Financial Crisis: How And Why It Happens

Financial Crisis: How And Why It Happens

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Financial Crises: How and Why and Lessons

Recent Major Financial Crises

1980's: Debt crisis for developing countries (Latin America and Africa)

1992: European Exchange Rate Mechanism (especially UK and Sweden)

1994-95: Mexico (Tequila crisis) and Argentina

1997-98: Asian financial crisis (Thailand, Indonesia, Korea, Philippines, Malaysia)

1998: Russia

1999: Brazil

2000-02: Turkey

2001-02: Argentina (again)

Nature of Financial Crises

Exchange rate crises

Sudden, drastic depreciation of the country's currency

Banking crises

Depositors lose confidence (disintermediation)
Banks can't perform lending function


Severe recession, due to:
Collapse of bank loans
Reduction in consumer demand
Higher interest rates

Inflation, due to:
Higher import costs

Causes of Financial Crises:
1. Macroeconomic Imbalances

Where: Russia 1999, Brazil 1999, Turkey 2000, Argentina 2001

Characteristics of imbalances:

Causes of Macroeconomic Imbalances

High government spending (G) due to:

Public subsidies for businesses
Infrastructure spending
Lack of fiscal discipline

Insufficient tax revenues (T) due to:

Poorly developed tax systems
Lack of tax enforcement

Money supply (M) growth too high due to:

Lack of independence of central bank
Political pressure on central bank to accommodate fiscal deficits

Pressure on Exchange Rates

CA deficit and inflation cause pressure in forex markets on currency to depreciate.

Government does not want that due to:
Higher import costs
Loss of prestige

Government tries to keep currency from depreciating too fast:
By raising interest rates domestically
By using foreign reserves to buy its currency back

But this creates problems:
Higher interest rates slow the domestic economy
Loss of foreign reserves

Loss of Confidence

Foreigners stop lending

Speculators think the currency will depreciate further

Domestic owners of financial capital move that capital out of the country (capital flight)

Causes of Financial Crises:
2. Capital Flow Volatility

Where: Mexico 1994, Asia 1997-98

Characteristics of capital flow patterns:

CA deficits
Offsetting inflows of capital to purchase assets
Real estate
Many investments were economically doubtful

Over-reliance on bank financing

Short-term borrowing and lending
Using foreign money

Recent Capital Flow Patterns

Capital Flows for Asian Crisis Countries (US $ billions)

Source: IMF, World Economic Outlook, Database tables, December 2001

Short-term Debt Exposure

Country S.T. Debt as % of Reserves
Q2 1997
Korea 200%
Indonesia 165%
Thailand 145%
Philippines 75%
Malaysia 40%
Taiwan 20%

Source: The Economist, "Global Finance Survey," January 30, 1999, p. 11

Effects of Dependence on Foreign Capital

Exposure to interest rate risk outside own control

Currency effects

Bank non-performing loans (NPL's)

Capital flight


Causes of Financial Crises:
3. Banking Practices

Where: Thailand, Indonesia, Korea 1997

Lack of diverse sources of capital:

Underdeveloped equity markets
Underdeveloped bond markets
Over-reliance on bank financing

Poor management

Crony lending
Lack of credit analysis
Moral hazard = risk taking

Non-performing Loan Problems, year-end 2001

NPL as % of GDP Estimated Amount $ billion Officially Reported
$ billion
China 44 – 55 480 – 604 343
Malaysia 36 – 48 32 – 43 20
Thailand 36 – 41 46 – 53 15
Taiwan 20 – 27 60 – 83 27
Japan 25 – 26 1,200 – 1,261 742
Indonesia 11 – 14 18 – 22 7
South Korea 7 – 14 31 – 64 29
Philippines 9 – 13 8 – 11 6
Source: Cited in Lawrence W. Berger, George R. Nast, and Christian Raubach, "Fixing Asia's Bad-Debt Mess," The McKinsey Quarterly, 2002, No.

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"Financial Crisis: How And Why It Happens." 26 Aug 2019

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Causes of Financial Crises:
4. Bad Exchange Rate Policies

Where: Thailand 1997, Brazil 1999, Argentina 2001
Almost: Hong Kong 1997-98, China (anytime?)

Problem: Fixed exchange rates are difficult to maintain.

Story #1: Thailand 1997

Thailand had fixed the THB at 25 per USD
Currency became over valued relative to PPP and to its neighbors.
Contributed to CA deficit
Attracted FDI

Required high domestic interest rates to attract money to preserve the peg.
Attracted "hot money" to banking sector
Hot money loaned out
Stock market
Property market

The lending expanded the money supply and created inflationary pressures.

Inflation created downward pressure on the THB, but since nominal exchange rate was fixed, the real exchange rate appreciated.

Interest rates had to be increased to maintain the THB peg.
Bank of Thailand uses international reserves to buy THB.

Eventually confidence in ability to maintain peg eroded.
Hot money leaves (capital flight)
Tried to maintain peg but can't.

Peg abandoned. Start of the Asian Financial Crisis.

Story #2: Hong Kong Withstands Speculative Attack

Appreciation of real exchange rate of HKD:

Speculators anticipated devaluation of HKD August 1998
Highly-leveraged institutions (HLI's)
(Also took positions in JPY, HKD, SGD, AUD, NZD)

"Double Play": Speculators took short positions in HKD and HK stock market
Borrow HKD
E.g., at 7.79 HKD/USD
Agree to sell them back (hopefully at lower price)
E.g., at 8.00 HKD/USD
Hope that profit from movement exceeds interest cost

HK Policy Response

Hong Kong Monetary Authority (HKMA):
• Raised short-term interest rates (Aug 98 avg = 12.24%)
• Used foreign reserves to buy HKD
• Use reserves to buy stocks
o August 13 – 28, 1998: HKMA intervened in exchange, stock, and futures markets
o Bought $15 billion of stocks to prop up markets

• To increase confidence (fight the herd mentality)
• Punish speculators (especially "double play" speculators)

• Stock market up 18% during intervention
• Down 10% after intervention stopped
• Exchange rate stabilized
• Economic slow-down and deflation


What is it:

Rapid spread of financial and exchange rate crises from one country to another, sometimes with no fundamental reason.

Is it increasingly likely?

Trade linkages
Financial linkages

Faster transmission
Open capital markets

What are the Causes of Contagion?

Economic fundamentals

Inability to maintain balance between exchange rate policies and domestic policies


Driven by economic fundamentals
Herd mentality due to imperfect information

Why Does Contagion Start and Spread?

Shocks with wide impact:

For example:
World-wide interest rate changes
Slowing of Japanese economy
Oil shock

Trade spillovers:

Terms of trade change with competitors or trading partners

For example:
Indonesia and Malaysia

Financial linkages:

For example:
Exposure of Japanese banks in SE Asia
Financial linkages between Malaysia and Singapore
Perceived linkages between Mexico and Argentina
Exposure of HK in China

Investor sentiments:

Affected by fundamentals

What are the Important Fundamental Factors?

External factors:

Appreciation of real exchange rates
CA deficits
High s.t. debt relative to total debt
High s.t. debt relative to reserves

Domestic imbalances:

Loose monetary policy
High real interest rates
Slow GDP growth
High unemployment
Excessive domestic credit growth
Bank lending problems

Trade linkages

Financial linkages

Measuring Credit Risk

Who evaluates country credit risk?
Standard and Poors
Fitch IBCA, Duff and Phelps

What do they evaluate?
Sovereign credit
Long term and short term
Local currency and foreign currency
Bank health

What they look at to make their ratings:
Indicators of economic strength
GDP per capita (at current exchange rates)
Real GDP growth
Investment as percent of GDP
Indicators of liquidity (ability to repay debt)
International debt to export ratio
International debt service as % of exports

Resolving and Avoiding Financial Crises

Dimensions of crisis resolution:

Unilateral or multilateral
Domestic or international focus
Short-term fixes or long-term structural reforms
Cosmetic or substantive

Obvious Answers to Obvious Problems

Cause of Problem Solutions Multilateral Role
Macroeconomic imbalances • Fiscal policy discipline
• Monetary policy discipline • Provide policy guidance
Capital flow volatility • Better regulation of domestic financial institutions
• Development of broader sources of capital domestic • Provide institutional guidance
• Develop regional cooperation
Banking sector weaknesses • Rationalize bank sector
• Improved bank management
• Better bank regulation
• Better bank supervision • International standards
Exchange rate policies • Avoid exchange rate over valuation
• Float exchange rate
• Capital controls
• Currency board • IMF support

Domestic Financial Reforms

Diversification of financing sources:

Less reliance on bank financing

More reliance on market financing
Equity markets
Bond markets

Requires institutional infrastructure
Property rights
Commercial codes
Bankruptcy laws

Banking sector reforms:

Rationalization of banking sector

Credit analysis (e.g., Thai Central Information System Comp.)

Debt restructuring (non-performing loans)

Role of Multinational Institutions in Domestic Reforms

Global standards

Banking (Bank for International Settlements)
Accounting (Intl Acc Stand Comm)
Securities (Intl Org of Securities Commissions)
Legal (International Bar Association)

Essential questions

What are the appropriate standards?
Who will determine them?
How will they be enforced?
Who will be held accountable?

Possible institutions

Global central bank
Global bankruptcy court

Appropriate Bank Regulation

Bank for International Settlements

Capital adequacy requirements

Supervisory review

Information disclosure

Commercial Bank of Jakarta

Assets Liabilities
Cash Deposits of customers
Government bonds
Loans to individuals
Loans to corporations

Multilateral Rescues

Mexico 1994-54:

U.S. takes leadership position

$50 billion stand-by credit to Mexico from the U.S. Treasury's Exchange Stabilization Fund

Asia 1997-98:

IMF and World Bank take leadership role

IMF Rescues: Thailand and Indonesia

Thailand Indonesia
When August 1997 November 1997
Total Initial Package (tranches)
World Bank
Asian Dev Bank
$17 billion

$4 bill
$1.5 bill
$1.5 bill
$10 bill (Japan, Sing, Aus, Mal, China, HK, Kor) $33 billion

$10 bill
$4.5 bill
$3.5 bill
$15 bill (Japan, Sing, USA, Aust, Mal)
Conditionality -increase excise tax to create fiscal surplus
-strengthen banks and finance companies:
* declare non-performing loans at 6 months instead of 12
* foreigners allowed to own majority share
-resolve 58 finance companies
* Financial Sector Restructuring Agency
* strict capital requirements and auditing standards
*set up asset management company to dispose of non-performing loans -removal of trading monololies on wheat, soybeans, garlic held by National Logistics Agency
- remove price ceilings on cement
-eliminate 2,000 local content rules for car assembly
-lower tariffs on chemicals and steel (now 15-40%) protecting state-run firms
-close 16 bad banks
Sources: FEER 10/23/97, p. 94; Economist, 11/8/97, p. 79;
FEER, 11/13/97, p. 68

IMF Rescue: South Korea

When December 1997
Total Initial Package (tranches)
World Bank
Asian Dev Bank
$55 billion

$21 bill
$10 bill
$ 4 bill
$20 bill (Japan, Aus, Belg, Can, France, Ger, Italy, Neth, Sweden, Switz, UK)
Conditionality Monetary and forex policies:
-reduce M growth; raise int rates
-allow won to float
Fiscal policy:
-increase taxes
-reduce spending
Financial sector restructuring:
-close bad banks
-more independence for BOK
-better supervision of institutions
-reform deposit insurance
-greater transparency
-international standards for reporting
Other restructuring:
-trade liberalization per WTO rules
-liberalization of foreign investment
-corporate governance reform
-increased labor market flexibility

To Rescue or Not To Rescue?

Why Rescue?

Maintain financial stability
Maintain political stability
Maintain trade relationships
Reduce the chance of "contagion"

Why Not Rescue?

Helps the wrong people
Protects domestic political powers
Protects reckless decision makers
Reckless borrowers
Careless lenders

Creates "moral hazard"
Could encourage reckless behavior in future

Does the IMF do it right?

Too much emphasis on austerity?

Asian Alternative to IMF?

Regional exchange rate stabilization fund

Led by Japan

Purpose: to provide short-term liquidity to countries if their currency comes under attack.
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