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Transcript
Financial Crises, Firms, and
the Open Economy
Chapter 11
Outline








Terminology
An asymmetric information view of financial crises
Disruptions and asymmetric information
A financial crisis framework
Financial crises in an open economy
Perverse savings
Twin crises: Empirical evidence
Fundamentals or investors?
- The illiquidity approach
- Financial crises as liquidity crises
- The vicious circle
- Third-generation model of currency crises
Definitions and terminology
 Speculative attack → devaluation → currency crises (a
disruption in the currency market).
 Capital account crisis (sudden reversal of capital flows):
The mirror image of a currency crises.
 Thus, a currency/capital account crisis is the potential
external channel of a financial crisis.
 A banking crisis is a potential internal channel of a
financial crisis.
 Twin crisis: When a banking crisis and a currency/capital
account crisis occur almost simultaneously.
 Financial crisis: Disruptions on the financial markets that
impair the functioning of these markets to such a degree
that they no longer are able to perform their primary
function, which is the efficient channeling of savings to
their most productive uses (investments).
 A financial crisis causes contraction in the real GDP.
Beugelsdijk, Brakman, Garretsen, and van Marrewijk
International Economics and
Business
© Cambridge University Press, 2013
Chapter 11 – Financial crises, firms, and the open
Table
11.1
Costs
and
duration
of
banking
crisis, 1970-2011
economy
Advanced economies
Number of banking crises
of which twin crises
10
3 (30%)
Developing countries &
emerging markets
111
53 (48%)
Average duration (in years)
Banking crisis only
Twin crisis
3.6
4.0
2.3
3.5
Fiscal costs (% of GDP)
Banking crisis only
Twin crisis
10
23
10
18
Average output loss (relative to trend output, % of GDP)
Banking crisis only
31
Twin crisis
51
24
38
Source: author’s calculations based on Laeven and Valencia (2012); only completed crises are
incorporated
An asymmetric information approach
 Riskiness of financial transactions is a major issue.
 Riskiness results from incomplete and asymmetric
information → Adverse selection and moral hazard
problems.
 A fall in the firm’s net worth (NW) increases the
asymmetric information problems and reduces the
efficiency of the financial system.
 Definition (Frederick Mishkin and others):
‘A financial crisis occurs when, due to disruption on
financial markets, the increase of the adverse selection
and moral hazard problems is such that the financial
system can no longer efficiently perform its main job of
channeling funds to the most productive investment
opportunities.’
Five categories of disruptions
1.
2.
3.
4.
5.
Increase in interest rates
Uncertainty increases
Asset prices fall
Deflation
Bank panic or bank run
Crucial question: How do these disruptions
increase the adverse selection and moral
hazard problems?
 Example of a banking crisis turned financial crisis.
 Assume the following.
- Closed economy
- The firm finances its activities by using bank loans
 To illustrate, we will use firms’ and banks’ balance sheets.
Figure 11.1 Stylized balance sheets of firms and banks
Firms
Banks
Capital
Bank loans
Bank loans
Net worth
banks
Other assets
firms
Net worth
firms
Other assets
banks
Deposits
1. An increase in interest rates increase the adverse
selection problem for banks (attracting more risky
loan applicants). It will also increase the moral
hazard problem because, as a result of higher
interest rates, firms will engage in more risky
behavior once they are granted the loan.
2. An increase in uncertainty: increases the adverse
selection and moral hazard problems because it
makes it hard for banks to distinguish more risky
from less risky projects.
3.
4.
5.
A drop in asset prices: decreases the NW of the firm and
this is a signal to the bank that the firm is now a more
risky borrower which increases the adverse selection
problem. A decrease in the firm’s NW also increases the
moral hazard problem because risk taking (by the firm)
increases as a result of the drop in the funds at stake. A
fall in the non-financial sector NW has an effect on the
balance sheet of the bank because the quality of its loan
portfolio deteriorates. The bank’s NW also falls.
Deflation: implies an increase in the real value of debt;
reduces the firm’s NW and indirectly the bank’s NW.
Bank panic or bank run: if most deposit holders try to ask
for their money back simultaneously we have a bank
panic or bank run (e.g., Russia in 1998, Turkey in 2001,
and Argentina in 2002).This has major negative effects
on the efficiency of the financial system.
A financial crisis framework
(Fig. 11.2)
 Suppose the supply of funds that the firms face
reflects the supply of bank loans (for external
finance).
 In a risk-free world the economy is at point 1
(Fig. 11.2) where the interest rate is at r0.
 With incomplete and asymmetric information the
supply schedule changes from horizontal
(perfectly interest-elastic) to upward sloping (for
external finance).
Figure 11.2 Financial crisis in an asymmetric information framework
r
Fd
A
5
4
C
3
B
r0
Fs(NW)
2
1
Funds
 Changes in NW reflect changes in the degree of
asymmetric information.
 Assume the economy is initially at point 2.
 Suppose we have a disruption that causes a fall in the NW
of the firm → supply shifts to the left (arrow A, point 3).
 Disruptions in the financial market may also imply that the
slope increases (banks perceive higher risk for any given
NW), i.e., the supply curve becomes steeper (Arrow B).
 If the financial intermediation system breaks down (as a
result of bank runs) firm investment may further decline. In
the absence of a properly functioning banking system, the
efficiency of the financial system decreases: both the
adverse selection and the moral hazard problems increase,
which leads to higher transaction costs.
 This leads to a wedge (reflecting transaction costs)
between the cost of capital for borrowers (firms) and the
actual return to the bank (point 5 in Fig. 11.2).
The open economy
The role of international capital mobility
If foreign investors lose confidence in an
economy → currency crisis → reversal of
capital flows
Current account imbalances: Figures 11.3
and 11.4.
Figure 11.3 Current account balance of selected EU countries, 2006-2012
EU imbalances; current account balance (% of GDP)
-7.0
2012
Greece
2011
-2.6
2009
Spain
2008
2007
-2.4
2006
Italy
-2.0
France
-1.5
Finland
5.5
Germany
7.7
Netherlands
-15
-10
-5
0
5
10
Source: van Marrewijk (2012), updated for 2012 with estimates from The Economist, 8 September 2012
Figure 11.4 Global imbalances; current account balance (US $ bn), 1970-2011
Current account balance; selected countries / regions (US $ bn), 1970-2011
450
421
China
300
150
Japan
Arab world
0
1970
1975
1980
1985
1990
1995
2000
2005
2010
-150
-161
EU
-300
-450
-600
USA
-750
-801
-900
Source: based on World Development Indicators online data; EU = European Union
How does a currency crisis relate to the
incomplete and asymmetric information
analysis?
Various channels:
1. International lending to domestic firms may be (directly
or indirectly) denominated in a foreign currency (e.g.,
US dollar). The domestic currency devaluation
increases the real debt burden of domestic firms and
banks. This in turn increases the adverse selection and
moral hazard problems.
Figure 11.5 Foreign-held US government debt (US $ billion), 2011
Foreign-held US government debt (US $ billion), 2011
1200
1160
1000
912
800
791
670
600
400
200
230
211
153
148
122
115
0
China
Japan
Europe
Oil exp nat
Brazil
Taiw an
Source: van Marrewijk (2012); oil exp nat = oil exporting nations
Carribean Hong Kong
Russia
Other
Various channels (cont.):
2. An increase in interest rates increases the asymmetric
information problem. Several countries hit by the
financial crises in the late 1990s had a large differential
(spread) in interest rates relative to US interest rates.
3. Domestic banks get into trouble because of currency
mismatch on their own and/or their domestic clients’
balance sheets →the quality of financial intermediation
may deteriorate.

The devaluation of the currency and the reversal in
capital flows are foreign channels that can impact banks’
performance.

Evidence shows that NW of firms in the countries
involved in the currency crises fell significantly.
Perverse savings



If foreign creditors begin to doubt the willingness and/or
ability of domestic government to fully guarantee the
banks’ liabilities the savings schedule will have positive
slope (higher risk).
Creditors will demand higher interest rates → reduces
investment expansion (see Fig. 11.6).
In addition to the effects covered in the discussion of Fig.
11.6, the example in Box 11.1 suggests two additional
possible negative effects.
1.
2.

The investment schedule might also shift to the left.
A higher interest rate depresses the (borrower) firm’s NW and
hence increases problems of asymmetric information.
What happens to savings if the increase in interest rates
implies a substantial added burden for the borrowers to
the point that the total return to savings drops? We get a
backward-bending savings curve!
Figure 11.6 Perverse savings and the backward-bending savings curve
r
I
S
3
2
S
r*
I
1
S
I
S, I
Twin crises: The empirical
evidence
 Figure 11.7
 The sequence of events: Figure 11.8.
 Two major questions:
1. Is it true for twin crises that banking crises typically
precede currency crises and that currency crises
deepen banking crises?
2. Are these crises the result of bad fundamentals?
Kaminsky and Reinhart (1999): Support the view
that banking crises precede currency crises, which
suggests that crises result from bad fundamentals.
Figure 11.7 Currency crises and ongoing banking crises, 1970-2012
# countries with currency crisis and # countries with ongoing banking crisis
35
30
ongoing banking crisis
# of countries
25
20
15
currency crisis
10
5
0
1970
1980
1990
year
2000
Source: author calculations based on data from Laeven and Valencia (2012)
2010
Figure 11.8
The unfolding
of a financial
crisis
Stage I Banking crisis
Domestic financial fragility due to ill-devised financial
liberalisation; under-regulated and over-guaranteed banks.
Large capital inflows; bank lending boom, but poor quality
of bank loans. Banking sector increasingly vulnerable,
possible bank runs.
1) Deterioration of firms and bank balance sheets.
2) Drop in asset prices.
3) Increase in uncertainty.
1) + 2) + 3): Problems of asymmetric information increase.
Stage II Currency crisis
Loss of confidence (foreign) investors; pressure on the
exchange rate.
Currency crisis and reversal of capital flows;
4) Debt-deflation (debt in foreign currency).
5) Interest rate increase.
4) + 5): Further increase in problems of asymmetric
information.
Beugelsdijk, Brakman, Garretsen, and van Marrewijk
International Economics and
Business
© Cambridge University Press, 2013
Chapter 11 – Financial crises, firms, and the open
Table 11.2 Possible relationships between signals and crises
economy
Crisis
No crisis
Signal
Possibility A
Possibility B
No signal
Possibility C
Possibility D
Beugelsdijk, Brakman, Garretsen, and van Marrewijk
International Economics and
Business
© Cambridge University Press, 2013
Chapter 11 – Financial crises, firms, and the open
predicted (possibility A in Table 11.2)
Table 11.3 Percentage of crises accurately
economy
Banking crisis
Currency crisis
Twin crisisa
Domestic credit/GDP
73
59
67
Money supply
75
79
89
Exports
88
83
89
Real exchange rate
58
57
67
Foreign exchange reserves
92
74
79
Output
89
73
77
Indicator:
Source: Kaminsky and Reinhart (1999). Note: a Twin crisis: A banking crisis is followed by a currency
crisis within forty-eight months.
Bad fundamentals vs. malicious investors
The illiquidity approach: Financial crises
are the consequence of a liquidity
shortage created by investors; they are not
crises of insolvency (study by Radelet and
Sachs, 1998).
Financial crises as liquidity crises.
The vicious circle
The liquidity view of financial crises implies
that self-fulfilling expectations of
international investors are a necessary
condition for a crisis to take place (stage II
in Fig. 11.8 becomes stage I).
Which stage is first? Does a crisis start with
bad fundamentals or investors’ self-fulfilling
expectations?
Krugman (2000): Both are correct.
We have a vicious circle (Fig. 11.9)
Figure 11.9 The vicious circle of financial crises
Domestic balance sheet problems
Currency depreciation
Source: Krugman (2000).
Loss of confidence
Suppose we start with investors’ self-fulfilling
expectations. Loss of confidence on the part
of investors → capital outflow → sharp real
devaluation/depreciation of the domestic
currency (to get a current account surplus) →
deterioration of firms’ balance sheets → drop
in NW → fall in investment and output →
further loss in confidence.
 Suppose we start with bad fundamentals
(fragility of the domestic financial system).
Deterioration of firms’ balance sheets → drop
in NW → fall in investment and output →
loss in confidence on the part of investors.
Does it matter where we start on the vicious
circle?
Yes! Depending on where we start the
policy implications would be quite different.
If investors’ self-fulfilling expectations view,
then there is a possible rationale for restricting
international capital mobility.
 If bad fundamentals view (start the circle with
the domestic balance sheet problems), then
there is a possible rationale for policies that
would remedy the regulatory and other
weaknesses in the domestic financial systems.
 Third-generation model of currency
crises: The synthesis between the
‘fundamentalists’ and the ‘self-fulfillers’.
 Differences from the second-generation
model:
1. A large and more direct role for self-fulfilling
expectations in the third-generation model.
2. The interaction between the exchange rate
and the domestic financial sector is explicitly
analyzed only in the third-generation model.
This makes the vicious circle model well
suited for the analysis of twin crises.