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Financial Crises & its Contagion Effect
What is a financial crisis?
What are the causes of financial crisis?
What cause the Asian financial crisis?
Other financial crises,
Why financial crises in the developing countries?
How can financial crisis be transmitted?
Definition of contagion & effect. and
Impact of industrial nation policies.
Financial Crises & its Contagion Effect
A
According to the most common definition of financial
crisis “ it is a sudden loss of confidence in a country’s
local currency or other financial assets causing
international investors to withdraw their funds from the
country at short notice”
A major withdrawal of funds from one country to another
overnight or within a short period of time is referred to
“capital flight” as well in the context of banking & finance
terminology.
Depending on the severity of the loss of confidence a
country, which is experiencing this sudden shift from the
investors’ behaviour may not only be placed at risk, but
could also impact on the region and create instability as
well.
Financial Crises & its Contagion Effect
A
Due to the integration of the world economy into a global
village, financial crisis knows no boundary, it can spread
to different level.
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From one neighbouring country to another,
From the neighbouring countries to a region,
From one region to intra-region, and
From intra-region to the rest of the world.
Again, depending on the severity, and the
policy measures taken to cure the problem, it can trigger
& threaten the entire financial architecture.
Financial Crises & its Contagion Effect
There are a number of reasons advanced by the experts in
researching around this topic.
 Fixed exchange rate,
 Weak banking system,
 Substantial real exchange rate appreciation,
 No barriers attach to the capital account,
 General lack of credibility (poor macro-economic track
record),
 Unrealistic composition of the capital inflows, (e.g. too
much short-term debts),
 Economic mis-management, and
 Political instability.
Financial Crises & its Contagion Effect
Fixed Exchange Rate
With pegged exchange rates, there is an alternative
school of thought that currency values should be pegged
to gold or some other standard of value and kept stable.
Those who view exchange rates in these terms may saw
the cause of the currency crises in the Asian countries as
excessive expansion of domestic money supplies by
central banks combined with burdensome government
regulations, protection of domestic industries, and other
government interference in the marketplace.
Once governments stopped maintaining their exchange
rates, investors lost confidence, and the crises began.
Financial Crises & its Contagion Effect
Weak Banking System
The banking system in the Asian economies were not
prepared to handle the financial crisis.
The monetary authorities were of the view that the event
would be an “over-night” drift that may be corrected with
half-hearted measures.
Other the other, it was more of a surprise that its occurrence
and consequences was much more pronounced than
expected.
The banks were unable and unified to deal with the problem
loans, threatening the financial stability (e.g. exposure in
the property market).
Financial Crises & its Contagion Effect
Substantial Appreciation in Real Exchange Rate
The effect of a slowdown in growth on a nation's
exchange rate is not immediately obvious.
It affects both trade and capital accounts in opposite
ways. On one hand, lower growth usually causes a
nation's trade balance to improve, since imports decline
relative to exports (unless demand in export markets is falling
faster).
This could strengthen a nation's currency. In the Asian
case, however, growth was continuing at a level high
enough that trade and current accounts tended to remain
in deficit. Even in Thailand, the slowdown had not
improved its balance of trade.
Financial Crises & its Contagion Effect
No Barriers Attach to the Capital Account
A number of emerging markets would not restrict the
transfer of portfolio flows in order to attract foreign direct
investment (FDI).
There is a tendency to have a liberal financial policy in as
far as the flows of capital.
The danger is for the investors to transfer their funds at
will with a view to make the maximum return within the
jurisdiction that offer greater incentives to investors.
Hence, when a country suffers from fiscal deficits couple
with other weaknesses in the financial system, an immediate
capital flight can easily trigger a financial crisis, subject to
availability of foreign currencies.
Financial Crises & its Contagion Effect
General Lack of Credibility
On the capital account side, a slowing growth rate generally
causes problems for a nation's debtors who have borrowed
to finance production facilities or have invested in real estate
or equities and are faced with repayment schedules. Lower
growth means lower demand, possible lower profits, and a
leveling off or fall in real estate and stock values.
As the slowdown intensifies, interest rates usually fall. This
can cause international lenders to look elsewhere for
investment for financing opportunities and may cause a
weakening of a nation's currency. Recessions also cause
loans to turn sour and may further drive away foreign
lenders. As the Asian financial crisis has developed,
forecasters have lowered their outlook for growth in these
countries.
Financial Crises & its Contagion Effect
Unrealistic Composition in the Capital Account Flows
A country that relies too much of short-term borrowings
to finance its development (e.g. long-term) places itself at
risk, when the lenders expects to repatriate its funds at
short notice.
One of the major causes with countries, which had
experienced financial crisis (e.g. Argentina, Mexico) were
heavily exposed to short- term debts its their capital
account of their balance of payments (BOP).
Financial Crises & its Contagion Effect
Economic Mis-management
Most research findings connected with the past financial
crises indicate that the bottom-line of crisis is tied to the
mis-management of the economy by the Government.
The economy is allowed to reach an alarming downturn,
whereby it becomes more difficult to implement draconian
measures at the cost of social difficulties.
Interestingly, in the developing countries where the crisis
originates, the Government allows political considerations
to override the economic considerations.
Financial Crises & its Contagion Effect
Political Instability
Some experts believe that the root cause of financial crisis
besides the mis-management of the economy emerges from
political instability.
There is a lack of continuity due to frequent changes at the
administrative level.
Many politicians tend to act as economists in their own way
of thinking, while ignoring the fundamental economic
principles – hence, the word “politico-economists”.
The danger is that there is always a mis-match in the
economic decisions taken contrary to addressing the real
problems confronting the country.
Financial Crises & its Contagion Effect
According to the researchers, the Asian financial crisis was
caused mainly by 4 reasons:
(1) under-developed financial system,
(2) shortage of foreign exchange,
(3) role, and operations of the international monetary fund,
(4) effects of the crisis on US & world economy.
There are also advocates, who are of the opinion that the
crisis was caused by the bubble of asset prices in Japan.
Financial Crises & its Contagion Effect
Under-developed Financial System
The Asian financial crisis, proved a point that a sound &
developed banking system is the key to further economic
development.
This is not an issue applying to Asian countries, but also to
other emerging markets around the world.
As a result of this experience, the banking systems of those
countries affected were forced to re-engineer their banking
system in order to accommodate more complex transactions
with greater controls and transparency.
(e.g. Nick Leeson from Barings Bank is a case in point).
The monetary authority in Singapore was unable to detect
abnormality in derivatives fraud in good time.
Financial Crises & its Contagion Effect
Shortage of Foreign Exchange
The foreign exchange reserves in those countries affected
(e.g. Malaysia, Indonesia, South Korea, Thailand) were just too
small to back up the demand for out-ward capital by the
foreign investors.
In spite of these countries turning to IMF, ADB & World
Bank for further assistance, the speculative attack was
enormous, and became a cost affair.
The IMF insisted that its assistance has been provided to
support programs that are designed to deal with
economy wide, structural imbalances and not to protect
commercial banks and private investors from financial
losses.
Financial Crises & its Contagion Effect
Role & Operations of the IMF
Some legislative issues dealing with IMF funding and
operations were deferred by the 105th Congress at the
close of its recent session.
The Asian financial crisis also has raised several questions
pertaining to IMF operations.
(1) Whether such crises have increased in scale and
whether IMF resources are sufficient to cope with them.
(2) Whether the Fund's willingness to lend in a crisis
contributes to moral hazard (a tendency for a potential
recipient country to behave recklessly knowing that the
IMF will likely bail them out in an emergency). .
Financial Crises & its Contagion Effect
Role & Operations of the IMF
(3) Whether the contagion of financial crises can be stopped
effectively.
(4) Whether the changes in economic policy and
performance targets that the IMF requires of the recipient
countries are appropriate and effective.
(5) Whether the IMF has sufficient leverage over nonborrowing member countries to prevent financial crises
from occurring, and
(6) Whether the IMF releases sufficient information to the
public, including investors, on its program design and
provisions imposed as a condition for borrowing allow for
accurate assessment and accountability. .
Financial Crises & its Contagion Effect
Effect of the Crisis on US & World Economy
This financial crisis was of interest to US because:
(1) The stock markets are inter-linked,
(2) Attempts to resolve the problems are led by the IMF,
World Bank and ADB and pledges of standby credit from
the Exchange Stabilization Fund of the United States,
(2) Americans are major investors in the region, both in the
form of subsidiaries of U.S. companies and investments
in financial instruments, and
(3) The currency turmoil affects U.S. imports and exports as
well as capital flows and the value of the U.S. dollar; the
U.S. deficit on trade was rising as these countries import
less and export more.
Financial Crises & its Contagion Effect
Russia’s Crisis
Russia embarked on a transition period in 1989 from a
command & control economy (sometimes referred as
centrally planned economy) to a market-led economic style.
The transition involved the following economic problems:
rapid inflation, steep output declines, and unemployment.
The Government only managed to stabilize the ruble and
reduce inflation with the help of IMF credits in 1997.
Obviously, the transition from centrally planned economy
to market-based policies only bear fruit in the year 2000
when they started to enjoy a rapid growth rate.
Financial Crises & its Contagion Effect
Mexico’s Crisis
In the late 1994, Mexico experienced a large current
account deficit. This was coupled by a weak banking
system.
The rapid growth in dollar-indexed Mexican government
debt (Cetes) led to a large devaluation and depreciation of
the Mexican peso – hence, a financial crisis as foreign
investors refused to buy new Cetes.
The contagion effect ( "tequila effect") spread the crisis to
other Latin American countries.
In early 1995, speculative attacks spread to other Latin
American countries. As a consequence, Argentina went
into a sharp recession.
Financial Crises & its Contagion Effect
Asia’s Economic Success
Until 1997 the countries of East Asia were having very high
growth rates.
The driving force for such economic success were
attributable to the underlying factors:
• Much emphasis laid on the standard of education,
• Introduction & implementation of sound macro-economic
fundamentals
• Promotion of high saving and investment rates,
• Heavy control on the level of inflation, and
• Recorded a high percentage of trade in the level of
GDP.
Financial Crises & its Contagion Effect
Asia’s Economic Weaknesses
Three weaknesses in the Asian economies’ structures
became apparent with the 1997 financial crisis:
(a) Level of Productivity
Asian countries were becoming uncompetitive due to the
Rapid growth of production costs, but little or no reduction in
the output cost.
(b) Banking regulation
The banking laws were far out of date with the current
economic development taking place – weak banking system
(c) Legal framework
Lack of a good legal framework for dealing with companies
in financial distress.
Financial Crises & its Contagion Effect
Asia’s Crisis Development
The devaluation of the Thai baht triggered the crisis on
2nd July 1997.
The sharp drop in the Thai baht was followed by
speculative attacks against the currencies of: Malaysia,
Indonesia, and South Korea.
All of the afflicted countries except Malaysia turned
to the IMF for assistance. Singapore, although not
affected remain
very resilient against speculative attacks.
The downturn in Asia was “V-shaped”: after the sharp
output contraction in 1998, growth returned in 1999 as
depreciated currencies spurred higher exports.
Financial Crises & its Contagion Effect
The Argentina’s Experience
Argentina has failed to make a debt repayment to the
World Bank that fell due on 14 November 1991.
It has repaid the interest - about $80m - but not the
entire debt, which stands at more than $800m.
This means the country was considered to be in
default, a situation which damaged its chances of
winning fresh, much hoped for funds from the
International Monetary Fund..
In 1991, during Domingo Cavallo's first spell as
economy minister, the government decided to peg the
peso to the US dollar to restore confidence and combat
hyperinflation.
Financial Crises & its Contagion Effect
The Argentina’s Experience
At the time, the strategy worked, but in time Argentina
suffered the disadvantages of such a fixed peg.
By linking the peso to the dollar, Argentines adopted a
currency whose exchange rate bore little relation to their
own economic conditions.
This was a boon in times of hyperinflation
But when stability returned to Argentina, the inability of its
currency to respond proved more of a burden than a
benefit.
Financial Crises & its Contagion Effect
This is a very useful question to ask about the origin of
financial crisis in the developing countries.
It is noticeable that financial crisis does not happen in the
industrial world, even if it does, it is easily contained so
that it does not affect a regional or international crisis.
Admittedly, due to our level of integration, the developing
countries can also experience its effect partially – the
spread of the crisis is referred as “contagion”.
One of the principal reasons that the industrial countries
are not too much at risk as compared to the developing
countries rest on the argument that the financial system
in the industrial countries are much developed, & equipped
to deal with any imminent financial threat.
Financial Crises & its Contagion Effect
Most developing countries have at least some of the
following features:
o History of extensive direct government control of the
economy,
o History of high inflation reflecting government attempts
to extract seignior age from the economy,
o Weak credit institutions and undeveloped capital markets,
o Pegged exchanged rates and exchange or capital controls,
o Heavy reliance on primary commodity exports, and
o High corruption levels.
Financial Crises & its Contagion Effect
Capital Inflows to Developing Countries
Many developing counties have received extensive capital
inflows from abroad and now carry substantial debts to
foreigners,
Developing country borrowing can lead to gains from
trade that make both borrowers and lenders better off,
Borrowing by developing countries has sometimes led to
default crises, and
The borrower fails to repay on schedule according
to the loan contract, without the agreement to the
lender (s).
Financial Crises & its Contagion Effect
Developing Countries Debts & Borrowings
History of capital flows to developing countries:
Early 19th century
A number of American states defaulted on European loans
they had taken out to finance the building of canals.
Throughout the 19th century
Latin American countries ran into repayment problems
(e.g., the Baring Crisis).
1917
The new communist government of Russia repudiated the
foreign debts incurred by previous rulers.
Great Depression (1930s)
Nearly every developing country defaulted on its external
debts.
Financial Crises & its Contagion Effect
Debts Crisis of the Past Two Decades
The great recession of the early 1980s sparked a crisis
over developing country debt.
The shift to contractionary policy by the U.S. led to:
 The fall in industrial countries' aggregate demand,
 An immediate and spectacular rise in the interest burden
debtor countries had to pay,
 A sharp appreciation of the dollar, and
 A collapse in the primary commodity prices
The crisis began in August 1982 when Mexico’s
central bank could no longer pay its $80 billion in
foreign debt.
By the end of 1986 more than 40 countries had
encountered several external financial problems.
Financial Crises & its Contagion Effect
Trade channels and exchange rate pressures.
 Through bilateral trade (ex. Chile 1997-98)
 Competition for trade with a common third
partner (e.g. East Asia’s trade with Japan)
Integrated financial markets
Banks are interconnected through loans (Mexican banks
were extending trade credit to Costa Rican banks prior to the 1994
crisis)
Interconnection through bond holdings. (Korea was
holding Brazilian and Russian bonds)
c. Liquidity management practices of open end mutual
funds.
(Thai share prices fall–sell Indonesia).
Financial Crises & its Contagion Effect
The word contagion is defined as the influence of “news” about the
creditworthiness, etc. of a borrower on the spreads charged to the
other borrowers or equity prices, after controlling for country
specific macroeconomic fundamentals (Doukas, 1989,Kaminsky
and Schmukler, 1998)
2. Other studies, such as Valdes (1995), defined contagion as excess
co movement across countries in asset returns, whether debt or
equity. The co movement is said to be excessive if it persists even
after common fundamentals, as well as idiosyncratic factors, have
been controlled for.
3. A recent variant to this approach is presented in Arias, Haussmann,
and Rigobon (1998) and Forbes and Rigobon (1998), who define
contagion more narrowly by requiring an increase in excess co
movement in crisis periods.
4. Eichengreen, Rose, and Wyplosz (1996) defined contagion as a
case where knowing that there is a crisis elsewhere increases the
probability of a crisis at home, even when fundamentals have been
properly taken into account.
Financial Crises & its Contagion Effect
After controlling for country specific macroeconomic
fundamentals must be corrected implemented.
The influence of “news” about the creditworthiness, of
a borrower on the spreads charged to the other
borrowers.
Excess co movement across countries in asset
returns, whether debt or equity.
An increase in excess co movement in crisis periods.
A case where knowing that there is a crisis elsewhere
increases the probability of a crisis at home especially
if the sovereign rating is poor.
Financial Crises & its Contagion Effect
Feldstein (2002) argues that there are a number of measures
which the industrial nations can do to minimize the financial
risk in the developing countries.
These measures can involve:
Stabilization of the exchange rates,
Avoiding high interest rates,
Opening markets to emerging market products,
Regulating lending by private industrial country creditors,
Central Banks acting as lender of last resort.
Financial Crises & its Contagion Effect
Stabilization of Exchange Rates
It is argued by Feldstein that fluctuations of exchange rates
among the dollar, yen, & euro can exacerbate trade deficits
of the emerging markets.
This can precipitate balance of payment difficulties &
eventually crises (e.g. currency mis-match).
A country that takes dollar denominated debts, but earns
say yen or euro from its exports could see its ability to
service its debts suffer – if the dollar appreciates relative
to the other currencies.
From past experience, there is no prospect that the US &
other countries will pursue deliberate policies to stabilize
their exchange rates – which will favour developing nations
Financial Crises & its Contagion Effect
Avoiding High Interest Rates
Countries that borrow in dollars or other hard currencies
are directly affected by an increase in interest rates in the
home countries currencies.
Market participants also believe that an increase in the
US$ interest rate causes interest rates on emerging market
loans to rise by more than an equal amount.
Since there is no prospect that the industrial countries will
modify their domestic monetary policy in order to reduce
adverse effects on the emerging market countries, the
private and public borrowers in those countries must take
into account the possibility of interest rate move against
their favour.
Financial Crises & its Contagion Effect
Opening Markets to Emerging Market Products
Opening the industrial country markets to increase imports
of textiles & agricultural products from the emerging
market countries would raise the standard of living in the
export countries as well as the importers.
It is widely supported by economists, and opposed by other
interest groups in the industrial countries that would be
hurt by the import competition.
Progress towards greater market opening will therefore
continue to be slow.
Such market opening might do little to reduce the risk of
economic crises.
Financial Crises & its Contagion Effect
Regulating Lending by Private Industrial Country
Creditors
After the Latin American (80s) & Asian (90s) financial crises
there was widespread agreement that there has been too
much borrowings by these countries and too much lending
from the industrial countries.
Many experts believe that steps should be taken to reduce
the amount of lending to emerging market countries and
to increase creditors’ sensitivity to the risks involved.
The Basel Accord demands as a result of such experiences
that bank supervisory authorities mark the credit portfolios
to market all the lending and risk taken by the borrowers.
Financial Crises & its Contagion Effect
Central Banks to Act as Lender of Last Resort
Any nation Central Bank can prevent runs on solvent banks
by providing sufficient liquidity to assure depositors &
other creditors that they have nothing to fear.
They can do so, by lending against good but illiquid
collateral.
The very existence of such a lender of last resort helps to
reduce the risk of domestic financial crises.
The emerging market countries must be prepared to protect
themselves against unwarranted currency attacks & bank
runs associated with “pure contagion” and with deliberate
attempts at destabilizing speculation.
Financial Crises & its Contagion Effect
I wish you all,
good luck
in your studies.
Financial Crises & its Contagion Effect
Financial Crises & its Contagion Effect
Financial Crises & its Contagion Effect