chapter  17
25 Pages

The future of global financial markets


Forecasting is always difficult, especially when it involves the future. More than the usual degree of difficulty is involved when the task is forecasting the future of global financial markets. In the mid-1970s, when Ernesto Zedillo, the editor of this volume, and I were in graduate school at Yale, global financial markets and private capital flows to developing countries were just awakening after a long period of somnolence. Those who anticipated that World Bank loans and official development assistance would remain the predominant sources of external finance for developing countries were surprised by the rapid growth of bank lending to Latin America and Eastern Europe by money-center banks recycling the surpluses of oil exporters and selected industrial economies. But no sooner had these facts been assimilated than lending to emerging markets collapsed in 1982 in response to rising interest rates in the US and UK and debt crises in the developing world. The result was the lost decade of the 1980s, when resources flowed upstream from developing to developed economies and growth stagnated in Latin America. The inability of governments to credibly commit to repay their borrowings, it was argued, constituted a fundamental obstacle to sovereign lending to emerging markets, and efforts by the International Monetary Fund to paper over the cracks were dismissed as creating more problems than they solved.2 But no sooner had observers accustomed themselves to this brave new world than nonperforming bank loans were converted into bearer bonds. The Brady Plan jump-started the market in fixed income securities, which quickly became the vehicle for renewed lending to emerging markets.3 Bond markets transferred an impressive quantity of resources to developing countries in the course of the 1990s, but the decade was also punctuated by a series of emerging-market crises that repeatedly interrupted the flow of finance, sent spreads skyrocketing, and prompted emergency intervention by the IMF. This period drew to a close with Argentina’s default at the end of 2001. Borrowers and lenders drew back from the market as if they had finally taken the lessons of the 1990s to heart. Developing countries shifted from external deficit to surplus, accumulating unprecedented quantities of international reserves. They repaid external debt to their private creditors and the IMF. By early 2006, no major Latin American or Asian country was in debt to the IMF, and virtually the

entire stock of Brady bonds had been retired from the market.4 The United States emerged as the world’s principal deficit country and capital importer, absorbing some two-thirds of the net savings of the rest of the world. But the idea, which gained currency following the Argentine crisis, that international investors had learned that the returns from lending to emerging markets did not justify the risks was again dissolved by the subsequent resurgence of flows into local markets and the decline in emerging market spreads to unprecedented lows (below 200 basis points in the spring of 2006).