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Chapter 12 International Financial Crises Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter Objectives • Explore the ways in which financial crises develop and spread • Explain why financial crises may occur in countries with sound macroeconomic policies • Identify mechanisms to prevent and remedy financial crises Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-2 Introduction • Economic integration has enhanced growth and development, but also made it easier for crises to spread across borders • Contagion effects of crises do not conform to a single patterns, and are thus difficult to predict • Financial crises could be prevented through a reform of the international financial architecture Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-3 Financial Crisis • Financial Crisis: banking crisis, exchange rate crisis, or a combination of the two – Banking crisis: banking system’s becoming unable to perform its normal lending functions • Disintermediation: banks becoming unable to serve as intermediaries between savers and investors • Exchange rate crisis: sudden and unexpected collapse in the value of a nation’s currency Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-4 Financial Crisis and Exchange Rates • Under a fixed exchange rate system, crisis entails the loss of international reserves and devaluation • Under a flexible exchange rate system, crisis means an uncontrolled, rapid depreciation of the currency • Countries with a pegged exchange rate may be more vulnerable to a crisis Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-5 Two Causes of Financial Crises • Crises caused by macroeconomic imbalances, such as large budget deficits caused by overly expansionary fiscal policies – Example: Third World debt crisis of the 1980s • Crises caused by volatile capital flows – Example: the East Asian financial crisis of 1997– 1998 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-6 Domestic Issues in Crisis Avoidance • Problem in financial sector regulation – Moral hazard: incentive to act in a manner that creates personal benefits at the expense of the common good: e.g., banks have an incentive to make riskier investments when they know they will be bailed out – Moral hazard problems are exacerbated by governments’ providing incentives or threatening banks to make bad loans for political ends • In East Asian crisis, such loans gave rise to the term crony capitalism Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-7 Escaping Moral Hazard • The problem of moral hazard is inescapable if policies to protect the financial sector exist • Way to decrease the problem: establish supervision and regulation standards for internationally active banks – Basel Capital Accord: formulated in 1989 by bank regulators from industrialized countries; adopted by more than 100 countries – The New Basel Capital Accord of 2001 updated the previous standards Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-8 New Basel Capital Accord • Recommends three best practices to reduce the problem of moral hazard – Capital requirements: require the owners of banks to invest a certain percentage of their own capital in the bank – Supervisory review: oversight mechanism to assist with risk management and to provide standards for daily business practices – Information disclosure: requires banks to disclose operational information to lenders, investors, depositors Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-9 Avoiding Crisis: Exchange Rate Policy • Crawling peg increases vulnerability to financial crises in two ways – Requires monetary authorities to exercise discipline in the issuance of new money; anti-inflationary tendencies are exacerbated by intentional slow devaluation, and a severe overvaluation of the real exchange rate may result – Exiting crawling peg is difficult: government leaving it may lose the confidence of investors • Current consensus: hard peg or floating rate Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-10 Capital Controls • Capital controls may be imposed to prevent capital movements in the financial account – Inflow restrictions tend to work better than outflow ones: reduce the inflow of short-run capital, which would add to the stock of liquid, possibly volatile capital – Outflow restrictions may help reduce the impact of a crisis, when it occurs • Malaysia weathered the Asian Crisis through outflow restrictions Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-11 Managing Crises: Domestic Policies • Crises caused by macroeconomic policies can be cured by: – Cutting the deficit – Raising the interest rates – Letting the currency float • However, these are politically difficult Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-12 Managing Crises: Domestic Policies (cont.) • Crises caused by sudden capital flight are harder to cure – Collapsing currency can be defended through interest rate hikes, but these may cause bankruptcies and other problems Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-13 Managing Crises in Sum • Crisis management is politically difficult: creates losers in the domestic economy • Fiscal and monetary policies are limited if the crisis has an international component – Defending currency with high interest rates: spreads the recessionary effects of the crisis – Defending the economy against recessionary effects: intensifies the problems of a collapsing currency Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-14 Reform of the International Financial Architecture • Reform of the international financial architecture: new international policies for avoiding and managing financial crises • The great variety of reform proposals focus on two issues – Role of an international lender of last resort – Conditionality: the changes in economic policy that borrowing nations are required to make in order to receive loans from the lender of last resort Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-15 Lender of Last Resort • Lender of last resort: a source of loanable funds after all commercial sources of lending become unavailable – The central bank in the national economy – The IMF, with the support of high-income countries, in the international economy • A country unable to make a payment on its international loans or lacking international reserves asks the IMF to intervene Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-16 Lender of Last Resort (cont.) • Opponents of international lender of last resort cite moral hazard problems – Trusting in a bailout, failing firms have an incentive to gamble on high-stakes, high-risk ventures • Proponents: moral hazard can be decreased by financial sector regulations, such as the Basel Capital Accord – If owners of financial firms risk losses in the event of a meltdown, they will not engage in excessive risk Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-17 Lender of Last Resort (cont.) • Debate on the IMF’s role as a lender of last resort and moral hazard centers on – Level of IMF interest rates: should the rates be higher? – Length of the payback period: should the period be shorter? – Size of loans: countries often exceed the borrowing limitation of 300% above their quota; should the borrowing limits be curbed? Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-18 Conditionality • Conditionality: the changes in economic policy that borrowing nations are required to make in order to receive loans from the lender of last resort – Typically covers monetary and fiscal policies, exchange rate policies, and structural policies affecting the financial sector, international trade, and public enterprises – The IMF makes loans in tranches—installments of the total loan • Each tranche hinges on the completion of reform targets Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-19 Conditionality (cont.) • Critics of conditionality argue – The need to comply with conditionalities may intensify the recessionary effects of a crisis – Conditionality may entail high social costs on the poorest members of the society Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-20 Conditionality (cont.) • Proponents argue that crises could be avoided by a pre-qualification criteria – To receive assistance, countries must meet requirements of sound financial sector policies – However, critics claim that (1) prequalification will not deter speculative attacks on the country´s currency and (2) IMF could not ignore crises cases that failed to prequalify Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-21 Emerging Issues in International Financial Architecture 1 • Need for greater transparency to make a country’s financial standing clearer to potential lenders – Basel Capital Accord includes issues of transparency and data reporting – Data dissemination standards: the IMF´s standards for data reporting; currently under development Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-22 Emerging Issues in International Financial Architecture 2 • Need to coordinate private sector involvement: private sector creditors’ insistence they be paid first make it more difficult to resolve a crisis • How to resolve the conflict between lenders? – Standstills: IMF’s recognition that a crisis country temporarily stop making repayments on its debt – Collective action clauses: lenders would have to agree on collective mediation among themselves and the debtor in the event of a crisis Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-23 Reform Urgency • Immediately following the Asian Crisis financial reform was at the top of everyone’s agenda. • A decade later, not much reform has occurred and it is no longer at the top of the agenda. – Attention has been diverted to other areas: • Security, terrorism, energy, climate change Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-24 Chapter 12 Chapter Art Copyright © 2008 Pearson Addison-Wesley. All rights reserved. FIGURE 12.1 Pesos Per Dollar: December 12, 1994 to March 22, 1995 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-26 TABLE 12.1 Current Account Balances and Currency Depreciations Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-27 TABLE 12.2 Real GDP Growth Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-28