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Financial Crises and its Contagion Effect Presented by: Dr. Peter Larose

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Focus of this Presentation What is a financial crisis? What are the causes of financial crisis? What cause the Asian financial crisis? Other financial crises, Why financial crises in the developing countries? How can financial crisis be transmitted? Definition of contagion & effect. and Impact of industrial nation policies. Financial Crises & its Contagion Effect

What Is A Financial Crisis? According to the most common definition of financial crisis “ it is a sudden loss of confidence in a country’s local currency or other financial assets causing international investors to withdraw their funds from the country at short notice” A major withdrawal of funds from one country to another overnight or within a short period of time is referred to “capital flight” as well in the context of banking & finance terminology. Depending on the severity of the loss of confidence a country, which is experiencing this sudden shift from the investors’ behaviour may not only be placed at risk, but could also impact on the region and create instability as well. Financial Crises & its Contagion Effect

What Is A Financial Crisis? Due to the integration of the world economy into a global village, financial crisis knows no boundary, it can spread to different level. From one neighbouring country to another, From the neighbouring countries to a region, From one region to intra-region, and From intra-region to the rest of the world. Again, depending on the severity, and the policy measures taken to cure the problem, it can trigger & threaten the entire financial architecture. Financial Crises & its Contagion Effect

What Are the Causes of Financial Crisis? There are a number of reasons advanced by the experts in researching around this topic. Fixed exchange rate, Weak banking system, Substantial real exchange rate appreciation, No barriers attach to the capital account, General lack of credibility (poor macro-economic track record), Unrealistic composition of the capital inflows, (e.g. too much short-term debts), Economic mis-management, and Political instability. Financial Crises & its Contagion Effect

What Are the Causes of Financial Crisis? Fixed Exchange Rate With pegged exchange rates, there is an alternative school of thought that currency values should be pegged to gold or some other standard of value and kept stable. Those who view exchange rates in these terms may saw the cause of the currency crises in the Asian countries as excessive expansion of domestic money supplies by central banks combined with burdensome government regulations, protection of domestic industries, and other government interference in the marketplace. Once governments stopped maintaining their exchange rates, investors lost confidence, and the crises began. Financial Crises & its Contagion Effect

What Are the Causes of Financial Crisis? Weak Banking System The banking system in the Asian economies were not prepared to handle the financial crisis. The monetary authorities were of the view that the event would be an “over-night” drift that may be corrected with half-hearted measures. Other the other, it was more of a surprise that its occurrence and consequences was much more pronounced than expected. The banks were unable and unified to deal with the problem loans, threatening the financial stability (e.g. exposure in the property market). Financial Crises & its Contagion Effect

What Are the Causes of Financial Crisis? Substantial Appreciation in Real Exchange Rate The effect of a slowdown in growth on a nation's exchange rate is not immediately obvious. It affects both trade and capital accounts in opposite ways. On one hand, lower growth usually causes a nation's trade balance to improve, since imports decline relative to exports (unless demand in export markets is falling faster). This could strengthen a nation's currency. In the Asian case, however, growth was continuing at a level high enough that trade and current accounts tended to remain in deficit. Even in Thailand, the slowdown had not improved its balance of trade. Financial Crises & its Contagion Effect

What Are the Causes of Financial Crisis? No Barriers Attach to the Capital Account A number of emerging markets would not restrict the transfer of portfolio flows in order to attract foreign direct investment (FDI). There is a tendency to have a liberal financial policy in as far as the flows of capital. The danger is for the investors to transfer their funds at will with a view to make the maximum return within the jurisdiction that offer greater incentives to investors. Hence, when a country suffers from fiscal deficits couple with other weaknesses in the financial system, an immediate capital flight can easily trigger a financial crisis, subject to availability of foreign currencies. Financial Crises & its Contagion Effect

What Are the Causes of Financial Crisis? General Lack of Credibility On the capital account side, a slowing growth rate generally causes problems for a nation's debtors who have borrowed to finance production facilities or have invested in real estate or equities and are faced with repayment schedules. Lower growth means lower demand, possible lower profits, and a leveling off or fall in real estate and stock values. As the slowdown intensifies, interest rates usually fall. This can cause international lenders to look elsewhere for investment for financing opportunities and may cause a weakening of a nation's currency. Recessions also cause loans to turn sour and may further drive away foreign lenders. As the Asian financial crisis has developed, forecasters have lowered their outlook for growth in these countries. Financial Crises & its Contagion Effect

What Are the Causes of Financial Crisis? Unrealistic Composition in the Capital Account Flows A country that relies too much of short-term borrowings to finance its development (e.g. long-term) places itself at risk, when the lenders expects to repatriate its funds at short notice. One of the major causes with countries, which had experienced financial crisis (e.g. Argentina, Mexico) were heavily exposed to short- term debts its their capital account of their balance of payments (BOP). Financial Crises & its Contagion Effect

What Are the Causes of Financial Crisis? Economic Mis-management Most research findings connected with the past financial crises indicate that the bottom-line of crisis is tied to the mis-management of the economy by the Government. The economy is allowed to reach an alarming downturn, whereby it becomes more difficult to implement draconian measures at the cost of social difficulties. Interestingly, in the developing countries where the crisis originates, the Government allows political considerations to override the economic considerations. Financial Crises & its Contagion Effect

What Causes of Financial Crisis? Political Instability Some experts believe that the root cause of financial crisis besides the mis-management of the economy emerges from political instability. There is a lack of continuity due to frequent changes at the administrative level. Many politicians tend to act as economists in their own way of thinking, while ignoring the fundamental economic principles – hence, the word “politico-economists”. The danger is that there is always a mis-match in the economic decisions taken contrary to addressing the real problems confronting the country. Financial Crises & its Contagion Effect

What Cause the Asian Financial Crisis? According to the researchers, the Asian financial crisis was caused mainly by 4 reasons: under-developed financial system, shortage of foreign exchange, role, and operations of the international monetary fund, effects of the crisis on US & world economy. There are also advocates, who are of the opinion that the crisis was caused by the bubble of asset prices in Japan. Financial Crises & its Contagion Effect

What Cause the Asian Financial Crisis? Under-developed Financial System The Asian financial crisis, proved a point that a sound & developed banking system is the key to further economic development. This is not an issue applying to Asian countries, but also to other emerging markets around the world. As a result of this experience, the banking systems of those countries affected were forced to re-engineer their banking system in order to accommodate more complex transactions with greater controls and transparency. (e.g. Nick Leeson from Barings Bank is a case in point). The monetary authority in Singapore was unable to detect abnormality in derivatives fraud in good time. Financial Crises & its Contagion Effect

What Cause the Asian Financial Crisis? Shortage of Foreign Exchange The foreign exchange reserves in those countries affected (e.g. Malaysia, Indonesia, South Korea, Thailand) were just too small to back up the demand for out-ward capital by the foreign investors. In spite of these countries turning to IMF, ADB & World Bank for further assistance, the speculative attack was enormous, and became a cost affair. The IMF insisted that its assistance has been provided to support programs that are designed to deal with economy wide, structural imbalances and not to protect commercial banks and private investors from financial losses. Financial Crises & its Contagion Effect

What Cause the Asian Financial Crisis? Role & Operations of the IMF Some legislative issues dealing with IMF funding and operations were deferred by the 105th Congress at the close of its recent session. The Asian financial crisis also has raised several questions pertaining to IMF operations. (1) Whether such crises have increased in scale and whether IMF resources are sufficient to cope with them. (2) Whether the Fund's willingness to lend in a crisis contributes to moral hazard (a tendency for a potential recipient country to behave recklessly knowing that the IMF will likely bail them out in an emergency). . Financial Crises & its Contagion Effect

What Cause the Asian Financial Crisis? Role & Operations of the IMF (3) Whether the contagion of financial crises can be stopped effectively. (4) Whether the changes in economic policy and performance targets that the IMF requires of the recipient countries are appropriate and effective. (5) Whether the IMF has sufficient leverage over non-borrowing member countries to prevent financial crises from occurring, and (6) Whether the IMF releases sufficient information to the public, including investors, on its program design and provisions imposed as a condition for borrowing allow for accurate assessment and accountability. . Financial Crises & its Contagion Effect

What Cause the Asian Financial Crisis? Effect of the Crisis on US & World Economy This financial crisis was of interest to US because: (1) The stock markets are inter-linked, (2) Attempts to resolve the problems are led by the IMF, World Bank and ADB and pledges of standby credit from the Exchange Stabilization Fund of the United States, (2) Americans are major investors in the region, both in the form of subsidiaries of U.S. companies and investments in financial instruments, and (3) The currency turmoil affects U.S. imports and exports as well as capital flows and the value of the U.S. dollar; the U.S. deficit on trade was rising as these countries import less and export more. Financial Crises & its Contagion Effect

Other Financial Crisis Russia’s Crisis Russia embarked on a transition period in 1989 from a command & control economy (sometimes referred as centrally planned economy) to a market-led economic style. The transition involved the following economic problems: rapid inflation, steep output declines, and unemployment. The Government only managed to stabilize the ruble and reduce inflation with the help of IMF credits in 1997. Obviously, the transition from centrally planned economy to market-based policies only bear fruit in the year 2000 when they started to enjoy a rapid growth rate. Financial Crises & its Contagion Effect

Other Financial Crisis Mexico’s Crisis In the late 1994, Mexico experienced a large current account deficit. This was coupled by a weak banking system. The rapid growth in dollar-indexed Mexican government debt (Cetes) led to a large devaluation and depreciation of the Mexican peso – hence, a financial crisis as foreign investors refused to buy new Cetes. The contagion effect ( "tequila effect") spread the crisis to other Latin American countries. In early 1995, speculative attacks spread to other Latin American countries. As a consequence, Argentina went into a sharp recession. Financial Crises & its Contagion Effect

Other Financial Crisis Asia’s Economic Success Until 1997 the countries of East Asia were having very high growth rates. The driving force for such economic success were attributable to the underlying factors: Much emphasis laid on the standard of education, Introduction & implementation of sound macro-economic fundamentals Promotion of high saving and investment rates, Heavy control on the level of inflation, and Recorded a high percentage of trade in the level of GDP. Financial Crises & its Contagion Effect

Other Financial Crisis Asia’s Economic Weaknesses Three weaknesses in the Asian economies’ structures became apparent with the 1997 financial crisis: (a) Level of Productivity Asian countries were becoming uncompetitive due to the Rapid growth of production costs, but little or no reduction in the output cost. (b) Banking regulation The banking laws were far out of date with the current economic development taking place – weak banking system (c) Legal framework Lack of a good legal framework for dealing with companies in financial distress. Financial Crises & its Contagion Effect

Other Financial Crisis Asia’s Crisis Development The devaluation of the Thai baht triggered the crisis on 2nd July 1997. The sharp drop in the Thai baht was followed by speculative attacks against the currencies of: Malaysia, Indonesia, and South Korea. All of the afflicted countries except Malaysia turned to the IMF for assistance. Singapore, although not affected remain very resilient against speculative attacks. The downturn in Asia was “V-shaped”: after the sharp output contraction in 1998, growth returned in 1999 as depreciated currencies spurred higher exports. Financial Crises & its Contagion Effect

Other Financial Crisis The Argentina’s Experience Argentina has failed to make a debt repayment to the World Bank that fell due on 14 November 1991. It has repaid the interest - about $80m - but not the entire debt, which stands at more than $800m. This means the country was considered to be in default, a situation which damaged its chances of winning fresh, much hoped for funds from the International Monetary Fund.. In 1991, during Domingo Cavallo's first spell as economy minister, the government decided to peg the peso to the US dollar to restore confidence and combat hyperinflation. Financial Crises & its Contagion Effect

Other Financial Crisis The Argentina’s Experience At the time, the strategy worked, but in time Argentina suffered the disadvantages of such a fixed peg. By linking the peso to the dollar, Argentines adopted a currency whose exchange rate bore little relation to their own economic conditions. This was a boon in times of hyperinflation But when stability returned to Argentina, the inability of its currency to respond proved more of a burden than a benefit. Financial Crises & its Contagion Effect

Why Financial Crisis in Developing Countries? This is a very useful question to ask about the origin of financial crisis in the developing countries. It is noticeable that financial crisis does not happen in the industrial world, even if it does, it is easily contained so that it does not affect a regional or international crisis. Admittedly, due to our level of integration, the developing countries can also experience its effect partially – the spread of the crisis is referred as “contagion”. One of the principal reasons that the industrial countries are not too much at risk as compared to the developing countries rest on the argument that the financial system in the industrial countries are much developed, & equipped to deal with any imminent financial threat. Financial Crises & its Contagion Effect

Why Financial Crisis in Developing Countries? Most developing countries have at least some of the following features: History of extensive direct government control of the economy, History of high inflation reflecting government attempts to extract seignior age from the economy, Weak credit institutions and undeveloped capital markets, Pegged exchanged rates and exchange or capital controls, Heavy reliance on primary commodity exports, and High corruption levels. Financial Crises & its Contagion Effect

Why Financial Crisis in Developing Countries? Capital Inflows to Developing Countries Many developing counties have received extensive capital inflows from abroad and now carry substantial debts to foreigners, Developing country borrowing can lead to gains from trade that make both borrowers and lenders better off, Borrowing by developing countries has sometimes led to default crises, and The borrower fails to repay on schedule according to the loan contract, without the agreement to the lender (s). Financial Crises & its Contagion Effect

Why Financial Crisis in Developing Countries? Developing Countries Debts & Borrowings History of capital flows to developing countries: Early 19th century A number of American states defaulted on European loans they had taken out to finance the building of canals. Throughout the 19th century Latin American countries ran into repayment problems (e.g., the Baring Crisis). 1917 The new communist government of Russia repudiated the foreign debts incurred by previous rulers. Great Depression (1930s) Nearly every developing country defaulted on its external debts. Financial Crises & its Contagion Effect

Why Financial Crisis in Developing Countries? Debts Crisis of the Past Two Decades The great recession of the early 1980s sparked a crisis over developing country debt. The shift to contractionary policy by the U.S. led to: The fall in industrial countries' aggregate demand, An immediate and spectacular rise in the interest burden debtor countries had to pay, A sharp appreciation of the dollar, and A collapse in the primary commodity prices The crisis began in August 1982 when Mexico’s central bank could no longer pay its $80 billion in foreign debt. By the end of 1986 more than 40 countries had encountered several external financial problems. Financial Crises & its Contagion Effect

How Can Financial Crisis be Transmitted? Trade channels and exchange rate pressures. Through bilateral trade (ex. Chile 1997-98) Competition for trade with a common third partner (e.g. East Asia’s trade with Japan) Integrated financial markets Banks are interconnected through loans (Mexican banks were extending trade credit to Costa Rican banks prior to the 1994 crisis) Interconnection through bond holdings. (Korea was holding Brazilian and Russian bonds) c. Liquidity management practices of open end mutual funds. (Thai share prices fall–sell Indonesia). Financial Crises & its Contagion Effect

Definition of Contagion. The word contagion is defined as the influence of “news” about the creditworthiness, etc. of a borrower on the spreads charged to the other borrowers or equity prices, after controlling for country specific macroeconomic fundamentals (Doukas, 1989,Kaminsky and Schmukler, 1998) 2. Other studies, such as Valdes (1995), defined contagion as excess co movement across countries in asset returns, whether debt or equity. The co movement is said to be excessive if it persists even after common fundamentals, as well as idiosyncratic factors, have been controlled for. 3. A recent variant to this approach is presented in Arias, Haussmann, and Rigobon (1998) and Forbes and Rigobon (1998), who define contagion more narrowly by requiring an increase in excess co movement in crisis periods. 4. Eichengreen, Rose, and Wyplosz (1996) defined contagion as a case where knowing that there is a crisis elsewhere increases the probability of a crisis at home, even when fundamentals have been properly taken into account. Financial Crises & its Contagion Effect

Contagion Effect. After controlling for country specific macroeconomic fundamentals must be corrected implemented. The influence of “news” about the creditworthiness, of a borrower on the spreads charged to the other borrowers. Excess co movement across countries in asset returns, whether debt or equity. An increase in excess co movement in crisis periods. A case where knowing that there is a crisis elsewhere increases the probability of a crisis at home especially if the sovereign rating is poor. Financial Crises & its Contagion Effect

Impact of Industrial Nation Policies Feldstein (2002) argues that there are a number of measures which the industrial nations can do to minimize the financial risk in the developing countries. These measures can involve: Stabilization of the exchange rates, Avoiding high interest rates, Opening markets to emerging market products, Regulating lending by private industrial country creditors, Central Banks acting as lender of last resort. Financial Crises & its Contagion Effect

Stabilization of Exchange Rates It is argued by Feldstein that fluctuations of exchange rates among the dollar, yen, & euro can exacerbate trade deficits of the emerging markets. This can precipitate balance of payment difficulties & eventually crises (e.g. currency mis-match). A country that takes dollar denominated debts, but earns say yen or euro from its exports could see its ability to service its debts suffer – if the dollar appreciates relative to the other currencies. From past experience, there is no prospect that the US & other countries will pursue deliberate policies to stabilize their exchange rates – which will favour developing nations Financial Crises & its Contagion Effect

Avoiding High Interest Rates Countries that borrow in dollars or other hard currencies are directly affected by an increase in interest rates in the home countries currencies. Market participants also believe that an increase in the US$ interest rate causes interest rates on emerging market loans to rise by more than an equal amount. Since there is no prospect that the industrial countries will modify their domestic monetary policy in order to reduce adverse effects on the emerging market countries, the private and public borrowers in those countries must take into account the possibility of interest rate move against their favour. Financial Crises & its Contagion Effect

Opening Markets to Emerging Market Products Opening the industrial country markets to increase imports of textiles & agricultural products from the emerging market countries would raise the standard of living in the export countries as well as the importers. It is widely supported by economists, and opposed by other interest groups in the industrial countries that would be hurt by the import competition. Progress towards greater market opening will therefore continue to be slow. Such market opening might do little to reduce the risk of economic crises. Financial Crises & its Contagion Effect

Regulating Lending by Private Industrial Country Creditors After the Latin American (80s) & Asian (90s) financial crises there was widespread agreement that there has been too much borrowings by these countries and too much lending from the industrial countries. Many experts believe that steps should be taken to reduce the amount of lending to emerging market countries and to increase creditors’ sensitivity to the risks involved. The Basel Accord demands as a result of such experiences that bank supervisory authorities mark the credit portfolios to market all the lending and risk taken by the borrowers. Financial Crises & its Contagion Effect

Central Banks to Act as Lender of Last Resort Any nation Central Bank can prevent runs on solvent banks by providing sufficient liquidity to assure depositors & other creditors that they have nothing to fear. They can do so, by lending against good but illiquid collateral. The very existence of such a lender of last resort helps to reduce the risk of domestic financial crises. The emerging market countries must be prepared to protect themselves against unwarranted currency attacks & bank runs associated with “pure contagion” and with deliberate attempts at destabilizing speculation. Financial Crises & its Contagion Effect

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