Chapter 7 – Dynamics of Financial Crises in

Emerging Economies and Applications

Financial Crisis in Emerging Economies- Fall 2023
LAU Beirut

1
1-Dynamics of Financial Crises in Emerging Market Economies
(according to the asymmetric information approach)

Stage one: Initiation of Financial Crisis.

The initiation of the financial crisis could be due to :

-Deterioration in financial institutions’ balance sheets (as a result of mismanagement

of financial liberalization or severe fiscal imbalances)

-Increase in interest rates

-Asset price decline

-Increase in uncertainty
1-Dynamics of Financial Crises in Emerging Market Economies

Deterioration in financial institutions’ balance sheets due to mismanagement of

financial liberalization/globalization:

Ill thought and not well sequenced financial liberalization (i.e. fast and unrestricted),
under weak supervision and lack of expertise, leads to a lending boom.

A weak credit culture and capital inflows (with domestic banks borrowing from
foreign banks and fixed exchange rates giving a sense of lower risk) exacerbate the
credit boom that follows liberalization, leading to risky lending. High loan losses
eventually appear.

As bank balance sheets deteriorate, lending is cut back and a lending crash fully
materializes.
 Capital inflows
Financial Risky lending
and credit Lending crash
liberalization and high losses
boom

Banks play a more important role in emerging markets financial intermediation than
direct finance since securities markets are not usually well developed. Thus, the
impact of the crisis is largely on banks:

-Decrease in Deposits especially non-resident ones.

-Increase in Loan defaults and non-performing loans.
-Deterioration in the value of government securities. when government debt loses
value, banks’ assets value decreases.
-Deterioration in the banks’ ability to borrow domestically and abroad.
-Deterioration in the banks’ ability to raise capital.
1-Dynamics of Financial Crises in Emerging Market Economies

Deterioration in financial institutions’ balance sheets due severe fiscal imbalances:

Governments with large deficits and in need of funds may force or persuade banks to
buy government debt/bonds.

High and persistent indebtedness may create fears of default on government debt
especially foreign currency debt. If confidence falls, the gov’t bonds are sold by
investors, leading to a price decline. Government debt loses value, banks lose and
their net worth decreases.

As a result, bank balance sheets deteriorate, and the usual lending freeze follows.
1- Dynamics of Financial Crises in Emerging Market Economies

Increase in interest rates

A rise in rates in developed economies (international interest rates) can translate into
higher domestic interest rates and spill over into risk taking in developing countries.

Asset price decrease

Asset price declines are less severe than in developed countries, but certainly increase
problems as they decrease the net worth of corporations and investors.

Uncertainty
Political instability, economic recession, stock market crashes and other factors create
high levels of uncertainty, increasing agency conflicts.
1- Dynamics of Financial Crises in Emerging Market Economies

These 4 factors:
Deteriorating financial institutions’ balance sheets
Increase in interest rates
Asset price decrease
Increase in uncertainty

Tend to increase adverse selection and moral hazard problems and weaken the lending
contracts and activity.

Deteriorating financial institutions’ balance sheets and severe fiscal imbalances would
lead or trigger a foreign exchange/currency crisis
1- Dynamics of Financial Crises in Emerging Market Economies

Stage two: currency crisis

Deterioration of bank balance sheets triggers currency crises:

The FX markets will soon start taking bets on the depreciation of the currency of the
emerging market, in what is called a speculative attack.

Over supply begins, the value of the currency falls, and a currency crisis ensues.

The government can attempt to defend the home currency by raising interest rates. That
should discourage currency conversion and encourage capital inflows.

However, banks must pay more to obtain funds, decreasing bank profitability, which
may lead to insolvency.
1- Dynamics of Financial Crises in Emerging Market Economies

Government cannot raise interest rates (doing so forces banks into insolvency).

Speculators in the FX market know this and expect a devaluation. Mass sell-offs of the
currency continue.

Severe fiscal imbalances can also trigger currency crises:

The currency crisis can also result from a large fiscal imbalance. If investors in a
country’s debt suspect the inability of the government to repay the loans, sell-offs will
occur.

This is accompanied by selling the domestic currency by foreign and domestic

investors, again leading to a speculative attack on the currency.
1- Dynamics of Financial Crises in Emerging Market Economies

Central Bank intervenes selling the foreign currency and losing foreign reserves.

Capital outflow causing further Central Bank intervention. More drain in foreign
reserves.

Adverse selection and moral hazard worsens.

Currency depreciates gradually.

Rise in actual and expected inflation.

The foreign exchange or currency crisis increases further adverse selection and moral
hazard problems and weakens the lending contracts, leading to a decline in economic
activity.
1-Dynamics of Financial Crises in Emerging Market Economies

Stage three: Full-Fledged Financial Crisis:

Many emerging market firms denominate their debt contracts in a foreign currency:
U.S. dollar, Euro, Swiss franc, British pound or yen. At the same time domestic income
is denominated in the local currency. Meaning a currency mismatch.

An unexpected currency devaluation increases firms’ debt burden in terms of domestic

currency, leading to a decline in corporate net worth and an increase in adverse
selection problems.

The currency collapse can also lead to higher actual and expected inflation. The
increase in interest rates reduces firms’ cash flows and increases agency problems.
1- Dynamics of Financial Crises in Emerging Market Economies

Banks are more likely to fail:

-Individuals and firms are less able to pay off their debts as debtors are no longer
able to meet interest obligations (value of bank assets falls)

-Debt denominated in foreign currency increases (value of bank liabilities

increases)

• Economic activity declines

• Banking and currency crisis causing capital control and possible haircuts
• Adverse selection and moral hazard worsens and lending contracts
• Further decline in economic activity and currency value.
• Government defaults on foreign debt.
Sequence of Events
in Emerging Market
Financial Crises
2-Application: The Financial Crisis in Mexico, 1994–1995

Long before the crisis: Financial liberalization in the early 1990s: Lending boom,
coupled with weak supervision and lack of expertise. Banks accumulated losses and
their net worth declined.

Rising international interest rates. This led to increased interest rates in Mexico, and
an accompanying increase in information problems.

Uncertainty also increased with the political instability and increased in turn
information problems.

Fixed exchange rate with the central bank intervening in the open market buying or
selling pesos to maintain the peg to protect against inflation or inflationary risks.
Fixed rates reduced exchange rate risk and encouraged foreign borrowing.
2-Application: The Financial Crisis in Mexico, 1994–1995

Short before the crisis:

• Large government spending in the election year 1994, raising substantially the
current account deficit in that year.

• Mexico’s treasury issuing short term peso denominated treasury bills with a
guaranteed repayment denominated in U.S dollars (“tesobonos” compared to
traditional “cetes”) offering lower yield but more attractive to foreign investors.

• The signing of North American Free Trade Agreement (NAFTA), increasing

investors’ confidence, reducing political risk perception and allowing access to new
foreign capital.
2-Application: The Financial Crisis in Mexico, 1994–1995

Short before the crisis:

• Violent insurrection in Chiapas, war on the Mexican government by Zapatista

Army of National Liberation, and the assassination of presidential candidate Luis
Donaldo Colosio in March 1994, increasing political uncertainties and risk premia.

• The central bank’s strategy to intervene in the market and maintain the peg partly
involved issuing short term public debt instruments denominated in U.S dollars in
order to use the borrowed funds to purchase pesos in the foreign exchange market.
2-Application: The Financial Crisis in Mexico, 1994–1995

Short before the crisis:

• Higher awareness of the overvalued domestic currency with a stronger peso than
what should actually be (mainly due to the peg that has been adopted since 1988),
and which allowed over the years more imports and led to large trade deficits.

• Drop in the central bank’s foreign exchange reserves due to speculative capital
flight, pressuring the peso, when speculators started to more and more realize that
the peso is overvalued, and also owing to servicing the “tesobonos” with US dollar
repayments.

• The continuous decline in these reserves ended in almost their complete depletion in
December 1994.
2-Application: The Financial Crisis in Mexico, 1994–1995

The crisis:

Domestic currency devaluated against the U.S dollar on December 20, 1994,
following capital flights and depletion of reserves. (Devaluation of around 14%)

Higher risk premium driven by investors’ fears of additional devaluations and a shift
to foreign investments instead of domestic assets (flight to safer investments).

Central bank raised interest rates to discourage capital flight but higher cost of debt/
borrowing due to higher premium and central bank action hurt economic activity and
growth. (short term rates increased to 32 percent)

Central bank unable to roll over its maturing debt obligations or sell new issues of
public debt as investors were uninterested in purchasing new government debt.
2-Application: The Financial Crisis in Mexico, 1994–1995

The crisis:

Central bank forced to purchase dollars with devalued currency to repay tesobonos.

The country faced an imminent sovereign debt default.

Two days after the devaluation, the central bank allowed on December 22, the peso to
float freely but the currency continued to depreciate thereafter (around 50%).

Rise in actual and expected inflation (more than 50%)

Mutual funds started to liquidate Mexican assets and emerging market assets in
general.

Spread of effects to Latin America economies and Asia. ”Tequila Effect”.

2-Application: The Financial Crisis in Mexico, 1994–1995

The aftermath:

Bailout in the amount of 50 billion USD in January 2015 organized by the U.S and
administered by the IMF with the support of G7 and BIS. (to avoid surge in illegal
immigration and lower imports of U.S goods, and mitigate the spread of effects to other
developing countries…).

The Mexican Government has been required in return to institute monetary and fiscal
policy controls. Mexico however refrained from balance of payment reforms (capital
controls and trade protectionism) to avoid violating its NAFTA commitments.

The bailout mostly in the form of loan guarantees (20 bill USD from the U.S, 18 bill
USD by the IMF…) allowed the country to restructure its short term public debt and
improve market liquidity. Loans were repaid ahead of maturity and generated good
profits for the U.S and other lenders.
2-Application: The Financial Crisis in Mexico, 1994–1995

The aftermath:

Collapse of many banks in the course of widespread mortgage defaults with borrowers
struggling to keep pace with rising interest rates.

Severe recession.

High unemployment.

High Inflation.

Poverty.
3-Application: The Financial Crisis in East Asia, 1997–1998.

Hit many Asian countries in late 1997, particularly Thailand, Indonesia and South
Korea.

Included sharp fall in the values of domestic currencies, stock markets, and other asset
prices (real estate).

Repercussions included reversal of gains made earlier in the boom years: sharp drop in
output/GDP and in income per capita, rising poverty, and collapse of many businesses.
Additionally, more than 10,000 people committed suicide.

Implications of the economic/financial crisis involved as well political turmoil leading

to the resignation of Indonesia president (Suharto) and Thailand Prime Minister
(Yongchaiyudh) .
3-Application: The Financial Crisis in East Asia, 1997–1998.

It started in Thailand in July 1997 and spread to neighboring countries: Indonesia,

Malaysia, South Korea, Philippines, Hong Kong, Singapore, Japan and others.

It created fears of worldwide economic disruption provoked by financial contagion

however these concerns rapidly receded and the recovery was rapid.

Given the scope and severity of the crisis, the IMF intervened with a series of
rescue packages to enable countries avoid default and address their problems
conditional on achieving certain economic reforms.

Countries were asked, among other things, to reduce government spending and
deficits to restore confidence in the country’s fiscal solvency.
3-Application: The Financial Crisis in East Asia, 1997–1998.

Countries were required also to allow insolvent banks and financial institutions to
fail to penalize insolvent firms on their behavior.

The conditions included as well raising aggressively interest rates to protect and
stabilize currency values by tightening money supply and discouraging currency
speculation.

(knowing that high interest rates hurt weak banks and corporations and during
crises governments should pursue expansionary policies such as lowering interest
rates, increase government spending and cut taxes to stimulate the economy).
3-Application: The Financial Crisis in East Asia, 1997–1998.

Pre-crisis environment:

Financial liberalization in the mid and late 1980s and early 1990s. Large capital inflows
(short term and many of which hot money seeking quick profit) associated with attractive
high interest rates to foreign investors and remarkable build up in asset prices (economic
bubble and excessive real estate speculation).

Large supply of credit and highly leverage operating environment. “Crony Capitalism” and
weak corporate governance with incoming money allocated in an inefficient and
uncontrolled manner to people close to the center of power.

High economic growth rates (8 to 12%); Achievement known by the “Asian economic
miracle”.

Large current account deficits and fixed exchange rates encouraging external borrowing
and leading to high exposure to the exchange rate risk in the financial and non financial
3-Application: The Financial Crisis in East Asia, 1997–1998.

The deterioration in the current account position has been linked to slower export growth
due to many external shocks and measures that rendered exports more expensive and less
competitive.

Of these:

-The devaluation of the Chinese and Japanese currencies in the mid 1990s (Plaza Accord
of 1985), and the implementation of China in the 1990s of export-oriented reforms.

-the raising of US interest rates to combat inflation and the resulting strong US dollar to
which the Asian currencies were pegged,

-and the sharp drop in semiconductor prices.

3-Application: The Financial Crisis in East Asia, 1997–1998.

The crisis:

Collapse of asset prices leading individuals and firms to default on their debt obligations
and even go bankrupt.

Panic and withdrawal of funds and credit from touched countries, causing credit crunch
and further bankruptcies, and exerting pressure on Asian countries exchange rates.

To counteract the capital flight and prevent the collapse of the currency, Asian countries
raised domestic interest rates to high levels and intervened in the markets buying their
own currencies with foreign reserves.

Such policies have been perceived as unsustainable as central banks were gradually
depleting their finite amount of foreign reserves, and high interest rates were damaging
the economy.
3-Application: The Financial Crisis in East Asia, 1997–1998.

The crisis:

At one point countries realized that capital flight cannot be stopped and speculation on
the currency is persistent, concerned authorities ceased defending their fixed exchange
rates and allowed their currencies to depreciate and float.

The currency depreciation raised the value of foreign currency debt in domestic currency
terms leading to further bankruptcies and the deepening of the crisis.

Role of contractionary fiscal and monetary policies in the crisis origination and role of
asymmetric information in the financial markets, driving investors’ “herd behavior or
mentality”.
3-Application: The Financial Crisis in East Asia, 1997–1998.

East Asia in a nutshell: Financial liberalization in the late 1980s and early 1990s:
Lending boom, coupled with weak supervision and lack of expertise. Banks
accumulated losses and their net worth declined.

Uncertainty increased (stock market declines and failure of prominent firms).

Domestic currencies devaluated by 1997.

Rise in actual and expected inflation.

3-Application: The Financial Crisis in East Asia, 1997–1998.

Thailand:

From mid 1980s to mid 1990s, the economy grew at an average annual rate of 9%,
inflation was in the range of 3 to 6%, and the currency was pegged at 25 baht to the
US dollar.

In May 1997, the Thai baht was knocked by massive speculative attacks.

On July 2, 1997, Thailand was forced to float the baht following government’s
resistance to devalue the currency and the lack of foreign reserves to support the peg.

This caused a chain reaction affecting countries of the region.

3-Application: The Financial Crisis in East Asia, 1997–1998.

Thailand:

Thailand’s booming economy has been interrupted and unemployment increased.

The domestic currency sharply deteriorated and reached its lowest level of 56 bath
to the US dollar in January 1998 (it lost more than half of its value).

The Thai stock market fell by around 75% and many companies collapsed.

Poverty and inequality increased.

3-Application: The Financial Crisis in East Asia, 1997–1998.

Thailand:

In August 2017, the IMF approved a rescue or bailout package for Thailand of
around 20 billion USD.

In return, Thailand had to take some reform measures including enacting new laws
relating to bankruptcy procedures and establishing stronger regulatory frameworks
for banks and financial institutions.

In 2001, Thailand’s economy recovered. Higher tax revenues reduced the budget
deficit leading to a balanced budget and allowed the government to pay its debt to
the IMF four years ahead of schedule.
3-Application: The Financial Crisis in East Asia, 1997–1998.

Indonesia:

In response to the floating of the baht in July 1997, Indonesia widened in that month the
currency trading band for its rupiah from 8% to 12%.

In August 1997, the rupiah came under severe attack as a result of the July move, and on
August 14, the existing managed floating exchange regime was replaced by a free
floating exchange rate arrangement. Yet, the rupiah fell further and the deprecation
intensified.

The rupiah’s decline affected corporate balance sheets as many Indonesian firms had
been borrowing before the crisis in U.S dollars and had to face the rising cost of the
currency deprecation.
3-Application: The Financial Crisis in East Asia, 1997–1998.

Indonesia:

To address the situation and hedge their foreign currency exposure, corporations
reacted by buying dollar and selling rupiah, thus reducing the value of the domestic
currency further.

The exchange rate deteriorated from around 2600 rupiah per 1 U.S dollar before the
crisis to more than 14000 rupiah per 1 U.S dollar in mid 1998.

The Jakarta stock exchange reached a historic low in September 2017.

Indonesia’s long term debt was downgraded to “junk bond”.

3-Application: The Financial Crisis in East Asia, 1997–1998.

Indonesia:

Output fell by around 14% in a year.

NB: Before the crisis, Indonesia had low inflation, a trade surplus, large
foreign exchanges reserves and a good banking sector.

The IMF provided a rescue package of 23 bill USD.

In February 1998 the central bank governor was sacked.

In May 1998 widespread riot and public pressure resulted in the resignation of the
president from office.
3-Application: The Financial Crisis in East Asia, 1997–1998.

South Korea: Pre-crisis

Financial liberalization and globalization mismanaged

-Financial liberalization in the 1990s, including financial de-regulation and
opening up of capital markets.
-Outcome: lending boom fueled by massive foreign borrowing - especially
short term.

Highly leveraged Chaebols

-large family-owned conglomerates (chaebols) had political and bank
ties:
too big to fail.
-Leading role in borrowing frenzy: very high leverage (but low profits)
-Facilitating role played by South Korean investment/merchant banks
3-Application: The Financial Crisis in East Asia, 1997–1998.
South Korea: Pre-crisis

Sound macroeconomic fundamentals

-Rapid growth, low unemployment, and fiscal surpluses
-“Asian miracle”
3-Application: The Financial Crisis in East Asia, 1997–1998.

South Korea: The Crisis

Stock market decline

-In early 1997, sequences of negative shocks to the already weakened chaebols
-Bankruptcy of one of the largest chaebols in January, followed by 5 more
-Uncertainty caused by such failure of firms and the decrease in chaebols' net
worth, resulted in sharp decline in stock market values

Adverse selection and moral hazard problems worsened, and the economy contracted
Stock Market Index, South Korea
3-Application: The Financial Crisis in East Asia, 1997–1998.

South Korea: The Crisis

Currency crisis ensues

-Speculative attack against the South Korean currency (won) fueled by
deterioration of financial health of high leveraged chaebols
-Crisis of confidence spread, affecting other Southeast Asian economies

Full-fledged financial crisis triggered by currency crisis

-50% decrease in value of the won increases the value of foreign debt by 50%
-Increased adverse selection and moral hazard
-Deterioration of banks' balance sheets burdened with non-performing loans
-GDP declines by 6%
Value of South Korean Currency
3-Application: The Financial Crisis in East Asia, 1997–1998.

South Korea: The Aftermath

Economic impact of the crisis

-Declining GDP causes a sharp increase in unemployment
-Inflation increases spurred by increases in import prices
-Central bank increases interest rates which worsen the balance sheet of banks
and firms
-Severe socio-economic consequences

Recovery
-IMF provided 58 bill USD bailout package against restructuring measures
-Aggressive policy by South Korean government to restore financial stability. In
particular, overhaul of financial regulation.
-Financial markets stabilize in 1998–99.
4-Application: The Financial Crisis in Argentina, 2001–2002

Argentina: Government forced banks to absorb large amounts of debt: Growing

fiscal imbalances led the government to ask banks to buy public debt.

The fiscal problems of the government weakened the banking system balance sheet.

Confidence in the government failed with investors (foreign and domestic) losing
trust in Argentina's ability to repay debt. The banks’ debt values (assets) fell
dramatically and bank balance sheets deteriorated.

Rise in interest rates.

Rise in Uncertainty.
4-Application: The Financial Crisis in Argentina, 2001–2002

Argentina:

Adverse selection and moral hazard problems worsened with banks losing deposits
and reducing lending.

Bank panic emerged with deposit withdrawals reaching US$1 billion/day in

November 2001 following growing doubts over sustainability of fiscal imbalances
and possible default coupled with investors losing trust in banks.

In November, restrictions on withdrawals imposed by government blew the flames of

social unrest and violent riots.
4-Application: The Financial Crisis in Argentina, 2001–2002

Argentina:

Currency crisis ensued. The bank panic made many question the ability of the
government to keep interest rates high to preserve the currency board (Arrangement in
which the Argentine government fixed the value of one Argentine peso to one U.S.
dollar by agreeing to buy and sell pesos at that exchange rate)

Speculative attacks against the peso started and multiplied

In December, 2001, the government announced the suspension of external debt

repayments.

In January 2002, the government announced the end of the currency board. Domestic
currency devaluated on January 6, 2002.
Argentine Peso
4-Application: The Financial Crisis in Argentina, 2001–2002

Argentina:

Currency crisis triggered full-fledged financial crisis

-Free fall of the peso, stabilizing at 25% of its value by the end of 2001.
-Rapid increase in capital outflows and decline in lending.
-Increase in inflation through higher import prices (like in South Korea),
compounded by historically poor inflation performance in the country
-Rise in actual and expected inflation.
-GDP decreases, dramatic increases in unemployment and poverty
-Worst crisis in Argentina's history

Recovery begins
Financial recovery in 2002 together with boom in demand for Argentinian exports
Growth resumes at fast pace in 2003: +10% annual rate
Inflation in Argentina
Unemployment Rate, Argentina