 Refers to exchange rate crises, banking crises or some combination of the two.  These are often the variables through which the contagion effects are spread from one country to another

 Economic integration = opportunities for growth and development but also =  Easier for crises to spread from one country to another  e.g currency speculation against British pound and other European currencies = near collapse of monetary arrangements in Europe

 A banking crisis occurs when  The banking system becomes unable to perform its normal lending functions and some or all of a nation’s banks are threatened with insolvency. (net worth is negative = assets are less than liabilities)  If banks cannot pay its creditors (depositors) because its debtors (businesses, loans) have gone under or defaulted = Disintermediation

 When depositors lose their money (unless they have deposit insurance), Consumption drops, new investments slows down, economy falls into deep vicious circle of recession.

 Sudden and unexpected collapse in the value of a nation’s currency.  May occur in either fixed or flexible regimes but research shows that countries with fixed regime are more vulnerable to this type of crisis  Result is steep recession e.g. A country borrows large amounts in international capital markets. Country’s currency collapses  value of debt increases  Many banks fail  capital outflow and no new I  economy goes into deep recession 5

 Banking system is the channel for transmitting recessionary effects  Prior to the Asian crisis, banks borrowed dollars in capital markets.  When home country currency collapsed, dollar value of debt increased.  Many banks failed. Disintermediation took place and economies slid into deep recession

 1994, speculation against the Mexican peso = its collapse and spread of “Tequila effect” through out South America.  1997 several East Asian economies were thrown into recession by a wave of sudden capital outflows  Contagion effect = not a single pattern = different rules of behavior 7

2 Sources 1. Macroeconomic imbalances 2. Volatile flows of financial capital that quickly move in and out a country (sudden changes in investor expectations may be the triggering factor) 8

Macroeconomic Imbalances -Best example is Third World Debt crisis (1980) -Overly expansionary fiscal policies creating large government deficits financed by high growth of money supply -potential problems of government spending are compounded by inefficient and unreliable tax systems  Tax revenue may be insufficient for government expenditure 9

-Governments resort to selling bonds to finance expenditures but capital markets are underdeveloped -So governments require central banks to buy the bonds -Money supply increase -Inflationary pressure -currency becomes overvalued -everyone tries to sell domestic assets and convert them to foreign exchange -Government begins to run out of international reserves -pressure on currency to depreciate 10

 If exchange rates are fixed  serious repercussions on real value of the exchange rate   Capital flight if people begin to think exchange rate is overvalued and correction is likely in future  In addition to large budget deficits and inflationary pressures is a large and growing current account deficit.  People try to sell their domestic assets and acquire foreign ones  run on a country’s international reserves

 Portfolio managers look at actions of each other for information about the direction of the market  Herd mentality  A small trickle of funds can be fueled by speculations which can lead to a huge capital flight. 12

 When this happens, international reserves disappear, exchange rates tumble and weakens the financial sector  A weak financial sector intensifies the problems 13

Steps Countries can take to minimize likelihood of crises and damage they cause when they happen -maintain credible and sustainable fiscal and monetary policies -engage in active supervision and regulation of the financial system -provide timely information about key economic variables such as central bank holding of international reserves 14

 Elements of macro imbalances, volatile capital flows and financial sector weakness.  Overvalued real exchange rates, current account deficits because domestic savings could not support investments  In 1990 – 1993 capital inflows of $91B made up of private investment, direct investment and bank loans 15

 In 1994, interest rate movements led to large losses for banks and investors  Investors called for reducing level of exposure to Mexico  Dec. 1994, newly elected president, Zedillo, announced a 15% devaluation 16

Currency speculators had expected a 20 – 30% devaluation  Zedillo’s announcement sent financial markets into turmoil More capital fled the country Dollar reserves shrank. Though 2 days after the announcement, Mexico said it would move to a flexible exchange rate, the damage had already been done 17

Both domestic and foreign capital continue to leave the country By March 1995, peso had lost more than 50% of its value NAFTA and IMF helped in the form of line of credit and loans with conditions of decreasing G and increasing T 18

 Began in Thailand in July 1997 and spread to Malaysia, Philippines, Indonesia and South Korea  Symptoms of crisis were fairly similar across countries -currency speculation and steep depreciation -capital flight -financial and industrial sector bankruptcies 19

Countries had large trade deficits (on average 5.2% of GDP, Thailand had a deficit of 8% of GDP) the year before the crisis Large current account deficits = large capital inflows Because for last 30 years these countries averaged 5% growth in GDP and foreign investors had no reasons to believe otherwise Also, Japan and Europe were losing grounds in growth and investors were looking elsewhere 20

 Exchange rates in the region were pegged to the dollar  dollar appreciating in the 90s meant many exchange rates appreciating as well.  Exchange rates were harder to sustain because it became more difficult to export. CA deficits increased  Financial sector problems because of family ties 21

 Investors lost confidence in Thailand to keep its exchange rate pegged  People began to suspect devaluation and refused to hold Thai baht 22

 Many loans to the Thai financial sector were in dollars so this raised the cost of devaluation  Thailand served as a wake-up call to investors in the region  Others think the devaluation in Thailand made exports from other countries less competitive which led them to devalue as well.  Whatever the case, the Thailand experience had a contagion effect 23

 Effect spread to countries as far as Brazil and Russia  With the exception of Singapore and Taiwan, every country affected by the crisis experienced a recession in 1998  Singapore and Taiwan had had large surpluses so they concentrated on domestic economies rather than defending their currencies  IMF helped with loans and conditions of interest rate hikes. Capital controls were implemented in some countries 24

 In the 1980s, high interest rates and an appreciation of the US dollar caused the burden of dollar denominated debts in Argentina, Mexico, Brazil and Chile to increase drastically.  A worldwide recession and a fall in many commodity prices also hurt export sectors in these countries.  In August 1982, Mexico announced that it could not repay its debts, mostly to private banks.

 After liberalization in 1991, Russia’s economic laws were weakly enforced or nonexistent. ◦ There was weak enforcement of banking regulations, tax laws, property rights, loan contracts, and bankruptcy laws. ◦ Financial markets were not well established. ◦ Corruption and crime became growing problems. ◦ Because of a lack of tax revenue, the government financed spending by seignoirage. ◦ Interest rates rose on government debt to reflect high inflation from seignoirage and the risk of default.

 The IMF offered loans of official international reserves to try to support the fixed exchange rate conditional on reforms.  But in 1998, Russia devalued the ruble and defaulted on its debt and froze financial asset flows.  Without international financial assets for investment, output fell in 1998 but recovered thereafter, partially due to the expanding petroleum industry.  Inflation rose in 1998 and 1999 but fell thereafter.