Transcript Chapter 10 File

Chapter 10
Financial Crises in
Emerging Market
Economies
Dynamics of Financial Crises in
Emerging Market Economies
• Stage one: Initiation of Financial Crisis.
– Path one: mismanagement of financial
liberalization/globalization:
• Weak supervision and lack of expertise leads to a
lending boom.
• Domestic banks borrow from foreign banks.
• Fixed exchange rates give a sense of lower risk.
• Banks play a more important role in emerging market
economies, since securities markets are not well
developed yet.
9-2
© 2013 Pearson Education, Inc. All rights reserved.
Dynamics of Financial Crises in
Emerging Market Economies (cont’d)
– Path two: 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.
– Additional factors:
• Increase in interest rates (from abroad)
• Asset price decrease
• Uncertainty linked to unstable political systems
9-3
© 2013 Pearson Education, Inc. All rights reserved.
Dynamics of Financial Crises in
Emerging Market Economies (cont’d)
• 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.
– How severe fiscal imbalances triggers currency
crises:
• Foreign and domestic investors sell the domestic
currency.
9-4
© 2013 Pearson Education, Inc. All rights reserved.
Dynamics of Financial Crises in
Emerging Market Economies (cont’d)
• Stage three: Full-Fledged Financial Crisis:
– The debt burden in terms of domestic currency
increases (net worth decreases).
– Increase in expected and actual inflation reduces
firms’ cash flow.
– 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).
9-5
© 2013 Pearson Education, Inc. All rights reserved.
Figure 7
Sequence of
Events in
Emerging
Market
Financial
Crises
9-6
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Crisis in South Korea, 19971998
• After 7 years of Korean War was over, S.Korea still
was extremely poor, income per person less than
2000$
• Pursued an export oriented strategy with annual
growth rate 8% from 1960-1997
• South Korea’s macroeconomic fundamentals were
strong before crisis: 5% of inflation and close to
7% of real output in 1996
9-7
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Crisis in South Korea, 19971998: Financial Liberalization/Globalization
• Starting in 1990s Korean government removed
many restrictive regulation on financial institutions
to liberalize the countries financial market
• Opening capital market to capital flow from
abroad: resulted in lending boom and massive
foreign borrowing at 20% rate.
• Weak bank regulator supervision and lack of
expertise in screening and monitoring borrowers:
losses on loans began to mount and bank’s net
worth started to erode
9-8
© 2013 Pearson Education, Inc. All rights reserved.
•
•
•
•
9-9
APPLICATION Crisis in South Korea, 19971998: Perversion of Financial
Liberalization/Globalization Process:
Chaebols and South Korean Crisis
Chaebols- large family owned conglomerates
dominated the economy with sale of nearly 50% of
GDP
Politically powerful and to big to fail, they knew
they will always receive governmental financial
assistance in the case of trouble
Credit was not enough in domestic market, the
Chaebols
encouraged
government
towards
liberalization of financial market
Foreign lending is still not enough for Chaebols:
merchant banks- wholesale financial institutions.
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Crisis in South Korea, 19971998: Stock Market decline and Failure of
Firms increase uncertainty
• Stock market declined sharply by more than 50%
from its peak
• Many largest firms declared bankruptcy, five more
of thirty largest chaebols
• Uncertainty increased
9-10
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Crisis in South Korea, 19971998: Adverse Selection and Moral Hazards
Worsen and Aggregate Demand Falls
• It is very difficult to screen out good borrowers
from bad ones, as asymmetric information
increased
• Asymmetric information caused lending to fall and
economy to contract
9-11
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Crisis in South Korea, 19971998:Currency Crisis Ensues
• As balance sheet’s value decline in financial sector
and increased exposure of the economy to a
sudden stop of capital flow
• Speculative attack began on Korea’s currency
• Speculators the knew that central bank could no
longer defend the currency by raising interest rate
9-12
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Crisis in South Korea, 19971998:Final Stage-Currency Crisis Triggers
Full Fledged Financial Crisis
• Speculative attack then led to a sharp drop in the
value of “won” by nearly 50%
• Doubled foreign dominated debt for nonfinancial
and financial firms in terms of domestic currency
• This loss in net worth led to severe increase in
asymmetric information
• Liquidity problems increased, because short term
loans should be paid back quickly
• Lending decreased, unemployment increased
sharply, as a result economy contracts again
9-13
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Financial Crises in Argentina,
2001–2002 Severe Fiscal Imbalances
• In contrast to Mexico and the East Asian Countries,
Argentina had well supervised banking system and
lending boom did not occur before crisis
• The problem was always with control of budgets
• The budget of Argentina was always in deficit
• As recession started, this reduces taxes
• Lost confidence to repay their debts on bonds
• Well supervised banking system started to lose
deposits
9-14
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Financial Crises in Argentina,
2001–2002 Asymmetric Information
Problems
• Deterioration of balance sheet of banks and loss of
deposits led the banks to cut back their lending
• As result Adverse selection and Moral Hazard
worsened
• Real output declined, unemployment increased and
inflation went up, like in South Korea
• Bank Panic Begins: outflows of deposits nearly 1
billion $ a day
• Government closed banks temporarily and putting
some restriction on withdrawals: corralito
9-15
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Financial Crises in Argentina,
2001–2002 Currency Crisis Ensues
• Government could no longer keep interest rate
high to prop up the value of “peso”
• Dollarization- 1 Argentine peso =1 US dollar
• Increasing interest rate would mean to destroy
already weakened banks
9-16
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Financial Crises in Argentina,
2001–2002 Currency Crisis Triggers Full
Fledged Financial Crisis
• As peso falls sharply to one-third of its value
before crisis, the dollar dominated debt tripled in
value in terms of peso
• Almost all firms became insolvent because all
debts must be paid from peso to dollar
• Losses on defaulted government bonds
• rising loan losses
• huge deposit outflow
• lacking new recourses to make new loans
• Curtailment of Lending let of contraction of
Economy
9-17
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Financial Crises in Mexico,
1994–1995; East Asia, 1997–1998; and
Argentina, 2001–2002
• Mexico: Financial liberalization in the early 1990s:
– Lending boom, coupled with weak supervision
and lack of expertise.
– Banks accumulated losses and their net worth
declined.
• Rise in interest rates abroad.
• Uncertainty increased (political instability).
• Domestic currency devaluated on December 20,
1994.
• Rise in actual and expected inflation.
9-18
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION Financial Crises in Mexico,
1994–1995; East Asia, 1997–1998; and
Argentina, 2001–2002 (cont’d)
• East Asia: Financial liberalization in the early
1990s:
– Lending boom, coupled with weak supervision and lack of
expertise.
– Banks accumulated losses and their net worth declined.
• Uncertainty increased (stock market declines and
failure of prominent firms).
• Domestic currencies devaluated by 1997.
• Rise in actual and expected inflation.
9-19
© 2013 Pearson Education, Inc. All rights reserved.
PREVENTING EMERGING MARKET
FINANCIAL CRISIS
• Beef up Prudential Regulation and Supervision of
Banks
• Encourage Disclosure and Market Based Discipline
• Limit Currency Mismatch
• Sequence Financial Liberalization
9-20
© 2013 Pearson Education, Inc. All rights reserved.
PREVENTING EMERGING MARKET
FINANCIAL CRISIS
• Beef
up
Prudential
Regulation
and
Supervision of Banks:
-Governments must improve prudential Regulation
and supervision of banks
1) Good risk measurement and monitoring systems
2) Policies to limit activities that presents significant
risks
3) Internal controls to prevent fraud or unauthorized
activities by employees
4) Ban commercial business to own banks
9-21
© 2013 Pearson Education, Inc. All rights reserved.
PREVENTING EMERGING MARKET
FINANCIAL CRISIS
• Encourage Disclosure and Market Based
Discipline:
-FIs have incentives to hide information from bank
supervisors
-Supervisors may be corrupt or give pressure and so
may not do their job properly
-To eliminate these problems, financial markets need
to discipline FIs from taking on too much risk
-Promoting banks and FIs to disclose financial
information
-Encourage FIs to hold more capital-more depositors
and creditors.
9-22
© 2013 Pearson Education, Inc. All rights reserved.
PREVENTING EMERGING MARKET
FINANCIAL CRISIS
• Limit Currency Mismatch:
-Emerging market financial systems can become
vulnerable to a decline in the value of domestic
currency
-Firms borrow in foreign currencies, even though
their products and assets are priced in domestic
currency
-Discourage issuance of debt denominated in foreign
currency-limit currency mismatch by regulations and
taxes
-Moving to a flexible exchange rate regimesdiscourage to borrow in foreign currency
9-23
© 2013 Pearson Education, Inc. All rights reserved.
PREVENTING EMERGING MARKET
FINANCIAL CRISIS
• Sequence Financial Liberalization:
-If financial liberalization process is not managed
properly, the result will be disastrous
-To avoid financial crisis, policy makers will need to
put in place the proper institutional infrastructure
before liberalizing their financial system.
9-24
© 2013 Pearson Education, Inc. All rights reserved.