FINANCIAL CRISIS

International Financial Crises

Currency Crises Loss of credibility of fixed exchange rate system. Banking Crisis Sudden collapse of the domestic banking system. Systemic Financial Crisis/Sudden Stops Breakdown of system of international capital flows. Sovereign Debt Crisis Govt unable to pay-off debts
IMF World Economic Outlook, 1998

Devaluation/Revaluation
Devaluation of the currency occurs when central bank operating an exchange rate peg increases the number of domestic dollars needed to purchase one foreign dollar. Revaluation is a decrease in domestic currency price of foreign dollars.

Currency Crises
Market believes that exchange rate will be devalued in the near future. Lenders demand higher interest rates to lend in domestic dollars to compensate for loss of value after devaluation. Central bank must use its foreign reserves to buy domestic currency and prop up exchange rate. If pain of interest rates is too painful or loss of reserves too severe, central bank may be forced to devalue.

ERM Crisis

Go for the Jugular

In 1980s, European economies constructed a system of linked currencies called the Exchange Rate Mechanism. Inflationary German fiscal policy following reunification led to high DM interest rates. To maintain link, other Euro currencies needed to have interest rates too high for their own situation. In Sept. 1992, markets expected a delinking/devaluation of currencies.

Currency Crisis
Speculation against the pound forced Bank of England to raise interest rates and buy pounds in forex markets. Pain of interest rates was viewed as too severe and B of E was forced to abandon the peg.
Principal Global Indicators Database

Roles of Banking System

Why Not Finance Corporate Sector w/ Stocks and Bonds?

Banks accept deposits from retail customers and make larger, longer-term loans. Information: Banking institutions study creditworthiness of borrowers. Monitoring: Banks can enforce covenants and conditions on lending. Liquidity : Deposits easily used for necessary transactions
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Banking Crises
Bank Runs Sudden withdrawal of deposit base forcing bank closures or govt assistance.
Solvency Crisis: Banks have substantial amounts of loans gone bad and thus have insufficient funds to repay depositors. Swedish Banking Crisis, 1991 Link Liquidity Crisis: Sudden deposit withdrawal requires liquidation of otherwise sound assets. Bank of East Asia, 2008 Link

Systemic Crisis
Bank failure can be contagious 1. Interbank Lending 2. Panic conditions

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Lender of Last Resort

Banking system sufficiently important that govts will usually protect depositors and prevent mass bankruptcies.
Liquidity Crisis: Lend at penalty rates against good collateral. Walter Bagehot, 1840s. Link Solvency Crisis: 1) Containment: Administrative intervention, temporary closure, nationalization. 2) Resolution. Recapitalize banks through govt purchase of equity, diluting or destroying shareholder value.

Moral Hazard: Banks creditors and (sometimes owners) are protected from consequences of risky behavior.

Fragile banking system makes high interest rates untenable and can lead to fears of devaluation (especially if central bank funds used to bailout banking system)

Banking Crisis

Currency Crisis

Exchange rate devaluation can damage balance sheets if balance sheets (deposits or borrowings) are dollarized.

Sudden Stops
International hot money (short-term lending) is subject to herding behavior from international financial market. Link
Rapid inflows and rapid outflows.

When capital inflows stop, either those can be replaced with forex reserves, or domestic borrowers will face bankruptcy.
Domestic firms can no longer finance investment Demand, GDP, and employment fall. Devaluation of currency.

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Sudden stop?
Net Capital Outflows

Current Account

Net Capital Outflows

Financial Crises
Sudden Stops: Foreign investors herding behavior and short-termism lead them to move in and out of countries rapidly. The greatest concern I have is that capital account convertibility would leave economic policy in a typical emerging market hostage to the whims and fancies of two dozens or so thirty-something country analysts in London, Frankfurt, and New York. Dani Rodrik, 1998

East Asian Crisis

IMF World Economic Outlook Database

East Asian Crisis

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Dealing with Hot Money

Short-term Money Flows
Zero-Interest Reserve Requirements Tobin Tax Administrative Controls

Buildup Foreign Reserve Assets

IMF Financial Statistics

Foreign Reserves
Measures of Adequate Reserves Import Coverage: Reserves > Imports for 2-3 Months Greenspan-Guidotti Rule: Reserves exceed 100% of debt due within one year.

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Korea

Dealing with Sudden Stops

Modern Approach
Swap lines Link

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Chiang Mai Initiative Multilateralization

ASEAN+3 has a pool of US$120billion (financed mostly by +3) in reserve swaps available for liquidity in a crisis to allow for region-wide insurance In size, amount seems reasonable. IMF-led programs in Thailand and Indonesia were about $20billion and $40 billion through 91998
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