Financial Crises, Firms, and the Open Economy Chapter 11

Outline  Terminology  An asymmetric information view of financial crises  Disruptions and asymmetric information  A financial crisis framework  Financial crises in an open economy  Perverse savings  Twin crises: Empirical evidence  Fundamentals or investors? -The illiquidity approach -Financial crises as liquidity crises -The vicious circle -Third-generation model of currency crises

Definitions and terminology Speculative attack → devaluation → currency crises (a disruption in the currency market). Capital account crisis (sudden reversal of capital flows): The mirror image of a currency crises. Thus, a currency/capital account crisis is the potential external channel of a financial crisis. A banking crisis is a potential internal channel of a financial crisis. Twin crisis: When a banking crisis and a currency/capital account crisis occur almost simultaneously. Financial crisis: Disruptions on the financial markets that impair the functioning of these markets to such a degree that they no longer are able to perform their primary function, which is the efficient channeling of savings to their most productive uses (investments). A financial crisis causes contraction in the real GDP.

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business © Cambridge University Press, 2013Chapter 11 – Financial crises, firms, and the open economy

An asymmetric information approach  Riskiness of financial transactions is a major issue.  Riskiness results from incomplete and asymmetric information → Adverse selection and moral hazard problems.  A fall in the firm’s net worth (NW) increases the asymmetric information problems and reduces the efficiency of the financial system.  Definition (Frederick Mishkin and others): ‘A financial crisis occurs when, due to disruption on financial markets, the increase of the adverse selection and moral hazard problems is such that the financial system can no longer efficiently perform its main job of channeling funds to the most productive investment opportunities.’

Five categories of disruptions 1.Increase in interest rates 2.Uncertainty increases 3.Asset prices fall 4.Deflation 5.Bank panic or bank run Crucial question: How do these disruptions increase the adverse selection and moral hazard problems?

Figure 11.1 Stylized balance sheets of firms and banks Example of a banking crisis turned financial crisis. Assume the following. - Closed economy - The firm finances its activities by using bank loans To illustrate, we will use firms’ and banks’ balance sheets.

1.An increase in interest rates increase the adverse selection problem for banks (attracting more risky loan applicants). It will also increase the moral hazard problem because, as a result of higher interest rates, firms will engage in more risky behavior once they are granted the loan. 2.An increase in uncertainty: increases the adverse selection and moral hazard problems because it makes it hard for banks to distinguish more risky from less risky projects.

3.A drop in asset prices: decreases the NW of the firm and this is a signal to the bank that the firm is now a more risky borrower which increases the adverse selection problem. A decrease in the firm’s NW also increases the moral hazard problem because risk taking (by the firm) increases as a result of the drop in the funds at stake. A fall in the non-financial sector NW has an effect on the balance sheet of the bank because the quality of its loan portfolio deteriorates. The bank’s NW also falls. 4.Deflation: implies an increase in the real value of debt; reduces the firm’s NW and indirectly the bank’s NW. 5.Bank panic or bank run: if most deposit holders try to ask for their money back simultaneously we have a bank panic or bank run (e.g., Russia in 1998, Turkey in 2001, and Argentina in 2002).This has major negative effects on the efficiency of the financial system.

A financial crisis framework (Fig. 11.2) Suppose the supply of funds that the firms face reflects the supply of bank loans (for external finance). In a risk-free world the economy is at point 1 (Fig. 11.2) where the interest rate is at r 0. With incomplete and asymmetric information the supply schedule changes from horizontal (perfectly interest-elastic) to upward sloping (for external finance).

Figure 11.2 Financial crisis in an asymmetric information framework

Changes in NW reflect changes in the degree of asymmetric information. Assume the economy is initially at point 2. Suppose we have a disruption that causes a fall in the NW of the firm → supply shifts to the left (arrow A, point 3). Disruptions in the financial market may also imply that the slope increases (banks perceive higher risk for any given NW), i.e., the supply curve becomes steeper (Arrow B). If the financial intermediation system breaks down (as a result of bank runs) firm investment may further decline. In the absence of a properly functioning banking system, the efficiency of the financial system decreases: both the adverse selection and the moral hazard problems increase, which leads to higher transaction costs. This leads to a wedge (reflecting transaction costs) between the cost of capital for borrowers (firms) and the actual return to the bank (point 5 in Fig. 11.2).

The open economy  The role of international capital mobility  If foreign investors lose confidence in an economy → currency crisis → reversal of capital flows  Current account imbalances: Figures 11.3 and 11.4.

Figure 11.3 Current account balance of selected EU countries, Source: van Marrewijk (2012), updated for 2012 with estimates from The Economist, 8 September 2012

Figure 11.4 Global imbalances; current account balance (US $ bn), Source: based on World Development Indicators online data; EU = European Union

How does a currency crisis relate to the incomplete and asymmetric information analysis? Various channels: 1.International lending to domestic firms may be (directly or indirectly) denominated in a foreign currency (e.g., US dollar). The domestic currency devaluation increases the real debt burden of domestic firms and banks. This in turn increases the adverse selection and moral hazard problems.

Figure 11.5 Foreign-held US government debt (US $ billion), 2011 Source: van Marrewijk (2012); oil exp nat = oil exporting nations

Various channels (cont.): 2.An increase in interest rates increases the asymmetric information problem. Several countries hit by the financial crises in the late 1990s had a large differential (spread) in interest rates relative to US interest rates. 3.Domestic banks get into trouble because of currency mismatch on their own and/or their domestic clients’ balance sheets → the quality of financial intermediation may deteriorate. The devaluation of the currency and the reversal in capital flows are foreign channels that can impact banks’ performance. Evidence shows that NW of firms in the countries involved in the currency crises fell significantly.

Perverse savings  If foreign creditors begin to doubt the willingness and/or ability of domestic government to fully guarantee the banks’ liabilities the savings schedule will have positive slope (higher risk).  Creditors will demand higher interest rates → reduces investment expansion (see Fig. 11.6).  In addition to the effects covered in the discussion of Fig. 11.6, the example in Box 11.1 suggests two additional possible negative effects. 1.The investment schedule might also shift to the left. 2.A higher interest rate depresses the (borrower) firm’s NW and hence increases problems of asymmetric information.  What happens to savings if the increase in interest rates implies a substantial added burden for the borrowers to the point that the total return to savings drops? We get a backward-bending savings curve!

Figure 11.6 Perverse savings and the backward-bending savings curve

Twin crises: The empirical evidence  Figure 11.7  The sequence of events: Figure  Two major questions: 1.Is it true for twin crises that banking crises typically precede currency crises and that currency crises deepen banking crises? 2.Are these crises the result of bad fundamentals? Kaminsky and Reinhart (1999): Support the view that banking crises precede currency crises, which suggests that crises result from bad fundamentals.

Figure 11.7 Currency crises and ongoing banking crises, Source: author calculations based on data from Laeven and Valencia (2012)

Figure 11.8 The unfolding of a financial crisis

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business © Cambridge University Press, 2013Chapter 11 – Financial crises, firms, and the open economy

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business © Cambridge University Press, 2013Chapter 11 – Financial crises, firms, and the open economy

Bad fundamentals vs. malicious investors  The illiquidity approach: Financial crises are the consequence of a liquidity shortage created by investors; they are not crises of insolvency (study by Radelet and Sachs, 1998).  Financial crises as liquidity crises.

The vicious circle  The liquidity view of financial crises implies that self-fulfilling expectations of international investors are a necessary condition for a crisis to take place (stage II in Fig becomes stage I).  Which stage is first? Does a crisis start with bad fundamentals or investors’ self-fulfilling expectations?  Krugman (2000): Both are correct.  We have a vicious circle (Fig. 11.9)

Figure 11.9 The vicious circle of financial crises Source: Krugman (2000).

 Suppose we start with investors’ self-fulfilling expectations. Loss of confidence on the part of investors → capital outflow → sharp real devaluation/depreciation of the domestic currency (to get a current account surplus) → deterioration of firms’ balance sheets → drop in NW → fall in investment and output → further loss in confidence.  Suppose we start with bad fundamentals (fragility of the domestic financial system). Deterioration of firms’ balance sheets → drop in NW → fall in investment and output → loss in confidence on the part of investors.

 Does it matter where we start on the vicious circle?  Yes! Depending on where we start the policy implications would be quite different. If investors’ self-fulfilling expectations view, then there is a possible rationale for restricting international capital mobility. If bad fundamentals view (start the circle with the domestic balance sheet problems), then there is a possible rationale for policies that would remedy the regulatory and other weaknesses in the domestic financial systems.

 Third-generation model of currency crises: The synthesis between the ‘fundamentalists’ and the ‘self-fulfillers’.  Differences from the second-generation model: 1.A large and more direct role for self-fulfilling expectations in the third-generation model. 2.The interaction between the exchange rate and the domestic financial sector is explicitly analyzed only in the third-generation model. This makes the vicious circle model well suited for the analysis of twin crises.