International Financial Crises What happened in Asia? Globalization, R. Bonoan & J. Shapiro November 21, 1999

Government policies toward the financial system Bank-centered financial system Weak bank supervision Moral hazard (Banks used as instrument of public policy and too big to fail) Government policies toward foreign capital Capital account liberalization biased toward short-term capital Foreign capital used to finance public debt Misallocation of capital Overinvestment Asset price bubble Corruption Financial vulnerability To banking crisis To public debt crisis Debt Maturity Structure Accumulation of short- term debt denominated in foreign currency Crisis Speculative attack on currency Capital outflow Spectre of public debt default Government macroeconomic policy Fixed exchange rate Loose fiscal policy (persistent budget deficits) Macroeconomic vulnerability High relative inflation caused by expansion of money supply Real exchange-rate appreciation Widening of current account deficit Triggers Depletion of foreign exchange reserves Economic vulnerabilities revealed Credibility of fixed exchange rate undermined Triggers Economic vulnerabilities revealed Credibility of fixed exchange rate undermined International Financial Crises 1. Vulnerabilities & Triggers Causes of foreign capital inflow Expansionary monetary policy in money centers Excess world liquidity (world capital glut) Financial deregulation Higher interest rates relative to money centers Liberalization of capital account Inflow of foreign capital

Financial system further weakened High interest rates force borrowers into default Specter of bank bailout Credibility of fixed exchange rate further undermined Domestic economy weakens Bankruptcies/bank collapses Increasing unemployment Rising political unrest Crisis Speculative attack on currency Capital outflow Spectre of public debt default Incentives to devalue increase Credibility of fixed exchange rate further undermined 2. International Financial Crises Government Response and Feedback Mechanisms Depletion of foreign exchange reserves Credibility of fixed exchange rate further undermined Government raises domestic interest rates Exchange rate peg under pressure Macroeconomic imbalances Competitive devaluation

Government policies toward financial system Bank-centered financial system Weak bank supervision Moral hazard (Banks used as instrument of public policy and too big to fail) Misallocation of capital Overinvestment Asset price bubble (real estate) Corruption Financial vulnerability To banking crisis Public debt crisis Crisis Speculative attack on currency Capital outflow Triggers Economic vulnerabilities revealed (bank collapses; corruption exposed) Credibility of fixed exchange rate undermined The Asian Financial Crisis 3. “Crony Capitalism” Causes of foreign capital inflow Expansionary monetary policy in money centers (US, Europe, and Japan) Excess world liquidity (yen bubble) Financial deregulation in Europe Higher interest rates in Asian countries relative to money centers Asian countries liberalize capital accounts Inflow of foreign capital

“Crony Capitalism ”

Inflow of foreign capital Government policies toward foreign capital Capital account liberalization biased toward short-term capital Financial vulnerability To banking crisis Debt Maturity Structure Accumulation of short- term debt denominated in foreign currency Crisis Speculative attack on currency Capital outflow The Asian Financial Crisis 4. Short-term Capital Flows (South Korea) Triggers Economic vulnerabilities revealed (collapse of chaebol; revelation of true short-term debt burden) Credibility of fixed exchange rate undermined Causes of foreign capital inflow Expansionary monetary policy in money centers (US, Europe, and Japan) Excess world liquidity (yen bubble) Financial deregulation in Europe Higher interest rates in Asian countries relative to money centers Asian countries liberalize capital accounts

Short-term Capital Flows

Crisis Speculative attack on currency Capital outflow Government macroeconomic policy Fixed exchange rate (dollar peg) Macroeconomic vulnerability High relative inflation caused by expansion of domestic money supply Real exchange-rate appreciation (also because dollar strengthening) Widening of current account deficit Triggers Depletion of foreign exchange reserves Economic vulnerabilities revealed (real estate bubble bursts and Bangkok Bank of Commerce fails) Credibility of fixed exchange rate undermined The Asian Financial Crisis 5. Macroeconomic Fundamentals (Thailand) Causes of foreign capital inflow Expansionary monetary policy in money centers (US, Europe, and Japan) Excess world liquidity (yen bubble) Financial deregulation in Europe Higher interest rates in Asian countries relative to money centers Asian countries liberalize capital accounts Inflow of foreign capital

Macroeconomic Fundamentals

Multiple variables to consider Variance across countries –Not all factors were present in all countries Triggers were important –Vulnerabilities not sufficient to cause crisis Several paths to crisis –Was the crisis inevitable? –How much weight should be assigned to each path? Conclusions