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Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 12 International Financial Crises.

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1 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 12 International Financial Crises

2 Copyright © 2011 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

3 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-3 Introduction: The Challenge to Financial Integration Economic integration has enhanced growth and development, but also made it easier for crises to spread across borders Financial crises could be prevented through a reform of the international financial architecture Contagion effects of crises do not conform to a single pattern, and are thus difficult to predict

4 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-4 Definition of a Financial Crisis Financial Crisis: A financial crisis is a banking crisis, an exchange rate crisis, or a combination of the two –Banking crisis: The banking system becomes unable to perform its role of intermediation and its normal lending functions Disintermediation: Banks becoming unable to serve as intermediaries between savers and investors Exchange rate crisis: A sudden and unexpected collapse in the value of a nations currency

5 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-5 Definition of a Financial Crisis (cont.) 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

6 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-6 Two Sources of International Financial Crises Two sources of international financial crises: 1) Crises caused by macroeconomic imbalances, such as large budget deficits caused by overly expansionary fiscal policies 2) Crises caused by volatile flows of financial capital that move in and out of a country quickly

7 Crises Caused by Macroeconomic Imbalances A number of crises over the last decades have been triggered by severe macroeconomic imbalances These are often accompanied by an exchange rate system that intensifies the countrys vulnerability - The current crisis which began in 2007 partially fits this description Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-7

8 Crises Caused by Macroeconomic Imbalances (cont.) Macroeconomic imbalances in government budgets, trade balances, and currency values have set off several crises in developing countries These are often the result of over- expansionary fiscal policies Once people suspect an overvalued exchange rate, capital flight out of the country begins Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-8

9 Crises Caused by Volatile Capital Flows The fundamental cause of this type of crisis is that financial capital is highly volatile and technological advances have reinforced this volatility A weak financial sector can also intensify problems Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-9

10 Crises Caused by Volatile Capital Flows (cont.) When banks take on short-term international debt to fund long-term domestic loans, several unsettling scenarios are possible: 1) There are multiple possible outcomes (multiple equilibria) 2) A self-fulfilling crisis 3) The crisis affects banks that are fundamentally sound, but have mismatches between maturities of assets and debts; illiquid but not insolvent Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-10

11 Figure 12.1 Pesos Per Dollar: December 12, 1994 to March 22, 1995 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-11

12 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-12 Domestic Issues in Crisis Avoidance: Moral Hazard and Financial Sector Regulation Problems in financial sector regulation include: –Moral hazard: The 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 the East Asian crisis, such loans gave rise to the term crony capitalism

13 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-13 Domestic Issues in Crisis Avoidance: Moral Hazard and Financial Sector Regulation (cont.) The problem of moral hazard is inescapable if policies to protect the financial sector exist The way to decrease the problem is to 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(Basel II) updated the previous standards

14 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-14 Domestic Issues in Crisis Avoidance: Moral Hazard and Financial Sector Regulation (cont.) The recommended 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

15 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-15 Exchange Rate Policy The 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: A government leaving it may lose the confidence of investors Current consensus: hard peg or floating rate

16 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-16 Capital Controls Capital controls may be imposed to prevent capital movements in the financial account –Inflow restrictions tend to work better than outflow ones because they 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

17 Table 12.1 Current Account Balances and Currency Depreciations Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-17

18 Table 12.1 (continued) Current Account Balances and Currency Depreciations Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-18

19 Table 12.2 Real GDP Growth Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-19

20 Table 12.2 (continued) Real GDP Growth Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-20

21 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-21 Domestic Policies for Crisis Management Crises caused by macroeconomic policies can be cured by: –Cutting the deficit –Raising interest rates to help defend the currency –Letting the currency float -However, these are politically difficult

22 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-22 Domestic Policies for Crisis Management (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

23 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-23 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: –The 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

24 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-24 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

25 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-25 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 of international lender of last resort state that 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

26 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-26 Lender of Last Resort (cont.) Debate on the IMFs 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?

27 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-27 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

28 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-28 Conditionality (cont.) Critics of conditionality argue that: –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

29 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-29 Conditionality (cont.) Proponents of conditionality 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) pre-qualification will not deter speculative attacks on the country's currency and (2) The IMF could not ignore crises cases that failed to pre-qualify

30 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-30 Conditionality (cont.) There is a need for greater transparency to make a countrys 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

31 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-31 Conditionality (cont.) The need to coordinate private sector involvement: private sector creditors insistence they be paid first makes it more difficult to resolve a crisis How to resolve the conflict between lenders? –Standstills: IMFs 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

32 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-32 Reform Urgency Immediately following the Asian Crisis, financial reform was at the top of everyones 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

33 Table 12.3 Current Account Deficits, 2000- 2007 (Billions of U.S. $) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-33

34 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 12-34


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