1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 12 International Financial Crises

2. Copyright © 2008 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 © 2008 Pearson Addison-Wesley. All rights reserved. 12-3 Introduction Economic integration has enhanced growth and development, but also made it easier for crises to spread across borders Contagion effects of crises do not conform to a single patterns, and are thus difficult to predict Financial crises could be prevented through a reform of the international financial architecture

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-4 Financial Crisis Financial Crisis: banking crisis, exchange rate crisis, or a combination of the two –Banking crisis: banking systems becoming unable to perform its normal lending functions Disintermediation: banks becoming unable to serve as intermediaries between savers and investors Exchange rate crisis: sudden and unexpected collapse in the value of a nations currency

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-5 Financial Crisis and Exchange Rates 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 © 2008 Pearson Addison-Wesley. All rights reserved. 12-6 Two Causes of Financial Crises Crises caused by macroeconomic imbalances, such as large budget deficits caused by overly expansionary fiscal policies –Example: Third World debt crisis of the 1980s Crises caused by volatile capital flows –Example: the East Asian financial crisis of 1997– 1998

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-7 Domestic Issues in Crisis Avoidance Problem in financial sector regulation –Moral hazard: 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 East Asian crisis, such loans gave rise to the term crony capitalism

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-8 Escaping Moral Hazard The problem of moral hazard is inescapable if policies to protect the financial sector exist Way to decrease the problem: 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 updated the previous standards

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-9 New Basel Capital Accord Recommends 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

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-10 Avoiding Crisis: Exchange Rate Policy 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: government leaving it may lose the confidence of investors Current consensus: hard peg or floating rate

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-11 Capital Controls Capital controls may be imposed to prevent capital movements in the financial account –Inflow restrictions tend to work better than outflow ones: 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

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-12 Managing Crises: Domestic Policies Crises caused by macroeconomic policies can be cured by: –Cutting the deficit –Raising the interest rates –Letting the currency float However, these are politically difficult

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-13 Managing Crises: Domestic Policies (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

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-14 Managing Crises in Sum Crisis management is politically difficult: creates losers in the domestic economy Fiscal and monetary policies are limited if the crisis has an international component –Defending currency with high interest rates: spreads the recessionary effects of the crisis –Defending the economy against recessionary effects: intensifies the problems of a collapsing currency

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-15 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 –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

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-16 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

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-17 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: 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

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-18 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?

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-19 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 tranchesinstallments of the total loan Each tranche hinges on the completion of reform targets

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-20 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

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-21 Conditionality (cont.) Proponents 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) prequalification will not deter speculative attacks on the country´s currency and (2) IMF could not ignore crises cases that failed to prequalify

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-22 Emerging Issues in International Financial Architecture 1 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

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-23 Emerging Issues in International Financial Architecture 2 Need to coordinate private sector involvement: private sector creditors insistence they be paid first make 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

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-24 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

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 12 Chapter Art

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-26 FIGURE 12.1 Pesos Per Dollar: December 12, 1994 to March 22, 1995

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-27 TABLE 12.1 Current Account Balances and Currency Depreciations

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 12-28 TABLE 12.2 Real GDP Growth