Financial Crises in Emerging Market Economies 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.

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

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.

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).

Figure 7 Sequence of Events in Emerging Market Financial Crises

APPLICATION Crisis in South Korea, 1997-1998 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

APPLICATION Crisis in South Korea, 1997-1998: 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

APPLICATION Crisis in South Korea, 1997-1998: 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.

APPLICATION Crisis in South Korea, 1997-1998: 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

APPLICATION Crisis in South Korea, 1997-1998: 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

APPLICATION Crisis in South Korea, 1997-1998: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

APPLICATION Crisis in South Korea, 1997-1998: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

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

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

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

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

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.

East Asia: Financial liberalization in the early 1990s: 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.

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

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

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.

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 regimes-discourage to borrow in foreign currency

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.