TRIP WIRES AND SPEED BUMPS: MANAGING FINANCIAL RISKS AND REDUCING THE POTENTIAL FOR FINANCIAL CRISES IN DEVELOPING ECONOMIES

Abstract

This paper investigates the shortcomings of the “early warning systems” (EWS) that are currently being promoted with such vigour in the multilateral and academic community. It then advocates an integrated “trip wire-speed bump” regime to reduce financial risk and, as a consequence, 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 generalized financial crises in developing countries have largely failed. It argues that EWS have failed because they are based on faulty theoretical assumptions, not least that the mere provision of information can reduce financial turbulence in developing countries. Second, the paper advances an approach to managing financial risks through trip wires and speed bumps. Trip wires are indicators of vulnerability that can illuminate the specific risks to which developing economies are exposed. Among the most significant of these vulnerabilities are the risk of large-scale currency depreciations, the risk that domestic and foreign investors and lenders may suddenly withdraw capital, the risk that locational and/or maturity mismatches will induce debt distress, the risk that non-transparent financial transactions will induce financial fragility, and the risk that a country will suffer the contagion effects of financial crises that originate elsewhere in the world or within particular sectors of their own economies. It argues that 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 to each type of trip wire. Third, the paper argues that the proposal for a trip wire-speed bump regime is not intended as a means to prevent all financial instability and crises in developing countries. Indeed, such a goal is fanciful. But insofar as developing countries remain highly vulnerable to financial instability, it is critical that policymakers vigorously pursue avenues for reducing the financial risks to which their economies are exposed and for curtailing the destabilizing effects of unpredictable changes in international private capital flows. Fourth, the paper responds to likely concerns about the response of investors, the IMF and powerful governments to the trip wire-speed bump approach. The paper also considers the issue of technical/institutional capacity to pursue this approach to policy. The paper concludes by arguing that the obstacles confronting the trip wire-speed bump approach are not insurmountable.