Lecture 8-Financial Crisis-E(halan)

8/14/2019 Lecture 8-Financial Crisis-E(halan)

1/33

Lecture 8:Financial Crises

Development Finance

2008


2/33

Financial Crises

Currency crisis

Currency or balance-of-payment crisis refers to thesituation where the government does not havesufficient foreign exchange reserves to satisfy theforeign exchange demand, and is forced to devalue itscurrency.

Banking Crisis

A banking crisis occurs when bank runs induce banksto suspend their operations or force the government toprovide financial support. The contributing factor is

often the amounting problem of bad debts which eatinto bank capital. Banking crisis may also be triggeredby contagion.

Twin crisis


3/33

Flood & Garber Model (1984)

Real moneydemand:

Purchasing powerparity

Pt= E

tP*

Interest rate parity

Money supply

Mt= R

t+ D

t

Domestic creditD = D (1 + .)t

Basic equation

t

t

trYk

P

M=

+=t

e

t

t

t

E

ErYk

EP

M **

t

et

tE

Err

=

*

Fixed ER 0=

t

e

t

E

E

= **

rYkEP

M

t

t tt

t MrYkP

ME

1

)( **=

=

Floating ER when R =

0 === t

et

t

t

t

t

E

E

M

M

D

D= *

*rYk

EP

M

t

t

tt

t M

rYkP

ME

=

=

1

)( **


4/33

Speculative Attack and CurrencyCrisis

When reserves fallto a critical level, aspeculative attackoccurs.

Domestic money

holders try toexchange all oftheir localcurrency into FX,causing thereserves to fall tozero.

DT

B

C

A

Money supply,Mt

Exchange rate,Et

tt ME

1=

tt ME

=

1

E

M

E

The reduction in the money supply is equal to thereserve loss.

The exchange rate is floated and the equilibrium isshifted from A to C; The exchange rate does not

change at the time of the shift.


5/33

Mexicos Currency Crisis in 1994

Early 1990s Large foreign capital inflows caused the peso to

appreciate 40% in real term in five years from 1988to 1993.

Current account deficit increased from 2.6% of GDP inmid 1989 to 5% of GDP in 1993.

Economic growth declined from 5.1% in 1990 to 3.6%in 1992, and to 2.0% in 1993.

1994 Foreign capital flows plummeted.

Large external debt would become due in 1995.

Foreign reserve were run down to finance tradedeficit.

The central bank decided to sterilize the effect ofreserve loses by increasing domestic credit.

Reserves declined further and speculative attacks

occurred in March 1994.


6/33

Mexican Currency Crisis in 1994(Tequila Crisis)

The 1994 Tequila Crisis show the inconsistencybetween exchange rate policy and a monetary policythat sterilized reserve loss which can be explained bythe first-generation crisis model.

However, the loss of reserves was not due to fiscal

deficit, but rather to the financing of current accountdeficits when foreign capital inflows declined.

The fact that the central bank allowed its reserves tofall and increased domestic credit reveals the banksconcern about other policy objectives. By choosing

not to tighten the monetary policy, which would haveraised interest rates, the central bank hoped to easethe pressure on the banking system and avoid thecost of unemployment. (Second-generation crisismodel)

International capital flows played a central role in thecrisis Third- eneration crisis model?


7/33

Krugman (1979) First GenerationModel

Starting PointsUnsustainablemacroeconomicpolicies

Fixed exchange rate

BudgetDeficits

Reservesdecline

CurrencyCrisis

Speculative attack

Financed byPrinting Money Pressure onfixed ER

Central Bankruns down reserves

to defend ER


8/33

Latin American Currency Crises in the1980s

Fiscal deficit and fixed exchangerate

Fiscal deficit financed by printingmoney

Increasing domestic credit

putting pressure on the fixedexchange rate

Central bank drawing downforeign exchange reserves to

protect the exchange rateReserves declining to a criticallevel, triggering a speculativeattack on the domestic currency

Central bank forced to float the

exchange rate

First-

Generatio

n

Currency

Crisis

Model


9/33

Obsfeld (1994) Second GenerationModel

Speculative attack depends

on government response: Determined to maintain fixed

ER; or

Willing to float ER in order topursue other objectives.

Government chooses whether

or not to defend ER on thebasis of economic situation.

Benefit: long-term credibility.

Cost: high interest rateaffecting growth.

Two equilibria:

Speculators attackand government

float ER

Speculators do notattack andgovernmentmaintains fixed ER.

Specu-lators 0; 20; 1

Dontattack

-2; -42; -1Attack

Defend

ER

Doesnt

defendER

Government


10/33

Self-fulfilling Expectation

Market expectationGovnt moves away from

the fixed ER to pursueother policies (e.g.

employment )

SpeculatorsAttack the local

currency

Expectation ofdevaluation and

interest rateincrease

Government

Floats the ER uponseeing the negative effects

of interest rateincrease on growthand employment

Crisis occurs, not because of economicfundamentals, but because of marketexpectation.


11/33

European Currency Crisis in 1992-93

Market expectation: the governmentmay consider to move away from thefixed exchange rate to pursue otherpolicies (e.g. employment).

Speculators: look at the possibility ofattacking the domestic currency.

The possibility of a speculative attackcreates expectation for devaluationand interest rate increase

Government: decides to float theexchange rate out of the concern onthe negative effects of the interest raterise on growth and employment (eventhough it has sufficient foreignexchange reserves to fend off anyspeculative attack).

Self-fulfilling

Expectati

on -

Second-

Generatio

n

Currency

Crisis

Model


12/33


European Monetary System (EMS) in the early1990s: ERs were allowed to fluctuate within thebands of 2,25% around a central parity.

After the German Reunification in 1990, budgedeficit and real as well as nominal interest rates

increased rapidly in Germany.Other members of the EMS had to increase theirinterest rates, creating a deflationary pressure atthe time when many of them were in a recession.

The first speculative attack occurred in September1992. The UK and Italy decided to leave the EMS.At the end of 1993, the ER bands were widened to15%.


13/33


European Monetary System (EMS) in the early1990s: ERs were allowed to fluctuate within thebands of 2,25% around a central parity.

After the German Reunification in 1990, budgedeficit and real as well as nominal interest rates

increased rapidly in Germany.Other members of the EMS had to increase theirinterest rates, creating a deflationary pressure atthe time when many of them were in a recession.

The first speculative attack occurred in September1992. The UK and Italy decided to leave the EMS.At the end of 1993, the ER bands were widened to15%.


14/33

East Asian Financial Crisis


15/33


16/33

Fiscal Balance (in percent of GDP)

Source: WB, World Development Indicators 2002 ADB (1999) and ADB database.

1993 1994 1995 1996

Korea 0.61 0.30 0.27 0.10

Thailand 2.09 1.85 2.94 2.34

Malaysia 1.21 4.25 2.24 2.02

Indonesia 0.61 0.94 2.22 1.16

Philippines -1.48 0.96 0.58 0.29

Singapore 15.72 16.25 14.65 10.58

Taiwan -3.92 -1.73 -1.09 -1.32

China -2.04 -1.85 -1.75 -1.59


17/33


18/33

Lending by International Banks, endof 1996 (billions of US$)

Source: WB, World Economic Outlook, December 1997.

US Banks Japanese

Banks

EU Banks Total

Lending

Korea 9.4 24.3 33.8 100.0

Thailand 5.0 37.5 19.2 70.2

Malaysia 2.3 8.2 9.2 22.2

Indonesia 5.3 22.0 21.0 55.5

Philippines 3.9 1.6 6.3 13.3

Hong Kong 8.7 87.5 86.2 207.2

Singapore 5.7 58.8 102.9 189.3

Taiwan 3.2 2.7 12.7 22.4

China 2.7 17.8 26.0 55.0

Vietnam 0.2 0.2 1.0 1.5

Total 46.4 260.6 318.3 736.6


19/33

Financial Claims on Private Sector(in percent of GDP)

Source: Radelet and Sachs(1998).

1991 1992 1993 1994 1995 1996

Korea 103.1 110.7 121.3 128.8 133.5 140.9

Thailand 88.6 98.4 110.8 128.1 142.0 141.9


20/33

Short-term Debt, Q2, 1997

Source: ADB, Asian Development Outlook, 1999.

Short-term

External Debt

(US$ bil) (1)

FX Reserves

(US$ bil)

(2)

(1)/(2)

Korea 70.18 34.07 2.06

Thailand 45.57 31.36 1.45

Indonesia 34.66 20.34 1.70

Malaysia 16.27 26.59 0.61

Philippines 8.29 9.78 0.85


21/33


22/33

Debt to Equity Ratio in KoreaManufacturing Sector (%)

270

280

290

300

310

320

1993 1994 1995 1996

Source: Reproduced from Marcus Miller & Pings Lunar (1998).

P i Offi C it l V l (1988


23/33

0

50

100

150

200

250

300

350

400

88 89 90 91 92 93 94 95 96 97

Jakarta

Prime Office Capital Values (1988 =100)

Bangkok

Source: Reproduced from Marcus Miller & Pings Lunar (1998).


24/33


25/33

Bilateral US Dollar Exchanger Rates

Malaysia

Indonesia

Philippines

Thailand

Singapore Hong Kong

Korea

Taiwan

Jan 5,1996=100

Source: IMF, World Economic Outlook, December

1997.


26/33


27/33

Bilateral US Dollar Exchanger Rates

Japanese Yen

DeuschMark

ChineseReminbi

Jan1990=100

Source: IMF, WorldEconomic Outlook,December 1997.


28/33

Export Prices for East Asiaand Other Regions

Source: Reproduced from WB, East Asia The Road to Recovery, 1998.


29/33

Annual Export Growth Rates (%)

1994 1995 1996 1997

Thailand 19 20 -1 3

Korea 14 23 4 5

Malaysia 20 21 6 1

Indonesia 8 12 9 7

Philippines 17 24 14 21

Hong Kong 11 13 4 4

Singapore 24 18 5 -1

Taiwan 9 17 4 4

China 25 19 2 21

Source: WB, East Asia The Road to Recovery, 1998.

Current Account Deficits (in percent of


30/33

Current Account Deficits (in percent ofGDP)

1994 1995 1996

Korea -0.96 -1.74 -4.42

Thailand -5.59 -8.05 -8.05

Malaysia -6.07 -9.73 -4.42

Indonesia -1.58 -3.18 -3.37

Philippines -4.60 -2.67 -4.77

Hong Kong 2.39 -2.40 -1.38

Singapore 16.32 17.87 14.05Taiwan 2.66 2.07 3.91

China 1.27 0.23 0.89

Source: WB, World Development Indicators 2002 and ADB Database.

East Asian Capital Outflows (Billions of


31/33

East Asian Capital Outflows (Billions ofUS$)

Source: WB, World Economic Outlook, May 1998 & March 2000.

1996 1997 1998 1999

Net Private Flows 65.8 -20.4 -25.6 -24.6

Net FDI 8.4 10.3 8.6 10.2

Net portfolio investment 20.3 12.9 -6.0 6.3

Commercial & other lending 37.1 -43.6 -28.2 -41.1

Net Official Flows -0.4 17.9 19.7 -4.7


32/33

Annual GDP Growth Rates (%)

Source: WB, World Development Indicators 2002 .

1995 1996 1997 1998 1999 2000

Korea 8.92 6.75 5.01 -6.69 10.89 8.81

Thailand 9.31 5.88 -1.45 -10.77 4.22 4.31

Malaysia 9.83 10.00 7.32 -7.36 6.08 8.30

Indonesia 8.40 7.64 4.70 -13.13 0.85 4.77

Philippines 4.68 5.85 5.19 -0.58 3.40 4.01

China 10.53 9.58 8.84 7.80 7.05 7.94

Vietnam 9.54 9.34 8.15 5.80 4.80 5.50


33/33

Domestic FinancialSystem

Bank-based system Inadequate supervision

Moral hazard

FinancialVulnerability

High level of baddebt

Maturity mismatch

Macroeconomic

PoliciesFixed exchange rate

Misallocation of Capital

Overinvestment Asset bubble

Corruption

Macroeconomic

Vulnerability Overvalued real

exchange rate

Current accountdeficits

Crisis

External CapitalInflows

Increase in short-termexternal debt

Third-Generation Financial CrisisModel

Lecture 8-Financial Crisis-E(halan)

Documents

Transcript of Lecture 8-Financial Crisis-E(halan)