1. Chapter 13 Financial Crises in Emerging Economies

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This chapter applies the asymmetric information theory of financial crises to investigate the cause of frequent and devastating financial crises in emerging market economies
This analysis is then applied to the events surrounding the financial crises that took place in South Korea and Argentina in recent years and explore why these events caused such devastating contractions of economic activity.

3. Dynamics of Financial Crisis in Emerging Market Economies
Stage one: Initial Phase
Path A: Credit Boom and Bust
A weak “credit culture”
Ineffective screening and monitoring of borrowers
Lax government supervision of banks
Financial liberalization allows domestic banks to borrow abroad.
Lending booms end in lending crashes, weakening bank balance sheets if financial institutions are weak.
Banks play a more important role in emerging market economies, since securities markets are not well developed yet.

4. Dynamics of Financial Crisis in Emerging Market Economies
Stage one: Initial Phase
Path B: Severe Fiscal Imbalances
Governments in need of funds sometimes force banks to buy government debt.
When government debt loses value, banks lose and their net worth decreases.
The decline in bank capital may trigger bank panic.
Additional factors:
Increase in interest rates (from abroad) can increase adverse selection problems.
Asset price declines lead to less collateral for lenders to seize, making moral hazard problems worse.
Uncertainty linked to unstable political systems

5. Dynamics of Financial Crisis in Emerging Market Economies
Stage two: Currency Crisis
Deterioration of bank balance sheets triggers currency crises:
Government cannot raise interest rates (doing so forces banks into insolvency)…
… and speculators expect a devaluation.
Speculators will engage in massive sale of the currency.
The central bank can either sell its reserve or allow a devaluation.
Severe fiscal imbalances triggers currency crises:
Foreign and domestic investors sell the domestic currency.

6. Dynamics of Financial Crisis in Emerging Market Economies
Stage three: Full-Fledged Financial Crisis
The debt burden in terms of domestic currency increases (firms’ net worth decreases).
A dramatic rise in expected and actual inflation causes domestic interest rate to increase, thus reducing firms’ cash flow.
A reduction in investment and economic activity.
Banks are more likely to fail:
Individuals are less able to pay off their debts (value of assets fall).
Debt denominated in foreign currency increases (value of liabilities increase).

7. Figure 7 Sequence of Events in Emerging Market Financial Crises

8. Application: Crisis in South Korea, 1997-98
Financial liberalization and weak bank supervision
Perversion of the financial liberalization and globalization process: chaebols (large industrial conglomerates) and the South Korean crisis
“Too big to fail” by the government
Chaebols borrowed too much and became highly leveraged.
However, their rate return on assets was low.

9. Application: Crisis in South Korea, 1997-98
Stock market decline and failure of firms increase uncertainty
Adverse selection and moral hazard problems worsen, and the economy contracts
Currency crisis ensues
Contagion spread after the devaluation of Thai currency and hit Korea vulnerable banking sector
Final stage: currency crisis triggers full-fledged financial crisis
Recovery commences

10. Application: Crisis in South Korea, 1997-98

11. Application: Crisis in South Korea, 1997-98

12. Application: The Argentine Financial Crisis, 2001-2002
Severe fiscal imbalances
Adverse selection and moral hazard problems worsen
Bank panic begins
Currency crisis ensues
Currency crisis triggers full-fledged financial crisis
Recovery begins

13. Foreign capital fled the country as a severe recession developed.
Global: When an Advanced Economy Is Like an Emerging Market Economy: The Icelandic Financial Crisis of 2008
The financial crisis and economic contraction in Iceland that started in 2008 followed the script of a financial crisis in an emerging market economy, even though Iceland is a wealthy nation.
Financial liberalization led to rising stock market values and currency mismatch.
Foreign capital fled the country as a severe recession developed.

14. Preventing emerging market financial crises
Beef up prudential regulation and supervision of banks
Encourage disclosure and market-based discipline
Limit currency mismatch
Sequence financial liberalization