Lecture 2 Financial Crises in Latin America and South-East Asia: An Overview

1. Lecture 2 Financial Crises in Latin America and South-East Asia: An Overview Professor Roman Matousek Kent Business School Kent University Anhui University of Finance &Economics Bengbu 12-14 May 2014

2. Learning Objectives • To understand three basic models of currency crisis. • To evaluate the causes and consequences of financial Crises in Latin America. • To understand driving forces behind the Asian Financial Crises in the late 1990s. • Compare the current Global financial Crisis with those in Latin America and South-East Asia.

3. Introduction • Financial crises can stem from problems of private or public sectors’ balance sheets and have domestic or external origins. Irrespective of its origins, a financial crisis is often an amalgam of events, including substantial changes in credit volume and asset prices, severe disruptions in financial intermediation, notably a reduction in the supply of external financing, large-scale balance-sheet problems, and often a need for substantial government and international support. • Although crises can be driven by a variety of factors, they are often preceded by asset and credit booms. As we already discussed

4. Do you Remember?Types of Financial Crises • Currency crises. • Sudden stops (in capital flows). • Debt crises. • Banking crises. You can have different classifications • Currency Crises • Banking Crises • International crises

5. A Currency Crisis: Definition • A currency crisis may be defined as a speculative attack on the foreign exchange value of a currency that either results in a sharp depreciation or forces the authorities to defend the currency by selling foreign exchange reserves or raising domestic interest rates. • For an economy with a fixed exchange rate regime, a currency crisis usually refers to a situation in which the economy is under pressure to give up the prevailing exchange rate peg or regime. • In a successful attack the currency depreciates, while an unsuccessful attack may leave the exchange rate unchanged, but at the cost of spent foreign exchange reserves or a higher domestic interest rate. • A speculative attack often leads to a sharp exchange rate depreciation despite a strong policy response to defend the currency value.

6. Con’t • Currency crises have always been a feature of the international monetary system, both during the Bretton Woods system of generalized fixed parities among major industrialized countries in the post-World War II period as well as after its breakdown in the early 1970s. • Dramatic episodes of currency crises include the breakdown of the Bretton Woods system in 1971-73. The crisis of the British pound in 1976. • The near-breakdown of the European Exchange Rate Mechanism in 1992-93. • The Latin American Tequila Crisis following Mexico’s peso devaluation in 1994-95, the financial crisis that swept through Asia in 1997-98 and, more recently. • The global financial crisis in 2008-09 that forced sharp depreciations in many advanced as well as developing economies.

7. Causes of Currency Crisis • There is an extensive literature on the causes and consequences of a currency crisis in a country with a fixed or managed exchange rate. • The models in the economic literature that are used to explain currency crises are often categorized as first-, second- and third-generation.

8. Recent Currency Crises • A currency crisis may be defined as a speculative attack on the foreign exchange value of a currency that either results in a sharp depreciation or forces the authorities to defend the currency by selling foreign exchange reserves or raising domestic interest rates. • Currency crises include the breakdown of the Bretton Woods system in 1971-73, the crisis of the British pound in 1976. • The crises of the European Exchange Rate Mechanism in 1992-93. • The Latin American Tequila Crisis following Mexico’s peso devaluation in 1994-95. • The financial crisis through Asia in 1997-98 . • The global financial crisis in 2008-09.

9. The First Generations Models • The first generation models of, for example, Krugman (1979) focus on inconsistencies between domestic macroeconomic policies, such as an exchange rate commitment and a persistent government budget deficit that eventually must be monetized. • The deficit implies that the government must either deplete assets, such as foreign reserves, or borrow to finance the imbalance. • However, it is infeasible for the government to deplete reserves or borrow indefinitely. Therefore, without fiscal reforms, the government must eventually finance the deficit by creating money. • Since excess money creation leads to inflation, it is inconsistent with keeping the exchange rate fixed and first-generation models therefore predict that the regime inevitably must collapse.

10. First Generation Models: Latin America • Consensus about a variety of factors. • These include the large scale of the current account deficit, which had reached almost 8% of GDP, this deficit was funded by relatively short-term capital inflows. • The Mexican authorities' commitment to a relatively fixed (in nominal terms) exchange rate, and the fact that a somewhat over-valued exchange rate was welcomed by a government strongly committed to reducing inflation very rapidly. • Lax monetary policy pursued in 1994, as reserves fell sharply. The causes include the fact that such a high proportion of government debt paper was so short-term, such a high proportion of it was in the hands of non-residents. • The government had allowed the transformation of a large part of its government debt into dollar-denominated paper. • Unexpected extra-economic (political) events, are seen to have played an important part in causing the crisis.

12. Con’t • iAnother sets of factors have either been neglected or not sufficiently emphasised. • The process of liberalisation in the financial sector and in the capital account too rapid. • The Mexican capital account should have been liberalised slower and/or more controls and/or taxes introduced to discourage short-term capital inflows when these surged. • Non-residents were allowed in late 1990 - without any restrictions - to buy Mexican government paper, whereas previously they were not allowed to do so. • This was part of a broader liberalisation, whereby foreigners were allowed to purchase bonds and money market instruments, as well as shares.

13. Evidence • In the case of Mexico, policymakers faced capital flight following upward U.S. interest rate movements and Mexican political developments in 1994. • Efforts by Mexico’s central bank to avoid raising domestic interest rates while also limiting depreciation of the peso proved unsustainable and contributed to the peso crisis in December 1994.

15. Case Study: Argentina • A model of successful policymaking. By pegging its exchange rate to the dollar under a currency board type arrangement in 1991,Argentina ended hyperinflation, reducing inflation rates to single-digit levels. • The banking sector in Argentina, traditionally weak, was strengthened considerably, in part because of an increase in foreign bank entry. • A 1998 World Bank financial sector review rated Argentina second only to Singapore among emerging markets in the quality of its bank supervision (Perry and Serven 2002). • Greater economic stability attracted foreign investment inflows, contributing to an acceleration in economic growth; indeed, even as lenders withdrew their financing in East Asia in 1997, capital inflows continued to Argentina. • Things began to turn sour in 1999.The collapse of the Brazilian currency led to sharp declines in export revenues, and economic growth was negative for three years in a row. • Nevertheless, with some brief exceptions, financial markets remained relatively undisturbed until 2001, when uncertainty about the growing public debt and the persistent economic contraction led to very sharp increases in the yields investors demanded to hold Argentine government bonds.

16. Con’t - Argentina • Uncertainty extended to the durability of the currency peg and the ability of the financial system to make good on dollar liabilities that were backed to a significant extent by peso assets, including government debt. • The result was massive deposit withdrawals from the banking system. • In response to these developments, in December 2001,Argentina suspended payments on its external debt and restricted deposit withdrawals (the “corralito”). • In January 2002, it abandoned its peg to the U.S. dollar. Reflecting continuing uncertainty about financial conditions, interest rates have continued to rise and the currency has depreciated 356% against the U.S. dollar in the year to September 2002. • The impact of the Argentine crisis has been severe. Output is forecast to decline 15% and inflation to rise to 72% in 2002.

19. Lessons from Argentina • Argentina’s debt position would have been sustainable if only market uncertainty had not triggered a crisis. • Argentina could have reduced its vulnerability to potentially destabilizing shifts in market sentiment by aggressively reducing its public and external debts. • This is illustrated by the contrasting experiences of Argentina and Asian economies like South Korea. • Cutting Argentina’s public debt requires reductions in government spending, tax reforms designed to increase government revenues, and policies to stimulate export growth over the medium to long run. • The successful adoption of such policies is the key challenge facing Argentina and a number of other emerging economies, and it is an important prerequisite for achieving stability in a globalized economy.

20. Second Generation Models • In second generation models of currency crises, best represented by Obstfeld (1986, 1994), policymakers weigh the cost and benefits of defending the currency and are willing to give up an exchange rate target if the costs of doing so exceed the benefits. • In these models doubts about whether the government is willing to maintain its exchange rate target can lead to the existence of multiple equilibria, and a speculative currency attack can take place and succeed even though current policy is not inconsistent with the exchange rate commitment. • This is because the policies implemented to defend a particular exchange rate level, such as raising domestic interest rates, may also raise the costs of defense by dampening economic activity and/or raising bank funding costs.

21. Con’t • The private sector may question the commitment to fixed exchange rate when other macroeconomic objectives are compromised. • In this framework, a speculative attack is more likely to succeed if higher interest rates exacerbating already weak domestic employment or banking sector conditions. • Consequently, the timing of the attack—and whether it will occur--cannot be determined, as it is no longer unique. • These different explanations for currency crises are not mutually exclusive. The fundamental imbalances stressed by first-generation models make a country vulnerable to shifts in investor sentiment, but once a crisis does occur, the second-generation models help explain its self-reinforcing features.

22. Second Generation Model: An Example • As Germany raised its interest rates to fight inflation following reunification in the early 1990s, other European countries who had linked their currencies to the Deutschemark through the EMS—found matching the higher German interest rates onerous for their economies. • In 1992 the system was overwhelmed by large speculative flows of capital, and consequently some countries dropped out of the EMS and let their currencies depreciate in order to allow their domestic interest rates to diverge from those in Germany

24. Third Generation Models • Third-generation models are harder to characterize simply but generally focus on how distortions in financial markets and banking systems can lead to currency crises. • Different third generation models offer various mechanisms through which these distortions may lead to a currency crisis. Some models stress how distortions may emerge in the form of credit constraints. • The origins of the Asia crisis of 1997-98 were in part related to the fact that many countries had effectively linked their currencies to the dollar at a time when the dollar appreciated relative to the Japanese yen and Chinese renminbi.

26. South East Asia(Based on Krugman’s paper – What Happened to Asia) • The Asian crisis arrived with little warning - government budgets were in good shape; current account deficits were large in Thailand and Malaysia, but relatively moderate in Korea and Indonesia; despite some slowdown in growth in 1996, there was not a strong case that any of the countries needed a devaluation for competitive or macroeconomic reasons. • So what went wrong? There are two major views in the post-crisis theoretical literature.

27. South-East Asia • The origins of the Asia crisis of 1997-98 were in part related to the fact that many countries had effectively linked their currencies to the dollar. •  With the Thai baht, Indonesia rupiah, and other Asian currencies rising relative to the yen and the renminbi, the products of Thailand, Indonesia, and other Asian countries grew more expensive relative to those of Japan and China. •  The decline in competitiveness put pressure on their currencies to depreciate. • Other important factors also were at work in the Asian crisis, including elements of bank depositor panic and fragile banking systems, attributable to the lack of incentives for effective risk management created by implicit or explicit government guarantees against failure.

28. Con’t • The first is that the apparent soundness of macroeconomic policy was a large, hidden subsidy to investment via implicit government guarantees to banks, cronies of politicians, etc - the “over-borrowing syndrome”. • The apparent soundness of budgetary and macroeconomic policy was an illusion: under the surface, the governments were actually engaged in reckless and unsustainable spending.

29. Con’t • The alternative view is that the countries were not doing anything wrong; their investments were basically sound. At most they can be said to have suffered from some kind of “financial fragility” that made them vulnerable to self-fulfilling pessimism on the part of international lenders • Both of these views capture some aspects of what happened to Asia. On one side, “crony capitalism” was certainly a reality: the excesses of Thai financial companies, of members of the Suharto family, of megalomaniac chaebol are undeniable. • On the other side, bank runs played an important role in the unfolding of the crisis, particularly in Indonesia, and a freezing up of the credit system played at least some role in deepening the recession after the crisis hit.

31. Con’t • Third-generation models emphasises that the crises are driven by weaknesses in the financial sector. These include a weakly supervised and regulated financial system; moral hazard; • Fixed exchange rates distorting external borrowing in the direction of short-term foreign currency debt. • Ineffective prudential regulation and supervision over the financial sector, especially in the process of capital market liberalisation, contributed to excessive borrowing from abroad and increased the risk that temporary liquidity shortages will trigger full-fledged financial crisis.

32. Con’t • Moral hazard as a result of implicit or explicit government guarantees encouraged overborrowing and excessive exposure to foreign exchange by financial institutions. • The essence of moral hazard is that, if things went wrong, agents “rationally expect the government to step in and modify its course of action in order to bail out troubled private firms”