How To Prevent A Financial Crisis And Avoid A Domino Effect

Roubini urged political forces to “stop bickering in public" about what the accurate policy response should be and realise that in such “dangerous times" political uncertainty leads to policy uncertainty and that cannot be good for “nervous and trigger happy investors".

He believes that if Hungary goes bust the risk of a domino effect would be significant as many of the economies in Emerging Europe share the same vulnerabilities as Hungary. 

Domino effect looms

With stock markets sharply down, interest rates up, the forint weaker and financial institutions short of liquidity Hungary is currently at the centre of financial pressures in emerging markets, Roubini said.

“A fully-fledged currency and financial crisis can still be avoided with appropriate and coherent policy actions but the financial pressures have intensified in the last week," Roubini said.

While the macro, financial and policy weaknesses of Hungary are not new, it was the global financial crisis that has been the external trigger leading to a liquidity and credit crunch, the risk of a sudden stop and of a reversal of capital inflows.

Among Hungary's key vulnerabilities Roubini mentioned a large current account deficit, a still excessive fiscal deficit, a partially overvalued currency, serious maturity and currency mismatches in the financial system, the household sector and the corporate sector, low stock of foreign reserve and high level of short term foreign currency debt that is at risk of a roll-off.

“However, at this point the crucial issue [...] is to figure out what are the possible policy actions that may restore confidence and prevent and currency and financial crisis."

Roubini believes such a crisis would be “devastating not only for Hungary but also for the Emerging Europe region".

“If Hungary goes bust the risk of a domino effect - like the one that in 1997 led the East Asian crisis to spread from Thailand to Malaysia, Indonesia and Korea - would be significant as many of the Emerging Europe region economies share the same vulnerabilities as Hungary (and indeed significant financial pressures are already underway in Estonia, Latvia, Poland, Romania, Bulgaria and Turkey). A crisis in Hungary would lead to a crisis in a large part of Emerging Europe; so preventing such a crisis in Hungary is essential to prevent a broader regional financial crisis." 

The necessary policy actions

What is necessary to prevent a major crisis:

1) A meaningful further reduction in the fiscal deficit is essential, as large fiscal deficits have been at the centre of concerns by international and domestic investors.

Roubini said that in the current confidence crisis the slashing of the budget deficit to 3.4% of GDP from above 9% in 2006 would not do.

The government revised the fiscal deficit for 2009 to 2.9% from the originally planned 3.2% “but a somewhat stronger fiscal adjustment - towards a 2.5% deficit together with commitments to further structural fiscal consolidation - would help to boost further investors' confidence," Roubini said.

“[...] postponing tax cuts and achieving some reduction in spending is more important as it will lead to a confidence-boosting reduction of the fiscal deficit," he added.

2) The government has now access to EUR 5 billion that were made available by the ECB in a swap operation.

“The willingness of the ECB to “bail out" a country that is not yet member of the Eurozone is quite significant and signals the concerns that EMU members now have about the disruptive effects of a crisis in Hungary."

Roubini also noted that unlike conditionality loans provided by the International Monetary Fund (IMF), the ECB liquidity support comes without any attached string.

Roubini also pondered whether the ECB would lend more if the EUR 5 bn proved not enough and whether the ECB will do similar swaps with other Emerging Europe economies that are likely candidates - in the next few year - for EMU membership.

“Also should Hungary now use this additional international liquidity to prevent a further depreciation of its currency or should it save this additional ammunition in case things get worse?"

3) Hungary may want to consider intervening in the forex market to inflict pain on “speculators" that are shorting the currency.

In Roubini's view, this strategy “is risky if aggressive intervention fails to stem the speculation and fails to reverse the fall in the currency value."

“Also sterilized intervention may not be very effective as it would not increase domestic short-term interest rates and thus make more costly to short the currency."

While he believes unsterilized intervention may be more effective, he notes that it would come at the cost of a sharp increase in short rates. “And if unsterilized intervention is performed the authorities may achieve the same increase in domestic interest rates through domestic open market operations that don't require the use of precious foreign currency reserves."

4) Authorities can try to use an interest rate defense of the currency (that is in principle equivalent to an unsterilized forex intervention). Roubini notes that same approach was taken last week by Romania where overnight and seven day rates have spiked to over 40%.

Roubini also labelled this approach as risky, saying that interest rate defense of a currency under pressure “is costly as a weak economy cannot take - for too long - such a sharp increase in real interest rates."

He said such a move needs to be temporary and should be able to break the back of speculation in a short period of time, i.e. a couple of weeks, or it becomes very expensive and it loses its credibility.

5) Authorities may want to seek an IMF programme as they have signalled in the past week.

Despite worries that a) an IMF programme would be a stigma for the country (as only countries in serious trouble and crisis would apply for it), b) the IMF botched its conditionality in previous EM crisis episodes, an IMF programme “may rather boost confidence and provide much needed foreign currency liquidity necessary to stem speculative pressures," Roubini said.

He believes the IMF might have learned from some of its previous mistakes and should disburse in short order with fewer strings attached international liquidity to countries that are regarded as illiquid but solvent - like Hungary.

He also noted that this time the IMF support would arrive early and not only after the eruption of a full-blown crisis.

“If the country waits too long that IMF support may indeed signal stigma and desperation. Ideally the country should have asked for an early disbursement IMF programme in conjunction with its rapid receipt of the ECB support," Roubini said.

He believes “there is still time to repair the damage and seek a rapid - and short-in-conditionality - IMF liquidity support."

6) The government may have to consider whether a soft bail in of foreign investors, especially foreign banks operating in Hungary, is necessary and desirable.

With about 85% of the banking system in Hungary in foreign hands (mostly Italian, German and Austrian banks), “there is now a risk that such foreign banks may reduce their exposure to their Hungarian subsidiaries and - in an extreme crisis situation - even let such subsidiaries go bust (as some US banks did in Argentina in 2001) if that is necessary to save their home country operation," Roubini said.

At the same time, he pointed out that as Hungarian operations of foreign banks are profitable “it should not be in their interest to roll-off their exposure to Hungary."

On the other hand, he said many European banks have their own domestic stresses...

Let's hope for the best

“So hopefully foreign banks operating in Hungary will maintain their cross-border exposure to Hungarian cross-border operations and will not sharply cut off the provision of new credit to the real economy (a new credit that is rapidly shrinking)," Roubini said.

“But things get sourer and an incipient financial crisis looks like imminent a bail-in of foreign banks operating in Hungary may become necessary to prevent a sharp and destructive roll-off of the cross border exposure," he added.

“Such bail-in of cross border interbank exposure took a more coercive form in the 1997 Korean crisis and a less coercive (voluntary subject to IMF monitoring) form in the 1999 Brazil and 2001 Turkey episodes. But if all else fails and international liquidity support (from ECB and/or IMF) is not sufficient to stop a cross border run on the country's short-term liabilities (especially those of the banking system) such soft or coercive bail-in of foreign banks may become necessary to avoid a more destructive crisis."

Roubini hopes such bail-in will not be necessary or it will take a “soft form".

In the short run authorities should try and convince foreign banks - using moral suasion - to stay in rather than run, he added.

“After all, this crisis of confidence has self-fulfilling elements: if a bank stays in and all the other run, the losses for those who don't roll off their claims would be severe; thus, there is an incentive for every player to rush to the exit in this non-cooperative Nash game."

You there, stop bickering! NOW!

“While the situation is dire, a full-blown crisis can still be prevented in Hungary and in other countries in the region, but rapid and coherent policy action is essential to restore investors' confidence and prevent a destructive currency and financial crisis," Roubini said.

“One should hope that the political forces - government and opposition - will stop bickering in public about what the right policy response should be and realize that the times are dangerous and further political uncertainty leads to policy uncertainty that does not boost confidence for nervous and trigger happy investors." 

Source: Portfolio Online Financial Journal