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The Volatility Machine: Emerging Economies and the Threat of Financial Collapse
This book presents a radically different argument for what has caused, and likely will continue to cause, the collapse of emerging market economies. Pettis combines the insights of economic history, economic theory, and finance theory into a comprehensive model for understanding sovereign liability management and the causes of financial crises. He examines recent financial crises in emerging market countries along with the history of international lending since the 1820s to argue that the process of international lending is driven primarily by external events and not by local politics and/or economic policies. He draws out the corporate finance implications of this approach to argue that most of the current analyses of the recent financial crises suffered by Latin America, Asia, and Russia have largely missed the point. He then develops a sovereign finance model, analogous to corporate finance, to understand the capital structure needs of emerging market countries. Using this
model, he finally puts into perspective the recent crises, a new sovereign liability management theory, the implications of the model for sovereign debt restructurings, and the new financial architecture.
Bridging the gap between finance specialists and traders, on the one hand, and economists and policy-makers on the other, The Volatility Machine is critical reading for anyone interested in where the international economy is going over the next several years.
model, he finally puts into perspective the recent crises, a new sovereign liability management theory, the implications of the model for sovereign debt restructurings, and the new financial architecture.
Bridging the gap between finance specialists and traders, on the one hand, and economists and policy-makers on the other, The Volatility Machine is critical reading for anyone interested in where the international economy is going over the next several years.
272 pages, Hardcover
First published January 1, 2001
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Displaying 1 - 20 of 20 reviews
June 4, 2023
Brilliant book. Having being written in 2001, very prescient about how the future of global liquidity could effect deving economies - though don't think Pettis expected that global liquidity would triple in barely more than 15 years! This in fact is a key disagreement I have - Pettis argues that local factors only matter in that it could cause relative changes in flows between countries, but when liquidity is so flush, local factors can mean that some countries can maintain huge inflows of debt for longer while others can't. This is less to do with the investors themselves, but ties more in line with the question of capital structures itself. When debt stocks are very large, even a very slight slowing down of liquidity can cause some economies to enter crashes even when global liquidity, is for all purposes, massive and rising rapidly. The exploration of his ideas here are brilliant overall, and will definitely be a reread, particularly alongside his newer books.
October 4, 2009
A simple but important thesis, that understanding capital structure is key to understanding volatility. Pettis argues that it is something we take note of at the corporate level, but not at the sovereign level.
Perhaps a more controversial part of the argument is that 'fundamental' policies don't matter for emerging economies when trying to avoid financial crises -- things like eradicating corruption, implementing sustainable value creating growth policies, investing in health and education, good infrastructure, etc. His point is that when there is a great reduction in external liquidity, everyone suffers, and it is those which have defensive capital structures that are best insulated, regardless of their 'fundamental' policies.
The way to reconcile this with traditional growth economists faith in fundamentals, is, I think, the way to reconcile technical and fundamental stock analysis. Looking at liquidity and capital structure is helpful in the short term in times of great liquidity expansion/contraction; but you need good fundamental policies to have relatively stronger economic growth over a long period. Similarly, every stock gets whacked in a big macro correction, but good companies will still outperform over time.
The other interesting point is that 1997-8 is interpreted as a short term liquidity contraction in the middle of a larger, long-term liquidity expansion. While 1931 and presumably 2007-8 are seen as long-term deleveraging cycles. The longer term global liquidity trends make a big difference in how economies perform and how rapidly they can rebound and how strong sustainable growth will be, even aside from good or bad fundamental policies.
Perhaps a more controversial part of the argument is that 'fundamental' policies don't matter for emerging economies when trying to avoid financial crises -- things like eradicating corruption, implementing sustainable value creating growth policies, investing in health and education, good infrastructure, etc. His point is that when there is a great reduction in external liquidity, everyone suffers, and it is those which have defensive capital structures that are best insulated, regardless of their 'fundamental' policies.
The way to reconcile this with traditional growth economists faith in fundamentals, is, I think, the way to reconcile technical and fundamental stock analysis. Looking at liquidity and capital structure is helpful in the short term in times of great liquidity expansion/contraction; but you need good fundamental policies to have relatively stronger economic growth over a long period. Similarly, every stock gets whacked in a big macro correction, but good companies will still outperform over time.
The other interesting point is that 1997-8 is interpreted as a short term liquidity contraction in the middle of a larger, long-term liquidity expansion. While 1931 and presumably 2007-8 are seen as long-term deleveraging cycles. The longer term global liquidity trends make a big difference in how economies perform and how rapidly they can rebound and how strong sustainable growth will be, even aside from good or bad fundamental policies.
February 27, 2020
informative book discussing the role of capital structure for emerging markets. takes a liquidity-oriented view towards cycles of expansion and contraction. between a 4 and a 5 because at times the writing and terminology is ambiguous, but closer to a 5. some key notes:
ch2: illiquidity vs. insolvency, the lack of foreign value buyers in unstable emerging markets
ch3: conjectures that liquidity and the hunt for yield pushes cash from rich nations to poor ones--policy does not pull cash, but virtuous cycle of excess liquidity and policy changes convinces policymakers the changes are working. assets operate on a spectrum of moneyness which can affect money supply and trigger these liquidity spikes.
ch4: examples of liquidity waves are 1820s british lending boom (french indemnity payments, huge bullion reserves without war spending, looser banking requirements), 1860-70s in europe (deposit banks, gold rush, sovereign bonds).
ch5: long-term liquidity contractions vs. short-term credit collapses
ch6: point of capital structure is to allow flexibility + stability while lowering vol and taking good deals. lower vol and lower prob of default = better funding costs. ways to lower vol include less leverage and more correlation (between earnings and liabilities). latter is particularly ignored for sovereigns. example of good = long-term, local currency bonds. bad = short-term, dollar-denominated bonds. "credibility" of a regime should be tied to balance sheet volatility.
ch7: capital structure trap = inverted funding + vicious cycle. mexico 1994 borrowed mainly in short-term peso and dollar bonds. when they devalued, they raised rates to fight capital flight, triggering liquidations and reducing bank lending in a cycle. indonesia 1997 private sector borrowed many dollars. hedging a small rupee break turned into a cycle of selling.
ch8: good list of questions to reference for analyzing asset-side and liability-side correlations. credit asymmetry (borrower owes more when its credit is better) on correlated capital structures. protecting sovereign credit is important because sovereign bankruptcies != corporate ones. sovereign ones basically suck a lot more so investors will remember more and be more cautious to return.
ch9: sovereign restructuring process sucks lol
appendix: can approximate equity with long call, and bonds with short put at debt value and long put at 0 or bond seniority (to limit losses). vol and delta implications follow naturally from this approximation. delta positive and high for bonds far from par, and vega is positive when close to default.
ch2: illiquidity vs. insolvency, the lack of foreign value buyers in unstable emerging markets
ch3: conjectures that liquidity and the hunt for yield pushes cash from rich nations to poor ones--policy does not pull cash, but virtuous cycle of excess liquidity and policy changes convinces policymakers the changes are working. assets operate on a spectrum of moneyness which can affect money supply and trigger these liquidity spikes.
ch4: examples of liquidity waves are 1820s british lending boom (french indemnity payments, huge bullion reserves without war spending, looser banking requirements), 1860-70s in europe (deposit banks, gold rush, sovereign bonds).
ch5: long-term liquidity contractions vs. short-term credit collapses
ch6: point of capital structure is to allow flexibility + stability while lowering vol and taking good deals. lower vol and lower prob of default = better funding costs. ways to lower vol include less leverage and more correlation (between earnings and liabilities). latter is particularly ignored for sovereigns. example of good = long-term, local currency bonds. bad = short-term, dollar-denominated bonds. "credibility" of a regime should be tied to balance sheet volatility.
ch7: capital structure trap = inverted funding + vicious cycle. mexico 1994 borrowed mainly in short-term peso and dollar bonds. when they devalued, they raised rates to fight capital flight, triggering liquidations and reducing bank lending in a cycle. indonesia 1997 private sector borrowed many dollars. hedging a small rupee break turned into a cycle of selling.
ch8: good list of questions to reference for analyzing asset-side and liability-side correlations. credit asymmetry (borrower owes more when its credit is better) on correlated capital structures. protecting sovereign credit is important because sovereign bankruptcies != corporate ones. sovereign ones basically suck a lot more so investors will remember more and be more cautious to return.
ch9: sovereign restructuring process sucks lol
appendix: can approximate equity with long call, and bonds with short put at debt value and long put at 0 or bond seniority (to limit losses). vol and delta implications follow naturally from this approximation. delta positive and high for bonds far from par, and vega is positive when close to default.
September 29, 2023
„any economic entity’s capital structure can be seen as a sort of volatility machine, one of whose main functions is precisely to manage the way external markets impact internal processes“ (p. XI)
Es wird unterschieden zwischen inverted und correlated capital structures:
inverted: revenues und borrowing costs korrelieren negativ zueinander. In guten Wirtschaftszeiten steigen revenues und borrowing costs sinken. Zu schlechten Zeiten hingegen treffen zwei negative Faktoren aufeinander (sinkende revenues und steigende borrowing costs) - zB. short-term debt denominated in USD (growth contractuon > fx depreciation > higher debt)
correlated: Gegenteil von inverted: positive Korrelation: bei sinkenden revenues trifft eine Erleichterung durch sinkende borrowings costs ein - zB. inverse floaters oder fixed-rate local currency debt (growth contraction > fx depreciation > imported inflation > debt inflated away while revenues sink)
Liquidity flows entscheiden oftmals darüber, ob ein Less Developed Country (LDC) Wirtschaftswachstum widerfährt. Dabei spielt es weniger eine Rolle, ob dieses Land vor dem Liquiditätszufluss die Weichen für ein nachhaltiges Wachstum stellt (durch zB. Wirtschaftsreformen oder erleichterte Kreditvergaben durch Banken). Am entscheidensten für die Absorbation von exogenen Schocks ist die Aufstellung der capital structure, um sich gegen Marktrisiko zu rüsten.
Die Boom and Bust-Phasen folgen oft einem bestimmten Muster:
1. liquidity expansion in der capital exporting country*
2. lending und investment boom im LDC, gefolgt von Wirtschaftswachstum
3. externer Schock, der zum Abzug des Kapitals führt und das LDC in Schwierigkeiten stürzt
*es werden mehrere Theorien kurz angesprochen, wieso Kapital in LDCs fließt:
-) liquidity model (vom Autor präferiert): Liquiditätsüberschuss im reichen Land, low yield im Inland und risk on sentiment führt zu investment im LDC
-) investment model: LDC reformiert das Land und macht es attraktiver für foreign investments
-) dependency theory, “classic liberal theory of international trade”, development economics
Es wird unterschieden zwischen inverted und correlated capital structures:
inverted: revenues und borrowing costs korrelieren negativ zueinander. In guten Wirtschaftszeiten steigen revenues und borrowing costs sinken. Zu schlechten Zeiten hingegen treffen zwei negative Faktoren aufeinander (sinkende revenues und steigende borrowing costs) - zB. short-term debt denominated in USD (growth contractuon > fx depreciation > higher debt)
correlated: Gegenteil von inverted: positive Korrelation: bei sinkenden revenues trifft eine Erleichterung durch sinkende borrowings costs ein - zB. inverse floaters oder fixed-rate local currency debt (growth contraction > fx depreciation > imported inflation > debt inflated away while revenues sink)
Liquidity flows entscheiden oftmals darüber, ob ein Less Developed Country (LDC) Wirtschaftswachstum widerfährt. Dabei spielt es weniger eine Rolle, ob dieses Land vor dem Liquiditätszufluss die Weichen für ein nachhaltiges Wachstum stellt (durch zB. Wirtschaftsreformen oder erleichterte Kreditvergaben durch Banken). Am entscheidensten für die Absorbation von exogenen Schocks ist die Aufstellung der capital structure, um sich gegen Marktrisiko zu rüsten.
Die Boom and Bust-Phasen folgen oft einem bestimmten Muster:
1. liquidity expansion in der capital exporting country*
2. lending und investment boom im LDC, gefolgt von Wirtschaftswachstum
3. externer Schock, der zum Abzug des Kapitals führt und das LDC in Schwierigkeiten stürzt
*es werden mehrere Theorien kurz angesprochen, wieso Kapital in LDCs fließt:
-) liquidity model (vom Autor präferiert): Liquiditätsüberschuss im reichen Land, low yield im Inland und risk on sentiment führt zu investment im LDC
-) investment model: LDC reformiert das Land und macht es attraktiver für foreign investments
-) dependency theory, “classic liberal theory of international trade”, development economics
January 9, 2024
8/10
I ended up having to read this more quickly than I would have liked, but its an excellent book about sovereign financial crises in emerging markets. The main premise of the book is that emerging market government finance should learn more from corporate finance. The author is clear that while the two are not equivalent, there are still important lessons overlooked often in favor of more macroeconomic perspectives focused on the real side of the economy. While EMs can have serious real economy challenges, the author argues many sovereign debt crises are more financial and balance sheet management oriented.
I wont recount all of the analysis in the book, but roughly it proceedes along the following main points. First, the author makes an argument for viewing EM financial crises from a "liquidity model" perspective rather than an "investment model" perspective. The latter of which focuses on domestic macroeconomic reforms, the real economy, and credibility of financial policies. Instead, the liquidity model focuses on changes in external/global capital as the source of most volatility. This is due to both their size relative to global financial markets and, relatedly, their investor base. It's interesting to me that this precedes by several years much of the excellent academic research by that has come to similar conclusions.
Second, the book argues that sovereigns focus too much on minizing borrowing costs and too little on reducing borrowing volatility. A simple example is governments often issue lots of short term debt which is cheaper, but increases the probability of rollover risk if interest rates increase. More broadly, it provides a useful framework for analyzing these and related challenges from a corporate finance perspective, thinking clearly about how to manage government balance sheets prudently.
The book is an excellent combination of market practioner experience, historical analysis, and providing a simple, yet useful theoretical framework for analyzing these episodes. Strongly recommended for anyone interested in EM debt and crises.
I ended up having to read this more quickly than I would have liked, but its an excellent book about sovereign financial crises in emerging markets. The main premise of the book is that emerging market government finance should learn more from corporate finance. The author is clear that while the two are not equivalent, there are still important lessons overlooked often in favor of more macroeconomic perspectives focused on the real side of the economy. While EMs can have serious real economy challenges, the author argues many sovereign debt crises are more financial and balance sheet management oriented.
I wont recount all of the analysis in the book, but roughly it proceedes along the following main points. First, the author makes an argument for viewing EM financial crises from a "liquidity model" perspective rather than an "investment model" perspective. The latter of which focuses on domestic macroeconomic reforms, the real economy, and credibility of financial policies. Instead, the liquidity model focuses on changes in external/global capital as the source of most volatility. This is due to both their size relative to global financial markets and, relatedly, their investor base. It's interesting to me that this precedes by several years much of the excellent academic research by that has come to similar conclusions.
Second, the book argues that sovereigns focus too much on minizing borrowing costs and too little on reducing borrowing volatility. A simple example is governments often issue lots of short term debt which is cheaper, but increases the probability of rollover risk if interest rates increase. More broadly, it provides a useful framework for analyzing these and related challenges from a corporate finance perspective, thinking clearly about how to manage government balance sheets prudently.
The book is an excellent combination of market practioner experience, historical analysis, and providing a simple, yet useful theoretical framework for analyzing these episodes. Strongly recommended for anyone interested in EM debt and crises.
November 24, 2019
It's tough to describe how much Pettis is able to pack into ~200 pages in this book. It's a seminal history and examination of the international money centers (New York, London, Hong Kong, etc) lending vast amounts of money to emerging markets as well as suggestions of how best for the EMs to manage these flows. His basic overall theme is that "Small changes in the center [the money 'centers'] have can have drastic effects on the periphery [EMs]". He examines how the capital structure transmutes external shocks from the more developed capital centers into the developing countries and how best to absorb those shocks in such a way that it doesn't end up devastating the economy of the EMs. Heavy emphasis in both the historical narrative as well the examination sections of the book is on how these effects are disproportionately outsized in the EM countries and that if there is not a careful (and often counter-intuitive) financial structure set up anticipating these volatile swings, then the EM countries are likely to go through horrendous bust cycles. The takeaway from this book is that "Capital structure is a volatility machine" and that policy makers need to be aware of not only why this is, but how their financial systems need to be structured in order to make sure that the volatility machine does not break down and set back countries for years.
December 7, 2020
Should be read by anyone involved or having keen interest in Emerging Markets, EM sovereign debt analysis. The author presents a unique concept of inverted and correlated sovereign capital strictures and borrows corporate finance and options framework to analyse sovereign balance sheets and what causes the fragility and financial distress of emerging markets sovereign debt issuers. At the end of the book the author also touches on the very interesting subject of sovereign debt restructuring. This is by far the best book I’ve read this year and the best book that deals with the subject of emerging markets investing. It is as relevant today as it was when it was first published 20 years ago
July 3, 2019
this book fuckin rocks. wild to see an MMT style argument grounded in something less tendentious. liquidity is really important. feel like he could have used a more aggressive editor and cut ~20 pages, but its obviously worth it anyway
December 11, 2018
Insightful framework and extensive history of EM crises
Excellent work for anyone interested in the history of EM crises and a market oriented framework for thinking about EM risk.
Excellent work for anyone interested in the history of EM crises and a market oriented framework for thinking about EM risk.
February 3, 2019
Michael Pettis is thorough in his analysis and focuses on completing the big picture for emerging markets
January 2, 2023
Liquidity from developed countries is the most important factor that influences developing countries' economies.
October 2, 2016
This is one of the very best books on macroeconomic finance and the relationship between liquidity and volatility. I am absolutely using this book for my thesis and was inspired enough to contact the author to try to learn more about his work.
The volatility machine goes into great detail about financial crisis of multiple periods. Unlike other authors who skate through the details, only looking at a few of their favorite crises, Petis incorporates work as far back as financial data has existed. As a result, his conclusions are more fleshed out than many of the more recent books that have been written on the topic. He also - unlike so many other economic writers - has solid financial experience; a big plus for practitioners. His ideas of volatility and it's relationship to liquidity and financial crisis are really unique in a nuanced way. They are practical and theoretical all at once.
This should be read by anyone who is interested in financial crisis or happens to work in any area of financial products that are impacted by liquidity (basically every financial product). It clearly links macroeconomics, volatility, and financial asset pricing/risk together.
If I could give it 6 stars if I would.
The volatility machine goes into great detail about financial crisis of multiple periods. Unlike other authors who skate through the details, only looking at a few of their favorite crises, Petis incorporates work as far back as financial data has existed. As a result, his conclusions are more fleshed out than many of the more recent books that have been written on the topic. He also - unlike so many other economic writers - has solid financial experience; a big plus for practitioners. His ideas of volatility and it's relationship to liquidity and financial crisis are really unique in a nuanced way. They are practical and theoretical all at once.
This should be read by anyone who is interested in financial crisis or happens to work in any area of financial products that are impacted by liquidity (basically every financial product). It clearly links macroeconomics, volatility, and financial asset pricing/risk together.
If I could give it 6 stars if I would.
June 15, 2008
I don't know enough yet to be able to tell if this stuff is right, but it sure makes a lot of sense to me. Pettis argues that big periodic emerging-market crises are almost always caused by external liquidity droughts and that the capital structure of a country determines how big the effects of those droughts are. Sounds technical and dry, but some of the implications go to the heart of why and how countries develop or not. It's an older book, from the turn of the 21st century (as I decree all shall refer to the years 2000-2002), but seeing as we're having just a wee bit of a problem with liquidity these days it's pretty relevant.
Plus, Pettis actually brings in pre-WWII financial history. Many things happened before 1945, but you wouldn't know that from most analysis out there. The term "Great Depression" used to refer to the early 1970s, for instance - djyaknow that?
By the way, Pettis has a great blog on Chinese financial markets going now. Google him and be enlightened.
Plus, Pettis actually brings in pre-WWII financial history. Many things happened before 1945, but you wouldn't know that from most analysis out there. The term "Great Depression" used to refer to the early 1970s, for instance - djyaknow that?
By the way, Pettis has a great blog on Chinese financial markets going now. Google him and be enlightened.
August 2, 2011
Michael Pettis impressively blends development economics and corporate finance to weave a compelling argument that many developing country crises need not happen. Citing history as well as case studies, Pettis shows how incompetent and misguided financial policies result in volatile market mismatches that are accidents waiting to happen. After reading this book, you will never look at development economics or emerging markets according to the conventional light.
February 21, 2015
great insights on emerging markets crisis
Michael Pettis highlights the importance of the liability side of a sovereigns balance sheet and not just asset side which is important.
Crisis invariably occurs as easy liquidity stops in developed countries and money flows out of emerging markets.
The ones which create natural hedges and think long term fare better in times of stress.
Michael Pettis highlights the importance of the liability side of a sovereigns balance sheet and not just asset side which is important.
Crisis invariably occurs as easy liquidity stops in developed countries and money flows out of emerging markets.
The ones which create natural hedges and think long term fare better in times of stress.
January 16, 2016
Despite the formatting and editing errors of the kindle version (I would go for the paper version if available), the methodology of sovereign balance sheet analysis exposed throughout the book is a must have tool of any macro toolkit.
June 9, 2022
Pettis again knocks it out of the park.
Wish our Macroeconomics teacher were like Pettis.
He explains dense & complex concepts in a manner that helps the reader to understand the dynamics intuitively.
Not many have this quality in them.
Wish he wrote more.
Wish our Macroeconomics teacher were like Pettis.
He explains dense & complex concepts in a manner that helps the reader to understand the dynamics intuitively.
Not many have this quality in them.
Wish he wrote more.
November 8, 2011
Best economics book I've ever read
February 9, 2012
Pettis isn't the most elegant writer but he is a very good thinker about market mechanics. A very good book.
Want to read
June 20, 2012Reviewed by Econintersect
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