Understanding The Russian Virus, with special reference to Latin America
Calvo, Guillermo A.
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Although Tequila and Asian crises took the world by surprise and had global repercussions, after a short while financial turmoil remained somewhat regionally confined. Tequila crisis started in Mexico and claimed Argentina as a victim, but the rest of the world was virtually unscathed. Similarly, the Asian crisis began in Thailand and spread all over Asia but did not cause major capital outflows in Latin America. Advanced economies’ financial sectors were little touched by either. Early results, however, strongly suggest that the recent Russian crisis may have more serious implications. Negative effects seem deeper, credit to emerging markets economies, EMs, has frozen, and a major recession in those economies is becoming more likely. Why? This is the central issue addressed in the present note. I will argue that the world capital market is populated by essentially two types of investors: informed, and non-informed (or less-informed). As a general rule, the former lead and the latter follow, and there is no major difference of opinion between the two groups. This system works reasonably well as long as there is no need for one group to carry out a significant portfolio recomposition. For, in that case, one group will have to sell and the other buy. This is precisely what, in my view, happened after Russia’s debt repudiation: the capital loss suffered by Russia’s bond holders, triggered ‘margin calls’ on highly leveraged informed investors, forcing them to sell some of their EM holdings to the other group, i.e., the non-informed (for whom leveraging was less attractive due to their poorer information). This is a complicated operation because the informed investors’ sellout makes the non-informed think that there must be some fundamental problem with EMs. As a result, EM security prices drop by more than can be accounted for by conventional fundamentals. This is key for the explanation offered in this note.
The paper was presented at the Deutsche Bank’s conference on “Emerging Markets: Can They Be Crisis Free?,” Washington, DC, October 3, 1998.