1. Chapter 12 International Financial Crises

2. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-2 Learning Objectives Define three types of crises. Distinguish a crisis caused by economic imbalances from one caused by volatile capital flows. List and explain three measures countries can take to reduce their exposure to financial crises.

3. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-3 Learning Objectives (cont.) Explain the need for reforms in the architecture of international finance and international financial institutions. Describe the main forces behind the global financial crisis that began in 2007.

4. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-4 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 (currency crisis) Financial crises have brought down governments, ruined economies, and destroyed individual lives Contagion effects of crises do not conform to a single pattern, and are thus difficult to predict

5. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-5 Introduction: The Challenge to Financial Integration (cont.) Many reform proposals are usually proposing reforms of the international financial architecture They often revolve around a set of proposed changes to the International Monetary Fund (IMF) and other multilateral institutions with a role in international financial relations Does the world economy need a lender of last resort? What type of conditions should a lender impose on the recipients of its assistance?

6. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-6 Definition of a Financial Crisis Financial crises have a variety of potential characteristics, but they usually involve an exchange rate crisis a banking crisis a debt crisis some combination of the three

7. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-7 Definition of a Financial Crisis (cont.) Banking crisis: The banking system becomes unable to perform its role of intermediation and its normal lending functions Disintermediation: Banks unable to serve as intermediaries between savers and investors

8. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-8 Definition of a Financial Crisis (cont.) Exchange rate crisis –A sudden and unexpected collapse in the value of a nation’s currency Debt crisis –Occurs when debtors cannot pay and must restructure their debt

9. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-9 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

10. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-10 Sources of International Financial Crises Two origins 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

11. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-11 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 country’s vulnerability

12. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-12 Crises Caused by Macroeconomic Imbalances (cont.) The current crisis which began in 2007 partially fits this description depending on the country and the time period Investment was facilitated by global imbalances in which countries with high savings rates and large current account surpluses lent to countries with large current account deficits and significant demand for investment

13. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-13 Crises Caused by Macroeconomic Imbalances (cont.) The 2007 financial crisis began when the housing bubble collapsed Banks were unable to lend as they either became insolvent or close to insolvent Resulting in a steeper decline in consumer and business spending

14. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-14 Crises Caused by Macroeconomic Imbalances (cont.) First phase, imbalances in most countries were a result of private sector decisions regarding saving and investment Second phase, government imbalances come into play as tax collections decline and spending on social programs and health care rises due to automatic stabilizers

15. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-15 Unsustainable deficits are not inevitable and depend on many other factors, such as the health of the banking system and the resiliency of the economy Sovereign default - a debt crisis in which the government cannot pay back its loans Crises Caused by Macroeconomic Imbalances (cont.)

16. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-16 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

17. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-17 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

18. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-18 FIGURE 12.1 Pesos Per Dollar: December 12, 1994 to March 22, 1995

19. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-19 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 (banks have an incentive to make riskier investments when they know they will be bailed out) –General agreement to eliminating moral hazard in financial institutions: increase capital requirements to raise the level of capital available in time of crisis

20. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-20 Domestic Issues in Crisis Avoidance: Moral Hazard and Financial Sector Regulation (cont.) The problem of moral hazard- inescapable if a general policy of protecting the financial system from collapse exist Basel Capital Accord: Formulated in 1989 by bank regulators from industrialized countries; adopted by more than 100 countries The New Basel Capital Accord of 2010(Basel III) updated the previous standards Basel Accords try to make banking systems more robust by setting new standards for bank supervision, information disclosure, and stress tests.

21. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-21 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

22. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-22 Exchange Rate Policy The crawling peg increases vulnerability to financial crises in two ways: 1.Requires monetary authorities to exercise discipline in the issuance of new money; anti- inflationary tendencies exacerbated by intentional slow devaluation; a severe overvaluation of the real exchange rate may result 2.Exiting crawling peg is difficult: A government leaving it may lose the confidence of investors

23. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-23 Capital Controls Capital controls may be imposed to prevent capital movements in the financial account –Inflow restrictions tend to work better than outflow ones- 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

24. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-24 TABLE 12.1 Current Account Balances and Currency Depreciations

25. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-25 The case of Thailand

26. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-26 The case of Thailand

27. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-27 The case of Thailand

28. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-28 TABLE 12.2 Real GDP Growth

29. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-29 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 The problem is that the economic austerity of budget cuts and higher interest rates may not be politically feasible

30. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-30 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

31. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-31 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

32. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-32 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

33. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-33 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 the owners of financial firms risk a substantial loss in the event of financial meltdown, they are less likely to take on excessive risk.

34. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-34 Lender of Last Resort (cont.) Debate on the IMF’s role as a lender of last resort and moral hazard centers on: –The rules for IMF loans is the size of the loan. Countries pay a subscription, called a quota, to join the IMF. quota depends mainly on the size of the economy and its strength. –Loan size up to 300 percent of their quota unless extraordinary circumstances (Mexican, Asian, contagion potential crises)

35. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-35 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: instalments of the total loan -Each tranche hinges on the completion of reform targets

36. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-36 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

37. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-37 Conditionality (cont.) Proponents of conditionality argue - 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

38. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-38 Conditionality (cont.) There is a 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

39. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-39 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: 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

40. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-40 Reform Urgency Immediately following the Asian Crisis, financial reform was at the top of everyone’s agenda A decade later, as the Asian crisis faded in memory, the urgency for reform diminished and not much had happened by the time the crisis in the U.S. housing market exploded in 2007 Attention has been diverted to other areas: -Security, terrorism, energy, climate change

41. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-41 The Global Crisis of 2007 The most recent financial crisis began in the United States in the fall of 2007 The first visible stage was called the subprime crisis in reference to housing Loans made in the United States to borrowers with less-than-prime credit ratings

42. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-42 The Global Crisis of 2007 (cont.) Banks and other “non-bank financial entities” (car financing firms, consumer credit firms, insurance companies, and others) entered the market Their strategy was not to profit from the interest they earned on the home loans, but to group a large number of loans together and sell shares in the entire package. This is known as securitization

43. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-43 The Global Crisis of 2007 (cont.) Securitization Accomplished with home loans, car loans, consumer credit loans, and other types of debt Buyers receive a return based on the interest the ultimate borrowers—home owners, car owners, credit card owners, pay to their lenders The company creates the securitized package of loans; sell shares to anyone willing to buy (another bank, a foreign-based insurance company, a foreign government)

44. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-44 The Global Crisis of 2007 (cont.) The savings held by governments are called sovereign wealth funds Private entities accumulated a large supply of international reserves by -increasing their savings -large current account surpluses to purchase dollars, U.S. Treasury securities, and other secure, highly liquid financial assets

45. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-45 TABLE 12.3 Current Account Deficits, 2000-2007 (Billions of U.S. $)