Dynamics of Financial Crises in Emerging Economies

1. Chapter 10 Financial Crises in Emerging Economies

2. Dynamics of Financial Crises in Emerging Market Economies • The dynamics of financial crisis in emerging economies resemble those found in the developed countries but with some important differences. • The sequence and stages of events in financial crisis in emerging economies are described in Figure1.

3. Dynamics of Financial Crises • Financial crises can be sequenced in three stages: • Stage One: Initiation of Financial Crisis • Stage Two: Currency Crisis • Stage Three: Full-Fledged Financial Crisis

4. FIGURE 1 Sequence of Events in Economies-Market Financial Crises

5. Stage One: Initiation of Financial Crisis • Financial crises can begin due to: • Mismanagement of financial liberalization and globalization • Severe fiscal imbalances • Other additional factors

6. Stage One: Initiation of Financial Crisis (cont’d) • Mismanagement of financial liberalization and globalization • Financial liberalization – elimination of restrictions on financial institutions and markets domestically • Financial globalization - opening up of economy to flows of capital and financial firms from other nations • Financial liberalization leads to lending booms that are marked by risky lending practices due to ineffective screening and monitoring of borrowers and lax government supervision of banks.

7. Stage One: Initiation of Financial Crisis (cont’d) • Financial globalization adds fuel to the fire as it allows domestic banks to borrow abroad. • Significant losses emerge, weakening banks balance sheets and prompting bank to cut back on lending but no other players to solve adverse selection and moral hazard problems. • Lending boom ends in a lending crash because weak prudential regulation and supervision to limit excessive risk-taking. • Principal-agent problem as well - powerful domestic business interests pervert the financial liberalization process.

8. Stage One: Initiation of Financial Crisis (cont’d) • Severe Fiscal Imbalances. • When governments in emerging market countries cannot finance their large fiscal imbalances, they often force banks to purchase their debts. • When investors lose confidence in the ability of the government to repay this debt, they will unload the bonds which causes their prices to plummet. • Banks that hold this debt face a huge decline in their net worth resulting in the decline of their lending and worsening of adverse selection and moral hazard problems

9. Stage One: Initiation of Financial Crisis (cont’d) • Other additional factors • Other factors that play a role in the first stage in crises are • A rise in interest rates from events abroad • A decline in asset price that causes a deterioration in banks’ balance sheets from asset write-downs • An increase in uncertainty due to unstable political systems

10. Stage Two: Currency Crisis • Deterioration Of Bank Balance Sheets Triggers Currency Crises • When banks and financial institutions are in trouble, governments cannot increase interest rate. • Speculators realize the government’s inability to defend the currency that it is likely to allow the currency to depreciate. They engage in a feeding frenzy and sell the currency in anticipation of its decline. • These sales rapidly use up the country’s reserves of foreign currency until it no longer has the resources to intervene in the foreign exchange market and must allow a devaluation.

11. Stage Two: Currency Crisis • Severe Fiscal Imbalances Trigger Currency Crises. • When government budget deficits spin out of control, foreign and domestic investors begin to doubt the ability of the country to pay back its government debt. • They start pulling money out of the country and selling the domestic currency resulting in a speculative attack against the currency, which eventually results in its collapse.

12. Stage Three: Full-Fledged Financial Crisis • Emerging market economies denominate many debt contracts in foreign currency (usually dollars) leading to currency mismatch • Unanticipated depreciation or devaluation of the domestic currency increases the debt burden of domestic firms in terms of domestic currency. • This lead to an increase in adverse selection and moral hazard problems followed by a decline in investment and economic activity.

13. Stage Three: Full-Fledged Financial Crisis • A currency crisis can then lead to a deterioration of firms’ balance sheets and increases adverse selection and moral hazard problems. • “Twin crises” - a concurrent currency crisis and financial crisis. • The collapse of a currency lead to increase in import prices followed by a rise in both actual and expected inflation causing domestic interest rates to rise. • This will cause reductions in firms’ cash flow and reduction in investment and economic activity.

14. Stage Three: Full-Fledged Financial Crisis • The collapse in economic activity makes many debtors no longer able to pay off their debts resulting in losses for banks. • Sharp rises in interest rates and in the value of foreign-currency-denominated liabilities also have a negative effect on banks’ profitability and balance sheets leading to a banking crisis • A further worsening of adverse selection and moral hazard problems and a further collapse of lending and economic activity.

15. Application: Crisis in South Korea, 1997–1998 • Before 1997 crisis, South Korea was one of the great economic success stories. • In the early 1990s, the Korean government liberalized the financial markets and opened up their capital markets to capital flows from abroad resulting in a lending boom fuelled by massive foreign borrowing. • However weak bank regulator supervision and a lack of expertise in screening and monitoring borrowers led to losses and erosion of banks’ net worth.

16. Application: Crisis in South Korea, 1997–1998 • Large family-owned conglomerates (chaebols) dominated the economy (sales nearly 50% of the country’s GDP). • They borrowed heavily and have little profits (return on asset less than 3%) but because of the implicit government guarantee, banks continued to lend to them. • Because of them, Korean government accelerated the process of opening up Korean financial markets to foreign capital, expanded the ability of domestic banks to make loans denominated in foreign currency and allowed unlimited short-term foreign borrowing by financial institutions.

17. Application: Crisis in South Korea, 1997–1998 • Many finance companies (some already owned by the chaebols) transformed into merchant banks which are allowed to borrow abroad. Chaebols could thus borrow all the money that they needed and these funds are channeled into unproductive investments in steel, automobile production, and chemicals. • When the loans went sour, the stage was set for a disastrous financial crisis.

18. Application: Crisis in South Korea, 1997–1998 • A negative shock to export prices hurt the chaeobols’ profit margins and the small-and-medium-sized firms that were tied to them. • A second major shock in January 23, 1997 created great uncertainty for the financial system: Hanbo, the fourteenth largest chaebol, declared bankruptcy followed by five more of the thirty largest by the end of the year. • And the stock market declined sharply by more than 50% from its peak (Figure 5).

19. FIGURE 5 Stock Market Index,South Korea, 1995–1999

20. Application: Crisis in South Korea, 1997–1998 (cont’d)  • The decline in net worth decreases the value of firms’ collateral and increases their incentives to make risky investments because there is less equity to lose if the investments are unsuccessful. • The increase in uncertainty and stock market declines, along with the deterioration in banks’ balance sheets, worsens adverse selection and moral hazard problems. • The weakening of the economy, along with the deterioration of bank balance sheets, ripened the South Korean economy for a currency crisis and send the economy into a full-fledged financial crisis and a depression.

21. Application: Crisis in South Korea, 1997–1998 (cont’d)  • A speculative attack on Korea’s currency was inevitable because of the weak balance sheets in the financial sector and the large amount of short-term external borrowing. • In July 1997, Thai baht collapsed and speculators recognized that the banking sector in South Korea was also in trouble and that the Korean central bank could no longer defend the currency so they pulled out of the won leading to a speculative attack.

23. Application: Crisis in South Korea, 1997–1998 (cont’d)   • Because of the speculative attack, the value of the won dropped by nearly 50% . • Because both nonfinancial and financial firms had so much foreign currency debt, the drop in won doubled the value of their foreign-denominated debt causing a severe erosion of their net worth. • Banks also had to pay these loans back so quickly because their borrowings are short term therefore increasing their liquidity problems. • The government stepped in to guarantee all bank deposits and prevent a bank panic, but the loss of capital meant that banks had to curtail their lending.

24. Application: Crisis in South Korea, 1997–1998 (cont’d)   • The curtailment of lending led to a further contraction of AD and real GDP while unemployment rose sharply. • Due to the currency crisis, iinflation, however, did not fall but rose: the collapse of the South Korean currency raised import prices and weakened the credibility of the Bank of Korea as an inflation fighter. • These factors led to a decline in output and rise in inflation.

26. Application: Crisis in South Korea, 1997–1998 (cont’d)  • To compensate for the high inflation and because a tight monetary policy recommended by the IMF, market interest rates soared to over 20%. • A drop in cash flows forced firms to obtain external funds and increased adverse selection and moral hazard problems in the credit markets resulting in a further contraction in investment and thus in aggregate demand.

27. Application: The Argentine Financial Crisis, 2001–2002 • Argentina had a well-supervised banking system but always had difficulty controlling its budgets. • The recession in 1998 led to declining tax revenues and a widening gap between government expenditures and taxes. • The large fiscal imbalances make it difficult for the government to sell its bonds, so it coerced banks into absorbing government debt. • By 2001, investors lost confidence that the Argentine government can repay its debt and the price of the debt plummeted, leaving big holes in banks’ balance sheets.

28. Application: The Argentine Financial Crisis, 2001–2002 • Deterioration of bank balance sheets and loss of deposits led the banks to cut back on their lending worsening the adverse selection and moral hazard problems. • Decline in lending led to a contraction of aggregate demand with inflation and output declining, and unemployment rising. • All these set the stage for the next stage of the crisis, a bank panic.

29. Application: The Argentine Financial Crisis, 2001–2002 • In October 2001, default on government bonds became inevitable as tax revenues continued to fall and negotiations between the central government and the provinces to improve the fiscal situation broke down. • Bank run began in November, with deposit outflows of $1 billion a day forcing the government to close banks temporarily in December and impose a restriction called the corralito (small fence), under which depositors could withdraw only $250 in cash per week.

30. Application: The Argentine Financial Crisis, 2001–2002 • The bank panic made it impossible for the government to keep interest rates high as it would destroy the banks • The government can no longer defend the peso and preserve the currency board leading to a speculative attack • The government’s dire fiscal position made it unable to pay back its debt, providing another reason for the investors to pull money out of the country. • On December 23, 2001, the government announced the suspension of external debt payments for at least sixty days and on January 2, 2002, the government abandoned the currency board.

31. Application: The Argentine Financial Crisis, 2001–2002 • The peso decrease sharply from $1.00 to less than $0.30 by June 2002 before stabilizing at $0.33 (Figure 11) with devastating effects on balance sheets because of the high debt denominated in dollars. • The banks found their balance sheets in a precarious state because of the losses on government debt, the rising loan losses and huge deposit outflows and since they lack resources to lend, they could no longer solve adverse selection and moral hazard problems. • As for foreigners, they were unwilling to lend and pulling their money out of the country.

32. FIGURE 11 Argentine Peso,1998–2004

33. Application: The Argentine Financial Crisis, 2001–2002 • With the financial system in jeopardy, financial flows came to a grinding halt. • The corralito further weakened the economy by making it more difficult to get cash causing a sharp slowdown in the large underground economy. • The fall of peso raised import prices, which directly fed into inflation, and weakened the credibility of the Argentine central bank to fight inflation. • The effects are bigger than in South Korea.

34. Application: The Argentine Financial Crisis, 2001–2002 • The rise in commodity prices in the rest of the world led to increased demand for Argentina’s exports. • By the end of 2003 economic growth was running at an annual rate of around 10%, and unemployment had fallen below 15% and Inflation fell to below 5%.

35. Box: When an Advanced Economy Is like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 • In 2003, Icelandic government sold its its state owned banks to local investors as part of a financial liberalization process. • These investors set up overseas branches and borrowed heavily from short term wholesale funding markets which are then are channelled into high-risk investments • The heavy borrowing in foreign currencies lead to a severe currency mismatch like in many emerging market countries. • The regulatory system in term of supervision of bank risk-taking is also ineffective.

36. Box: When an Advanced Economy Is like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 (cont’d)  • The wholesale lending system was shut down in October 2008 with the failure of Lehman Brothers. • Because they are so large, not even the government could credibly rescue the banks from failure. • Foreign capital fled Iceland, and the value of the Icelandic krona tumbled by over 50% leading to a full-scale financial crisis. • The economy went into a severe recession and relationships with foreign creditors became tense, with the United Kingdom even freezing assets of Icelandic firms under an antiterrorism law.

37. Policy and Practice: Preventing Emerging Market Financial Crises • Policies that can help make financial crises in emerging market countries less likely • Beef Up Prudential Regulation and Supervision of Banks • Encourage Disclosure and Market-Based Discipline • Limit Currency Mismatch • Sequence Financial Liberalization