ECS 3701 Monetary Economics Boston | UNISA 2015
Unit 3 - 10 Financial crises in emerging economies
Errol Goetsch Lorraine
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Monetary Economics Units 1 - 6
Unit 1 – Introduction 01 Why study money, banking, financial markets 02 Overview of the financial system 03 What is Money? Unit 2 – Financial Markets 04 Understanding interest rates 05 The behaviour of interest rates 06 The risk and term structure of interest rates Unit 3 – Financial Institutions 08 An economic analysis of financial structure 09 Financial crises in advanced economies 10 Financial crises in emerging economies 11 Banking and management of financial institutions Unit 4 – Central banking and monetary policy 14 Central banks: a global perspective 15 The money supply process 16 Tools of monetary policy 17 The conduct of monetary policy: strategy & tactics Unit 6 – Monetary theory 20 Quantity theory, inflation and demand for money 21 The IS curve 24 Monetary policy theory 25 The role of expectations in Monetary Policy 26 Transmission mechanisms of Monetary Policy
10.0 Financial crises in Emerging Economies Definition 10.1 2 Paths to Financial Crisis Path A (Mismanagement) vs. Path B (Fiscal Imbalances) 10.2 Causes of Financial Crisis: Stage 1 (1) Mismanaged financial liberalisation or globalisation (2) Government fiscal imbalances (3) Additional factors (cash flow effects) (3) Additional factors a) rising interest rates (3) Additional factors b) falling asset prices (3) Additional factors c) increase in uncertainty 10.2 Causes of Financial Crisis: Stage 2 (4) Currency crisis a) speculative attack (4) Currency crisis a) investor exit 10.2 Causes of Financial Crisis: Stage 3 5) Currency mismatch 10.3 Preventing a Financial Crisis Government options Slide 2 of 19
10.0 Financial crises in Emerging Economies Definition
Economies in early stage of market development that have recently opened up to the flow of good, services and capital from the rest of the world.
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The emerging economies of Mexico (1994), Thailand, Malaysia, Indonesia, the Philippines, Korea (1997) and Argentina (2001) opened their economies to the world in the 1990's, hoping for greater prosperity. Instead, they experienced the equivalent of the US Great Depression
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Monetary Economics Units 1 - 6
Unit 1 – Introduction 01 Why study money, banking, financial markets 02 Overview of the financial system 03 What is Money? Unit 2 – Financial Markets 04 Understanding interest rates 05 The behaviour of interest rates 06 The risk and term structure of interest rates Unit 3 – Financial Institutions 08 An economic analysis of financial structure 09 Financial crises in advanced economies 10 Financial crises in emerging economies 11 Banking and management of financial institutions Unit 4 – Central banking and monetary policy 14 Central banks: a global perspective 15 The money supply process 16 Tools of monetary policy 17 The conduct of monetary policy: strategy & tactics Unit 6 – Monetary theory 20 Quantity theory, inflation and demand for money 21 The IS curve 24 Monetary policy theory 25 The role of expectations in Monetary Policy 26 Transmission mechanisms of Monetary Policy
10.0 Financial crises in Emerging Economies Definition 10.1 2 Paths to Financial Crisis Path A (Mismanagement) vs. Path B (Fiscal Imbalances) 10.2 Causes of Financial Crisis: Stage 1 (1) Mismanaged financial liberalisation or globalisation (2) Government fiscal imbalances (3) Additional factors (cash flow effects) (3) Additional factors a) rising interest rates (3) Additional factors b) falling asset prices (3) Additional factors c) increase in uncertainty 10.2 Causes of Financial Crisis: Stage 2 (4) Currency crisis a) speculative attack (4) Currency crisis a) investor exit 10.2 Causes of Financial Crisis: Stage 3 5) Currency mismatch 10.3 Preventing a Financial Crisis Government options Slide 4 of 19
10.1 2 paths to financial crisis in Emerging Economies Path A (Mismanaged liberalisation) vs. Path B (Fiscal imbalances)
1 Initiation
2 Currency Crisis 3 Full-fledged Financial crisis
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Monetary Economics Units 1 - 6
Unit 1 – Introduction 01 Why study money, banking, financial markets 02 Overview of the financial system 03 What is Money? Unit 2 – Financial Markets 04 Understanding interest rates 05 The behaviour of interest rates 06 The risk and term structure of interest rates Unit 3 – Financial Institutions 08 An economic analysis of financial structure 09 Financial crises in advanced economies 10 Financial crises in emerging economies 11 Banking and management of financial institutions Unit 4 – Central banking and monetary policy 14 Central banks: a global perspective 15 The money supply process 16 Tools of monetary policy 17 The conduct of monetary policy: strategy & tactics Unit 6 – Monetary theory 20 Quantity theory, inflation and demand for money 21 The IS curve 24 Monetary policy theory 25 The role of expectations in Monetary Policy 26 Transmission mechanisms of Monetary Policy
10.0 Financial crises in Emerging Economies Definition 10.1 2 Paths to Financial Crisis Path A (Mismanagement) vs. Path B (Fiscal Imbalances) 10.2 Causes of Financial Crisis: Stage 1 (1) Mismanaged financial liberalisation or globalisation (2) Government fiscal imbalances (3) Additional factors (cash flow effects) (3) Additional factors a) rising interest rates (3) Additional factors b) falling asset prices (3) Additional factors c) increase in uncertainty 10.2 Causes of Financial Crisis: Stage 2 (4) Currency crisis a) speculative attack (4) Currency crisis a) investor exit 10.2 Causes of Financial Crisis: Stage 3 5) Currency mismatch 10.3 Preventing a Financial Crisis Government options Slide 6 of 19
10.2 Causes: Stage 1
(1) Mismanaged financial liberalisation or globalisation
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1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
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1. Financial Liberalisation (South Korea 1997) Countries liberalise by removing restrictions on financial institutions and markets domestically, while having a weak credit culture. The credit boom ends in a credit crash. 2. Financial Globalisation Banks take advantage of open borders to borrow from abroad, paying high rates of interest to increase lending.
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1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
10.2 Causes: Stage 1
(2) Government fiscal imbalances
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2. Fiscal imbalance (Argentina 2001|1) Russia 1998 Ecuador 1999 Turkey 2001 Zimbabwe 2012 Greece 2015 ↑G debt causes fears of G default. Demand for G bonds ↓, so G may force FI to buy them. Bond prices ↓when default is likely, so FI balance sheets weaken and lending ↓.
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1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
10.2 Causes: Stage 1
(3) Additional factors having cash flow effects
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3 Cash flow effects i↑so Asset Prices ↓so Net worth ↓ 1. less collateral, so AS increases. Asset-price bubble bursts make borrowers less credit-worthy, reducing lending and spending. 2. The asset price bust can also lead to a deterioration in financial institutions’ balance U sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity. Rising interest rates reduce borrowing and can contract economy
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1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
10.2 Causes: Stage 1
(3) Additional factors a) rising interest rates
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3a Rising interest rates Mexico (1994) Mexico relied on cheap US loans and was affected by the change in US monetary policy that increased the price of money. The increases were passed on, intensifying problems of AS and MH
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1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
10.2 Causes: Stage 1
(3) Additional factors b) Asset booms and busts 3b ↓ Asset Prices Asset markets are less developed and play a smaller role but asset busts still reduce net worth (worsening AS) and collateral (worsening MH). Falling asset price loans also reduce firm and household balance sheets and cause write-down of bank balance sheets.
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3b ↓ Asset Prices Rapid and unexpected ↓causes expectation of further ↓, so value of assets put up as collateral ↓. As a result, firms accepting collateral assets require larger and larger haircuts, or discounts on the value of collateral in expectation of future lower values. Firms must ↑collateral for same loans over time. U Due to the falling asset prices and rising haircuts, it becomes a “buyers market” for these rapidly falling assets; any firms needing to raise funds quickly would then be forced to sell assets at a fraction of their original worth.
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1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
10.2 Causes: Stage 1
(3) Additional factors c) Increases in uncertainty
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3c Uncertainty The failure of a major financial institution, which leads to a dramatic increase in uncertainty in financial markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity.
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Monetary Economics Units 1 - 6
Unit 1 – Introduction 01 Why study money, banking, financial markets 02 Overview of the financial system 03 What is Money? Unit 2 – Financial Markets 04 Understanding interest rates 05 The behaviour of interest rates 06 The risk and term structure of interest rates Unit 3 – Financial Institutions 08 An economic analysis of financial structure 09 Financial crises in advanced economies 10 Financial crises in emerging economies 11 Banking and management of financial institutions Unit 4 – Central banking and monetary policy 14 Central banks: a global perspective 15 The money supply process 16 Tools of monetary policy 17 The conduct of monetary policy: strategy & tactics Unit 6 – Monetary theory 20 Quantity theory, inflation and demand for money 21 The IS curve 24 Monetary policy theory 25 The role of expectations in Monetary Policy 26 Transmission mechanisms of Monetary Policy
10.0 Financial crises in Emerging Economies Definition 10.1 2 Paths to Financial Crisis Path A (Mismanagement) vs. Path B (Fiscal Imbalances) 10.2 Causes of Financial Crisis: Stage 1 (1) Mismanaged financial liberalisation or globalisation (2) Government fiscal imbalances (3) Additional factors (cash flow effects) (3) Additional factors a) rising interest rates (3) Additional factors b) falling asset prices (3) Additional factors c) increase in uncertainty 10.2 Causes of Financial Crisis: Stage 2 (4) Currency crisis a) speculative attack (4) Currency crisis a) investor exit 10.2 Causes of Financial Crisis: Stage 3 5) Currency mismatch 10.3 Preventing a Financial Crisis Government options Slide 13 of 19
1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
10.2 Causes: Stage 2
(4) Currency crisis: a) speculative attack
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4a Currency crisis against attack G can ↑i to ↑E but ↑cost of borrowing and ↓ loans can sink the bank and ↓I can sink the economy. Speculators attack the currency until foreign reserves are exhausted.
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1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
10.2 Causes: Stage 2
(4) Currency crisis: b) Investor Exit
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4b 4b Fiscal imbalance 1. ↑G debt causes fears of G default. Demand for G bonds ↓, so G may force FI to buy them. Bond prices ↓when default is likely, so FI balance sheets weaken and lending ↓. 2. Fears cause foreign exchange crisis. The domestic currency ↓ sharply because investors pull their money out of the country. This destroys balance sheets of firms with debt denominated in foreign currency.
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Monetary Economics Units 1 - 6
Unit 1 – Introduction 01 Why study money, banking, financial markets 02 Overview of the financial system 03 What is Money? Unit 2 – Financial Markets 04 Understanding interest rates 05 The behaviour of interest rates 06 The risk and term structure of interest rates Unit 3 – Financial Institutions 08 An economic analysis of financial structure 09 Financial crises in advanced economies 10 Financial crises in emerging economies 11 Banking and management of financial institutions Unit 4 – Central banking and monetary policy 14 Central banks: a global perspective 15 The money supply process 16 Tools of monetary policy 17 The conduct of monetary policy: strategy & tactics Unit 6 – Monetary theory 20 Quantity theory, inflation and demand for money 21 The IS curve 24 Monetary policy theory 25 The role of expectations in Monetary Policy 26 Transmission mechanisms of Monetary Policy
10.0 Financial crises in Emerging Economies Definition 10.1 2 Paths to Financial Crisis Path A (Mismanagement) vs. Path B (Fiscal Imbalances) 10.2 Causes of Financial Crisis: Stage 1 (1) Mismanaged financial liberalisation or globalisation (2) Government fiscal imbalances (3) Additional factors (cash flow effects) (3) Additional factors a) rising interest rates (3) Additional factors b) falling asset prices (3) Additional factors c) increase in uncertainty 10.2 Causes of Financial Crisis: Stage 2 (4) Currency crisis a) speculative attack (4) Currency crisis a) investor exit 10.2 Causes of Financial Crisis: Stage 3 5) Currency mismatch 10.3 Preventing a Financial Crisis Government options Slide 16 of 19
1. Financial Liberalisation | Globalisation 2. Government Fiscal imbalances 3. Additional factors a Rising interest rates b. Falling asset prices c. Increase in uncertainty 4. Currency crisis 5. Currency mismatch
10.2 Causes: Stage 3 (5) Currency mismatch
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5. Currency mismatch Where debts are denominated in a foreign currency, ↓E causes ↑debt While income sold to local markets stays the same. This causes ↓net worth and ↑AS and MH. ↓E causes ↓assets, so bank balance sheets ↓, so lending contracts, i↑ causes ↓firm cash flows. Banks squeezed between ↑debts and ↓assets
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Monetary Economics Units 1 - 6
Unit 1 – Introduction 01 Why study money, banking, financial markets 02 Overview of the financial system 03 What is Money? Unit 2 – Financial Markets 04 Understanding interest rates 05 The behaviour of interest rates 06 The risk and term structure of interest rates Unit 3 – Financial Institutions 08 An economic analysis of financial structure 09 Financial crises in advanced economies 10 Financial crises in emerging economies 11 Banking and management of financial institutions Unit 4 – Central banking and monetary policy 14 Central banks: a global perspective 15 The money supply process 16 Tools of monetary policy 17 The conduct of monetary policy: strategy & tactics Unit 6 – Monetary theory 20 Quantity theory, inflation and demand for money 21 The IS curve 24 Monetary policy theory 25 The role of expectations in Monetary Policy 26 Transmission mechanisms of Monetary Policy
10.0 Financial crises in Emerging Economies Definition 10.1 2 Paths to Financial Crisis Path A (Mismanagement) vs. Path B (Fiscal Imbalances) 10.2 Causes of Financial Crisis: Stage 1 (1) Mismanaged financial liberalisation or globalisation (2) Government fiscal imbalances (3) Additional factors (cash flow effects) (3) Additional factors a) rising interest rates (3) Additional factors b) falling asset prices (3) Additional factors c) increase in uncertainty 10.2 Causes of Financial Crisis: Stage 2 (4) Currency crisis a) speculative attack (4) Currency crisis a) investor exit 10.2 Causes of Financial Crisis: Stage 3 5) Currency mismatch 10.3 Preventing a Financial Crisis 4 Government options Slide 18 of 19
10.3 Preventing a Financial Collapse 4 Government options
1. Strengthen prudential regulation and supervision of banks - Capital reserve requirements - Risk supervision systems at banks - Resourced and independent regulator
2. Encourage disclosure and market-based discipline - Standardised reports of bank's balance sheet and activities 3. Limit currency mismatch - Regulations or taxes to limit for-ex exposure/ require hedging - Flexible exchange rates - Monetary policy to promote price / currency stability 4. Sequence financial liberalisation - Create supervision infrastructure before opening economy or financial markets
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