Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 12 International Financial...

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 12

International Financial Crises

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-2

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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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


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?


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


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


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


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


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


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


FIGURE 12.1 Pesos Per Dollar: December 12, 1994 to March 22, 1995


TABLE 12.1 Current Account Balances and Currency Depreciations


TABLE 12.2 Real GDP Growth

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 12 International Financial...

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