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International Monetary Fund
This Selected Issues paper for Seychelles argues that sound fiscal policies and smaller governments can be conducive to growth and help reduce a country’s economic vulnerability. Growth in Seychelles has been volatile and underperformed most small states from 1998 to 2005. Seychelles’s revenues, expenditures, and total public debt are higher after an improvement in 2003. Its fiscal balance has worsened and has been weaker in comparison with most small states for most of the period. Seychelles’s expenditure composition is most similar to that of low-growth small states.
Mr. V. Hugo Juan-Ramon, Emiliano Basco, Carlos Quarracino, and Mr. Adolfo Barajas
The simple answer to both questions in the title of this paper is: No. We concentrate on the three main risk elements that contributed to the banking system’s difficulties during the crisis: increasing dollarization of the balance sheet, expanding exposure to the government, and, eventually, the run on deposits. We find that there was substantial cross-bank variation in these elements—that is, not all banks were hurt equally by macroeconomic shocks. Furthermore, using panel data estimation for the 1998–2001 period, we find that depositors were able to distinguish high- from low-risk banks, and that individual banks’ exposure to currency and government default risk depended on bank fundamentals and other characteristics. Thus, not all banks behaved equally in the run-up to the crisis. Finally, our results have implications for the existence of market discipline in periods of stress and for banking regulation, which may have led banks to underestimate some of the risks they incurred.
Mr. V. Hugo Juan-Ramon, Emiliano Basco, Carlos Quarracino, and Mr. Adolfo Barajas

foreign currency. A dollarized debt coupled with an overvalued currency 4 implied that the true size of the debt was much greater than it appeared, as was the risk of default. The banking sector was seen to play a part in the crisis as well. Several studies have shown how the macroeconomic imbalances impacted the banking system in the years prior to the crisis, increasing its vulnerability to devaluation and its exposure to government default risk. 5 Eventually, the banking system also suffered a deposit run, which led the government to impose measures that severely

Mr. Adolfo Barajas, Emiliano Basco, Mr. V. Hugo Juan-Ramon, and Carlos Quarracino

currency. A dollarized debt coupled with an overvalued currency 3 implied that the true size of the debt was much greater than it appeared, as was the risk of default. The banking sector was seen to play a part in the crisis as well. Several studies have shown how the macroeconomic imbalances affected the banking system in the years prior to the crisis, increasing its vulnerability to devaluation and its exposure to government default risk. 4 Eventually, the banking system also suffered a deposit run that led the government to impose measures that severely curtailed

International Monetary Fund

’s three commercial banks . Reported banking soundness indicators show that all three banks made profits in 2006 and 2007. However, vulnerability tests indicate that: (i) while two banks would be able to withstand credit, liquidity, or foreign exchange shocks, the third bank remains vulnerable and (ii) all banks are vulnerable to government default risk. The mission recommends: (i) continuing with ongoing efforts to capitalize the banking system through reinvesting of profits, and (ii) strengthening supervision through off-site monitoring and more frequent inspections

Mr. Philip R. Gerson and Mr. Manmohan S. Kumar

’ relative equity prices are the percentage change from October 2009 to June 2010 of banks’ stock market price indexes as a ratio of the overall stock market price index. Other indicators of government default risk confirm increased polarization of market sentiment. Relative asset swap (RAS) spreads—which correspond to the difference between 10-year government bond yields and the fixed-rate arm of interest rate swap contracts denominated in the same currency and for the same maturity—have markedly increased in the Euro area countries under market pressure (Greece

International Monetary Fund

improving private investment and consumption ( Tsibouris and others, 2006 ). Expansionary fiscal contractions have been found to be particularly connected with high-debt countries because the risk premium on interest rates declines and confidence rises when government default risk is lower and there is less probability that taxes will go up ( Perotti, 1999 ). 8. This study of episodes of large fiscal adjustment in small states confirms that in most cases growth actually rose ( Table 1.1 ). An episode of large fiscal adjustment is defined as occurring when the average

Mr. Eswar S Prasad and Raghuram Rajan

bring down government default risk, unless they are fully securitized investors will not give the government the full credit for holding them (since the government or the central bank can always spend those holdings at will – in fact, in a crisis, those reserves will probably vanish, leaving little protection for investors). Not only will investors apply a large discount for potential government mismanagement of reserves, they will not see the reserve holdings as a form of personal diversification. But this discussion also highlights what the government needs to do

Mr. Eswar S Prasad and Raghuram Rajan
In this paper, we develop a proposal for a controlled approach to capital account liberalization for economies experiencing large capital inflows. The proposal essentially involves securitizing a portion of capital inflows through closed-end mutual funds that issue shares in domestic currency, use the proceeds to purchase foreign exchange from the central bank and then invest the proceeds abroad. This would eliminate the fiscal costs of sterilizing those inflows, give domestic investors opportunities for international portfolio diversification and stimulate the development of domestic financial markets. More importantly, it would allow central banks to control both the timing and quantity of capital outflows. This proposal could be part of a broader toolkit of measures to liberalize the capital account cautiously when external circumstances are favorable. It is not a substitute for other necessary policies such as strengthening of the domestic financial sector or, in some cases, greater exchange rate flexibility. But it could in fact help create a supportive environment for these essential reforms.