web chapter 25 financial crises in emerging market economies

Web Chapter 25

Financial Crises in Emerging

Market Economies

Copyright ©2015 Pearson Education, Inc. All rights reserved. 25-2

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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?


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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


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.


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.


Emerging Market Financial Crisis: Sequence of Events (a)

Figure 25.1 Sequence of Events in Emerging Market Financial Crises


Emerging Market Financial Crisis: Sequence of Events (b)

Figure 25.1 Sequence of Events in Emerging Market Financial Crises


Stage One: Initiation

Financial crises in emerging market countries develop along two basic paths:

•Credit Boom and Bust

•Severe Fiscal Imbalances



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



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



• 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



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



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


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.



• 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.



• 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


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.



• 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.



With this framework in mind, we now turn to three actual financial crises in emerging economies:•South Korea, 1997–1998•Argentina, 2001–2002


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.



• South Korea started with strong macroeconomic fundamentals, as seen in the next three figures. As you can see, conditions changed quickly in 1997.



Figure 25.2 Inflation, South Korea, 1995–1999



Figure 25.3 Real GDP Growth, South Korea, 1995–1999



Figure 25.4 Unemployment, South Korea, 1995–1999



• 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.



• 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.



• 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.



Figure 25.5 Stock Market Index, South Korea, 1995–1999



• 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.



Figure 25.6 Value of South Korean Currency, 1995–1999



• 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.



Figure 25.7 Interest Rates, South Korea, 1995–1999



• 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.



Figure 25.8 Inflation, Argentina, 1998–2004



Figure 25.9 Real GDP Growth, Argentina, 1998–2004



Figure 25.10 Unemployment Rate, Argentina, 1998–2004



• 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.



• 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



Figure 25.11 Argentine Peso, 1998–2004



• 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%.



Figure 25.12 Interest Rates, Argentina, 1998–2004



• 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


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.


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!


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.


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


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.


Chapter Summary (cont.)

• Preventing Emerging Market Financial: We discussed steps emerging markets can take to avoid the pitfalls of a financial crisis.

web chapter 25 financial crises in emerging market economies

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