Chapter 10
Financial Crises in
Emerging
Economies
Dynamics of Financial Crises in
Emerging Market Economies
• The dynamics of financial crisis in emerging
economies resemble those found in the
developed countries but with some
important differences.
• The sequence and stages of events in
financial crisis in emerging economies are
described in Figure 1.
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Dynamics of Financial Crises
• Financial crises can be sequenced in three
stages:
– Stage One: Initiation of Financial Crisis
– Stage Two: Currency Crisis
– Stage Three: Full-Fledged Financial Crisis
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FIGURE 1 Sequence of Events in
Economies-Market Financial Crises
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Stage One: Initiation of Financial
Crisis
• Financial crises can begin due to:
– Mismanagement of financial liberalization and
globalization
– Severe fiscal imbalances
– Other additional factors
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Stage One: Initiation of Financial
Crisis (cont’d)
• Mismanagement of financial liberalization
and globalization
– Financial liberalization – elimination of
restrictions on financial institutions and markets
domestically
– Financial globalization - opening up of
economy to flows of capital and financial firms
from other nations
– Financial liberalization leads to lending booms
that are marked by risky lending practices due to
ineffective screening and monitoring of
borrowers and lax government supervision of
banks.
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Stage One: Initiation of Financial
Crisis (cont’d)
– Financial globalization adds fuel to the fire as it
allows domestic banks to borrow abroad.
– Significant losses emerge, weakening banks
balance sheets and prompting bank to cut back
on lending but no other players to solve adverse
selection and moral hazard problems.
– Lending boom ends in a lending crash because
weak prudential regulation and supervision to
limit excessive risk-taking.
– Principal-agent problem as well - powerful
domestic business interests pervert the financial
liberalization process.
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Stage One: Initiation of Financial
Crisis (cont’d)
• Severe Fiscal Imbalances.
– When governments in emerging market countries
cannot finance their large fiscal imbalances, they
often force banks to purchase their debts.
– When investors lose confidence in the ability of
the government to repay this debt, they will
unload the bonds which causes their prices to
plummet.
– Banks that hold this debt face a huge decline in
their net worth resulting in the decline of their
lending and worsening of adverse selection and
moral hazard problems
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Stage One: Initiation of Financial
Crisis (cont’d)
• Other additional factors
– Other factors that play a role in the first stage in
crises are
– A rise in interest rates from events abroad
– A decline in asset price that causes a
deterioration in banks’ balance sheets from
asset write-downs
– An increase in uncertainty due to unstable
political systems
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Stage Two: Currency Crisis
• Deterioration Of Bank Balance Sheets
Triggers Currency Crises
- When banks and financial institutions are in
trouble, governments cannot increase interest
rate.
- Speculators realize the government’s inability to
defend the currency that it is likely to allow the
currency to depreciate. They engage in a feeding
frenzy and sell the currency in anticipation of its
decline.
- These sales rapidly use up the country’s reserves
of foreign currency until it no longer has the
resources to intervene in the foreign exchange
market and must allow a devaluation.
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Stage Two: Currency Crisis
• Severe Fiscal Imbalances Trigger Currency
Crises.
- When government budget deficits spin out of
control, foreign and domestic investors begin to
doubt the ability of the country to pay back its
government debt.
- They start pulling money out of the country and
selling the domestic currency resulting in a
speculative attack against the currency, which
eventually results in its collapse.
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Stage Three: Full-Fledged Financial
Crisis
• Emerging market economies denominate
many debt contracts in foreign currency
(usually dollars) leading to currency
mismatch
• Unanticipated depreciation or devaluation of
the domestic currency increases the debt
burden of domestic firms in terms of
domestic currency.
• This lead to an increase in adverse selection
and moral hazard problems followed by a
decline in investment and economic activity.
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Stage Three: Full-Fledged Financial
Crisis
• A currency crisis can then lead to a deterioration
of firms’ balance sheets and increases adverse
selection and moral hazard problems.
• “Twin crises” - a concurrent currency crisis and
financial crisis.
• The collapse of a currency lead to increase in
import prices followed by a rise in both actual
and expected inflation causing domestic interest
rates to rise.
• This will cause reductions in firms’ cash flow and
reduction in investment and economic activity.
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Stage Three: Full-Fledged Financial
Crisis
• The collapse in economic activity makes many
debtors no longer able to pay off their debts
resulting in losses for banks.
• Sharp rises in interest rates and in the value of
foreign-currency-denominated liabilities also
have a negative effect on banks’ profitability
and balance sheets leading to a banking crisis
• A further worsening of adverse selection and
moral hazard problems and a further collapse of
lending and economic activity.
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Application: Crisis in South Korea, 1997–
1998
• Before 1997 crisis, South Korea was one of the
great economic success stories.
• In the early 1990s, the Korean government
liberalized the financial markets and opened up their
capital markets to capital flows from abroad
resulting in a lending boom fuelled by massive
foreign borrowing.
• However weak bank regulator supervision and a
lack of expertise in screening and monitoring
borrowers led to losses and erosion of banks’ net
worth.
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Application: Crisis in South Korea, 1997–
1998
• Large family-owned conglomerates (chaebols)
dominated the economy (sales nearly 50% of the
country’s GDP).
• They borrowed heavily and have little profits (return
on asset less than 3%) but because of the implicit
government guarantee, banks continued to lend to
them.
• Because of them, Korean government accelerated
the process of opening up Korean financial markets
to foreign capital, expanded the ability of domestic
banks to make loans denominated in foreign
currency and allowed unlimited short-term foreign
borrowing by financial institutions.
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Application: Crisis in South Korea, 1997–
1998
• Many finance companies (some already owned by
the chaebols) transformed into merchant banks
which are allowed to borrow abroad. Chaebols could
thus borrow all the money that they needed and
these funds are channeled into unproductive
investments in steel, automobile production, and
chemicals.
• When the loans went sour, the stage was set for a
disastrous financial crisis.
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Application: Crisis in South Korea, 1997–
1998
• A negative shock to export prices hurt the
chaeobols’ profit margins and the small-andmedium-sized firms that were tied to them.
• A second major shock in January 23, 1997 created
great uncertainty for the financial system: Hanbo,
the fourteenth largest chaebol, declared bankruptcy
followed by five more of the thirty largest by the
end of the year.
• And the stock market declined sharply by more than
50% from its peak (Figure 5).
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FIGURE 5 Stock Market Index,
South Korea, 1995–1999
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Application: Crisis in South Korea, 1997–
1998 (cont’d)
• The decline in net worth decreases the value of
firms’ collateral and increases their incentives to
make risky investments because there is less equity
to lose if the investments are unsuccessful.
• The increase in uncertainty and stock market
declines, along with the deterioration in banks’
balance sheets, worsens adverse selection and
moral hazard problems.
• The weakening of the economy, along with the
deterioration of bank balance sheets, ripened the
South Korean economy for a currency crisis and
send the economy into a full-fledged financial crisis
and a depression.
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Application: Crisis in South Korea, 1997–
1998 (cont’d)
• A speculative attack on Korea’s currency was
inevitable because of the weak balance sheets in
the financial sector and the large amount of
short-term external borrowing.
• In July 1997, Thai baht collapsed and
speculators recognized that the banking sector in
South Korea was also in trouble and that the
Korean central bank could no longer defend the
currency so they pulled out of the won leading to
a speculative attack.
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Application: Crisis in South Korea, 1997–
1998 (cont’d)
• Because of the speculative attack, the value of the
won dropped by nearly 50% .
• Because both nonfinancial and financial firms had so
much foreign currency debt, the drop in won
doubled the value of their foreign-denominated debt
causing a severe erosion of their net worth.
• Banks also had to pay these loans back so quickly
because their borrowings are short term therefore
increasing their liquidity problems.
• The government stepped in to guarantee all bank
deposits and prevent a bank panic, but the loss of
capital meant that banks had to curtail their
lending.
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Application: Crisis in South Korea, 1997–
1998 (cont’d)
• The curtailment of lending led to a further
contraction of AD and real GDP while unemployment
rose sharply.
• Due to the currency crisis, iinflation, however, did
not fall but rose: the collapse of the South Korean
currency raised import prices and weakened the
credibility of the Bank of Korea as an inflation
fighter.
• These factors led to a decline in output and rise in
inflation.
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Application: Crisis in South Korea, 1997–
1998 (cont’d)
• To compensate for the high inflation and because a
tight monetary policy recommended by the IMF,
market interest rates soared to over 20%.
• A drop in cash flows forced firms to obtain external
funds and increased adverse selection and moral
hazard problems in the credit markets resulting in a
further contraction in investment and thus in
aggregate demand.
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Application: The Argentine Financial Crisis,
2001–2002
• Argentina had a well-supervised banking system but
always had difficulty controlling its budgets.
• The recession in 1998 led to declining tax revenues and
a widening gap between government expenditures and
taxes.
• The large fiscal imbalances make it difficult for the
government to sell its bonds, so it coerced banks into
absorbing government debt.
• By 2001, investors lost confidence that the Argentine
government can repay its debt and the price of the debt
plummeted, leaving big holes in banks’ balance sheets.
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Application: The Argentine Financial Crisis,
2001–2002
• Deterioration of bank balance sheets and loss of
deposits led the banks to cut back on their lending
worsening the adverse selection and moral hazard
problems.
• Decline in lending led to a contraction of aggregate
demand with inflation and output declining, and
unemployment rising.
• All these set the stage for the next stage of the
crisis, a bank panic.
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Application: The Argentine Financial Crisis,
2001–2002
• In October 2001, default on government bonds
became inevitable as tax revenues continued to fall
and negotiations between the central government
and the provinces to improve the fiscal situation
broke down.
• Bank run began in November, with deposit outflows
of $1 billion a day forcing the government to close
banks temporarily in December and impose a
restriction called the corralito (small fence), under
which depositors could withdraw only $250 in cash
per week.
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Application: The Argentine Financial Crisis,
2001–2002
• The bank panic made it impossible for the
government to keep interest rates high as it would
destroy the banks
• The government can no longer defend the peso and
preserve the currency board leading to a speculative
attack
• The government’s dire fiscal position made it unable
to pay back its debt, providing another reason for
the investors to pull money out of the country.
• On December 23, 2001, the government announced
the suspension of external debt payments for at
least sixty days and on January 2, 2002, the
government abandoned the currency board.
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Application: The Argentine Financial Crisis,
2001–2002
• The peso decrease sharply from $1.00 to less than
$0.30 by June 2002 before stabilizing at $0.33
(Figure 11) with devastating effects on balance
sheets because of the high debt denominated in
dollars.
• The banks found their balance sheets in a
precarious state because of the losses on
government debt, the rising loan losses and huge
deposit outflows and since they lack resources to
lend, they could no longer solve adverse selection
and moral hazard problems.
• As for foreigners, they were unwilling to lend and
pulling their money out of the country.
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FIGURE 11 Argentine Peso,
1998–2004
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Application: The Argentine Financial Crisis,
2001–2002
• With the financial system in jeopardy, financial flows
came to a grinding halt.
• The corralito further weakened the economy by making
it more difficult to get cash causing a sharp slowdown in
the large underground economy.
• The fall of peso raised import prices, which directly fed
into inflation, and weakened the credibility of the
Argentine central bank to fight inflation.
• The effects are bigger than in South Korea.
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Application: The Argentine Financial Crisis,
2001–2002
• The rise in commodity prices in the rest of the world
led to increased demand for Argentina’s exports.
• By the end of 2003 economic growth was running at
an annual rate of around 10%, and unemployment
had fallen below 15% and Inflation fell to below 5%.
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Box: When an Advanced Economy Is like an
Emerging Market Economy: The Icelandic
Financial Crisis of 2008
• In 2003, Icelandic government sold its its state
owned banks to local investors as part of a financial
liberalization process.
• These investors set up overseas branches and
borrowed heavily from short term wholesale funding
markets which are then are channelled into highrisk investments
• The heavy borrowing in foreign currencies lead to a
severe currency mismatch like in many emerging
market countries.
• The regulatory system in term of supervision of
bank risk-taking is also ineffective.
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Box: When an Advanced Economy Is like an
Emerging Market Economy: The Icelandic
Financial Crisis of 2008 (cont’d)
• The wholesale lending system was shut down in
October 2008 with the failure of Lehman Brothers.
• Because they are so large, not even the
government could credibly rescue the banks from
failure.
• Foreign capital fled Iceland, and the value of the
Icelandic krona tumbled by over 50% leading to a
full-scale financial crisis.
• The economy went into a severe recession and
relationships with foreign creditors became tense,
with the United Kingdom even freezing assets of
Icelandic firms under an antiterrorism law.
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Policy and Practice: Preventing
Emerging Market Financial Crises
• Policies that can help make financial crises in
emerging market countries less likely
• Beef Up Prudential Regulation and Supervision of
Banks
• Encourage Disclosure and Market-Based
Discipline
• Limit Currency Mismatch
• Sequence Financial Liberalization
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