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Good Afternoon to You All. I Wish You a Very
Warm Welcome to this Presentation
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Financial Crises and its Contagion Effect
Presented by Dr. Peter Larose
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Relax,
Enjoy,
The Presentation
Financial Crises its Contagion Effect
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Focus of this Presentation

• What is a financial crisis?
• What are the causes of financial crisis?
• What cause the Asian financial crisis?
• Other financial crises,
• Why financial crises in the developing countries?
• How can financial crisis be transmitted?
• Definition of contagion effect. and
• Impact of industrial nation policies.

Financial Crises its Contagion Effect
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What Is A Financial Crisis?
A According to the most common definition of financial crisis it is a sudden loss of confidence in a countrys local currency or other financial assets causing international investors to withdraw their funds from the country at short notice A major withdrawal of funds from one country to another overnight or within a short period of time is referred to capital flight as well in the context of banking finance terminology. Depending on the severity of the loss of confidence a country, which is experiencing this sudden shift from the investors behaviour may not only be placed at risk, but could also impact on the region and create instability as well.
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What Is A Financial Crisis?
A Due to the integration of the world economy into a global village, financial crisis knows no boundary, it can spread to different level. From one neighbouring country to another, From the neighbouring countries to a region, From one region to intra-region, and From intra-region to the rest of the world. Again, depending on the severity, and the policy measures taken to cure the problem, it can trigger threaten the entire financial architecture.
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What Are the Causes of Financial Crisis?

• There are a number of reasons advanced by the
  experts in
• researching around this topic.
• Fixed exchange rate,
• Weak banking system,
• Substantial real exchange rate appreciation,
• No barriers attach to the capital account,
• General lack of credibility (poor macro-economic
  track
• record),
• Unrealistic composition of the capital inflows,
  (e.g. too
• much short-term debts),
• Economic mis-management, and
• Political instability.

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What Are the Causes of Financial Crisis?
Fixed Exchange Rate

With pegged exchange rates, there is an
alternative school of thought that currency
values should be pegged to gold or some other
standard of value and kept stable. Those who
view exchange rates in these terms may saw the
cause of the currency crises in the Asian
countries as excessive expansion of domestic
money supplies by central banks combined with
burdensome government regulations, protection of
domestic industries, and other government
interference in the marketplace. Once
governments stopped maintaining their exchange
rates, investors lost confidence, and the crises
began.
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What Are the Causes of Financial Crisis?
Weak Banking System

The banking system in the Asian economies were
not prepared to handle the financial crisis. The
monetary authorities were of the view that the
event would be an over-night drift that may be
corrected with half-hearted measures. Other the
other, it was more of a surprise that its
occurrence and consequences was much more
pronounced than expected. The banks were unable
and unified to deal with the problem loans,
threatening the financial stability (e.g.
exposure in the property market).
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What Are the Causes of Financial Crisis?
Substantial Appreciation in Real Exchange Rate

The effect of a slowdown in growth on a nation's
exchange rate is not immediately obvious. It
affects both trade and capital accounts in
opposite ways. On one hand, lower growth usually
causes a nation's trade balance to improve, since
imports decline relative to exports (unless
demand in export markets is falling faster).
This could strengthen a nation's currency. In
the Asian case, however, growth was continuing at
a level high enough that trade and current
accounts tended to remain in deficit. Even in
Thailand, the slowdown had not improved its
balance of trade.
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What Are the Causes of Financial Crisis?
No Barriers Attach to the Capital Account

A number of emerging markets would not restrict
the transfer of portfolio flows in order to
attract foreign direct investment (FDI). There
is a tendency to have a liberal financial policy
in as far as the flows of capital. The danger is
for the investors to transfer their funds at will
with a view to make the maximum return within
the jurisdiction that offer greater incentives to
investors. Hence, when a country suffers from
fiscal deficits couple with other weaknesses in
the financial system, an immediate capital flight
can easily trigger a financial crisis, subject
to availability of foreign currencies.
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What Are the Causes of Financial Crisis?
General Lack of Credibility
On the capital account side, a slowing growth
rate generally causes problems for a nation's
debtors who have borrowed to finance production
facilities or have invested in real estate or
equities and are faced with repayment schedules.
Lower growth means lower demand, possible lower
profits, and a leveling off or fall in real
estate and stock values. As the slowdown
intensifies, interest rates usually fall. This
can cause international lenders to look
elsewhere for investment for financing
opportunities and may cause a weakening of a
nation's currency. Recessions also cause loans
to turn sour and may further drive away foreign
lenders. As the Asian financial crisis has
developed, forecasters have lowered their
outlook for growth in these countries.
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What Are the Causes of Financial Crisis?
Unrealistic Composition in the Capital Account
Flows

A country that relies too much of short-term
borrowings to finance its development (e.g.
long-term) places itself at risk, when the
lenders expects to repatriate its funds at short
notice. One of the major causes with countries,
which had experienced financial crisis (e.g.
Argentina, Mexico) were heavily exposed to short-
term debts its their capital account of their
balance of payments (BOP).
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What Are the Causes of Financial Crisis?
Economic Mis-management

Most research findings connected with the past
financial crises indicate that the bottom-line of
crisis is tied to the mis-management of the
economy by the Government. The economy is
allowed to reach an alarming downturn, whereby it
becomes more difficult to implement
draconian measures at the cost of social
difficulties. Interestingly, in the developing
countries where the crisis originates, the
Government allows political considerations to
override the economic considerations.
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What Causes of Financial Crisis?
Political Instability

Some experts believe that the root cause of
financial crisis besides the mis-management of
the economy emerges from political
instability. There is a lack of continuity due
to frequent changes at the administrative
level. Many politicians tend to act as
economists in their own way of thinking, while
ignoring the fundamental economic principles
hence, the word politico-economists. The
danger is that there is always a mis-match in
the economic decisions taken contrary to
addressing the real problems confronting the
country.
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What Cause the Asian Financial Crisis?

• According to the researchers, the Asian financial
  crisis was
• caused mainly by 4 reasons
• under-developed financial system,
• shortage of foreign exchange,
• role, and operations of the international
  monetary fund,
• effects of the crisis on US world economy.
• There are also advocates, who are of the opinion
  that the
• crisis was caused by the bubble of asset prices
  in Japan.

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What Cause the Asian Financial Crisis?
Under-developed Financial System
The Asian financial crisis, proved a point that a
sound developed banking system is the key to
further economic development. This is not an
issue applying to Asian countries, but also
to other emerging markets around the world. As a
result of this experience, the banking systems of
those countries affected were forced to
re-engineer their banking system in order to
accommodate more complex transactions with
greater controls and transparency. (e.g. Nick
Leeson from Barings Bank is a case in
point). The monetary authority in Singapore was
unable to detect abnormality in derivatives fraud
in good time.
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What Cause the Asian Financial Crisis?
Shortage of Foreign Exchange The foreign
exchange reserves in those countries
affected (e.g. Malaysia, Indonesia, South Korea,
Thailand) were just too small to back up the
demand for out-ward capital by the foreign
investors. In spite of these countries turning
to IMF, ADB World Bank for further assistance,
the speculative attack was enormous, and became
a cost affair. The IMF insisted that its
assistance has been provided to support programs
that are designed to deal with economy wide,
structural imbalances and not to protect
commercial banks and private investors from
financial losses.
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What Cause the Asian Financial Crisis?
Role Operations of the IMF Some legislative
issues dealing with IMF funding and operations
were deferred by the 105th Congress at the close
of its recent session. The Asian financial
crisis also has raised several questions
pertaining to IMF operations. (1) Whether such
crises have increased in scale and whether IMF
resources are sufficient to cope with them. (2)
Whether the Fund's willingness to lend in a
crisis contributes to moral hazard (a tendency
for a potential recipient country to behave
recklessly knowing that the IMF will likely bail
them out in an emergency). .
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What Cause the Asian Financial Crisis?
Role Operations of the IMF (3) Whether the
contagion of financial crises can be stopped
effectively. (4) Whether the changes in
economic policy and performance targets that the
IMF requires of the recipient countries are
appropriate and effective. (5) Whether the IMF
has sufficient leverage over non-borrowing member
countries to prevent financial crises from
occurring, and (6) Whether the IMF releases
sufficient information to the public, including
investors, on its program design and provisions
imposed as a condition for borrowing allow for
accurate assessment and accountability. .
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What Cause the Asian Financial Crisis?

• Effect of the Crisis on US World Economy
• This financial crisis was of interest to US
  because
• (1) The stock markets are inter-linked,
• (2) Attempts to resolve the problems are led by
  the IMF, World Bank and ADB and pledges of
  standby credit from the Exchange Stabilization
  Fund of the United States,
• (2) Americans are major investors in the region,
  both in the form of subsidiaries of U.S.
  companies and investments in financial
  instruments, and
• (3) The currency turmoil affects U.S. imports and
  exports as well as capital flows and the value of
  the U.S. dollar the U.S. deficit on trade was
  rising as these countries import less and export
  more.

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Other Financial Crisis
Russias Crisis Russia embarked on a transition
period in 1989 from a command control economy
(sometimes referred as centrally planned economy)
to a market-led economic style. The transition
involved the following economic problems rapid
inflation, steep output declines, and
unemployment. The Government only managed to
stabilize the ruble and reduce inflation with the
help of IMF credits in 1997. Obviously, the
transition from centrally planned economy to
market-based policies only bear fruit in the year
2000 when they started to enjoy a rapid growth
rate.
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Other Financial Crisis
Mexicos Crisis In the late 1994, Mexico
experienced a large current account deficit. This
was coupled by a weak banking system. The rapid
growth in dollar-indexed Mexican government debt
(Cetes) led to a large devaluation and
depreciation of the Mexican peso hence, a
financial crisis as foreign investors refused to
buy new Cetes. The contagion effect ( "tequila
effect") spread the crisis to other Latin
American countries. In early 1995, speculative
attacks spread to other Latin American countries.
As a consequence, Argentina went into a sharp
recession.
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Other Financial Crisis

• Asias Economic Success
• Until 1997 the countries of East Asia were having
  very high growth rates.
• The driving force for such economic success were
• attributable to the underlying factors
• Much emphasis laid on the standard of education,
• Introduction implementation of sound
  macro-economic fundamentals
• Promotion of high saving and investment rates,
• Heavy control on the level of inflation, and
• Recorded a high percentage of trade in the level
  of GDP.

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Other Financial Crisis
Asias Economic Weaknesses Three weaknesses in
the Asian economies structures became apparent
with the 1997 financial crisis (a) Level of
Productivity Asian countries were becoming
uncompetitive due to the Rapid growth of
production costs, but little or no reduction in
the output cost. (b) Banking regulation The
banking laws were far out of date with the
current economic development taking place weak
banking system (c) Legal framework Lack of a
good legal framework for dealing with companies
in financial distress.
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Other Financial Crisis
Asias Crisis Development The devaluation of the
Thai baht triggered the crisis on 2nd July
1997. The sharp drop in the Thai baht was
followed by speculative attacks against the
currencies of Malaysia, Indonesia, and South
Korea. All of the afflicted countries except
Malaysia turned to the IMF for assistance.
Singapore, although not affected remain very
resilient against speculative attacks. The
downturn in Asia was V-shaped after the sharp
output contraction in 1998, growth returned in
1999 as depreciated currencies spurred higher
exports.
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Other Financial Crisis
The Argentinas Experience
Argentina has failed to make a debt repayment to
the World Bank that fell due on 14 November 1991.
It has repaid the interest - about 80m - but
not the entire debt, which stands at more than
800m. This means the country was considered to
be in default, a situation which damaged its
chances of winning fresh, much hoped for funds
from the International Monetary Fund.. In 1991,
during Domingo Cavallo's first spell as economy
minister, the government decided to peg the peso
to the US dollar to restore confidence and combat
hyperinflation.
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Other Financial Crisis
The Argentinas Experience
At the time, the strategy worked, but in time
Argentina suffered the disadvantages of such a
fixed peg. By linking the peso to the dollar,
Argentines adopted a currency whose exchange rate
bore little relation to their own economic
conditions. This was a boon in times of
hyperinflation But when stability returned to
Argentina, the inability of its currency to
respond proved more of a burden than a benefit.
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Why Financial Crisis in Developing Countries?
This is a very useful question to ask about the
origin of financial crisis in the developing
countries. It is noticeable that financial
crisis does not happen in the industrial world,
even if it does, it is easily contained so that
it does not affect a regional or international
crisis. Admittedly, due to our level of
integration, the developing countries can also
experience its effect partially the spread of
the crisis is referred as contagion. One of
the principal reasons that the industrial
countries are not too much at risk as compared to
the developing countries rest on the argument
that the financial system in the industrial
countries are much developed, equipped to deal
with any imminent financial threat.
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Why Financial Crisis in Developing Countries?

• Most developing countries have at least some of
  the
• following features
• History of extensive direct government control
  of the
• economy,
• History of high inflation reflecting government
  attempts
• to extract seignior age from the economy,
• Weak credit institutions and undeveloped capital
  markets,
• Pegged exchanged rates and exchange or capital
  controls,
• Heavy reliance on primary commodity exports, and
• High corruption levels.

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Why Financial Crisis in Developing Countries?
Capital Inflows to Developing Countries Many
developing counties have received extensive
capital inflows from abroad and now carry
substantial debts to foreigners, Developing
country borrowing can lead to gains from trade
that make both borrowers and lenders better
off, Borrowing by developing countries has
sometimes led to default crises, and The
borrower fails to repay on schedule according to
the loan contract, without the agreement to the
lender (s).
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Why Financial Crisis in Developing Countries?
Developing Countries Debts Borrowings History
of capital flows to developing countries Early
19th century A number of American states
defaulted on European loans they had taken out
to finance the building of canals. Throughout
the 19th century Latin American countries ran
into repayment problems (e.g., the Baring
Crisis). 1917 The new communist government of
Russia repudiated the foreign debts incurred by
previous rulers. Great Depression (1930s) Nearly
every developing country defaulted on its
external debts.
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Why Financial Crisis in Developing Countries?

• Debts Crisis of the Past Two Decades
• The great recession of the early 1980s sparked a
  crisis
• over developing country debt.
• The shift to contractionary policy by the U.S.
  led to
• The fall in industrial countries' aggregate
  demand,
• An immediate and spectacular rise in the
  interest burden
• debtor countries had to pay,
• A sharp appreciation of the dollar, and
• A collapse in the primary commodity prices
• The crisis began in August 1982 when Mexicos
• central bank could no longer pay its 80 billion
  in
• foreign debt.
• By the end of 1986 more than 40 countries had
• encountered several external financial problems.

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How Can Financial Crisis be Transmitted?

• Trade channels and exchange rate pressures.
• Through bilateral trade (ex. Chile 1997-98)
• Competition for trade with a common third
• partner (e.g. East Asias trade with Japan)
• Integrated financial markets
• Banks are interconnected through loans (Mexican
  banks were extending trade credit to Costa
  Rican banks prior to the 1994
• crisis)
• Interconnection through bond holdings. (Korea
  was holding Brazilian and Russian bonds)
• c. Liquidity management practices of open end
  mutual
• funds.
• (Thai share prices fallsell Indonesia).

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Definition of Contagion.
The word contagion is defined as the influence of
news about the creditworthiness, etc. of a
borrower on the spreads charged to the other
borrowers or equity prices, after controlling for
country specific macroeconomic fundamentals
(Doukas, 1989,Kaminsky and Schmukler, 1998) 2.
Other studies, such as Valdes (1995), defined
contagion as excess co movement across countries
in asset returns, whether debt or equity. The co
movement is said to be excessive if it persists
even after common fundamentals, as well as
idiosyncratic factors, have been controlled
for. 3. A recent variant to this approach is
presented in Arias, Haussmann, and Rigobon (1998)
and Forbes and Rigobon (1998), who define
contagion more narrowly by requiring an increase
in excess co movement in crisis periods. 4.
Eichengreen, Rose, and Wyplosz (1996) defined
contagion as a case where knowing that there is a
crisis elsewhere increases the probability of a
crisis at home, even when fundamentals have been
properly taken into account.
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Contagion Effect.
After controlling for country specific
macroeconomic fundamentals must be corrected
implemented. The influence of news about the
creditworthiness, of a borrower on the spreads
charged to the other borrowers. Excess co
movement across countries in asset returns,
whether debt or equity. An increase in excess co
movement in crisis periods. A case where knowing
that there is a crisis elsewhere increases the
probability of a crisis at home especially if the
sovereign rating is poor.
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Impact of Industrial Nation Policies

• Feldstein (2002) argues that there are a number
  of measures
• which the industrial nations can do to minimize
  the financial
• risk in the developing countries.
• These measures can involve
• Stabilization of the exchange rates,
• Avoiding high interest rates,
• Opening markets to emerging market products,
• Regulating lending by private industrial country
  creditors,
• Central Banks acting as lender of last resort.

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Stabilization of Exchange Rates
It is argued by Feldstein that fluctuations of
exchange rates among the dollar, yen, euro can
exacerbate trade deficits of the emerging
markets. This can precipitate balance of payment
difficulties eventually crises (e.g. currency
mis-match). A country that takes dollar
denominated debts, but earns say yen or euro from
its exports could see its ability to service its
debts suffer if the dollar appreciates
relative to the other currencies. From past
experience, there is no prospect that the US
other countries will pursue deliberate policies
to stabilize their exchange rates which will
favour developing nations
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Avoiding High Interest Rates
Countries that borrow in dollars or other hard
currencies are directly affected by an increase
in interest rates in the home countries
currencies. Market participants also believe
that an increase in the US interest rate causes
interest rates on emerging market loans to rise
by more than an equal amount. Since there is no
prospect that the industrial countries
will modify their domestic monetary policy in
order to reduce adverse effects on the emerging
market countries, the private and public
borrowers in those countries must take into
account the possibility of interest rate move
against their favour.
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Opening Markets to Emerging Market Products
Opening the industrial country markets to
increase imports of textiles agricultural
products from the emerging market countries
would raise the standard of living in the export
countries as well as the importers. It is widely
supported by economists, and opposed by
other interest groups in the industrial countries
that would be hurt by the import
competition. Progress towards greater market
opening will therefore continue to be slow. Such
market opening might do little to reduce the risk
of economic crises.
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Regulating Lending by Private Industrial
Country Creditors After the Latin American (80s)
Asian (90s) financial crises there was
widespread agreement that there has been too much
borrowings by these countries and too much
lending from the industrial countries. Many
experts believe that steps should be taken to
reduce the amount of lending to emerging market
countries and to increase creditors sensitivity
to the risks involved. The Basel Accord demands
as a result of such experiences that bank
supervisory authorities mark the credit
portfolios to market all the lending and risk
taken by the borrowers.
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Central Banks to Act as Lender of Last Resort
Any nation Central Bank can prevent runs on
solvent banks by providing sufficient liquidity
to assure depositors other creditors that they
have nothing to fear. They can do so, by lending
against good but illiquid collateral. The very
existence of such a lender of last resort helps
to reduce the risk of domestic financial
crises. The emerging market countries must be
prepared to protect themselves against
unwarranted currency attacks bank runs
associated with pure contagion and with
deliberate attempts at destabilizing speculation.
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I wish you all, good luck in your studies.
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Thank You for Your Attention
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The End
Financial Crises its Contagion Effect