0. Financial Crises in Emerging
Web Chapter 25
Financial Crises in Emerging
Market Economies

1. Chapter Preview
In the 1990s, emerging market economies opened their markets in hopes of rapid expansion. Instead, many experienced crises as bad as the Great Depression. How can a developing country shift from a path of high growth to such a sharp decline in economic activity?

2. Chapter Preview
In this chapter, we will continue to explore the theory developed in Chapter 8. Topics include:
Dynamics of Financial Crises in Emerging Market Economies
Preventing Emerging Market Financial Crises

3. Asymmetric Information and Financial Crises
In chapter 7, we discussed how a functioning financial system is critical to a robust economy.
However, both moral hazard and adverse selection are still present. The study of these problems (agency theory) is the basis for understanding and defining a financial crisis.

4. Dynamics of Financial Crises in Emerging Market Economies
The dynamics of financial crises in emerging market economies have many of the same elements as those found in advanced countries like United States
However, there are some important differences.
The next slide outlines the key stages.

5. Emerging Market Financial Crisis: Sequence of Events (a)
Figure 25.1 Sequence of Events in Emerging Market Financial Crises

6. Emerging Market Financial Crisis: Sequence of Events (b)
Figure 25.1 Sequence of Events in Emerging Market Financial Crises

7. Stage One: Initiation
Financial crises in emerging market countries develop along two basic paths:
Credit Boom and Bust
Severe Fiscal Imbalances

8. Stage One: Initiation
Crisis initiation involving a credit boom and bust usually proceeds as follows:
The country often starts with a solid fiscal policy
A weak credit culture and capital inflows exasperate the credit boom that follows liberalization, leading to risky lending
High loan losses eventually materialize

9. Stage One: Initiation
Crisis initiation involving a credit boom and bust usually proceeds as follows :
As bank balance sheets deteriorate, lending is cut back (more severe here since the rest of the economy is not as developed)
A lending crash fully materializes

10. Stage One: Initiation
Why does prudential regulation fail to stem a banking crisis? Is this different than the U.S. and other developed economies?
The story is similar to the U.S., with various interests trying to prevent regulators from doing their jobs. However, in developing economies, these interest (business) probably have more power

11. Stage One: Initiation
Crisis initiation can also involve severe fiscal imbalances:
The government faces a large deficit and either cajoles or forces banks to buy gov’t bonds
If confidence falls, the gov’t bonds are sold by investors, leading to a price decline
As a result, bank balance sheets deteriorate, and the usual lending freeze follows

12. Stage One: Initiation
Crisis initiation can also involve other factors:
A rise in rates in developed economies can spill over into risk taking in developing countries (e.g., the Mexican crisis)
Asset price declines are less severe, but certainly increase problems
Unstable political systems create high levels of uncertainty, increasing agency conflicts

13. Stage Two: Currency Crisis
The FX markets will soon start taking bets on the depreciation of the currency of the emerging market, in what is called a speculative attack. Over supply begins, the value of the currency falls, and a currency crisis ensues.

14. Stage Two: Currency Crisis
The government can attempt to defend the home currency by raising interest rates. That should encourage capital inflows. However, banks must pay more to obtain funds, decreasing bank profitability, which may lead to insolvency.
Speculators in the FX market know this. Mass sell-offs of the currency continue.

15. Stage Two: Currency Crisis
The currency crisis can also result from a large fiscal imbalance.
Investors suspect inability to repay the loans
Sell-offs of debt
Sell-off of the domestic currency follows
A speculative attack on the currency ensues

16. Stage Three: Full Financial Crisis
Many emerging market firm denominate their debt in U.S. dollars or yen. An unexpected currency devaluation increases their debt burden, leading to a decline in their net worth.
This crisis, along with the currency crisis, leads the country into a full–fledged financial crisis.

17. Stage Three: Full Financial Crisis
The currency collapse can also lead to higher inflation. The increase in interest rates again leads to lower firm cash flows and increased agency problems.
Bank losses are inevitable as debtors are no longer able to meet interest obligations. Banks will likely fail as well.

18. Stage Three: Full Financial Crisis
With this framework in mind, we now turn to three actual financial crises in emerging economies:
South Korea, 1997–1998
Argentina, 2001–2002

19. Case: Financial Crises in Emerging Market Countries
South Korea and Argentina
These countries show how a country can shift from a path of high growth just before a financial crises.
An important factor is the deterioration in banks’ balance sheets due to increasing loan loses.

20. Case: Financial Crises in Emerging Market Countries
South Korea started with strong macroeconomic fundamentals, as seen in the next three figures. As you can see, conditions changed quickly in 1997.

21. Case: Financial Crises in Emerging Market Countries
Figure 25.2 Inflation, South Korea, 1995–1999

22. Case: Financial Crises in Emerging Market Countries
Figure 25.3 Real GDP Growth, South Korea, 1995–1999

23. Case: Financial Crises in Emerging Market Countries
Figure 25.4 Unemployment, South Korea, 1995–1999

24. Case: Financial Crises in Emerging Market Countries
South Korea removed FI regulations, resulting in a lending boom.
Growth close to 20% per year!
But, loan losses mounted, and bank balance sheets deteriorated.

25. Case: Financial Crises in Emerging Market Countries
Large, family-owned conglomerates, known as chaebols, accounted for nearly 50% of GDP. Borrowed excessively during boom.
Were never very profitable, but considered too-bog-to-fail. Gov’t would make good on bad loans.
Chaebols even encouraged liberalization.

26. Case: Financial Crises in Emerging Market Countries
Expanded short-term foreign borrowing (highly mobile) but restricted long-term foreign lending. Perfect recipe for disaster.
Merchant banks appeared, which had little or no regulation.
Increased uncertainly leads to a stock market decline.

27. Case: Financial Crises in Emerging Market Countries
Figure 25.5 Stock Market Index, South Korea, 1995–1999

28. Case: Financial Crises in Emerging Market Countries
Erosion of won nearly doubles foreign-denominated debt on bank balance sheets.
Banks paid foreign debt, but unable to collect on domestic loans. Lending curtailed.
Economic activity takes a severe fall.

29. Case: Financial Crises in Emerging Market Countries
Figure 25.6 Value of South Korean Currency, 1995–1999

30. Case: Financial Crises in Emerging Market Countries
In 1998, government implements reforms to restore confidence.
Poor in South Korea grew from 6m to 10, divorce rates jumped, crime jumped …
But, the recovery was in sight.

31. Case: Financial Crises in Emerging Market Countries
Figure 25.7 Interest Rates, South Korea, 1995–1999

32. Case: Financial Crises in Emerging Market Countries
Argentina had a well-supervised banking system.
Govt fiscal problems weakened the banking system - banks forced to take on gov’t debt.
Provinces had incentives to spend beyond receipts and call on federal gov’t to fund the deficit. Recession in 1998 didn’t help.

33. Case: Financial Crises in Emerging Market Countries
Figure 25.8 Inflation, Argentina, 1998–2004

34. Case: Financial Crises in Emerging Market Countries
Figure 25.9 Real GDP Growth, Argentina, 1998–2004

35. Case: Financial Crises in Emerging Market Countries
Figure Unemployment Rate, Argentina, 1998–2004

36. Case: Financial Crises in Emerging Market Countries
In October 2001, bank panic begins as default on gov’t debt becomes inevitable.
Depositors restricted to withdrawing only $250 in cash per week.
Confidence falls, riots ensue.

37. Case: Financial Crises in Emerging Market Countries
Full–blown speculative attacks developed in the foreign exchange for the Argentine Peso
Raising interest rates no longer possible
December 2001 – gov’t suspends debt payments
Currency board abandoned

38. Case: Financial Crises in Emerging Market Countries
Figure Argentine Peso, 1998–2004

39. Case: Financial Crises in Emerging Market Countries
By June 2002, peso falls to less than $0.30
Dollar denominated debt triples in value, many firms insolvent
Huge bank outflows, financial flows halt
Inflation rises, nearing 40%.

40. Case: Financial Crises in Emerging Market Countries
Figure Interest Rates, Argentina, 1998–2004

41. Case: Financial Crises in Emerging Market Countries
Recovery begins by the end of 2003
Unemployment falls below 15%
Inflation drops to 5%
Crisis took a huge toll on the economy as a whole

42. Global: Icelandic Crisis of 2008
In 2003, Iceland sells state-owned banks to investors to manage
Borrowed in international markets (deposits) to fund local firms.
Stock market rises to 250% of GDP.
Everyone borrows heavily, supervision falls weak.

43. Global: Icelandic Crisis of 2008
In 2008, with the failure of Lehman, Icelandic banks lose funding source.
Gov’t unable to rescue system; krona falls by over 50%.
Severe recession starts: unemployment, wages falling
Only silver lining: exports!

44. Preventing Emerging Market Financial Crises
Increase bank regulation
Capital requirements adequate
Risk measurement / monitoring systems
Policies to limit risk-taking
Fraud prevention
Independent (from political pressure) regulation.

45. Preventing Emerging Market Financial Crises
Disclosure and Market-based discipline
Limit currency mismatch – limit foreign borrowing
Liberalization only after correct policies and procedures in place

46. Chapter Summary
Dynamics of Financial Crises in Emerging Market Economies: We examined the stages of a crisis in emerging economies, contrasting those with advanced economies. We examined actual crises in South Korea and Argentina, as well as Iceland.

47. Chapter Summary (cont.)
Preventing Emerging Market Financial: We discussed steps emerging markets can take to avoid the pitfalls of a financial crisis.