Lecture 8:

Financial Crises

Development Finance

2008
Financial Crises
Currency crisis
 Currency or balance-of-payment crisis refers to the
situation where the government does not have
sufficient foreign exchange reserves to satisfy the
foreign exchange demand, and is forced to devalue its
currency.
Banking Crisis
 A banking crisis occurs when bank runs induce banks
to suspend their operations or force the government to
provide financial support. The contributing factor is
often the amounting problem of bad debts which eat
into bank capital. Banking crisis may also be triggered
by contagion.
 Twin crisis
Flood & Garber Model (1984)
Real money Basic equation
demand:
Mt Mt  * ∆Ete 
= kY − γrt = kY − γ  r + 
Pt *
P Et  Et 
∆Ete
Purchasing power Fixed ER =0
Et
parity Mt Mt 1
= kY − γr * ⇒ Et = = Mt
Pt = Et∆ PE
*
e P*Et P* (kY − γr * ) α
rt − r * = t
Interest rate Et parity
Floating ER when R =
0∆D ∆M ∆E e
Mt
t = t = t =µ⇒ = kY − γr * ⇒
Dt Mt Et P*Et
Money supply
Mt = Rt + Dt Mt 1
Et = = Mt
P* (kY − γr *µ ) α−β
Domestic credit
D = D (1 + µ.)t
Speculative Attack and Currency
Crisis
When reserves fall Exchange rate,
Et
to a critical level, a 1
speculative attack Et = Mt
α−β
occurs. E’ B
Domestic money 1
Et = M t
holders try to C α
E
exchange all of A
their local
currency into FX,
causing the DT M Money supply,
reserves to fall to Mt
The reduction in the money supply is equal to the
zero.
reserve loss.
The exchange rate is floated and the equilibrium is
shifted from A to C; The exchange rate does not
change at the time of the shift.
Mexico’s Currency Crisis in 1994
Early 1990s
 Large foreign capital inflows caused the peso to
appreciate 40% in real term in five years from 1988
to 1993.
 Current account deficit increased from 2.6% of GDP in
mid 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 trade
deficit.
 The central bank decided to sterilize the effect of
reserve loses by increasing domestic credit.
 Reserves declined further and speculative attacks
occurred in March 1994.
Mexican Currency Crisis in 1994
(Tequila Crisis)
The 1994 Tequila Crisis show the inconsistency
between exchange rate policy and a monetary policy
that sterilized reserve loss which can be explained by
the first-generation crisis model.
However, the loss of reserves was not due to fiscal
deficit, but rather to the financing of current account
deficits when foreign capital inflows declined.
The fact that the central bank allowed its reserves to
fall and increased domestic credit reveals the bank’s
concern about other policy objectives. By choosing
not to tighten the monetary policy, which would have
raised interest rates, the central bank hoped to ease
the pressure on the banking system and avoid the
cost of unemployment. (Second-generation crisis
model)
International capital flows played a central role in the
crisis ⇒ Third-generation crisis model?
Krugman (1979) – First Generation
Model
Starting Points
Budget Unsustainable
Deficits macroeconomic
policies
Fixed exchange rate
Financed by Pressure on
Printing Money fixed ER

Central Bank
runs down reserves
to defend ER

Reserves Speculati Currency

decline ve attack Crisis
Latin American Currency Crises in the
1980s
Fiscal deficit and fixed exchange
rate
First-
Fiscal deficit financed by printing
money
Generatio
Increasing domestic credit
putting pressure on the fixed
exchange rate
n
Central bank drawing down
Currency
foreign exchange reserves to
protect the exchange rate
Crisis
Reserves declining to a critical
level, triggering a speculative
attack on the domestic currency Model
Central bank forced to float the
exchange rate
 Obsfeld (1994) – Second Generation
Model
Speculative attack depends
on government response:
 Determined to maintain fixed
ER; or
 Willing to float ER in order to
pursue other objectives.
Government chooses whether
or not to defend ER on the
basis of economic situation.
 Benefit: long-term credibility.
 Cost: high interest rate
affecting growth.

Two equilibria: Government

Speculators attack Doesn’t Defend
and government defend ER
float ER
ER
Speculators do not Spec Attack 2; -1 -2; -4
attack and u-
government Don’t
lators 0; 1 0; 2
maintains fixed ER. attack
 Self-fulfilling Expectation

Market expectation
Govn’t moves away from
the fixed ER to pursue
other policies (e.g.
employment )
Government
Expectation of Floats the ER upon
Speculators
devaluation and seeing the negative effects
Attack the local
interest rate of interest rate
currency
increase increase on growth
and employment

Crisis occurs, not because of economic

fundamentals, but because of market
expectation.
European Currency Crisis in 1992-93
Market expectation: the government Self-
may consider to move away from the
fixed exchange rate to pursue other fulfilling
policies (e.g. employment).
Expectati
Speculators: look at the possibility of
attacking the domestic currency. on -
The possibility of a speculative attack
creates expectation for devaluation Second-
and interest rate increase
Generatio
Government: decides to float the
exchange rate out of the concern on n
the negative effects of the interest rate Currency
rise on growth and employment (even
though it has sufficient foreign Crisis
exchange reserves to fend off any
speculative attack). Model
European Currency Crisis in 1992-93
European Monetary System (EMS) in the early
1990s: ERs were allowed to fluctuate within the
bands of ±2,25% around a central parity.
After the German Reunification in 1990, budge
deficit and real as well as nominal interest rates
increased rapidly in Germany.
Other members of the EMS had to increase their
interest rates, creating a deflationary pressure at
the time when many of them were in a recession.
The first speculative attack occurred in September
1992. The UK and Italy decided to leave the EMS.
At the end of 1993, the ER bands were widened to
±15%.
European Currency Crisis in 1992-93
European Monetary System (EMS) in the early
1990s: ERs were allowed to fluctuate within the
bands of ±2,25% around a central parity.
After the German Reunification in 1990, budge
deficit and real as well as nominal interest rates
increased rapidly in Germany.
Other members of the EMS had to increase their
interest rates, creating a deflationary pressure at
the time when many of them were in a recession.
The first speculative attack occurred in September
1992. The UK and Italy decided to leave the EMS.
At the end of 1993, the ER bands were widened to
±15%.
East Asian Financial Crisis
East Asian Financial Crisis
Moral hazard and investment bubbles
 Directed credit and moral hazard
 Financial liberalization and international
capital inflows
 Asset bubbles
 Macroeconomic imbalances
 Twin crisis
Bank runs and coordination failures
Speculative attacks
Fiscal Balance (in percent of GDP)
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

Source: WB, “World Development Indicators 2002” ADB (1999) and ADB database.
International Capital Flows to East Asia
(billions of US$)
  1991 1992 1993 1994 1995 1996

Net private capital flows 24.8 29.0 31.8 36.1 74.2 65.8

   Net FDI 6.2 7.3 7.6 8.8 7.5 8.4

   Net portfolio investment 3.2 6.4 17.2 9.9 17.4 20.3

   Commercial & other      15.4 15.3 7.0 17.4 49.2 37.1

lending
Net official flows 4.4 2.0 0.6 0.3 0.7 -0.4

Source: WB, “World Economic Outlook”, May 1998 & March 2000.
Lending by International Banks, end
of 1996 (billions of US$)
  US Banks Japanese  EU Banks Total 
Banks 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
Source: WB, “World Economic Outlook”, December 1997.
Financial Claims on Private Sector
(in percent of GDP)

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

Source: Radelet and Sachs

(1998).
Short-term Debt, Q2, 1997
  Short-term  FX Reserves (1)/(2)
External Debt  (US$ bil) – 
(US$ bil) – (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

Source: ADB, “Asian Development Outlook”, 1999.

Loans to Real Estate and Manufacturing Sectors
by Thai Finance Companies (Share of total
outstanding loans)

30

25 Real Estate

20

15
Manufacturing
10

5
87 88 89 90 91 92 93 94 95 96

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

Debt to Equity Ratio in Korea
Manufacturing Sector (%)
320

310

300

290

280

270
1993 1994 1995 1996

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

Prime Office Capital Values (1988 =
100)
400

350 Jakarta

300

250
Bangkok
200

150

100

50

0
88 89 90 91 92 93 94 95 96 97

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

Stock Indices
Jan 5,
1996=100
Hong Kong
Taiwan
Indonesia
Philippine
s

Thailand Singapore
Kore
a
Malaysia

Source: IMF, “World Economic Outlook”, December

1997.
Bilateral US Dollar Exchanger Rates
Jan 5,
1996=100
Malaysi Singapore Hong Kong
a
Indonesia
Korea

Philippine
s
Thailand Taiwan

Source: IMF, “World Economic Outlook”, December

1997.
Real Effective Exchange Rate
Appreciation (%)

1990-1997

Thailand 25

Korea 12

Malaysia 28

Indonesia 25

Philippines 47

Source: Eichengreen (1999)

Bilateral US Dollar Exchanger Rates

Jan Japanes
1990=100 e Yen

Source: IMF, “World

Deusch Economic Outlook”,
Mark December 1997.

Chinese
Reminbi
Export Prices for East Asia
and Other Regions

Source: Reproduced from WB, “East Asia – The Road to Recovery”, 1998.
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
GDP)
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 14.05
Taiwan 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
US$)

  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

Source: WB, “World Economic Outlook”, May 1998 & March 2000.
Annual GDP Growth Rates (%)
  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

Source: WB, “World Development Indicators 2002” .

 Third-Generation Financial Crisis
Domestic Financial
Model
External Capital
System Macroeconomic
Inflows
• Bank-based system Policies
• Inadequate supervision Increase in short-term
Fixed exchange rate
external debt
• Moral hazard

Misallocation of Capital Macroeconomic

• Overinvestment Vulnerability
• Asset bubble • Overvalued real
• Corruption exchange rate
• Current account
deficits

Financial
Vulnerability
• High level of bad Crisis
debt
• Maturity mismatch