1. Financial Crises in Emerging Market Economies
Chapter 10
Financial Crises in Emerging Market Economies

2. 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.

3. 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

4. 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.

5. 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).

6. Figure 7 Sequence of Events in Emerging Market Financial Crises

7. 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
South Korea’s macroeconomic fundamentals were strong before crisis: 5% of inflation and close to 7% of real output in 1996

8. 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

9. APPLICATION Crisis in South Korea, : 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.

10. APPLICATION Crisis in South Korea, : 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

11. APPLICATION Crisis in South Korea, : 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

12. 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

13. APPLICATION Crisis in South Korea, :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

14. 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

15. 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

16. 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

17. 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

18. 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.

19. 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.

20. 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

21. 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

22. 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.

23. 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

24. 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.