Transcript Chapter 12

Chapter 12
International
Financial
Crises
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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
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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 could be prevented through a
reform of the international financial architecture
• Contagion effects of crises do not conform to a
single pattern, and are thus difficult to predict
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Definition of a Financial Crisis
• Financial Crisis: A financial crisis is a
banking crisis, an exchange rate crisis, or
a combination of the two
– Banking crisis: The banking system becomes
unable to perform its role of intermediation
and its normal lending functions
• Disintermediation: Banks becoming unable to serve
as intermediaries between savers and investors
• Exchange rate crisis: A sudden and unexpected
collapse in the value of a nation’s currency
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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
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Two Sources of
International Financial Crises
Two sources 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
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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
- The current crisis which began in 2007
partially fits this description
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Crises Caused by
Macroeconomic Imbalances (cont.)
• Macroeconomic imbalances in government
budgets, trade balances, and currency
values have set off several crises in
developing countries
• These are often the result of overexpansionary fiscal policies
• Once people suspect an overvalued
exchange rate, capital flight out of the
country begins
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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
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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
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Figure 12.1 Pesos Per Dollar: December 12, 1994
to March 22, 1995
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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, 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 the East Asian crisis, such loans gave rise to the term
crony capitalism
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Domestic Issues in Crisis Avoidance:
Moral Hazard and Financial Sector Regulation
(cont.)
• The problem of moral hazard is inescapable if
policies to protect the financial sector exist
• The way to decrease the problem is to 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(Basel II)
updated the previous standards
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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
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Exchange Rate Policy
• The 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: A government leaving it
may lose the confidence of investors
• Current consensus: “hard peg” or floating rate
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Capital Controls
• Capital controls may be imposed to prevent capital
movements in the financial account
– Inflow restrictions tend to work better than outflow
ones because 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
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Table 12.1 Current Account Balances and
Currency Depreciations
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Table 12.1 (continued) Current Account
Balances and Currency Depreciations
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Table 12.2 Real GDP Growth
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Table 12.2 (continued) Real GDP Growth
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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
-However, these are politically difficult
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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
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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
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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
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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 owners of financial firms risk losses in the event of a
meltdown, they will not engage in excessive risk
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Lender of Last Resort (cont.)
• Debate on the IMF’s 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?
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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: installments of the
total loan
-Each tranche hinges on the completion of reform
targets
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Conditionality (cont.)
• Critics of conditionality argue that:
– 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
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Conditionality (cont.)
• Proponents of conditionality 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) 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
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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
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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
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Reform Urgency
• Immediately following the Asian Crisis,
financial reform was at the top of everyone’s
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
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Table 12.3 Current Account Deficits, 20002007 (Billions of U.S. $)
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