Financial Crises

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OUTLINE
 What is a Financial crisis?
 Sequence of EFM Financial crises
 Causes of Financial crises: Is financial liberalization
responsible?
 Case study: The Asian Crisis 1997-98
 Lessons from the financial crises
 Potential Reforms

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WHAT IS A FINANCIAL CRISES?
A financial crisis in an economy may involve
1. a debt crisis: an inability to repay government debt or
private sector debt.
2. a balance of payments crisis under a fixed exchange
rate system.
3. a banking crisis: bankruptcy and other problems for
private sector banks.
 A “TWIN” FINANCIAL CRISIS
 A banking crisis together with massive currency
devaluation due to balance of payments crisis

 Associated with high interest rates and capital

flight out of the country due to fear of currency
collapse and banking failure/default*.

The common economic causes are:

 Financial liberalization
 Capital mobility (inflows and sudden outflows)
 A fixed exchange rate policy
 The growth of bad debts in banks (loan losses)
 High leverage and poor investment decisions of
firms 4
A “TRIPLET” FINANCIAL CRISIS
 A debt crisis, a balance of payments crisis and a
banking crisis can occur together, and each can
make the other worse.
 Each
can cause aggregate demand, output and
employment to fall (further).
 If people expect a default on sovereign debt,
a currency devaluation, or bankruptcy of private
banks, each can occur, and each can lead to
another.
 SEQUENCE OF EFM FINANCIAL CRISIS*
1. Sudden capital outflow
 capital outflow implies that the demand for
domestic currency falls leading to devaluation
pressure.
 In order to maintain a fixed exchange rate, the
CB intervenes by buying domestic currency in
exchange for foreign reserves.
 This reduces the supply of domestic currency
and alleviates the devaluation pressure, but if
foreign exchange reserves are low, the value of
domestic currency falls.
 Market perception here causes capital flight and
forces a devaluation
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SEQUENCE OF EFM FINANCIAL
CRISIS
2. Devaluation or collapse of currency value
 Investors will require a higher risk premium
 Government raise interest rate to stem capital
outflow
3. So interest rates rise substantially
 Caused by reduction in domestic money supply
and attempt to slow capital outflow
4. Adverse impact on firms and banks
 Foreign currency denominated debt obligations
rise substantially in terms of domestic currency
 Interest rates hike means rising cost of capital
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 WHAT CAUSES THE TWIN CRISIS?
 With limited foreign exchange reserves, markets
perceive devaluation and investors further
withdraw their capital, leading to a collapse of
the fixed exchange rate policy.
 The interest rate rises significantly (20-50%) to
fall in domestic money supply
 Firms begin to default on their debts
 Banks are left with increasing nonperforming
assets and loan defaults, while ever increasing
foreign debt burden.
High interest rates and exchange rate risk cause a
vicious cycle, resulting in currency collapse and
bank failures.
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 EFM FINANCIAL CRISIS
A VICIOUS CYCLE

Currency value
comes under
pressure due to
fear of
devaluation but
the crises can
be triggered by
other things e.g.
macroeconomic
instability,
microeconomic
failure or
rumour.

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FUNDAMENTAL CAUSES OF FINANCIAL
CRISIS
 A fixed exchange rate policy with an overvalued
currency generally to facilitate export-led
economic growth
 Capital mobility with over-borrowing in foreign
markets to fuel domestic economic expansion
 Weak financial institutions with lack of prudential
regulation and monitoring*
 Low foreign exchange reserves to defend the fixed
exchange rate

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WEAK FINANCIAL INSTITUTIONS: A
CHARACTERISTIC FEATURE OF
DEVELOPING COUNTRIES
Weak enforcement of banking and financial regulations
(e.g., lack of examinations, asset restrictions, capital
requirements) causes banks and firms to engage in
risky or even fraudulent activities and makes savers
less willing to lend to these institutions.
 A lack of monitoring causes a lack of transparency
(a lack of information).
 Moral hazard: a hazard that a borrower (e.g., bank or firm) will
engage in activities that are undesirable (e.g., risky
investment, fraudulent activities) from the less informed
lender’s point of view.
BORROWING AND DEBT IN EFMS
 Another common characteristic for many high growth
developing countries is that they have borrowed
extensively from foreign countries.
 Financialcapital flows from foreign countries are able
to finance investment projects, eventually leading to
higher production and consumption.
 Butsome investment projects fail and other borrowed
funds are used primarily for consumption purposes.
 Some countries have defaulted on their foreign debts
when the domestic economy stagnated or during
financial crises.

22-12
FIXED EXCHANGE RATE AND
OVERVALUATION
 An exchange rate pegged at a low rate against
the reserve currency (i.e. overvalued) leads to
higher inflationary pressure and triggers a
currency crisis.
Example: Bretton Woods period (1948-1973), all
currencies were pegged to the US$.
1. Inflating currencies became overvalued.
 Recall PPP: X = S (P /P )
FC DC

 If PDC increases, in order to maintain X, S

(number of DC per FC) should increase.
 With fixed exchange rate, S cannot increase and
so becomes overvalued 13
2. Overvaluation causes current account deficit.
 X = S (P /P ): prices of domestic goods become
FC DC
higher than foreign goods
3. Current account deficit is financed by drawing
down reserves or by borrowing*
 The consequence is decline of reserves or a huge
external debt.
4. Devaluation is inevitable because of capital flight

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 ILLUSTRATION:FLOATING EXCHANGE RATE

(RS: RUPEES, INDIAN CURRENCY)

Price of
Rs FOREIGN EXCHANGE
S MARKET

E At E, domestic investors try to

buy foreign assets. Demand
E’ for Rs decreases. D shifts to
the left.

Price of Rs decreases or
depreciation of Rs
D
New equilibrium is at E’ as the
exchange rate depreciates
Q of
Rs

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 ILLUSTRATION: FIXED EXCHANGE RATE
Price of
Rs FOREIGN EXCHANGE
MARKET

Exchange rate is fixed at

this level
E
At E, domestic investors buy
foreign assets. D shifts to the
left.
E’
At E’ there is devaluation
pressure on Rs
D

Q of Rs
Central bank (CB) intervenes by buying domestic currency, which
increase demand for Rs. With excess reserves, D shifts back to the right.
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BORROWING AND DEBT DEFAULT IN EFMS
 A debt crisis in which governments default on
their debt can be a self-fulfilling mechanism.

 Fear of default reduces financial capital inflows

and increases financial capital outflows (capital
flight), decreasing investment and increasing
interest rates, leading to low aggregate demand,
output and income.
BORROWING AND DEBT DEFAULT (CONT.)
 Financialcapital outflows must be matched with an
increase in net exports or a decrease in official
international reserves in order to pay people who
desire foreign funds.

 Otherwise,
the country cannot afford to pay people
who want to remove their funds from the domestic
economy.

 Thedomestic government may have no choice but to

default on its sovereign debt when it comes due and
investors are unwilling to re-invest.
 RECENT CRISES IN EFMS
Chile in 1979-1982
 High inflation and fixed exchange rates
 Chilean peso was overvalued
 Chilean goods became less competitive
 Reserves fell and debt burden increased

NB. Other currency crises, e.g. Mexico 1994-95,

SE Asia 1997-98, Russia 1998 happened for
similar but slightly different economic reasons –
see “introductory overview” lecture slides

Question: Why does overvaluation lead to

currency crises?
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 OVERVALUATION AND CURRENCY
CRISIS
 If the pegging is perceived to be unsustainable,
devaluation is imminent and the scope for
speculative attack on currency increases.

 Speculators sell their currency, expecting to

gain from devaluation (or there is capital flight)

 Speculative attack forces devaluation as

reserves run out (balance of payments crisis)

 The actual value of currency falls drastically:

currency collapse.
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CAPITAL INFLOWS AND TWIN CRISIS
 A high level of foreign borrowing in short-term
may lead to financial crisis.
 The crisis is caused by subsequent sudden
withdrawal of foreign capital.
 Excessive short-term borrowing creates the risk
of a liquidity crisis.
 When short-term debt is denominated in foreign
currency, liquidity risk is also compounded with
foreign exchange risk – the problem of original
sin

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FINANCIAL LIBERALISATION AND CRISES
 Financial crises tend to occur following financial
liberalisation (including privatisation) because
such reforms attract foreign capital. It can
spread to other countries quickly (contagion)
and hence crises

 What should be done to avoid such crises?

- Capital controls on short-term inflows or
outflows?
But this may change investment incentives and
cause higher cost of capital.
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SEQUENCE OF EAST ASIAN CRISIS (1997-
98)
Real GDP growth averaged 9% in 1992-95
 E.g. China, Indonesia, Malaysia and Thailand at
more than 7%
 Growth is characterised by highly competitive
economy, export-led, restrictions on import
 Net private capital flows into East Asia reached
$110 billion in 1996

So far, so good but

Non performing bank loans started increasing,

esp. China, Korea and Thailand.

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The East Asian currencies were all pegged to the
US$ as reserve currency
 Thailand, Philippines, Malaysia and Indonesia all
abandoned their exchange rate peg in 1997
 Capital outflow increased
 Stock market prices fell under heavy selling
pressure (e.g. South Korea)
Currency declined against US$ in 1997-98
 S. Korea 34%, Thailand 37%, Philippines 38%,
Malaysia 40% and Indonesia 78%
All countries went into economic recession and
bank failures and bailouts were widespread.
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EXAMPLES OF OVERVALUED
CURRENCY
Currency value in index against US$

1996 1997
Thailand 107.6 72.3
Malaysia 112.1 84.8
Indonesia 105.4 62.3
Korea 87.1 59.2

The currency was overvalued in 1996, as

compared with the values in 1997

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Sudden Outflows: Illiquidity problem

Short term capital inflows (bank lending) were

large during the mid 1990s
Short term debt/reserves ratio
1994 1997
 Thailand 99.2 145.3
 Malaysia 25.2 61.2
 Korea 161 206
The short-term debt were mostly denominated in
foreign currency.
Illiquidity problem (lack of capital due to sudden
outflow) played an important role in the East
Asian crises.
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RISKY LENDING AND BAD DEBTS
The nonperforming loans to total loans in 1999
 Thailand47.5% Indonesia 75%

Causes:
Firms were not earning enough to pay their
interest costs.
 Returns on capital employed were less than
bank interest rates throughout 1992-1996
 In S. Korea failing chaebols (firms): 25 of 30
largest chaebols had profit being less than 1% in
1996.
 Thailand and Malaysia: 30-40% bank loans were
made to the risky real estate sector*
 Indonesia: 200 new banks with high loan growth
after financial liberalisation.
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LESSONS OF CRISES
1. Fixing the exchange rate has risks:
governments desire to fix exchange rates to
provide stability in the export and import sectors,
but the price to pay may be high interest rates or
high unemployment.
 High inflation (caused by government deficits or
increases in the money supply) or a drop in
demand for domestic exports leads to an over-
valued currency and pressure for devaluation.
 Given pressure for devaluation, commitment to a
fixed exchange rate usually means high interest
rates (a reduction in the money supply) and a
reduction in domestic prices.
.
LESSONS OF CRISES (CONT.)
 Pricesare reduced through a reduction in government
deficits, leading to a reduction in aggregate demand,
output and employment.
A fixed currency may encourage banks and firms to
borrow in foreign currencies, but a devaluation will
cause an increase in the burden of this debt and may
lead to a banking crisis and bankruptcy.
 Commitment of a fixed exchange rate can cause a
financial crisis to worsen: high interest rates make
loans for banks and firms harder to repay, and the
central bank cannot freely print money to give to
troubled banks (can not act as a lender of last resort).
LESSONS OF CRISES (CONT.)
2. Weak enforcement of financial regulations can
lead to risky investments and a banking crisis
when a currency crisis erupts or when a fall in
output, income and employment occurs.

3. Liberalizing financial capital flows without

implementing sound financial regulations can
lead to financial capital flight when risky loans
or other risky assets lose value during a
recession.
LESSONS OF CRISES (CONT.)
4. The importance of expectations: even healthy
economies are vulnerable to crises when
people’s expectations change.
 Expectations about an economy often change when
other economies suffer from adverse events.
 International crises may result from contagion: an
adverse event in one country leads to a similar
event in other countries.
POTENTIAL MACROECONOMIC REFORMS:
RESTRICT CAPITAL MOBILITY?
 Countries face trade-offs when trying to liberalize and
achieve the following goals:
 exchange rate stability
 financial capital mobility
 using monetary policy to control inflation

 Generally, countries can attain only 2 of the 3 goals,

and as financial capital has become more mobile,
maintaining a fixed exchange with an independent
monetary policy has been difficult.
 Some economists have advocated restriction on capital
mobility in the process of liberalization, although others
argue there are better measures
POTENTIAL INSTITUTIONAL
REFORMS
Preventative measures:
1. Better monitoring and more transparency: more
information for the public allows investors to make
sound financial decisions in good and bad times
2. Stronger enforcement of financial regulations: reduces
moral hazard
3. Deposit insurance and reserve requirements
4. Increased equity finance relative to debt finance
5. Increased credit for troubled banks through the
central bank or the IMF?
POTENTIAL REFORMS (CONT.)
Reforms for after a crisis occurs:
1. Bankruptcy procedures for default on sovereign debt
and improved bankruptcy law for private sector debt.
2. A bigger or smaller role for the IMF as a lender of last
resort? (See 5 above.)
 Moral hazard versus benefit of insurance before
and after a crisis occurs.

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POTENTIAL REFORMS (CONT.)
Building financial institutions: what matters?
Size
 Broad reach and a diversity of service
 Strength and capacity corresponds with a reasonable
size.
Capital
 A strong institutions need sufficient capital relative to
its assets
 Sufficient capital can absorb losses*

Reputation
 Financial institution should be credible and trustworthy.
 Savers should feel confidence that their money will be
safe.
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REFERENCES
 Beim and Calomiris, Chapter 8

 Krugman and Obstfeld, International Economics,

Ch. 22 (Developing Countries: Growth, Crisis and
Reform)

 Lecture slides on “introductory Overview”

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