Chapter 12

International
Financial
Crises
 Chapter Objectives

● Explore the ways in which financial crises

develop and spread
● Explain why financial crises may
occur in countries with sound macroeconomic
policies
● Identify mechanisms to prevent and remedy
financial crises
Introduction The Challenge to Financial Integration
● Economic integration has enhanced growth and development, but also
made it easier for crises to spread across borders
● Financial crises are not new – developed and spread evolve with the
world's financial and economics integration – result from inconsistent
or unrealistic macroeconomics policies.
● Financial crises could be prevented through a reform of the
international financial architecture – such as IMF or other multilateral
institutions with a role in intern. financial relation

● Contagion effects of crises do not conform to a single patterns, and are

thus difficult to predict
● FC – brought down government, ruined economies, and destroyed
individuals lives.
● ?? ~ does the economy need a lender of last resort ? And what type of
conditions should a lender impose on the recipients of its assistance?
 Definition of Financial Crisis

● Financial Crisis: banking crisis, exchange rate crisis,

or a combination of the two

i. Banking crisis: banking system’s becoming unable to perform its

normal lending functions
● Intermediate : between savers (customers) and borrowers (banks).
● Disintermediation: banks becoming unable to serve as intermediaries
between savers and investors
ii. Exchange rate crisis: sudden and unexpected collapse in the
value of a nation’s currency
 Financial Crisis and Exchange Rates

● Under a fixed exchange rate system, crisis

entails the loss of international reserves and
devaluation
● Under a flexible exchange rate system, crisis
means an uncontrolled, rapid depreciation of the
currency
● Countries with a pegged exchange rate may be
more vulnerable to a crisis
 TWO CAUSES OF FINANCIAL
CRISES
1. Crises caused by macroeconomic imbalances,
such as large budget deficits caused by overly
expansionary fiscal policies
– Example: Third World debt crisis of the 1980s

2. Crises caused by volatile capital flows

– Example: the East Asian financial crisis of 1997–1998
DOMESTIC ISSUES IN CRISIS AVOIDANCE

● Problem in financial sector regulation

– Moral hazard: incentive to act in a manner that creates
personal benefits at the expense of the common good: e.g.,
banks have an incentive to make riskier investments when
they know they will be bailed out
– Moral hazard problems are exacerbated by governments’
providing incentives or threatening banks to make bad loans
for political ends
● In East Asian crisis, such loans gave rise to the term crony capitalism
 Escaping Moral Hazard

● The problem of moral hazard is inescapable if policies

to protect the financial sector exist
● Way to decrease the problem: establish supervision and
regulation standards for internationally active banks
– Basel Capital Accord: formulated in 1989 by bank
regulators from industrialized countries; adopted by more
than 100 countries
– The New Basel Capital Accord of 2001 updated the previous
standards
 New Basel Capital Accord

● Recommends three best practices to reduce the problem

of moral hazard
– Capital requirements: require the owners of banks to invest
a certain percentage of their own capital in the bank
– Supervisory review: oversight mechanism to assist with risk
management and to provide standards for daily business
practices
– Information disclosure: requires banks to disclose
operational information to lenders, investors, depositors
 Avoiding Crisis:
Exchange Rate Policy

● Crawling peg increases vulnerability to financial crises

in two ways
– Requires monetary authorities to exercise discipline in the
issuance of new money;
anti-inflationary tendencies are exacerbated by intentional
slow devaluation, and a severe overvaluation of the real
exchange rate may result
– Exiting crawling peg is difficult: government leaving it may
lose the confidence of investors

● Current consensus: hard peg or floating rate

 Capital Controls

● Capital controls may be imposed to prevent capital

movements in the financial account
– Inflow restrictions tend to work better than outflow ones:
reduce the inflow of short-run capital, which would add to
the stock of liquid, possibly volatile capital
– Outflow restrictions may help reduce the impact of a crisis,
when it occurs
● Malaysia weathered the Asian Crisis through
outflow restrictions
 Managing Crises: Domestic Policies
● Crises caused by macroeconomic policies can be cured by:
– Cutting the deficit
– Raising the interest rates
– Letting the currency float
● However, these are politically difficult

● Crises caused by sudden capital flight are harder to cure

– Collapsing currency can be defended through interest rate

hikes, but these may cause bankruptcies and other problems
 Managing Crises in Sum

● Crisis management is politically difficult: creates losers

in the domestic economy
● Fiscal and monetary policies are limited if the crisis has
an international component
– Defending currency with high interest rates: spreads the
recessionary effects of the crisis
– Defending the economy against recessionary effects:
intensifies the problems of a
collapsing currency
 Reform of the International
Financial Architecture
● Reform of the international financial architecture:
new international policies for avoiding and managing
financial crises
● The great variety of reform proposals focus on two
issues
– Role of an international lender of last resort
– Conditionality: the changes in economic policy that
borrowing nations are required to make in order to receive
loans from the lender of last resort
 Lender of Last Resort

● Lender of last resort: a source of loanable funds after

all commercial sources of lending become unavailable
– The central bank in the national economy
– The IMF, with the support of high-income countries, in the
international economy
● A country unable to make a payment on its international loans or
lacking international reserves asks the IMF to intervene
 Lender of Last Resort (cont.)

● Opponents of international lender of last resort cite

moral hazard problems
– Trusting in a bailout, failing firms have an incentive to
gamble on high-stakes, high-risk ventures

● Proponents: moral hazard can be decreased by financial

sector regulations, such as the Basel Capital Accord
– If owners of financial firms risk losses in the
event of a meltdown, they will not engage in excessive risk
 Lender of Last Resort (cont.)

● Debate on the IMF’s role as a lender of last resort and

moral hazard centers on
– Level of IMF interest rates: should the rates
be higher?
– Length of the payback period: should the period be shorter?
– Size of loans: countries often exceed the borrowing
limitation of 300% above their quota; should the borrowing
limits be curbed?
 Conditionality
● Conditionality: the changes in economic policy that
borrowing nations are required to make in order to
receive loans from the lender of last resort
– Typically covers monetary and fiscal policies, exchange rate
policies, and structural policies affecting the financial sector,
international trade, and public enterprises
– The IMF makes loans in tranches—installments of the total
loan
● Each tranche hinges on the completion of reform targets
 Conditionality (cont.)

● Critics of conditionality argue

– The need to comply with conditionalities may
intensify the recessionary effects
of a crisis
– Conditionality may entail high social costs on the
poorest members of the society
 Conditionality (cont.)

● Proponents argue that crises could be avoided by a pre-

qualification criteria
– To receive assistance, countries must meet requirements of
sound financial sector policies
– However, critics claim that (1) prequalification will not deter
speculative attacks on the country´s currency and (2) IMF
could not ignore crises cases that failed to prequalify
 Emerging Issues in International Financial
Architecture 1

● Need for greater transparency to make a

country’s financial standing clearer to potential
lenders
– Basel Capital Accord includes issues of transparency
and data reporting
– Data dissemination standards: the IMF´s
standards for data reporting; currently under
development
 Emerging Issues in International Financial
Architecture 2

● Need to coordinate private sector involvement: private

sector creditors’ insistence they be paid first make it
more difficult to resolve a crisis
● How to resolve the conflict between lenders?
– Standstills: IMF’s recognition that a crisis country
temporarily stop making repayments on its debt
– Collective action clauses: lenders would have to agree on
collective mediation among themselves and the debtor in the
event of a crisis