The final stage of the Asian crisis – Russia defaults on its debt; this was also the most dramatic stage. The Russian government had significant budget shortfall financed by issuing large amounts of short-term rubble-denominated bonds (GKOs). Attracted by high yields expectations and boom mentality, foreign investors bought GKOs aggressively and assumed that IMF would step in to help in case of emergency. Russia was “too nuclear to fail” -> clearly a problem of moral hazard. Bur GKOs were coming due soon at the rate of 1 bill usd/week, meaning that Russia was raising a new familiar problem: What to do about a country that isn’t prepared to participate adequately in its own rescue? IMF announced a 23 bill usd rescue program, approved by Rubin, as there was always the fear that Russia would sell nuclear material and experts to Iran. Investors were still buying Russian bonds at very high yield in the expectation of being bailed out => providing more money to Russia could do serious harm. The IMF was in Russia, trying to persuade the implementation of needed measures, but US didn’t act any more. Russia announced the devaluation of its ruble and defaulting on its foreign debt. The default triggered immediate consequences for Russian people and financial markets, that became increasingly volatile. But the moral hazard problem diminished. The investors paid highly for their faulty assumptions of the US willingness to support Russia without conditions. The most visible effect from Russia was a time of worrying instability and decline in the stock market (the Dow dropped 357 points), but the greater concern was how long the crisis would last. Japan was doing too little, and Europe was introducing the euro. Long-Term Capital Management……. Brazil – Brazil is the 8th largest world economy and 45% of South American GDP. It also had a fixed currency, large current account and budget deficits, a lot of short-term debt and presidential elections. The turmoil in the bond market, increased by Russia and LTCM, made it difficult and expensive for Brazil to roll-over its debt. But Brazil was willing o reform. The reforms adopted were: cutting spending and raising taxes. But they were unwilling to devalue real, due to the Plan Real that fixed it to the dollar and a devaluation could lead to an inflationary spiral. IMF agreed to support even with a fixed overvalued currency. One of the problem then became the incalculable size of potential domestic capital flight. This can be the largest issue in any crisis recovery. If Brazilians started losing confidence in the country’s currency and converted the reals in dollars, then the potential would exist for vast additional outflows. In Russia, concerns about politics and nuclear were the key; here the external environment was. Demanding Brazil to float the real in the middle of the Asian crisis could be very risky. A disorderly currency devaluation in Brazil could lead to additional currency disruption and contagion elsewhere, and Brazil could go into deeper crisis. The IMF helped Brazil for a while, but Brazil loosened prematurely and didn’t follow the planned actions. The deteriorating fiscal positions led investors to exists, lowering the reserves again. A controlled devaluation seldom works while the trouble has begun. But Brazil’s major US creditors agreed to extend Brazil credit and IMF to release additional funds. Later, the crisis was over in Latin America. Conclusions: - Switching to floating exchange rates, although painful initially, provides the basis for recovery - The combination of international loans and policy reforms have been effective - The financial crisis were not solely a function of the structural and policy problems of developing countries (standard view) but the excess of credit and investment in good times also (Rubin).

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