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CHAPTER 15
Financial Crises, Multinational Policymaking,
and the International Financial Architecture
CHAPTER OVERVIEW
This chapter discusses capital flows, financial intermediaries, and the factors that contribute to financial crises.
It concludes with a discussion of the role of policy to ward off financial crises and whether there is a need to
redesign financial structures.
The first section of the chapter examines the types of financial flows: portfolio flows and foreign direct
investment flows. The point is made, contrary to popular opinion, that the majority of foreign direct investment
takes place between developed economies and is long term in nature. Trends in mergers and acquisitions as
opposed to greenfield investment are also considered. A significant discussion is given to the stabilizing force
of FDI in a host economy.
The chapter next addresses the role of financial intermediaries and the cost and benefits of their efforts to match
savers and borrowers. The authors nicely point out that for every dollar channeled through a financial
intermediary from a saver to a borrower, a portion of that dollar is lost to the intermediary. It is noted, however,
that the dollar may be well spent if the intermediary is able to minimize market imperfections brought about by
asymmetric information (such as adverse selection, herding, moral hazard).
The discussion naturally leads to an evaluation of recent financial crises, along with what may lead to them. The
timing and mix of portfolio (typically a short run capital flow) and FDI (typically a long-term flow) are
discussed. The authors also take the time to address the stabilizing nature of FDI and the role (both destabilizing
and stabilizing) of capital controls.
The IMF and World Bank are next introduced, along with the initial motivation for the establishment of each.
The development of each organization is then discussed along with relevant current debates as to whether their
missions ought to be re-evaluated. The point is made that intervention by each organization may have a
destabilizing effect based on some critics’ arguments.
Finally, the design of current financial structures is examined. The authors touch on indicators of financial
crises; for example, fundamentals in the economy, self-fulfilling prophecies and contagion, and structural moral
hazard. Various indicators and their interpretation are then considered. The chapter concludes with a brief
discussion of thought given to restructuring the mission of international institutions.
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OUTLINE
I.
International Capital Flows
A. Introduction
1. Mexican Crisis
2. International Financial Architecture
B. Direction of Capital Flows
1. FDI
a. Mergers and Acquisitions
b. Emerging Economies
2. Capital Allocations and Growth
a. Stability
b. Development
C. Capital Misallocations and Their Consequences
1. Market Imperfections
a. Asymmetric Information
b. Adverse Selection
c. Herding
d. Moral Hazard
2. Policy Created Distortions
D. Financial Intermediaries
1. Cost
2. Economies of Scale
II. Capital Flows and International Financial Crises
A. Types of Capital Flows
1. Portfolio
a. Short Run
b. Easily Reversed
2. FDI
a. Long Run
b. Not Easily Reversed
B. Role of Capital Flows in Recent Crises
1. FDI as a Stabilizing Element
2. Capital Controls
III. Financial Crises and Multilateral Policy Making
A. Current Structure
1. IMF
2. World Bank
B. Evaluation of Current Structure
1. Ex-Ante Conditionality
2. Ex-Post Conditionality
3. Mission at World Bank
IV. Need For Redesign of Current Structure
A. Prediction of Crises
1. Economic Fundamentals
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2. Self Fulfilling Expectations and Contagion
3. Structural Moral Hazard Problems
B. Financial Indicators
C. Redesign of Institutions and Policies
V. Summary
FUNDAMENTAL ISSUES
1.
What are the most important developments in the recent evolution of global capital markets?
2.
What is the relationship between capital allocations and economic growth, and what is the role of financial
intermediaries in this relationship?
3.
What is the difference between portfolio capital flows and foreign direct investment, and what role did
these types of capital flows play in recent financial crises?
4.
What are the main activities of the International Monetary Fund and the World Bank?
5.
What aspects of IMF and World Bank policymaking have proved controversial in recent years?
CHAPTER FEATURES
1.
Policy Notebook: “Is the European Bank for Reconstruction and Development Promoting Corruption in
Russia?”
This notebook examines the idea introduced in the text that global multinational institutions may be forced into
a position of issuing loans to a country even though it has pilfered away past loans. The question arises whether
“good money is chasing bad money”. In this case, Russia is examined. Critics argue that the loans deter
economic development by simply financing continued corruption; thereby avoiding the structural adjustments
required for development.
For Critical Analysis: The EBRD could impose high conditionality restrictions (akin to what the IMF may do)
and thereby impose more accountability to avoid pitfalls that past loans encountered.
2.
Policy Notebook: “Do Financial Markets Predict Financial Crises?”
This notebook discusses the idea that markets reflect significant amounts of knowledge. Consequently,
information in the market is likely to be more reliable than policy makers in predicting crises. An example is
given of J.P. Morgan’s emerging market bond index (EMBI) which measures the spread between an average of
yields on emerging markets’ bonds and the yield on a U.S. Treasury bond. As the spread rises, a financial crisis
may be looming.
For Critical Analysis: The fact that the EMBI spread failed to indicate the Asian crisis does not mean that it is
not a useful criterion. It could well be used in conjunction with other indicators to arrive at a more
comprehensive set of tools to signal future crises. For instance, since it is based on market conditions, it is most
suited to signaling economic imbalances. As discussed in the text, there are other causes such as contagion and
moral hazard issues. Thus, it may not be well suited to predicting all crises.
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ANSWERS TO END OF CHAPTER QUESTIONS
1.
The difference between direct and indirect financing has to do with whether the borrower and lender seek
each other out or whether an intermediary matches borrowers and lenders. Direct financing requires no
intermediary to match savers and borrowers. An economy will benefit from having both direct and indirect
financing because both are appropriate ways to save and invest under different circumstances. As discussed
in the text, financial intermediaries absorb a fraction of each saver’s dollar that is borrowed. Thus, the
intermediary takes some of the funds that otherwise would have gone to a borrower. However, the financial
intermediary provides an important service by reducing information asymmetries, allowing savers to pool
risk, and matching risk and return. Therefore, when an individual cannot research these issues on his/her
own, the intermediary is necessary to help the financial markets operate. However, a strong bond market, in
which borrowers and savers can directly interact, allows for informed parties to save the funds that
otherwise would go to an intermediary. This, in turn, uses the savings more efficiently.
2.
Portfolio flows are relatively short term in nature (have a shorter term to maturity), involve lower
borrowing costs, and can generate near-term income. They also do not require a firm to give up control to a
foreign investor. Consequently, they may help to improve capital allocation within an economy and help
the economy’s financial sector develop. These are all potential benefits of portfolio investments. By the
same token, however, they are also relatively easy to reverse in direction, which is a potential disadvantage
of portfolio investment.
On the other hand, foreign direct investment (FDI) involve some degree of ownership and control of a
foreign firm, are typically long term in nature, and help provide a stabilizing influence on a nation’s
economy. As such, FDI is typically more difficult to arrange.
It is not advantageous to rely on either type of investment exclusively, in so far as each type accomplishes
different goals for an economy. Both near-and long-term capital are important for an economy’s growth.
3.
As either portfolio investment of FDI increase, the demand for the local currency rises (e.g., there is a shift
from D0 to D1), which puts upward pressure on the value of the currency. If the central bank expects to hold
the value of the currency constant, it will have to increase the supply of the currency (e.g., a shift from S 0 to
S1) to maintain the peg. The opposite would hold for capital outflows.
4.
Suppose that a multinational bank (MNB) headquartered in a developed economy enters a developing
economy. The MNB has gained considerable expertise in working as a financial intermediary, and likely
has achieved economies of scale in doing so. By entering a foreign market, it helps to allocate the savings
more efficiently through its intermediation services; which in turn will lead to additional economic
development. Specifically, it should help to make sure that the best investment projects are funded.
Moreover, the competition it introduces into the capital market helps to improve the quality of the
indigenous financial intermediaries. This, in turn, should also add to financial stability.
5.
Savers and borrowers can also benefit from the regulation of financial intermediaries when portfolio capital
flows dominate a country’s capital inflows. It can be argued that regulation to limit short-term inflows can
stabilize the economy and that these regulations can be gradually lifted as the economy becomes more
stable (financial markets develop) and resilient to external shocks. These regulations do impose costs in
that they require resources to enforce, and may inhibit otherwise helpful capital inflows which may aid
economic development. However, these costs must be considered against the potential losses that may be
incurred if the absence of capital controls would lead to more volatile and capital markets (which may deter
the inflow of foreign capital).
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6.
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The IMF may repeat its loans to Russia, even though Russia had historically defaulted on some of its loans,
because Russia’s economic growth impacts more countries than just Russia. The development of Russia’s
economy has effects throughout the increasingly global economy. The IMF could do either or both of the
following to minimize the possibility of such default happening again. First, it could make the loan
agreement public, such that there would be additional public pressure for Russia not to default. Second, the
IMF could impose high conditionality rules immediately to catch possible misuse earlier in the loan period.
7. The World Bank was initially established to help countries rebuild after WWII and in the 1960s expanded
to also make long term loans to developing nations in order to help reduce poverty and improve living
standards. Recently, some of the World Bank’s activities have begun to overlap the IMF’s activities to
finance long-term structural adjustments and provide refinancing for some heavily indebted countries.
Critics may argue that the tasks that are duplicated by the IMF and the World Bank create conflicting goals
for the World Bank. Thus, the two organizations may each benefit by focusing on different aims. For
instance, the IMF may return to financing shorter-term objectives and leave the World Bank to worry about
longer-term projects.
Another conflicting line of reasoning involves donors’ expectation that the World Bank maintain a revenue
stream form its projects. This can be argues as unrealistic, however, in that the poorest countries are less
likely to yield a payoff for the needed projects; and these are precisely the countries that the World Bank is
designed and intended to help. On the other hand, the less risky projects, that could provide a positive
revenue stream are likely to attract private capital.
8.
Answers will vary. A potential strength of this proposal would be the centralized, and assumedly unified,
efforts to stabilize the global economic environment. If it works, the global economy would be more stable.
A potential weakness involves the question of how practical this proposal would be, and how easy it would
be to match individual countries’ domestic policy goals with the organization’s global goals and economic
interventions. A potential of conflict between the organization’s interventions and national interests could
be a significant weakness.
9.
The first cause of a crisis could be an imbalance in the economy. In other words, an incongruity in
economic fundamentals could cause a crisis. Possible indicators include theoretical divergences between
various economic variables such as the exchange rate and interest rates, income, and money supply. The
policy notebook o financial market indicators also offers J.P. Morgan’s emerging market bond index
(EMBI) spread as a potential indicator. In terms of evaluation, if fundamental economic variables seem to
be out of line, there may be an impending crisis. In terms of the EMBI spread, if it becomes too large, there
may be an impending crisis.
A second cause is that of self-fulfilling expectations and contagion effects. In this case, mere expectations
of a potential inability to maintain a specified exchange rate or a slight incongruity between economic
conditions and the market exchange rate may cause a cascade of speculation that leads to a crisis. Since this
is based on perception, it is difficult to find an indicator. One possible indicator would be trading volumes
of currency for countries that may be at risk from the viewpoint of economic fundamentals. If trading
volumes grew quickly, a crisis may be on the horizon.
Finally, the structural moral hazard problem may indicate a crisis. In this case, a credit rating bureau, such
as Moody’s may provide the data needed to indicate a potential crisis. The quality of the credit rating would
be relatively easily interpreted to indicate a potential crisis.
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10. It can be argued that such below market interest rate loans are critical for a developing nation’s economy in
order for the economy to grow unburdened by high interest payments when it is trying to funnel profits
back into the economy and sustain growth. Conversely, providing these non-market rate loans can also be
argued to distort the market for loanable funds and attract inefficient investment. Students’ perspectives
will vary as to which argument is the best.
MULTIPLE CHOICE EXAM QUESTIONS
1.
Foreign Direct Investment (FDI) is the acquisition of foreign assets that results in at least what percentage
ownership?
A.
B.
C.
D.
5%
10%
15%
20%
Answer: B
2.
The acquisition of foreign assets resulting in at least 10 percent ownership is known as
A.
B.
C.
D.
portfolio investment.
strategic investment.
foreign direct investment.
speculative investment.
Answer: C
3.
FDI flows tend to be concentrated in
A.
B.
C.
D.
developing economies.
emerging economies.
developed economies.
transitional economies.
Answer: C
4.
Mergers and acquisitions are the driving force behind ________ investment between developed nations.
A.
B.
C.
D.
portfolio
foreign direct
strategic
speculative
Answer: B
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Foreign capital inflows tend to
A.
B.
C.
D.
destabilize the domestic economy by reinforcing domestic business cycles.
destabilize the domestic economy by offsetting domestic business cycles.
stabilize the domestic economy by reinforcing domestic business cycles.
stabilize the domestic economy by offsetting domestic business cycles.
Answer: D
6.
Recent research suggests that financial development
A. negatively affects economic development by diverting resources from the development of real
resources.
B. negatively affects economic development by encouraging less saving.
C. positively affects economic development by encouraging less saving.
D. positively affects economic development by directing funds to the most productive resources.
Answer: D
7.
A terminally ill person purchasing life insurance and failing to disclose the illness is an example of
A.
B.
C.
D.
moral hazard.
herding behavior.
adverse selection.
policy distortion.
Answer: C
8.
When a previously safe driver becomes careless after purchasing collision insurance, this is an example of
A.
B.
C.
D.
moral hazard.
herding behavior.
adverse selection.
policy distortion.
Answer: A
9.
How do portfolio flows compare in time frame to foreign direct investment flows?
A.
B.
C.
D.
Portfolio flows tend to be short run while FDI flows tend to be long run.
Both portfolio and foreign direct investment flows tend to be short run in nature.
Both portfolio and foreign direct investment flows tend to be long run in nature.
Portfolio flows tend to be long run while FDI flows tend to be short run.
Answer: A
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10. In the 1990s, developed economies generally attracted mostly ________ flows, and emerging economies
generally attracted mostly ________ flows.
A.
B.
C.
D.
portfolio; foreign direct investment
foreign direct investment; portfolio
both attracted portfolio investment
both attracted foreign direct investment
Answer: B
11. Critics of the IMF argue its secrecy and tendency to impose high conditionality only when pressed to
increases the IMF’s risk of encountering
A.
B.
C.
D.
adverse selection.
moral hazard.
neither A nor C
both A and C
Answer: D
12. Which of the following is not a standard theory for explaining financial crises?
A.
B.
C.
D.
economic fundamentals
self fulfilling expectations and contagion effects
structural moral hazard problems
policy distortions
Answer: D
13. Financial intermediaries perform all of the following functions except
A.
B.
C.
D.
matching savers and borrowers.
providing low interest loans.
reducing information asymmetries.
pooling risks.
Answer: B
14. Asymmetric information may result in all of the following problems except
A.
B.
C.
D.
adverse selection.
herding behavior.
moral hazard.
dominant strategies.
Answer: D
Chapter Fifteen
15. Portfolio capital flows tend to ________ and foreign direct investment flows tend to ________.
A.
B.
C.
D.
generate near term income; establish financial control
establish financial control; generate near term income
both tend to generate near term income
both tend to establish financial control
Answer: A
16. By their nature, portfolio flows _______ and foreign direct investment ___________.
A.
B.
C.
D.
are difficult to reverse; are easy to reverse
are to easy reverse; are difficult to reverse
both are easy to reverse
both are difficult to reverse
Answer: B
17. Countries that wish to attract FDI tend to invest in
A.
B.
C.
D.
education.
research.
infrastructure.
all of the above.
Answer: D
18. The IMF was established primarily to issue ________ -term loans and the World Bank was established
primarily to issue ________ -term loans.
A.
B.
C.
D.
short; short
short; long
long; long
long; short
Answer: B
19. Which of the following is NOT a funding program offered by the IMF?
A.
B.
C.
D.
Poverty Reduction and Growth Facility
Contingent Credit Lines
External Fund Facility
Historical Loan Misuse Credit Lines
Answer: D
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20. The World Bank issues loans aimed at
A.
B.
C.
D.
improving overall budget resources for needy countries.
improving national defense in needy countries.
improving specific projects to accelerate economic development.
accelerating short term projects.
Answer: C
21. The World Bank is composed of ______ separate institutions.
A. 4
B. 5
C. 6
D. 7
Answer: B
22. Critics of the World Bank argue
A.
B.
C.
D.
that is low-interest loans distort private markets for capital.
inappropriate countries receive the loans.
both A and B
neither A nor B
Answer: C