk is theratio of official reserves to private and bi-/multi-


lateral foreign-currency denominated debt (withshort-term obligations receiving a greater weight inthe calculation).

Portfolio investment flight risk refers to thepossibility that portfolio investors will sell off theassets in their portfolio, causing a reduction in assetprices and increasing the cost of raising new sourcesof finance. Vulnerability to the flight of portfolioinvestment can be measured by the ratio of total ac-cumulated foreign portfolio investment to grossequity market capitalization or gross domestic capi-tal formation.

Lender and portfolio investment flight risk of-ten creates a self-fulfilling prophecy that deflatesasset and loan collateral values, induces bank dis-tress and elevates ambient economic risk. In addition,lender and/or portfolio investment flight risk caninteract with currency risk to render the economyvulnerable to financial crisis causing inter-sectoralcontagion.

3.2.4.Trip wires for cross-border contagion risk

Cross-border contagion risk refers to the threatthat a country will fall victim to financial and macr-oeconomic instability that originates elsewhere. Thisthreat has been amply demonstrated in recent years,of course. It would seem that a trip wire-speed bumpapproach must take account of this risk. Fortunately,this mechanism is well suited to the task: a trip wireis activated in �country A� whenever crisis condi-tions emerge in �country B� or whenever speedbumps are implemented in �country B�, assumingthat policymakers in �country A� have reason toexpect that investors would view countries A and Bin a similar light (correctly or incorrectly).

3.3. Speed bumps

Speed bumps are narrowly targeted, gradualchanges in policies and regulations that are activatedwhenever trip wires reveal particular vulnerabilitiesin the economy. (See table 1 for a summary of thetrip wires and speed bumps presented here.)

The trip wire-speed bump strategy is straight-forward. It would be the task of policymakers within

their own countries to establish appropriate thresh-olds for each trip wire, taking into account thecountry�s particular characteristics (e.g., size, levelof financial development, regulatory capacity) andits unique vulnerabilities (e.g., existing conditionsin the domestic banking system, stock market, cor-porate sector, etc.). Critical values for trip wires andthe calibration of speed bumps would be revised overtime in light of experience, changes in the economy,and improvements in institutional and regulatorycapacity.

Sensitive trip wires would allow policymakersto activate graduated speed bumps at the earliest signof heightened risk, well before conditions for inves-tor panic had materialized (cf. Neftci, 1998; Taylor,1998). When a trip wire indicates that a country isapproaching trouble in some particular domain (suchas new short-term external debt to GDP has increasedover a short period of time), policymakers could thenimmediately take steps to prevent crisis by activat-ing speed bumps. Speed bumps would target the typeof risk that is developing with a graduated series ofmitigation measures that compel changes in financ-ing and investment strategies and/or dampen marketliquidity.

Trip wires could indicate to policymakers andinvestors whether a country approached high levelsof currency risk or particular types of fragility orflight risk. The speed bump mechanism providespolicymakers with a means to manage measurablerisks, and in doing so, reduces the possibility thatthese risks will culminate in a national financial cri-sis. Speed bumps affect investor behaviour directly(e.g., by forcing them to unwind risky positions, byproviding them with incentives to adopt prudent fi-nancing strategies, etc.) and indirectly (by reducingtheir anxiety about the future). Together, their ef-fects mitigate the likelihood of crisis. Those countriesthat have trip wires and speed bumps in place wouldalso be less vulnerable to cross-country contagion be-cause they would face lower levels of risk themselves.

3.3.1.Specific speed bumps for the risks revealedby trip wires

Speed bumps can take many forms. A range ofpossible speed bumps that correspond to the spe-cific financial risks illuminated by trip wires ispresented below.


Table 1

KEY FINANCIAL RISKS CONFRONTING DEVELOPING COUNTRIES;AND EXAMPLES OF ASSOCIATED TRIP WIRES AND SPEED BUMPS

Key financial risks Examples of trip wires Examples of speed bumps

Trip wires measure the types of Speed bumps are narrowly targeted,financial risks that confront individual gradual changes in policies and regulations economies. that are activated whenever trip wires

reveal particular vulnerabilities inthe economy.

Currency risk

Investors flee currency, Ratio of official reserves to total short- Limit the fluctuation of theinducing sudden, dramatic term external obligations (the sum of domestic currency value. ORdepreciation. accumulated foreign portfolio

investment and short-term hard-currency Restrict currency convertibility in a varietydenominated foreign borrowing). OR of ways (e.g., foreign exchange licensing,

selective currency convertibility, controlsRatio of official reserves to the over non-resident access to the domesticcurrent account deficit. currency).

Flight risks

Portfolio investmentPortfolio investors sell Ratio of total accumulated foreign Graduated series of speed bumps would slowoff a country�s assets, portfolio investment to gross equity the entrance of new inflows until the ratiocausing a reduction in market capitalization or gross domestic falls either because domestic capitalasset prices and increasing capital formation. formation or gross equity marketthe cost of raising new capitalization increased sufficiently or becausesources of finance. foreign portfolio investment falls. OR

Outflow controls can be employed.

LenderPrivate, bi-, or multi-lateral Ratio of official reserves to private and Preclude new inflows of foreign loanslenders call loans or cease bi-/multi-lateral foreign-currency (particularly those with a dangerous maturitymaking new loans in the face denominated debt (with short-term and/or locational profile) untilof perceived difficulty. obligations receiving a greater circumstances improved. OR

weight in the calculation).Use the tax system to discourage domesticborrowers from incurring new foreign debtobligations (e.g., surcharges based onmaturity/locational structure of loans,level of indebtedness of particularborrowers, or type of activity financedby foreign loan).


Fragility risks (in general)

Shocks that jeopardize the abilityof private and public borrowers tomeet current obligations.

Locational mismatchProliferation of debts that Ratio of foreign-currency denominated Locational and/or maturity mismatch could beare repayable in foreign debt (with short-term obligations mitigated by a graduated series of speed bumpscurrency. receiving a greater weight in the that require borrowers to reduce their extent

calculation) to domestic-currency of locational or maturity mismatch. ORdenominated debt.

Impose surcharges or ceilings on financingstrategies that involve loc./maturity mismatchwhenever trip wires reveal the early emergenceof these vulnerabilities.

Maturity mismatchProliferation of long-term Ratio of short-term debt to long-term See speed bump for locational mismatchdebts financed with debt (with foreign-currency denominated above.short-term credit. obligations receiving a greater weight in

the calculation).

Off-balance sheetProliferation of financing This type of fragility risk is not amenable Policy options: ban the use of non-transparentstrategies that involve risky, to trip wires precisely because data on instruments in developing countries. ORnon-transparent financial these activities are not readily available.instruments. Mandate the transparency of these

instruments so that trip wires and speedbumps can be devised.

Cross-border contagion riskGuilt by association: threat Trip wire is activated in �country A� See discussion of trip wire for cross-border induced by crisis abroad. whenever crisis conditions emerge in contagion risk (left column).

�country B� or whenever speed bumpsare implemented in �country B�, assuming Note: Well-functioning trip wires andthat policymakers in country A have speed bumps would reduce levels ofreason to expect that investors would financial risk in the economy, and as aview countries A and B in a similar light consequence, mollify anxious investors.(correctly or incorrectly). Moreover, trip wires and speed bumps

would increase the resilience of aneconomy to a speculative attack wereit nevertheless to materialize.

Table 1 (concluded)

KEY FINANCIAL RISKS CONFRONTING DEVELOPING COUNTRIES;AND EXAMPLES OF ASSOCIATED TRIP WIRES AND SPEED BUMPS

Key financial risks Examples of trip wires Examples of speed bumps


3.3.1.i.) Speed bumps for currency risk.

Currency risk can be managed through activa-tion of speed bumps that limit the fluctuation of thedomestic currency value or that restrict currencyconvertibility in a variety of ways. The fluctuationof the domestic currency might be managed througha short-term programme of sterilized intervention.

Historical and contemporary experience dem-onstrates that there are a variety of means by whichcurrency convertibility can be managed. For in-stance, the government can manage convertibilityby requiring that those seeking access to the cur-rency apply for a foreign exchange license. Thismethod allows authorities to influence the pace ofcurrency exchanges and distinguish among transac-tions based on the degree of currency and financialrisk associated with the transaction. The governmentcan suspend or ease foreign exchange licensing as atype of speed bump whenever trip wires indicate theearly emergence of currency risk.

The government can also activate a policy ofselective currency convertibility, if trip wires illu-minated the emergence of currency risk. Specifically,a speed bump might allow the currency to be con-vertible for current account transactions only. It isimportant note that the IMF�s Articles of Agreement(specifically, Article 8) provide for this type of se-lective convertibility.

Another type of speed bump might allow thegovernment to curtail (but not eliminate) the possi-bility that non-residents will speculate against thedomestic currency by controlling their access to it.This can be accomplished by preventing domesticbanks from lending to non-residents and/or bypreventing non-residents from maintaining bank ac-counts in the country. The Malaysian Governmenttook precisely these steps in the aftermath of theAsian financial crisis. It restricted foreigners� accessto the domestic currency via restrictions on banklending and bank account maintenance and bydeclaring currency held outside the country incon-vertible.

3.3.1.ii.) Speed bumps for lender flight risk.

Policymakers would monitor a trip wire thatmeasures the economy�s vulnerability to the cessa-tion of foreign lending. If the trip wire approachedan announced threshold, policymakers could then

activate a graduated speed bump that precluded newinflows of foreign loans (particularly those with adangerous maturity and/or locational profile) untilcircumstances improved.

Alternatively, a speed bump might rely uponthe tax system to discourage domestic borrowersfrom incurring new foreign debt obligations when-ever trip wires indicated that it would be desirableto slow the pace of new foreign borrowing.17 In thisscenario, domestic borrowers might pay a fee to thegovernment or the central bank equal to a certainpercentage of any foreign loan undertaken. This sur-charge might vary based on the structure of the loan,such that loans that involve a locational or maturitymismatch incur a higher surcharge. Surcharges mightalso vary based on the level of indebtedness of theparticular borrower involved, such that borrowerswho already hold large foreign debt obligations facehigher surcharges than do less-indebted borrowers.This tax-based approach would encourage borrow-ers to use (untaxed) domestic sources of finance.Surcharges might also vary according to the type ofactivity that was being financed by foreign loans.For instance, borrowers might be eligible for a par-tial rebate on foreign loan surcharges when loansare used to finance export-oriented production.

Note that policymakers in Chile and Colombiaemployed several types of tax-based policies to dis-courage foreign borrowing during much of the 1990s.Consistent with the trip wire-speed bump approach,the level and scope of these taxes were adjusted asdomestic and international economic conditionschanged. For instance, in Chile, foreign loans faceda tax of 1.2 per cent per year (payable by the bor-rower), and all foreign debts and indeed all foreignfinancial investments in the country faced a non-in-terest bearing reserve requirement tax during thistime. In Colombia, foreign loans with relativelyshort-maturities faced a reserve requirement tax of47 per cent, and foreign borrowing related to realestate transactions was simply prohibited.18

3.3.1.iii.) Speed bumps for portfolio investment flightrisk.

If a trip wire revealed that a country was par-ticularly vulnerable to the reversal of portfolioinvestment inflows, a graduated series of speedbumps would slow the entrance of new inflows un-til the ratio falls either because domestic capitalformation or gross equity market capitalization in-


creased sufficiently or because foreign portfolio in-vestment falls. Thus, a speed bump on portfolioinvestment would slow unsustainable financing pat-terns until a larger proportion of any increase ininvestment could be financed domestically. I empha-size the importance of speed bumps governinginflows of portfolio investment because they exerttheir effects at times when the economy is attractiveto foreign investors, and so are not as likely as out-flow restrictions to trigger investor panic. Thoughnot a substitute for outflow controls, inflow restric-tions also reduce the frequency with which outflowcontrols must be used, and their magnitude.19

Consistent with the trip wire-speed bump ap-proach, Malaysian authorities twice imposed tem-porary, stringent restrictions over portfolio investmentin the 1990s. The first such effort was in early 1994.At that time, the Malaysian economy received dra-matic increases in the volume of private capitalinflows (including, but not limited to, portfolio in-vestment). Policymakers were concerned that theseinflows were feeding an unsustainable speculativeboom in real estate and stock prices and were creat-ing pressures on the domestic currency. In this con-text, policymakers implemented stringent, temporaryinflow controls. These measures included restrictionson the maintenance of domestic currency-denomi-nated deposits and borrowing by foreign banks, con-trols on the foreign exchange exposure of domesticbanks and large firms, and prohibitions on the saleof domestic money market securities with a matu-rity of less than one year to foreigners. Reaction tothese measures was rapid and dramatic, so much sothat authorities were able to dismantle them asplanned in under a year (as they achieved their goalsduring this time). The immediate, powerful reactionto these temporary controls underscores the poten-tial of speed bumps to stem incipient difficulties suc-cessfully.

The Malaysian Government again implementedstringent controls over capital inflows and outflowsin 1998 during the East Asian crisis. This effort in-volved restrictions on foreign access to the domesticcurrency, on international transfer and trading of thecurrency, and on the convertibility of currency heldoutside of the country. The Government also estab-lished a fixed value for the domestic currency, closedthe secondary market in equities, and prohibited non-residents from selling local equities held for lessthan one year. By numerous accounts, these ratherstringent measures prevented the further financial

implosion of the country � a notable achievementsince the country was also gripped by a severe po-litical and social crisis during this time. Comparingthe situation of Malaysia to other countries that wereparty to the East Asian crisis, studies find that thecountry�s capital controls were responsible for thefaster recovery of its economy and stock market aswell as the smaller reductions in employment andwages (Kaplan and Rodrik, 2002). The latter achieve-ments were possible because capital controls providedthe Government with the ability to implementreflationary economic and social policies uninhib-ited by the threat of additional capital flight or IMFdisapproval.

As discussed in the context of speed bumps onforeign borrowing, policymakers in Chile and Co-lombia adjusted restrictions on portfolio investmentduring much of the 1990s as domestic and interna-tional circumstances warranted. Consistent with thetrip wire-speed bump approach, many other devel-oping countries (such as China and India) haveadjusted their restrictions on portfolio investment ascircumstances warranted. (For details, see Grabel(2003b), Epstein, Grabel and Jomo K. S. (2004), andChang and Grabel (2004: ch.9)).

3.3.1.iv.) Speed bumps for fragility risks.

The fragility risk that stems from excessive re-liance on inflows of international portfolioinvestment or foreign loans could be curtailed bythe speed bumps that focus on these types of flightrisks (see above). The fragility risk from locationaland/or maturity mismatch could be mitigated by agraduated series of speed bumps that requires bor-rowers to reduce their extent of locational or maturitymismatch by unwinding these activities, or by im-posing surcharges or ceilings on them whenevertrip wires revealed the early emergence of thesevulnerabilities. Recall that speed bumps for off-balance sheet activities necessitate legislating theirtransparency.

3.3.1.v.) Speed bumps for cross-border contagionrisks.

A trip wire-speed bump programme that re-duces currency, flight and fragility risks would renderan individual economy far less vulnerable to cross-border contagion. This is because well-functioningtrip wires and speed bumps would reduce levels offinancial risk in the economy, and as a consequence,


mollify anxious investors. Moreover, trip wires andspeed bumps would increase the resilience of aneconomy to a speculative attack were it neverthe-less to materialize.20 This certainly helps to accountfor the resiliency of the Chilean, Malaysian and othereconomies during recent financial crises. (See sec-tion 3.2.4 above for further discussion of trip wiresand speed bumps for cross-border contagion.)

3.3.2.Considerations in the design of speed bumps

There are several guidelines that might guidethe design of speed bumps in particular countries.

Speed bumps that govern inflows are prefer-able to those that govern outflows because measuresthat target outflows are more apt to trigger and ex-acerbate panic than to prevent it.21 This does notmean that outflow controls are not useful duringtimes of heightened vulnerability, especially if thegovernment uses the �breathing room� garnered bytemporary outflow controls to make changes in eco-nomic policy or to provide time for an investor panicto subside. Indeed, Malaysia�s successful use of tem-porary controls on outflows in 1994 and again in1998 shows that temporary outflow controls can pro-tect the economy from cross-border contagion riskin a time of heightened financial risks.

Graduated, modest, and transparent speedbumps can address a financial risk before it is toolate for regulators to take action. Such speed bumpsare also less likely to cause an investor panic.

Finally, should speed bumps be automatic (i.e.,rule based) or subject to policymaker discretion?Automatic speed bumps have the advantage oftransparency and certainty, attributes that may beparticularly important to investors. They also havelower administrative costs. But discretionary speedbumps have advantages, too. They provide regula-tors with the opportunity to respond to subtle andunique changes in the international and domestic en-vironment. However, discretionary speed bumpshave higher administrative costs and require a greaterlevel of policymaking capacity.

The most prudent answer to the question of dis-cretion is that there is no single, ideal frameworkfor speed bumps in all developing countries. In gen-eral, the best that can be said is that speed bumps

should be largely automatic and transparent in theiroperation, though this does not mean that regulatorscould or even should be expected to eliminate alldiscretion in the activation of speed bumps. It is thetask of national policymakers to determine the ap-propriate balance between automatic and discre-tionary speed bumps, particularly in light of theirassessment of immediate technical capacities.

4. The feasibility of the trip wire-speedbump approach

In what follows, I anticipate and respond to anumber of likely concerns raised by skeptics of thisapproach.

4.1. Concern #1. A trip wire-speed bumpprogramme cannot reduce theunpredictability and volatility of cross-border and/or cross-currency capitalflows. Therefore the utility of thisapproach is questionable.

This approach to policy responds precisely tothe volatility and lack of predictability of cross-bor-der capital and currency flows in largely unregulatedglobal financial markets. Rather than trying to do abetter job of predicting what cannot be predicted (i.e.,financial flows in unregulated global financial mar-kets), this approach manages and �domesticates�otherwise unruly flows.

4.2. Concern #2. The activation of trip wiresand speed bumps might ironically triggerthe very instability that they are designedto prevent.

This is usually referred to as the �Lucas cri-tique�. However, the Lucas critique does not takeaccount of the possibility that if an economy is lessfinancially fragile by virtue of a trip wire-speed bumpprogramme, then investors and lenders will not beso likely to rush to the exits at the first sign of diffi-culty. Moreover, an economy in which financial risksare curtailed (by trip wires and speed bumps) will bemore resilient in the face of investor/lender flight risk.


The EWS magnifies the problem highlightedby Lucas because this mechanism is crude and blunt.The trip wire-speed bump approach entails moder-ate and graduated responses to small changes inconditions. The activation of speed bumps is there-fore not apt to trigger market anxiety in the sameway as an EWS announcement of pending crisis.

4.3. Concern #3. The trip wire-speed bumpproposal is unnecessary because privateinvestors and credit rating agencies cando a better job of identifying financialvulnerabilities than can governments.

There is no reason to expect that private inves-tors will identify financial risks as they emerge, andengage in behaviours that curtail these risks. More-over, the panicked responses of private foreign anddomestic investors to identified risks can actually ag-gravate � rather than ameliorate � financial instability.Indeed, we saw precisely this dynamic unfold in all ofthe recent financial crises in developing countries.

The experience of the East Asian crisis providesno basis to expect that trip wires and speed bumpsare unnecessary since private credit rating agenciesprovide useful diagnostics on emerging financialvulnerabilities. Indeed, evidence shows that assess-ments by private credit rating agencies failed tohighlight emerging problems in Argentina, Turkey,East Asia and Turkey (Reisen, 2002; Goldstein,Kaminsky, Reinhart, 2000: ch. 4).

By contrast, there is ample evidence thatpolicymakers in a large number of developing coun-tries have effectively curtailed particular financialrisks in their own economies by modifying existingfinancial regulations and even implementing newones as circumstances warranted. Indeed, Epstein,Grabel and Jomo K.S. (2004) show that from the1990s to early 2003 policymakers in Chile, Colom-bia, China, Taiwan Province of China, India,Singapore and Malaysia tightened existing regula-tions and implemented new ones when financialvulnerabilities were identified. The success of thesestrategies illustrates the broader potential of a tripwire-speed bump approach.

4.4. Concern #4. Trip wires and speed bumpswill not achieve their objectives becauseeconomic actors will evade them.

Policy evasion (in any domain of policy) can-not be ignored. In the case of trip wires and speedbumps, financial innovation may provide a meansfor some economic agents to evade these polices.However, the middle-income countries that have themost to gain by trip wires and speed bumps are alsoin the best position to enforce them. It is also impor-tant to acknowledge that a degree of policy evasiondoes not imply policy failure (see Grabel, 2003b).This is clearly illustrated by the achievements ofnumerous financial controls in the Republic of Ko-rea, Chile, Colombia, Malaysia, China, TaiwanProvince of China, and Singapore. It is imperativethat the particular speed bumps adopted be consist-ent with national conditions, including state/regulatorcapacity.

4.5. Concern #5. Many developing countriesdo not have the technical policy-makingcapacity that is necessary for the successof trip wires and speed bumps.

It is certainly true that policy-making capacitydiffers dramatically across developing countries.Those developing countries (generally speaking,middle-income countries) that have the highest lev-els of policy-making capacity are certainly in thebest position to utilize trip wires and speed bumps.This is, in some sense, a happy coincidence becausepolicymakers in these same countries have the mostto gain by curtailing many of the financial risks thatare targeted by trip wires and speed bumps.

It also bears mentioning that the technical pre-requisites for operating trip wires and speed bumpsare no greater than those that are demanded ofpolicymakers that operate in an environment of lib-eralized, internationally integrated financial markets.Moreover, technical capacity can be acquired. Sup-port for increased education and technical trainingof financial policymakers by the Bretton Woods in-stitutions could be fruitful, particularly in smaller,low-income countries where financial policymakers


may have had less opportunity to develop highlevels of capacity. Regional cooperation amongdeveloping countries and/or the leadership of mid-dle-income countries is another avenue for increasingthe capacity of smaller, low-income countries todesign and utilize trip wires and speed bumps thatare most germane to their economies.

4.6. Concern #6. The negative reaction of theBretton Woods institutions, the UnitedStates Government and/or internationalinvestors is an obstacle to the implemen-tation of trip wires and speed bumps.

It is certainly true that these actors have indi-vidually and collectively been quite corrosive ofpolicy autonomy in developing countries over thelast two decades. But there are several reasons to becautiously optimistic about the political feasibilityof a trip wire-speed bump programme.

First, recent studies (by academics, policy-makers and even the IMF) have concluded thatcertain types of financial controls in developingcountries have enabled developing countries to man-age the challenges and opportunities associated withglobal financial integration (Grabel, 2003b; Grabel,2003e; Epstein, Grabel and Jomo K. S., 2004; Prasad,Rogoff, Wei, and Kose, 2003; Ariyoshi et al., 2000).

Second, the position of negotiators for Chileand Singapore in their individual discussions withthe United States on bilateral free trade agreementsis heartening. In these negotiations, these representa-tives vigorously defended their countries� rights toactivate temporary financial controls during timesof financial crisis. Though the Bush administrationsteadily refused this point, the final agreementsreached did incorporate these rights, though in at-tenuated forms (e.g., under certain circumstancesUnited States investors have the right to sue eithercountry for losses incurred as a consequence of thecapital controls).22 On a related note, the assertive-ness and the expression of solidarity among manydeveloping countries at the Cancun WTO talks inSeptember 2003 may signal a greater resolve to pressthe case that new types of trade and financial poli-cies are needed at the present time.

Third, there may be reason to expect that for-eign investors value financial stability in developingcountries. Indeed, there is no empirical evidence thatforeign investors shun developing countries that havewell functioning financial controls in place, providedthat they also offer investors attractive opportuni-ties and an environment of economic growth. It maybe the case that in the post-Asian, post-Argentineancrisis environment, developing countries with wellfunctioning and transparent financial controls mighthave a comparative advantage in attracting interna-tional private capital inflows.

Fourth, as mentioned in section 3.1.2., circuitbreakers and price limits in United States stock mar-kets and futures exchanges are utilized effectivelyby regulators. This suggests that the broader tripwire-speed bump approach presented here may ulti-mately be accepted as a necessary evil even byadvocates of liberalized markets, since it appears thatplay an important, beneficial role even in the mostadvanced financial markets in the world.

4.7. Concern #7. Countries that implementtrip wires and speed bumps will faceincreased capital costs and lower rates ofeconomic growth.23

Contrary to the predictions of orthodox eco-nomic theory, there is no unambiguous empiricalevidence of a tradeoff between speed bumps andincreased capital costs or reduced economic growth.24

This may be because although foreign investorsvalue the liquidity associated with unregulated fi-nancial markets, they may come to favour econo-mies that give them less reason to fear financial crisis(since during sudden crises liquidity is jeopardized).For this reason, developing economies as a wholemight find it substantially easier and less costly toattract private capital flows if they reduced their vul-nerability to crisis through collective implementa-tion of trip wire-speed bump policies. In short, andcontrary to orthodox economic predictions, the�hurdle rate� (the anticipated return sufficient to in-duce investment) might actually decline followingthe imposition of regulations that, in the first in-stance, reduce investor freedoms to liquidate theirholdings.


4.8. Summary

Critics are likely to advance many argumentsagainst the feasibility and utility of a trip wire-speedbump approach. Upon examination, I find these ar-guments unconvincing.

Trip wires and speed bumps represent one newdirection for managing the financial risks that areidentified by national policymakers. The chief ad-vantages of this approach are that it can target onlythose risks that policymakers deem most important,it can be implemented gradually, it is transparent,and it provides a way for developing countries topursue international financial integration withoutincreasing the likelihood of financial crises.

Notes

1 The case of the European currency crisis of 1992�1993is a notable exception in the recent literature as this cri-sis involved wealthy countries. Like the financial crisesin the developing world over the last decade, the Euro-pean currency crisis stimulated a rather large body ofetiological research. (Section 2 below briefly discussesresearch on the European currency crisis and the cur-rency crises in wealthy countries in the 1970s.)

2 Certainly, other analysts present alternative views on theetiology of financial crises in developing countries. Forinstance, some explain it as the product of widespreadcronyism and corruption in developing countries, othersas the outcome of policy mistakes (such as the mistakendecision to maintain a soft or a hard currency peg), andothers as the outcome of a rational self-fulfilling proph-ecy. Concise and somewhat critical reviews of this lit-erature appear in Eichengreen (1999: App. B) and Arias(2003). More extensive critiques appear in the studiesof the link between financial crisis and financial liber-alization (see above for citations), and also in Chang(1998) and Grabel (1999).

3 Accordingly, parts of the discussion in sections 2 and 3below draw heavily on Grabel (1999, 2003a, 2003b). Sec-tion 3 draws modestly on Chang and Grabel (2004: ch. 9.).

4 The vast theoretical literature on currency crises is re-viewed in Arias (2003), Eichengreen (1999, App. B),Goldfajn and Valdés (1997), and Kaminsky, Lizondo,Reinhart (1997). Many reviews of the literature correctlypoint out that the differences between the first and sec-ond generation models of crises are far less importantthan their architects suggest (e.g., this point is made byEichengreen (1999) and Arias (2003)).

5 See Eichengreen and Portes (1997) and the papers col-lected in Kenen (1996) for a summary and evaluation ofthe decisions taken at the Halifax Summit. These worksalso discuss the recommendations of the Rey Commit-tee (formed at Halifax) and the decisions taken at the1996 G-7 Summit (in Lyons) on crisis prevention andthe need for information dissemination.

6 General descriptions of these two approaches draw onEdison (2000), Goldstein, Kaminsky and Reinhart(2000), and Sharma (1999).

7 Goldstein, Kaminsky and Reinhart (2000) draw on the�signals methodology� elaborated in Kaminsky andReinhart (1999) and other related work by these authors,e.g., Goldstein (1997a), Kaminsky, Lizondo, Reinhart(1997), and Kaminsky and Reinhart (2000). The descrip-tion of the authors� empirical findings is taken fromGoldstein, Kaminsky and Reinhart (2000: ch. 8).

8 Note that they find that banking crises in developingeconomies are harder to predict using monthly data thanare currency crises.

9 They acknowledge that their EWS would neither havepredicted difficulties in Indonesia during the Asian cri-sis, nor Argentina�s difficulties following the Mexicancrisis.

10 Indeed, numerous IMF reports on Argentina during the1990s extolled the virtues of the country�s currency boardand made a case for its export to other developing coun-tries (Grabel 2000, 2003c).

11 I discuss the relevance of this issue in the context of thetrip wire-speed bump approach in section 3 below.

12 Financial liberalization is a variable that rarely figuresinto EWS models. Kaminsky and Reinhart (1999) are anexception among orthodox economists in this regard.

13 I thank James Crotty for bringing this point to my atten-tion. Lowenstein (2000) on the failure of Long TermCapital Management.

14 I thank Randall Dodd for raising this point.15 Of course, rapid currency appreciation can also cause

problems from the perspective of export performance.Though this is beyond the scope of this paper, the tripwire-speed bump approach could also address this �traderisk�.

16 I thank Randall Dodd for raising this point.17 Tax-based speed bumps on foreign borrowing are dis-

cussed in Chang and Grabel (2004: ch. 9).18 Grabel (2003b, 2003d) for further details on tax-based

policies in Chile and Colombia; and Epstein, Grabel andJomo K. S. (2004), and Chang and Grabel (2004: ch. 10)for details on policies toward foreign borrowing in otherdeveloping countries.

19 Outflow controls can play a useful role in some circum-stances as suggested by Malaysia�s experience in 1998.

20 The reduction in financial risks associated with trip wiresand speed bumps would also increase the economy�sresilience to external shocks.

21 The same argument regarding inflow versus outflowcontrols pertains to speed bumps that compel investorsto unwind risky positions. It is preferable to employ speedbumps that provide incentives to change new financingbehaviour rather than those that force investors to un-wind existing positions (as the latter can trigger a crisisin other sectors).

22 For instance, investors can sue for losses only when re-strictions on the sale of bonds and FDI extends beyondsix months. For other financial assets, the �cooling offperiod� is twelve months.

23 Discussion in this subsection borrows heavily fromGrabel (2003b).

24 See Edwards (1999) for a dissenting view on capital costsin Chile during its financial controls of the 1990s. SeeEpstein, Grabel and Jomo K. S. (2004) for a critical re-sponse to Edwards.


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