5 finance and crises1

7/29/2019 5 Finance and Crises1

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Money and finance in the global

economy

The international monetary system is the bodyof rules and procedures by which differentnational currencies are exchanged for each other

in world trade. Theglobal financial system (GFS) refers to those

financial institutions and regulations that act onthe international level.

The main players are private(banks, hedge fundsetc) and public (central banks and governmentdepartments) and international organizations(the IMF, Bank for International Settlements etc).


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Money and finance in the global

economy

The international monetary system is

closely tied to the international finance

system. Flows of international capital and FDI are

conducted in money. If there is a change in

exchange rates they inevitably impact onthe value of investment.


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The role of the international

monetary system

It requires a nation, or a group of nations, tomaintain and manage it; leading nations mightagree to entrust an international organization toachieve this, see IMF and World Bank.

It has to determine the way to solve imbalances ofnational economies, by some agreed form ofadjustment.

It has to provide sufficient international liquidity.Countries need to rely on sufficient financialreserves to meet sudden shocks.


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The post-Bretton Wood

international monetary system

Fixed exchange rates broke down in 1971. Whatfollowed were fluctuating exchange rates with nogeneral rule on exchange rate adjustments.

The dollar remains the key reserve currency,although the system is based on some cooperationamong the FED, the European Central Bank (the

Bundesbank before 1999) and the Bank of Japan.

The IMF act as regulator of the world internationalmonetary system.


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Many countries have chosen either to create monetaryunions (the euro), or to peg their currencies to the dollar(dollar peg as in many South East Asian countries

before 1997). Some countries manage their currencies with currency

reserve boards, which means relinquishing control tothe IMF, which will cover their money supply with

dollars (for example Hong Kong in the 1990s, andArgentina in early 2000s).


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The International Monetary Fund

TheInternational Monetary Fund (IMF)oversees exchange rates and balance of

payments. It offers financial and technical

assistance when requested.

Its headquarters are located in Washington D.C.

and offices around the world. It has currently 185

members.

It came into existence in December 1945, when

the first 29 countries signed its Articles of

Agreement.


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The International Monetary Fund

An unwritten rule establishes that the IMF'smanaging directormust be European and thatthe president of the World Bank must be from

the US. The IMF is for the most part controlled by the

major Western Powers, especially the US, withvoting rights on the Executive board based on aquota which reflects its monetary stake in theinstitution.


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Desirable objectives of IMS:

1) exchange rate stability;

2) independent monetary policy;

3) free capital flows.

The three objectives however are incompatible,only two are achievable at the same time.

Under Bretton Woods there was 1 and 2, but not 3. Currently most countries, have 2 and 3, but not 1.

The Euro means that each UE member stateenjoys 1 and 3, but not 2.


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Flexible, fluctuating exchange rates

Pros

They prevent currency

misalignments Allow countries to

conduct independentmonetary policies

Cons.

They produce too

much fluctuations on aday-to day basis:volatility.

They produce long

periods of currencyunder or over-evaluation, distortingtrade.


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International monetary system: alternative

solutions

Possible alternatives:

Return to gold. Advocated by extreme neo-liberals.

Managed currencies. Imply limitations to the free flow of

capital. see Tobin tax.

Regional monetary Unions.Currency pegs.


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Financial markets are central

Well functioning financial markets are a central

feature of a modern market economy. They allow

resources to be taken from people who do notneed them or can not use them to people who need

them and can use them.

1) they mobilize savings, 2) they allocate capital,

to finance investment; 3) they pool risk anddistribute risks to those who can bear them; 4)

they monitor managers.


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Financial markets are risky and fragile

Financial markets are fragile and vulnerable.

They suffer from inadequate information.

Banks have short term liabilities in domestic orforeign currency, which are payable on demand,

while most of their assets are long-term, and

subject to fluctuations.

Financial markets are liable to wild swings in

prices. They tend towards herd behaviour.


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Capital flows in the global economy

Under Bretton Woods countries controlled their capital

market. Free capital flows started to materialize

with the Eurodollar market in the 1960s. After the end of

Bretton Woods the situation gradually evolved with:

A) Liberalisation of financial markets. Scrapping of capital

controls.

B) Innovation in financial instruments (Derivates etc.)

Today huge amounts of capital is exchanged every day on

the foreign exchange market: in 2007 the daily volume of

foreign currency transactions was $ 3.2 trillion.


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Liberalization of capital markets in the 1980s

and 1990s

Since the late 1980s the IMF became astrong supporter of free capital markets: it

advised countries that came under its

influence to dismantle controls over cross-border lending and borrowing.

The removal of capital controls would

increase the demand for services from theCity and Wall Street. The US and Britain

pushed for capital liberalization.


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Liberalization of capital markets in

the 1980s and 1990s

The EU during the 1980s turned towards capital

liberalization. During the late 1980s capital

controls had been removed in all the major

European countries. Free capital movements wereenshrined in the Maastricht Treaty.

The OECD adopted free capital flows as part of it

Code of Liberalization of capital controls. New

member countries, such as Mexico and S.Korea,adopted the Code.


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Global finance: new developments,

opportunities and risks

Todays global financial movements are different fromthose of the past, since they have no relation withinternational trade.

Financial globalisation has made all national economiesclosely interdependent. It has also made available vastfinancial resources for developing countries.

A large share of global finance consists of short termcapital flows, which by definition are highly volatile andspeculative. Speculators can attack currencies whose

exchange rate is deemed to be non-credible.


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Free capital flows

Pros

They improve the globalallocation of resources

They provide an incentiveto governments to pursuesound fiscal monetarypolicy

Cons

International capitalmarkets do not allocate

resources efficiently.Speculators and investorstend to be irrational andshort-term.

Global finance isunregulated and lacksinstitutional support(standards, supervision,lenders of last resort.


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Tobin tax

Already in 1978 James Tobin (a keynesianeconomist from Yale) criticized excessivefinancial capital mobility. These flows constrained

the ability of governments to pursue adequatedomestic economic policies.

He recommended a tax on international currencytransactions: consisting in a small levy on eachtransaction.

Tobin met with considerable opposition but hissuggestion is being reconsidered in the light of therecent massive global financial crises.


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Financial crises: general outline

How do they break out?

Speculation fuelled by euphoria over the performance

of a single sector or of a particular countrys economy

(herd psychology)

Rise in profits and in investment.

Prices rise and the velocity of exchanges accelerates,generating a boom.


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Financial crises: general outline

Ad one point the bubble bursts. This can be theresult of a single event such as a bank failure or acorporate bankruptcy.

The large increase in prices and profits suddenlygoes into reverse gear.

Overreaction generates a run on the countries.

Banks stop extending credit, and in fact demand

payment for the credits they earlier had granted,i.e. there is a credit squeeze. Foreign capital movesout. Currencies are forced to devalue.


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Financial crises1970s- early 1980s: Crisis in developing

countries, especially Latin America.

Build-up of high debt levels with Western banks, which had

used their lines of credit to recycle Petrodollars.

Starting in 1979, Paul Volcker, the Fed Chairman, raised

interests drastically to fight US inflation.

International banks followed suit, raised interest rates and

the unsustainable debt ofmany countries position was

exposed.


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Japan: crisis of the 1990s

At the end of the 1980s real estate prices rose by three times,producing a real estate bubble. This uncovered one of the unspokenfactors of the Japanese economic miracle, i.e. the power of bigspeculators, with ties to the criminal world as well as top politicians.

Japans Central Bankresponded first by raising interest rates and thisdetermined a steep fall of house prices in 1991. This was not,however, accompanied by economic recovery, rather it was followedby a creeping recession.

In the next stage, interest rates were lowered, down to zero, in order tojump start the economy. The State launched big public expenditureprograms, borrowing large quantities of money.

The economy did not react as hoped. Japans economy was based on alow rate of private consumption. GDP growth rates remained low,

below the economys growth potential. In otherworkds Japan hadfallen into a deflationary trap.


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Japans growth rate.


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Japans economic crisis

Japans economic problems were compounded by the factthat its banking sector became heavily indebted.

Stagnation also meant a rise in unemployment, whichreached 5% of the work force. Investment and

consumption both were flat or negative. Reflationary policies proved too weak.

Reforming the economy proved difficult, because of overregulation and structural rigidities.

Japanese society resisted steps towards liberalization. TheJapanese social model was called into question, butreforming it was slow and painful.


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Japans economic crisis in the 1990s

Two mistakes in economic policy (Krugman):

A) Government did not act consistently. In 1997 after a fewyears of slow recovery, fears were raised about the rise in publicdebt due to government deficits and projected pension costs. As a

result taxes were raised, growth was throttled and the countryplunged again in recession.

B) Politicians failed to address the real weakness which lay in thebanking system. Banks had suffered from the fall in real estatestock and, following that, they had exposed themselves by lendingto the State. Protracted recession compounded the problem.

Recapitalization of the banks was carried out in 1998, with a Stateinjection of $ 500 bn.


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Japan recovers?

First signs of recovery of the Japanes economyhad to wait until 2003. In that year GDP grew bymore than 2% and the deflationary spiral began to

loosen.

Japanese exports benefited from the rise in UStrade deficit and from the strong performance ofChina. Big flows of Japanese FDI to China.Interest rates remained very low, leaving Japanesemonetary policy almost defenceless against thenew economic crisis of 2008.


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Financial crises1990s

1992-3 Crisis in the European Exchange RateMechanism. (ERM). The Italian Lira and thepound sterling devalue.

1994-5, a boom in Mexico attracts short termcapital flows from the US.In December 1994 the Mexican peso devalues,following an abrupt crisis of confidence in theMexican economy. President Clinton leads a

recovery effort, sustained by US Treasury funds aswell as by the IMF. In 1995 Mexicos GDP fell by6%.


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Financial crisesEast Asia

1997-2000Crisis in South and South-east

Asia. Possible background causes: growing

Chinese competition with the exports of theAsian Tigers casts doubts on the durability

of the boom. Overvaluation of Asian

currencies.


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The origins of the Asian crisis

Asian economies had liberalizedtheir capital marketssince the early 1990s. This factor is seen by some as theorigins of the subsequent financial crisis.

Rapid capital liberalization was deeply unsettling to the

paradigms of the Asian model, which was based ongovernment soft control of the economy.

Liberalization was not accompanied by regulation, i.e. bynew rules and standards to govern capital markets (forexample transparency, reserve requirements for banks

etc). The combination ofsemi-fixed exchangerates (dollar

peg) and capital liberalization was also potentially deeplyunsettling.


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The origins of the crisis The Asian capitalist model is different from the American

or European models. Although each country had its ownspecific features, there were some common trends. TheAsian model can be described as a developmental State,based on close links between the government, banks andother businesses in the industrial and service sectors. Often

loans were granted on a personal basis, on the basis ofclose connectionshence the term crony capitalism. Amore benign interpretation speaks of alliance capitalism.

Bad loans of Asian banks had reached astronomicproportions.


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The origins of the crisis

There was a strong resistance to liberalization of

inward flows of FDI, which possibly aggravated the

crisis. South Korea for example, even after the crisis

has broken out, ruled out allowing its banks toborrow long-term, rather than short term. Although

short term debts were one of the keys to the current

crisis, long term borrowing meant leaving the door

open for FDI to penetrate the S. Korean economy. Many bad or dubious debts were concealed to

everybody until the end.


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Asias financial crisis: 1997-8

Japan had already incurred into financial and

economic difficulties since the early 1990s.

Japans crisis had originated from bad loans of

its banking system and had developed into a full

scale recession, with a protracted fall in theeconomys demand.

Speculation on shares is hit by a crisis of

confidence. In the preceding decade, highgrowth rates had been customary for South East

Asian countries. This record of success prevents

a stronger reaction to the crisis.


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Asias financial crisis: 1997-8

Throughout the 1990s East Asia was booming. Largeinflows of foreign capital, about $90 bn. a year of shortterm capital fuel the boom, plus FDI inflows as well.

By 1997 prosperity brought its own problems, there wasrising prices and exports from East Asia faltered.

Banks were becoming highly indebted. There was a realestate bubble. At this point investors got nervous andstarted moving out their capital from these countries.

This generated a sell-off. Currencies devalued. Stockmarkets collapse and the real estate market crumbled.

The outflow of foreign capital from Indonesia, Maleysia,the Philippines, S. Korea and Thailand in 1997 was $12bn. From net creditors they turned net debtors (-$100bn,io.e 10% of their combined GDP).

Chronology of the Asian financial crisis
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Chronology of the Asian financial crisis

Thailand had benefited from dollar and yen loans, converted intobaht to speculate in local real estate and other assets.International banks and hedge funds poured money intoThailand. By 1996 doubt began to creep in: were these loanssecure? Selling of baht assets into dollars commenced. To

counter the impending crisis and maintain the value of the baht,the Thai central bank raised interest rates. However higherinterest rates reduced the demand for real estate and broughtprices down. Selling of the baht increased and the Bank ran out

of dollars to support the baht.July 1997- Thailand dropped the baht-dollar peg, leaving thebath free to float
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August 1997- The IMF grants a 17 billion dollarloan to Thailand. Indonesia prime minister blames

foreign speculators for the crisis

October 1997. The Hong Kong stock market fallsby 25% over just 4 days and a few days later falls

by another 5%. Shares fall all over the world,including on Wall Street. The IMF approves arescue package of 42 billion dollars for Indonesia.

November 1997: The crisis spreads to Brasil. TheSouth Korean currency, the won, crashes. InJapan Yamaichi Securities collapse, revealinghow the acute problems of the Japanese

economy have not been solved.
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December 1997 . Fears for the South Koreaneconomy dramatize the crisis. The IMF grants ahuge bailout loan of 58 billion $ to South Korea.

January 1998. The IMF and the Indonesiangovernment agree on a package of economicreforms while Indonesia sinks deeper.

April 1998. Signs of crisis in Japan. Newagreement between the IMF and Indonesia. TheUS Congress criticizes the IMFs role in the Asian

crisis.May 1998. Student revolts in Indonesia. Amidstfurther economic trouble, the Indonesianpresident, Suharto, resigns.
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January 1998. One of the most importantinvestment banks in Hong Kong, PeregrineInvestments Holding folds. However despite

renewed heavy losses on the stock markets inthe entire region, the Hong Kong dollar resists.

Monetary policy in H.K is managed through a

Currency Board, which backs the money supplywith of US dollars. Also China is prepared tosupport the Hong Kong dollar with its own vastmonetary reserves. Speculators retreat.
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May 1998: devaluation of the ruble. Bad news fromRussia sparks a wave of panic on world markets,with a sharp fall in Wall Street. Brazils currency,

the real, comes under attack

October 1998. The IMF, strongly backed by the USTreasury, grants Brazil a huge, 40 bn. $ loan,

demanding a change in Brazils economic policyand further market reform.

January 1999: failure by Brazil to carry out

economic reform leads to a 35% devaluation of thereal and the flight of investors.

China and India escaped the crisis. Their capitalmarkets had remained closed

Asian financial crisis: 1997-8
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Asian financial crisis: 1997-8

Exchange rates in Asia were semi-fixed and pegged to the dollar.

Countries did not have the credibility however to maintain their dollar

peg, and this encouraged speculators.

Governments acted to defend their overvalued exchange rates by

raising interest rates. This hurt domestic businesses, while

international investors were facilitated.

There was a flight of capital away from local currencies to the dollar,

pushing them to devalue.

Domestic banks were exposed, having taken out large dollar loans; a

weaker domestic currency meant paying a higher dollar rate.

Moreover they had borrowed short and loaned long-term to domestic

businesses.


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Asian crisis: the IMF steps in.

The IMF followed a bailout strategy. It granted

substantial loans to the countries hit by the crisis and at

the same time it imposed upon them a strict medicine ofstructural reforms. Ailing banks and firms were shut

down.

The economies were supposed to eliminate any

remaining barrier to foreign capital. Budget disciplinemeant drastic cuts in expenditure. Cuts in subsidies hurt

the poor and caused social unrest.


43/59

Asian crisis: the IMF steps in

The IMF prescription included the following elements:

Cuts in public expenditure

Higher interest rates

Currency revaluation and stabilization Structural reform, especially bank mergers.

Improvement in accounting standards

Opening the market to foreign acquisitions.

Cuts in subsidies.

The IMF package caused deep resentment in many SouthAsian countries. Many countries resisted to what they sawas US-inspired measures to destroy the Asian model.


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Debates and recriminations

Was the IMF prescription correct?

According to Stiglitz the Asian crisis was different from the financialcrises in Latin America during the 1980s. Whereas in LatinAmerica the problem had been inflation and debts in the public

sector, in Asia public finances were in good shape, whereas thecorporate sector was badly in debt.

The solution therefore should have been different, and should nothave included budget cuts and austerity measures. It should have,instead, concentrated on macro-economic stability, and incorporate restructuring.

Rather than imposing austerity, the IMF should have let corporationspay the price of their profligacy, by allowing exchange ratedevaluation. Interest rates should not have been raised.


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Financial crisis in Asia: debate

Left wing critics: They blame the IMF for its arroganceand insensitivity and for its neo-liberal ideological

approach. The IMF proved to be the tool of international

finance, and its prescriptions followed the wishes of the

US government and Wall Street.

Right wing, free market critics, the IMF should not have

spent so much money bailing out speculators.


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Financial crisis in Asia: debate

The IMF defence. Only a strong IMF package stoppedthe crisis from damaging the entire world economy.

According to Martin Wolf the IMF was made the

scapegoat, while responsibility for bad economicmanagement rests with governments.

It is reasonable and consistent that the IMF shouldfollow to a certain degree the will of its paymasters,

i.e. the lending nations. If it were to act otherwisecreditors would stop funding it and would seek tomanage their relations with debtor countriesbilaterally.


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Proposals and remedies.

Gilpin believes that short term capital flows should be regulated.

A tax could be levied to discourage speculation. Other observers

think this solutioncalled the Tobin tax -both impractical and

unreasonable.

The Asian crisis highlighted the need for better internationalrules. Prescription on bank reserves were introduced through the

Basel convention. Proposals were floated for an international

bankruptcy procedure.

It remains true that the international financial system is the

weakest link in the global economy and that its governance is

very weak and contested.


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Outcome of the crisis

Of the five most affected countries, Malaysia, the

Philippines, S. Korea, Thailand, Indonesia, in 2001 only

Indonesia had failed to recover previous GDP levels.

South Korea, on the other hand, had experienced GDPgrowth of over 20% on its pre-crisis level. The aggregate

GDP level of the five was 13% higher than in 1996.

The quick recovery suggests that the crisis was mainly

financial. Economic fundamentals were not to blame.Global finance is a factor of instability (Roderick)


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Argentina 2001

Argentina had pegged its currency to the dollar,but the peso weakened and to sustain the peg itwas necessary to raise interest rates, causing aneconomic recession.

An aggravating factor was the fact that theBrazilian currency depreciated against the dollar,as did the euro, causing all kinds of problems forArgentinean exports.

The peg could not be sustained, and the currencywas devalued and following from that there thecountry defaulted on its debts.


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The 2007-2010 crisis. The origins.

Long term. Structural imbalances in the world

economy, with USA and China.

Greenspans two bubbles: A) The new economy bubble (dot.com) burst in 2000

determining a sharp fall in the stock market and a domestic and

international recession. The Fed reacts with aggressive cuts

interest rate cuts.

B) The real estate bubble was a consequence of very low realinterest rates after 2001. There was a boom in risky mortgage

lending. Dubious loans were securitized as widely traded

instruments. Speculative activity was fuelled by the rise in

prices.

h 200 2010 i i h i i


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The 2007-2010 crisis. The origins. The financial crisis in the US was centered, at least

initially, not on the big commercial banks, but on theinformal or shadow unregulated financial sector, (hedgefunds, futures, money markets and corporate bondmarkets), where a huge amount of transactions was carriedout. The size of the informal market in 2007 amounted to

various trillion dollars, much larger than the formalbanking sector. Also the big investment banks GoldmanSachs, JP Morgan, Lehman) were heavily involved in it.

After the Great Depression, up until the 1980s, themajority of financial transactions were carried out by

institutions supervised by the FED. After the 1980s, a parallel market without formal rules and

no supervision, highly leveraged, had grown in size andimportance.


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The financial crisis spreads.

The growth in short term capital movementshas encouraged the spread of the crisis in

many countries, with serious effects in someemerging economies. Iceland, the Ukraine,the Baltic States all requested IMF help.Other countries followed


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The crisis and the lessons of the past.

The current crisis includes a number of features ofthe previous financial crises.

A) the real estate bubble (Japan, end of the 1980s)

B) collapse of the financial system (GreatDepression 1929-31)

C) deflationary trap in the USA and in WesternEurope (Japan 1990s)

D) waves ofinternational speculative hot moneyand competitive devaluations. (South East Asia,1997-1999)


54/59

What was the ERM (Exchange Rate

Mechanism) and how did it work?

What is the 1987 Single European Act ?

How did the process of German unification

affect the progress towards EMU?

Why were convergence criteria established

by the Maastricht Treaty ?

How important has the enlargement of the

EU from 15 to 25 members been for the

global economy?


55/59

Was the creation of the Euro in 2002

beneficial both for the member states and

for the global economy or was the Euro aflawed project from the start?


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5 finance and crises1

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