International Financial Crises

Current Account: Net income earned overseas through trade, interest, dividends, profits, wages or gifts. (NFI +NX) Bureau of Economic Analysis Balance of Payments Table

Sources of Income

East Asian Crisis IMF World Economic Outlook Database

Private Savings: Disposable Income less Consumption. Public Savings: Budget Balance Domestic/National Savings: Private plus Public Savings If Savings is insufficient to finance investment, funds must be made up from global sources. Capital Inflows = Domestic Investment – Domestic Savings

Capital & Financial Account Net Capital Inflows Two Parts Capital Account: Transfers of copyright, patents, mineral rights, debt forgiveness by govt Financial Account: Vast bulk of international capital movements [Inflows less outflows] – Inflows: Foreign purchases of domestic securities, FDI, loans from foreign banks. – Outflows: Domestic purchases of foreign securities, FDI, loans from domestic banks

Balance of Payments IMF Balance of Payments Manual Reserve Assets: Holdings of liquid foreign currency assets used by government to stabilize currency markets.

Link

Current account and capital account Public Savings GNI + Transfers –Taxes -Household Consumption Private Savings Taxes - Government Consumption-Transfers Capital Inflows = GCF - Savings GCF-( GNI – Consumption ) Consumption +GCF – GDP – NFI -(NFI + NX)

Current Account What if economy does not have enough capital inflows to support its current account deficit? Net Capital Outflows Too many buyers for foreign currency assets Not enough buyers for domestic currency goods

Two Possibilities Floating Exchange Rates – Changes in the exchange rate equalize forex market. Pegged Exchange Rate – Changes in reserve assets equalize forex market.

Current Account Not enough demand for domestic currency causes exchange rate to depreciate. Net Capital Outflows Falling price of currency makes domestic goods & financial assets more competitive Current Account Net Capital Outflows

Net Capital Outflows Central bank must use forex reserves to buy domestic currency to absorb pressure on its value. Current Account Net Capital Outflows

Current Account What if economy receives a surge in inflows? Net Capital Outflows Hot Money

Current Account Excess demand for domestic currency causes exchange rate to appreciate? Net Capital Outflows Floating exchange rates Current Account Net Capital Outflows

Net Capital Outflows Central bank purchases inflows and increases reserves Current Account Net Capital Outflows

Capital Controls Zero-Interest Reserve Requirements: Thailand (2006, 2009) Tobin Tax: Tax on currency transactions Administrative Controls

Link

Global Imbalances

Imbalances

FINANCIAL CRISIS

International Financial Crises Currency Crises – Loss of credibility of fixed exchange rate system. Banking Crisis – Sudden collapse of the domestic banking system. Systemic Financial Crisis/Sudden Stops – Breakdown of system of international capital flows. Sovereign Debt Crisis – Gov’t unable to pay-off debts IMF World Economic Outlook, 1998

Devaluation/Revaluation Devaluation of the currency occurs when central bank operating an exchange rate peg increases the number of domestic dollars needed to purchase one foreign dollar. Revaluation is a decrease in domestic currency price of foreign dollars.

Currency Crises Market believes that exchange rate will be devalued in the near future. Lenders demand higher interest rates to lend in domestic dollars to compensate for loss of value after devaluation. Central bank must use its foreign reserves to buy domestic currency and prop up exchange rate. If pain of interest rates is too painful or loss of reserves too severe, central bank may be forced to devalue.

ERM Crisis In 1980’s, European economies constructed a system of linked currencies called the Exchange Rate Mechanism. Inflationary German fiscal policy following re- unification led to high DM interest rates. To maintain link, other Euro currencies needed to have interest rates too high for their own situation. In Sept. 1992, markets expected a delinking/devaluation of currencies. Go for the Jugular

Currency Crisis Speculation against the pound forced Bank of England to raise interest rates and buy pounds in forex markets. Pain of interest rates was viewed as too severe and B of E was forced to abandon the peg. Principal Global Indicators Database

Roles of Banking System Why Not Finance Corporate Sector w/ Stocks and Bonds? Banks accept deposits from retail customers and make larger, longer-term loans. Information: Banking institutions study credit- worthiness of borrowers. Monitoring: Banks can enforce covenants and conditions on lending. Liquidity : Deposits easily used for necessary transactions Link

Banking Crises Bank Runs – Sudden withdrawal of deposit base forcing bank closures or gov’t assistance. – Solvency Crisis: Banks have substantial amounts of loans gone bad and thus have insufficient funds to repay depositors. Swedish Banking Crisis, 1991 LinkLink – Liquidity Crisis: Sudden deposit withdrawal requires liquidation of otherwise sound assets. Bank of East Asia, 2008 Link Link

Systemic Crisis Bank failure can be contagious 1.Interbank Lending 2.Panic conditions Link

Lender of Last Resort Banking system sufficiently important that gov’ts will usually protect depositors and prevent mass bankruptcies. – Liquidity Crisis: Lend at penalty rates against good collateral. Walter Bagehot, 1840’s. – Solvency Crisis: Recapitalize banks through gov’t purchase of equity, diluting or destroying shareholder value. Moral Hazard: Banks creditors and (sometimes owners) are protected from consequences of risky behavior. Link

Banking Crisis Currency Crisis Fragile banking system makes high interest rates untenable and can lead to fears of devaluation (especially if central bank funds used to bailout banking system) Exchange rate devaluation can damage balance sheets if balance sheets (deposits or borrowings) are dollarized.

Sudden Stops International hot money (short-term lending) is subject to herding behavior from international financial market. – Rapid inflows and rapid outflows. When capital inflows stop, either those can be replaced with forex reserves, or domestic borrowers will face bankruptcy. – Domestic firms can no longer finance investment – Demand, GDP, and employment fall. – Devaluation of currency. Link

East Asian Crisis Link

Current Account Sudden stop? Net Capital Outflows Net Capital Outflows

Buildup Foreign Reserve Assets IMF Financial Statistics

Foreign Reserves Measures of Adequate Reserves Import Coverage: Reserves > Imports for 2-3 Months Greenspan-Guidotti Rule: Reserves exceed 100% of debt due within one year. Link

Korea

Dealing with Sudden Stops Modern Approach Swap lines LinkLink

Chiang Mai Initiative Multilateralization ASEAN+3 has a pool of US$120billion (financed mostly by +3) in reserve swaps available for liquidity in a crisis to allow for region-wide insurance In size, amount seems reasonable. IMF-led programs in Thailand and Indonesia were about $20billion and $40 billion through Link

II. The debate over financial globalization Broad agreement (among economists at least) that trade liberalization is beneficial and leads to faster growth → Free trade in good and services makes countries better off In contrast, much controversy over whether the liberalization of international financial flows is desirable → Free trade in financial assets may not make countries better off

Financial Globalization Link

…and recovered from the crisis Financial integration has been fastest in developed economies. But emerging markets financial flows have also been substantial. weo/2011/01/pdf/c4.pdf

Reaping the Benefits of Financial Globalization But there are several factors which have been shown to allow countries with open capital accounts to: A.Increase consumption risk-sharing and; B.Increase economic growth and; C.Reduce the likelihood of crises. Empirical evidence shows that the benefits of opening capital account are mixed.

Keys to Benefiting from Globalization 1.Financial sector development. Well- regulated domestic financial markets 2.Institutional Quality. Low corruption, high transparency, good corporate governance. 3.Sound Macroeconomic Policies. Low deficits and price stability. 4.Trade Integration. High degree of trade openness. ft/fandd/2007/03/kose.htm

How to Liberalize During the early 1990’s, some authors argued in favor of a “big bang” approach to capital account liberalization. Since mid-1990’s, taking empirical evidence in mind, IMF has adopted a more moderate approach referred to as sequencing or ‘integrated approach’

Integrated Approach (1) capital account liberalization is best undertaken against a background of sound and sustainable macroeconomic policies; (2)domestic financial reform should be complemented by prudential regulation and supervision, and financial restructuring policies; (3) liberalization of capital flows by instruments and/or sectors should be sequenced to take into account concomitant risks—in general, long-term and non-debt creating flows (especially FDI) should be liberalized before short-term and debt- creating flows; Link

Final Exam Cumulative: 2/3’s after the mid-term. Same format as mid-term. Semi-open book: 1 A4 paper w/ handwritten notes on both sides. LG1027, December 15, 2012, 12:30-14:30

The Sequencing of Financial Liberalization Three types of financial liberalization – Capital Account Liberalization – Stock Market Liberalization – acquisition of shares in the domestic stock market by foreigners, repatriation of capital, interests and dividends – Domestic Financial Liberalization Banking System – deposit interest rates, lending interest rates, lending reserve requirements

On Sequencing Different countries’ situations vary greatly: – e.g., level of economic and financial development, existing institutional structures, legal systems etc No general recipe for the sequence of steps to undertake in financial and capital account liberalization. In general, maintaining tight restrictions on virtually all forms of international financial flows until the domestic financial system is fully liberalized is not an advisable strategy. Domestic and financial liberalization can benefit from symbiotic interactions.