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1
Chapter
Chapter
STAGE ONE
Initiation of Financial Crisis
Deterioration in
Increase in Asset Price Increase in
Financial Institutions’
Interest Rates Decline Uncertainty
Balance Sheets
STAGE TWO
Currency Crisis
STAGE THREE
Full-Fledged
Financial Crisis
Economic Activity
Declines
Banking Crisis
Economic Activity
Declines
Path A: Credit Boom and Bust The seeds of a financial crisis in an emerging mar-
ket economy are often sown when the country liberalizes its domestic financial systems
by eliminating restrictions on financial institutions and markets, a process known as
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-3
financial liberalization, and opens up its economy to flows of capital and financial
firms from other nations, a process called financial globalization. Countries often
begin the process with solid fiscal policy. In the period prior to its crisis, Mexico ran
a budget deficit of only 0.7% of GDP, a number to which most advanced countries
would aspire. And the countries of East Asia even ran budget surpluses before their
crises struck.
It is often said that emerging market financial systems have a weak “credit culture,”
characterized by ineffective screening and monitoring of borrowers and lax government
supervision of banks. Credit booms that accompany financial liberalization in emerg-
ing market nations are typically marked by especially risky lending practices, sowing
the seeds for enormous loan losses down the road. The financial globalization process
adds fuel to the fire because it allows domestic banks to borrow abroad. Banks pay high
interest rates to attract foreign capital and so are able to rapidly increase their lending.
The capital inflow is further stimulated by government policies that fix the value of
the domestic currency to the U.S. dollar, which provides foreign investors a sense
of comfort.
Just as in advanced countries like the United States, lending booms in emerging
market economies end in lending crashes. Significant loan losses emerge from long
periods of risky lending, weakening bank balance sheets and prompting banks to cut
back on lending. The deterioration in bank balance sheets has an even greater nega-
tive impact on lending and economic activity than in advanced countries, which tend
to have sophisticated securities markets and large nonbank financial sectors that can
pick up the slack when banks falter. So as banks stop lending, there are really no other
players to solve adverse selection and moral hazard problems (as shown by the arrow
pointing from the first factor in the top row of Figure 1).
The story so far suggests that a lending boom and crash are inevitable outcomes of
financial liberalization and globalization in emerging market countries, but this is not
the case. These events occur only when there is an institutional weakness that prevents
the nation from successfully navigating the liberalization/globalization process. More
specifically, if prudential regulation and supervision to limit excessive risk-taking are
strong, the lending boom and bust will not happen. Why are regulation and supervision
typically weak? The answer is the principal–agent problem, discussed in Chapter 8,
in which powerful domestic business interests are encouraged by the prospect of
high payoffs to pervert the financial liberalization process. Politicians and prudential
supervisors are ultimately agents for voters-taxpayers (principals): that is, the goal
of politicians and prudential supervisors is, or should be, to protect the taxpayers’
interest. Taxpayers almost always bear the cost of bailing out the banking sector if
losses occur.
Once financial markets have been liberalized, however, powerful business interests
that own banks may benefit if prudential supervisors do not do their jobs properly,
and so they may encourage these supervisors to act in ways that are not in the public
interest. Powerful business interests that contribute heavily to politicians’ campaigns
are often able to persuade politicians to weaken regulations that restrict the business
interests’ banks from engaging in high-risk/high-payoff strategies. After all, if bank
owners achieve growth and expand bank lending rapidly, they stand to make a fortune.
But if a bank gets into trouble, the government is likely to bail it out, and the taxpayer
will be left holding the bill. In addition, these business interests can make sure that the
supervisory agencies, even in the presence of tough regulations, lack the resources they
need to effectively monitor banking institutions or to close them down.
Powerful business interests have acted to prevent supervisors from doing their jobs
properly in advanced countries like the United States. However, the weak institutional
W-4 w e b C h a p t e r 1 Financial Crises in Emerging Market Economies
Additional Factors Other factors often play a role in the first stage of a financial
crisis. For example, a precipitating factor in some crises (such as the Mexican crisis) was
a rise in interest rates caused by events abroad, such as a tightening of U.S. monetary
policy. When interest rates rise, high-risk firms are the firms most willing to pay the
high interest rates, so the adverse selection problem becomes more severe. In addition,
high interest rates reduce firms’ cash flows, forcing them to seek funds in external capi-
tal markets in which asymmetric information problems are greater. Thus increases in
interest rates abroad, which raise domestic interest rates, can increase adverse selection
and moral hazard problems (as shown by the arrow from the second factor in the top
row of Figure 1).
Because asset markets are not as large in emerging market countries as they are
in advanced countries, they play a less prominent role in financial crises. Asset price
declines in the stock market do, nevertheless, decrease the net worth of firms and so
increase adverse selection problems. There is less collateral for lenders to seize, which
leads to increased moral hazard problems because, given their lower net worth, the
owners of the firm have less to lose if they engage in riskier activities than they engaged
in before the crisis. Asset price declines therefore can worsen adverse selection and
moral hazard problems directly and also indirectly, by causing deteriorations in banks’
balance sheets from asset write-downs (as shown by the arrow pointing from the third
factor in the first row of Figure 1).
As happens in advanced countries, when an emerging market economy is in a
recession or a prominent firm fails, people become more uncertain about the returns
on their investment projects. In emerging market countries, notoriously unstable politi-
cal systems are another source of uncertainty. When uncertainty increases, it becomes
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-5
hard for lenders to screen good credit risks from bad ones and to monitor the activities
of the firms to which they have loaned money, again worsening adverse selection and
moral hazard problems (as shown by the arrow pointing from the last factor in the first
row of Figure 1).
Severe Fiscal Imbalances Trigger Currency Crises We have seen that severe
fiscal imbalances can lead to a deterioration of bank balance sheets and so can indirectly
help produce a currency crisis. Fiscal imbalances can also directly trigger a currency cri-
sis. When government budget deficits spin out of control, foreign and domestic inves-
tors begin to suspect that the country may not be able to pay back its government debt
and so will start pulling money out of the country and selling the domestic currency.
Recognition that the fiscal situation is out of control thus results in a speculative attack
against the currency, which eventually results in its collapse.
W-6 w e b C h a p t e r 1 Financial Crises in Emerging Market Economies
1
For more detail on the South Korean and Argentine crises as well as a discussion of other emerging market financial
crises, see Frederic S. Mishkin, The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial
Systems to Get Rich (Princeton, NJ: Princeton University Press, 2006).
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-7
Korean crisis of 1997–1998 because it illustrates the first path toward a financial crisis,
which operates through mismanagement of financial liberalization and globalization.
Second, we look at the Argentine crisis of 2001–2002, which was triggered by severe
fiscal imbalances, the second path that we studied.
10
8
Inflation Rate (%)
0
1995 1996 1997 1998 1999
Year
Figure 3
Real GDP Growth, 15
South Korea,
–10
1995 1996 1997 1998 1999 2000
Year
Figure 4
Unemployment, 10
South Korea,
1995–1999 8
Unemployment Rate (%)
The unemployment
rate was below 3%
before the crisis but 6
jumped to above 8%
during the crisis.
Source: International 4
Monetary Fund.
International Financial
Statistics. www.imfstatistics 2
.org/imf/.
0
1995 1996 1997 1998 1999
Year
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-9
sharply, with lending fueled by massive foreign borrowing that expanded at rates close
to 20% per year. Because of weak bank regulator supervision and a lack of expertise in
screening and monitoring borrowers at banking institutions, losses on loans began to
mount, causing an erosion of banks’ net worth (capital).
Although South Korean financial institutions now had access to foreign capital,
the chaebols still had a problem. Because they were not allowed to own commercial
banks, the chaebols might not get all the bank loans they needed. However, a type of
financial institution specific to South Korea existed that would enable them to get the
loans they needed: the merchant bank. Merchant banking corporations were wholesale
financial institutions that engaged in underwriting securities, leasing, and short-term
lending to the corporate sector. They obtained funds for these loans by issuing bonds
and commercial paper and by borrowing from interbank and foreign markets. At the
time of the Korean crisis, merchant banks were allowed to borrow abroad and were
virtually unregulated. The chaebols saw their opportunity and convinced government
officials to convert many finance companies (some already owned by the chaebols) into
merchant banks. The merchant banks channeled massive amounts of funds to their
chaebol owners, where they flowed into unproductive investments in steel, automobile
production, and chemicals. When the loans went sour, the stage was set for a disastrous
financial crisis.
Figure 5
Stock Market 1,200
Index, South
Korea, 1995–1999 1,000
Stock prices fell by
over 50% during
Stock Price Index
800
the crisis.
Source: Global Financial 600
Data, available at www
.globalfinancialdata.com/.
400
200
0
1995 1996 1997 1998 1999
Year
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-11
Figure 6
Value of South 0.001
Korean Currency,
1995–1999 0.0009
0.0005
0.0004
1995 1996 1997 1998 1999
Year
currency crisis was behind this key difference. Specifically, the collapse of the South
Korean currency after the successful speculative attack on it raised import prices, which
fed directly into inflation and weakened the credibility of the Bank of Korea as an infla-
tion fighter. The rise in import prices led to a price shock, while the weakened cred-
ibility of the Bank of Korea led to a rise in expected inflation, with inflation climbing
sharply from around the 5% level to nearly 10%.
Market interest rates soared to over 20% by the end of 1997 (Figure 7) to compen-
sate for the high inflation. They also rose because the Bank of Korea pursued a tight
Figure 7 Interest
Rates, South Korea, 30
1995–1999
Market interest rates 25
soared to over 20%
during the crisis.
Interest Rate (%)
20
Source: International
Monetary Fund.
International Financial 15
Statistics. www.imfstatistics
.org/imf/. 10
0
1995 1996 1997 1998 1999
Year
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-13
monetary policy in line with recommendations from the International Monetary Fund.
High interest rates led to a drop in cash flows, which forced firms to obtain external
funds and increased adverse selection and moral hazard problems in the credit markets.
The increase in asymmetric information problems in the credit markets, along with the
direct effect of higher interest rates on investment decisions, led to a further contrac-
tion in investment spending, providing another reason for the falling economic activity.
Recovery Commences
In 1998, the South Korean government responded very aggressively to the crisis by
implementing a series of financial reforms that helped restore confidence in the finan-
cial system. Financial markets began to recover, which helped stimulate lending, and
the economy finally began to recover.
The South Korean financial crisis inflicted a high human cost, too. The ranks of the
poor swelled from six million to over ten million, suicide and divorce rates jumped by
nearly 50%, drug addiction rates climbed by 35%, and the crime rate rose by over 15%.
Figure 8
Real GDP Growth, 15
Argentina,
–20
1998 1999 2000 2001 2002 2003 2004 2005
Year
and lending began to decline. The resulting weakening of the economy and deteriora-
tion of bank balance sheets set the stage for the next stage of the crisis, a bank panic.
Figure 9
Argentine Peso, 1.50
1998–2004
The value of the 1.25
Exchange Rate ($ per peso)
0.00
1998 1999 2000 2001 2002 2003 2004
Year
W-16 w e b C h a p t e r 1 Financial Crises in Emerging Market Economies
Figure 10
Inflation, Argentina, 45
1998–2004
Inflation surged to 35
over 40% during the
crisis.
Source: International Inflation Rate (%) 25
Monetary Fund.
International Financial
Statistics. www.imfstatistics 15
.org/imf/.
–5
1998 1999 2000 2001 2002 2003 2004
Year
Just as in South Korea, the collapse of the Argentine currency after the successful
speculative attack on the currency raised import prices, which fed directly into inflation
and weakened the credibility of the Argentine central bank to keep inflation under con-
trol. Indeed, Argentina’s history of very high inflation meant that there was an even larger
rise in expected inflation in Argentina than in South Korea. Inflation in Argentina rose as
high as 40% at an annual rate, as shown in Figure 10. Because the rise in actual inflation
was accompanied by a rise in expected inflation, interest rates went to even higher levels,
as indicated in Figure 11. The higher interest payments led to a decline in the cash flow
Figure 11
Interest Rates, 100
Argentina,
1998–2004 85
the crisis.
55
Source: International
Monetary Fund.
International Financial
40
Statistics. www.imfstatistics
.org/imf/. 25
10
–5
1998 1999 2000 2001 2002 2003 2004
Year
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-17
Figure 12
Unemployment 24
Rate, Argentina,
1998–2004 22
14
12
10
1998 1999 2000 2001 2002 2003 2004
Year
of both households and businesses, which now had to seek external funds to finance
their investments. Given the uncertainty in financial markets, asymmetric information
problems were particularly severe, and this meant that investment could not be funded.
Households and businesses cut back their spending further. As predicted by our aggregate
demand and supply analysis, the Argentine economy plummeted. In the first quarter
of 2002, output was falling at an annual rate of more than 15%, as shown in Figure 8.
Figure 12 demonstrates that unemployment shot up to over 20%. The increase in
poverty was dramatic: the percentage of the Argentine population living in poverty
rose to almost 50% in 2002. Argentina was experiencing the worst depression in
its history—one every bit as bad as, and maybe even worse than, the U.S. Great
Depression.
Recovery Begins
As the financial crisis receded, a boom in the demand for Argentina’s commodity
exports encouraged the beginnings of recovery in the Argentine economy. By the end of
2003, economic growth was running at an annual rate of around 10%, and as Figure 12
demonstrates, unemployment had fallen to below 15%. Inflation also had fallen, to
below 5%, as shown in Figure 10.
Although we have drawn a strong distinction between financial crises in
emerging market economies and those in advanced economies, there have been
financial crises in advanced economies that have had much in common with
financial crises in emerging market economies. This is illustrated by the Global
box, “When an Advanced Economy Is Like an Emerging Market Economy: The
Icelandic Financial Crisis of 2008.” ◆
W-18 w e b C h a p t e r 1 Financial Crises in Emerging Market Economies
The financial crisis and economic contraction in lending system that had kept the Icelandic banks
Iceland that started in 2008 followed the script of afloat. Without access to funding, the banks couldn’t
a financial crisis in an emerging market economy, a repay their foreign currency debts, and much of the
remarkable turn of events for a small, wealthy nation collateral they held—including shares in other Ice-
with one of the world’s highest standards of living. landic banks—fell to a fraction of its previous value.
As part of a financial liberalization process, in Banks had grown so large—their assets were nearly
2003 the government of Iceland sold its state-owned nine times the nation’s gross domestic product—that
banks to local investors who supersized the Icelandic not even the government could credibly rescue the
banking industry. These investors set up overseas banks from failure. Foreign capital fled Iceland, and
branches to take foreign-currency deposits from the value of the Icelandic krona tumbled by over 50%.
thousands of Dutch and British households and bor- As a result of the currency collapse, the debt
rowed heavily from short-term wholesale funding burden in terms of domestic currency more than
markets in which foreign-denominated credit was doubled, destroying a large part of Icelandic firms’
ample and cheap. The investors channeled the funds and households’ net worth, leading to a full-scale
to local investment firms, many of which had ties to financial crisis. The economy went into a severe
the bank owners themselves. Not surprisingly, many recession, with the unemployment rate tripling, real
of the funds went into high-risk investments like wages falling, and the government incurring huge
equities and real estate. Iceland’s stock market value budget deficits. Relationships with foreign creditors
ballooned to 250% of GDP, and firms, households, became tense, and the United Kingdom even froze
and banks borrowed heavily in foreign currencies, assets of Icelandic firms under an antiterrorism law.
leading to a severe currency mismatch such as had Many Icelandic people returned to traditional jobs in
occurred in many emerging market countries. Mean- the fishing and agricultural industries, where citizens
while, Iceland’s regulatory system provided ineffec- could find a silver lining: the collapse of the Icelandic
tive supervision of bank risk taking. currency made exports of Iceland’s famous cod fish,
In October 2008, the failure of the U.S. investment Arctic char, and Atlantic salmon more affordable to
bank Lehman Brothers shut down the wholesale foreigners.
2
For a more extensive discussion of reforms to prevent financial crises in emerging market countries, see Chapter 9,
“Preventing Financial Crises,” in Frederic S. Mishkin, The Next Great Globalization: How Disadvantaged Nations Can
Harness Their Financial Systems to Get Rich (Princeton, NJ: Princeton University Press, 2006), 137–163.
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-19
shocks and to give bank owners, who have more to lose, an incentive to pursue
safer investments.
Prudential supervision can also help promote a safer and sounder banking system
by ensuring that banks have proper risk management procedures in place, including
(1) good risk measurement and monitoring systems, (2) policies to limit activities that
present significant risks, and (3) internal controls to prevent fraud or unauthorized
activities by employees. As indicated in the South Korea example, regulations should
also ban commercial businesses from owning banking institutions. When commercial
businesses own banks, they are likely to use them to channel lending to themselves,
as the chaebols did in South Korea, leading to risky lending that can provoke a bank-
ing crisis.
For prudential supervision to work, prudential supervisors must have adequate
resources with which to do their jobs. This is a particularly serious problem in emerging
market countries, where prudential supervisors earn low salaries and lack basic tools
such as computers. Because politicians often put pressure on prudential supervisors
to discourage them from being “too tough” on banks that make political contributions
(or outright bribes), a more independent regulatory and supervisory agency can better
withstand political influence, increasing the likelihood that prudential supervisors will
do their jobs and limit bank risk taking.
associated with doing so. Monetary policy that promotes price stability also helps
by making the domestic currency less subject to decreases in its value as a result of
high inflation, thus making it more desirable for firms to borrow in domestic rather
than foreign currency.
Summary
1. Financial crises in emerging market countries develop a currency crisis, and then a full-fledged financial cri-
along two basic paths: one involving the misman- sis. The financial crisis led to a sharp contraction in
agement of financial liberalization/globalization that economic activity and a rise in inflation, as well as a
weakens bank balance sheets, and the other involving weakening of the social fabric.
severe fiscal imbalances. Both lead to a speculative 3. In contrast to the crisis in South Korea, the Argentine
attack on the currency and eventually to a currency financial crisis started with severe fiscal imbalances.
crisis in which there is a sharp decline in the value A recession that had been going on since 1998, along
of the domestic currency. The decline in the value of with a deterioration of bank balance sheets that
the domestic currency causes a sharp rise in the debt occurred when fiscal imbalances led to losses from
burden of domestic firms, which leads to a decline government bonds that the banks had on their bal-
in firms’ net worth, as well as increases in inflation ance sheets, led to a worsening of adverse selection and
and interest rates. Adverse selection and moral hazard moral hazard problems, a bank panic, a currency crisis,
problems then worsen, leading to a collapse of lending and then a full-fledged financial crisis. As in South
and economic activity. The worsening economic condi- Korea, the financial crisis in Argentina led to a decline
tions and increases in interest rates result in substantial in economic activity and a rise in inflation, but the eco-
losses for banks, leading to a banking crisis, which fur- nomic contraction and rise in inflation were even worse
ther depresses lending and aggregate economic activity. because Argentina’s central bank lacked credibility as
2. The financial crisis in South Korea followed the pattern an inflation fighter.
described above. It started with a mismanagement of 4. Policies to prevent financial crises in emerging market
financial liberalization and globalization, followed by a economies include improving prudential regulation and
stock market crash and a failure of firms that increased supervision, limiting currency mismatch, and sequencing
uncertainty, a worsening of adverse selection problems, of financial liberalization.
Key Terms
currency mismatch, p.W-6 financial globalization, p.W-3 speculative attack, p.W-5
emerging market economies, p.W-1 financial liberalization, p.W-3
w e b C h a p t e r 1 Financial Crises in Emerging Market Economies W-21
Questions
All questions are available in MyEconLab at 7. How did the financial crises in South Korea and
http://www.myeconlab.com. Argentina affect aggregate demand, short-run aggregate
1. What are the two basic causes of financial crises in supply, and output and inflation in these countries?
emerging market economies? 8. What can emerging market countries do to strengthen
2. Why might financial liberalization and globalization prudential regulation and supervision of their banking
lead to financial crises in emerging market economies? systems? How might these steps help avoid future
financial crises?
3. Why might severe fiscal imbalances lead to financial
crises in emerging market economies? 9. How can emerging market economies avoid the
problems of currency mismatch?
4. What other factors can initiate financial crises in
10. Why might emerging market economies want to
emerging market economies?
implement financial liberalization and globalization
5. What events can ignite a currency crisis? gradually rather than all at once?
6. Why do currency crises make financial crises in
emerging market economies even more severe?