COMPARING FINANCIAL

SYSTEMS

Lesson 26

Financial crises 2

1997 Asian financial crisis From the early 1950’s until the eve of the crisis in 1997 the “Dragons” (Hong

Kong, Singapore, South Korea, and Taiwan) and the “Tigers” (Indonesia,

Malaysia, the Philippines, and Thailand) were held up as models of successful

economic development.

Their economies grew at high rates for many years.

After sustained pressure, the Thai central bank stopped defending the baht on July

2, 1997 and it fell 14% in the onshore market and 19% in the offshore market.

This marked the start of the Asian financial crisis.

The next currencies to come under pressure were the Philippine peso and the

Malaysian ringitt.

The Philippine central bank tried to defend the peso by raising interest rates but it

nevertheless lost $1.5 billion of foreign reserves.

On July 11 it let the peso float and it promptly fell 11.5%.

1997 Asian financial crisis The Malaysian central bank also defended the ringitt until July 11 before letting it

float.

The Indonesian central bank defended the rupee until August 14.

The Dragons were also affected.

At the beginning of August, Singapore decided not to defend its currency and by

the end of September it had fallen 8%.

Taiwan also decided to let their currency depreciate and were not much affected.

Hong Kong’s exchange rate, which was pegged to the dollar came under attack.

However, it was able to maintain the peg.

Initially the South Korean won appreciated against the other South East Asian

currencies.

1997 Asian financial crisis However, in November it lost 25% of its value.

By the end of December 1997 which marked the end of the crisis the dollar had

sharply appreciated against the Malaysian, Philippine, Thai, South Korean, and

Indonesian currencies.

Although the turbulence in the currency markets was over by the end of 1997, the

real effects of the crisis continued to be felt throughout the region.

Many financial institutions, and industrial and commercial firms went bankrupt

and output fell sharply.

Overall, the crisis was extremely painful for the economies involved.

The causes of the crisis The cause of the debacle are many and disputed.

Thailand's economy developed into an economic bubble fueled by hot money

(speculative movements of capital).

More and more was required as the size of the bubble grew.

The same type of situation happened in Malaysia and Indonesia, which had the

added complication of what was called "crony capitalism".

The short-term capital flow was expensive and often highly conditioned for quick

profit.

Development money went in a largely uncontrolled manner to certain people only,

not necessarily the best suited or most efficient, but those closest to the centers of

power (crony capitalism).

In the mid-1990s, Thailand, Indonesia and South Korea had large private current

account deficits, and the maintenance of fixed exchange rates encouraged external

borrowing and led to excessive exposure to foreign exchange risk in both the

financial and corporate sectors.

The causes of the crisis In the mid-1990s, a series of external shocks began to change the economic

environment.

The devaluation of the Chinese renminbi, and the Japanese yen due to the Plaza

Accord of 1985, the raising of U.S. interest rates which led to a strong U.S. dollar,

and the sharp decline in semiconductor prices, all adversely affected their growth.

As the U.S. economy recovered from a recession in the early 1990s, the U.S.

Federal Reserve Bank under Alan Greenspan began to raise U.S. interest rates to

head off inflation.

This made the United States a more attractive investment destination relative to

Southeast Asia, which had been attracting hot money flows through high short-

term interest rates, and raised the value of the U.S. dollar.

For the Southeast Asian nations which had currencies pegged to the U.S. dollar,

the higher U.S. dollar caused their own exports to become more expensive and

less competitive in the global markets.

The causes of the crisis At the same time, Southeast Asia's export growth slowed dramatically in the

spring of 1996, deteriorating their current account position.

Some economists have advanced the growing exports of China as a factor

contributing to ASEAN nations' export growth slowdown, though these

economists maintain the main cause of their crises was excessive real estate

speculation.

China had begun to compete effectively with other Asian exporters particularly in

the 1990s after the implementation of a number of export-oriented reforms.

Other economists dispute China's impact, noting that both ASEAN and China

experienced simultaneous rapid export growth in the early 1990s.

Many economists believe that the Asian crisis was created not by market

psychology or technology, but by policies that distorted incentives within the

lender–borrower relationship.

Panic and withdrawal of credit The resulting large quantities of credit that became available generated a highly

leveraged economic climate, and pushed up asset prices to an unsustainable level.

These asset prices eventually began to collapse, causing individuals and

companies to default on debt obligations.

The resulting panic among lenders led to a large withdrawal of credit from the

crisis countries, causing a credit crunch and further bankruptcies.

In addition, as foreign investors attempted to withdraw their money, the exchange

market was flooded with the currencies of the crisis countries, putting depreciative

pressure on their exchange rates.

To prevent currency values collapsing, these countries' governments raised

domestic interest rates to exceedingly high levels (to help diminish flight of

capital by making lending more attractive to investors) and intervened in the

exchange market, buying up any excess domestic currency at the fixed exchange

rate with foreign reserves.

Neither of these policy responses could be sustained for long.

Panic and withdrawal of credit Very high interest rates, which can be extremely damaging to a healthy economy,

wreaked further havoc on economies in an already fragile state, while the central

banks were hemorrhaging foreign reserves, of which they had finite amounts.

When it became clear that the tide of capital fleeing these countries was not to be

stopped, the authorities ceased defending their fixed exchange rates and allowed

their currencies to float.

The resulting depreciated value of those currencies meant that foreign currency-

denominated liabilities grew substantially in domestic currency terms, causing

more bankruptcies and further deepening the crisis.

Other possible causes Other economists, such as Joseph Stiglitz and Jeffrey Sachs, have downplayed the

role of the real economy in the crisis compared to the financial markets.

The rapidity with which the crisis happened has prompted Sachs and others to

compare it to a classic bank run prompted by a sudden risk shock.

Sachs pointed to strict monetary and contractionary fiscal policies implemented by

the governments on the advice of the IMF in the wake of the crisis, while Frederic

Mishkin points to the role of asymmetric information in the financial markets that

led to a "herd mentality" among investors that magnified a small risk in the real

economy.

The crisis has thus attracted interest from behavioral economists interested in

market psychology.

Other possible causes Another possible cause of the sudden risk shock may also be attributable to the

handover of Hong Kong sovereignty on 1 July 1997.

During the 1990s, hot money flew into the Southeast Asia region through financial

hubs, especially Hong Kong.

The investors were often ignorant of the actual fundamentals or risk profiles of the

respective economies, and once the crisis gripped the region, the political

uncertainty regarding the future of Hong Kong as an Asian financial centre led

some investors to withdraw from Asia altogether.

This shrink in investments only worsened the financial conditions in Asia,

subsequently leading to the depreciation of the Thai baht on 2 July 1997.

The robustness of hubs Several case studies on the topic of the application of network analysis of a

financial system help to explain the interconnectivity of financial markets, as well

as the significance of the robustness of hubs (or main nodes).

Any negative externalities in the hubs creates a ripple effect through the financial

system and the economy (as well as any connected economies) as a whole.

The foreign ministers of the 10 ASEAN countries believed that the well co-

ordinated manipulation of their currencies was a deliberate attempt to destabilize

the ASEAN economies.

Former Malaysian Prime Minister Mahathir Mohamad accused George Soros of

ruining Malaysia's economy with "massive currency speculation".

Soros claims to have been a buyer of the ringgit during its fall, having sold it short

in 1997.

The robustness of hubs At the 30th ASEAN Ministerial Meeting held in Subang Jaya, Malaysia, the

foreign ministers issued a joint declaration on 25 July 1997 expressing serious

concern and called for further intensification of ASEAN's cooperation to

safeguard and promote ASEAN's interest in this regard.

Thus, the crisis could be seen as the failure to adequately build capacity in time to

prevent currency manipulation.

However, this hypothesis enjoyed little support among economists, who argue that

no single investor could have had enough impact on the market to successfully

manipulate the currencies' values.

In addition, the level of organization necessary to coordinate a massive exodus of

investors from Southeast Asian currencies in order to manipulate their values

rendered this possibility remote.

The financial crisis of 2007-2008 The US financial crisis of 2007–2008 is considered by many economists as the

worst financial crisis since the Great Depression of the 1930s.

The US financial crisis can be seen as ‘a typical case of professional malpractice

by hundreds of professionals in banks and rating agencies who created and

certified as almost risk-free securities and assets that were actually highly risky.

It can be viewed as a typical case of market failure.

Yet it can also be argued that it is a state failure.

Bad regulation implies scanty oversights on the part of the public authorities, which did

not prevent the public, the economy and public finances from being exposed to

excessive risks.

Interpretations of the crisis A large strand of literature on this financial crisis revolves around two approaches.

The first includes studies on the dynamics of the crisis, its most obvious causes

and the reforms needed to prevent it occurring once more, or at least to mitigate

the impact.

The second approach concerns the relationship between the development of

financial capitalism and the distribution of income.

Once again, the analysis cannot be limited to the national framework, because

economic interdependence means we must also take account of the international

movements of capital, businesses and individuals.

The comparative approach is particularly useful to identify the essential variables

at play and their significance.

A particularly complex phenomenon such as financial capitalism is difficult to

understand from abstract economic models, albeit well structured in analytical

terms and based on precise statistical data.

The theory of efficient financial markets

According to De Grauwe, one of the causes of the last financial crisis was the

uncritical adoption of the theory of efficient financial markets.

This theory, proposed and defended by leading economists, has become ingrained

in the minds of many bank managers, financial funds, investors and savers.

It became a kind of public doctrine, supported by Federal Reserve Chairman Alan

Greenspan, who deregulated the US financial system in the belief that the

financial markets would regulate themselves, and there was no need for

government-imposed rules and regulations.

The roots of the crisis lie in the ideology of international neoliberalism, which has

been the point of reference for economic policies not only within the USA, but on

the world market, to the extent that other countries have accepted American

leadership as an indisputable fact.

Background causes of the crisis The first cause of the 2007–8 financial crisis can be found in excessively low

interest rates, facilitated by the Federal Bank’s policy of abundant liquidity.

The central bank kept interest rates very low in the years preceding the crash, and

only raised them when forced to do so by the US twin deficits (the link between

the US government budget balance and its current account balance).

Thus, there was an interaction between the monetary excesses and the risk-taking

excesses.

However, the low interest rates were also connected to flows of capital from the

rest of the world (Europe, Asia and the Middle East in particular).

This reveals that the US financial crisis not only had global consequences, but also

global causes.

Background causes of the crisis The second cause regards the relationship between growing income inequality in

and private debt, widely used by families for house-buying.

This relationship cannot be interpreted merely as spontaneous behaviour on the

part of the American people.

It is the result of economic policy implemented and backed by the federal

government.

The Clinton and Bush administrations, aware of the growing poverty and the

impoverishment of the middle classes, attempted to stem the phenomenon using

the Federal National Mortgage Association (FNMA, or Fannie Mae) and Federal

Home Loan Mortgage Corporation (or Freddie Mac) to help the neediest families

buy homes.

These two federal agencies are classed as government-sponsored enterprises

(GSEs - corporations partly financed by the federal government and partly by

private funding).

Background causes of the crisis In recent decades they were instrumental in supporting the policy of home

ownership for every American family, a crucial strand of the American Dream.

The two agencies encouraged the creation of mortgages standardised according to

certain types of risk, and also went one further.

In order to increase the amount of credit, they combined various mortgages with

similar risks into bundles, which they then put on the credit market, thus obtaining

new resources for new mortgages.

In June 2008, the total loans of the two agencies represented ‘approximately 59%

of total loans to these categories.

This was in practice money supply driven by government.

Alongside this publicly funded credit market, the private credit market began to

use these credit bundles (whose value was guaranteed by federal agencies) for

further transactions.

Background causes of the crisis The opportunity for high returns on financial investments naturally contributed to

the exponential growth of the market.

Families got into debt easily due to the low interest rates applied by the agencies.

The growing demand for housing caused property prices to rise.

The increase in the value of housing facilitated mortgage applications, because

borrowers could count on the increasing value of the property they had purchased.

In this way a speculative bubble formed.

When interest rates rose in order to contrast capital flight, demand slowed, house

prices began to fall, and those who had got into debt did not have enough money

to pay off the interest or repay the debt.

So an economic policy introduced with the aim of increasing people’s quality of

life turned into a serious social crisis.

Background causes of the crisis While the housing and credit bubbles were building, a series of factors caused the

financial system to both expand and become increasingly fragile, a process called

financialization.

US government policy from the 1970s onward has emphasized deregulation to

encourage business, which resulted in less oversight of activities and less

disclosure of information about new activities undertaken by banks and other

evolving financial institutions.

Thus, policymakers did not immediately recognize the increasingly important role

played by financial institutions such as investment banks and hedge funds, also

known as the shadow banking system.

The shadow banking system Some economists believe these institutions had become as important as

commercial (depository) banks in providing credit to the US economy, but they

were not subject to the same regulations.

These institutions, as well as certain regulated banks, had also assumed significant

debt burdens while providing the loans described above and did not have a

financial cushion sufficient to absorb large loan defaults or MBS losses.

These losses affected the ability of financial institutions to lend, slowing economic

activity.

Concerns regarding the stability of key financial institutions drove central banks to

provide funds to encourage lending and restore faith in the commercial paper

markets, which are integral to funding business operations.

Governments also bailed out key financial institutions and implemented economic

stimulus programs, assuming significant additional financial commitments.

The shadow banking system There is strong evidence that the riskiest, worst performing mortgages were

funded through the "shadow banking system" and that competition from the

shadow banking system may have pressured more traditional institutions to lower

their own underwriting standards and originate riskier loans.

In a June 2008 speech, President and CEO of the New York Federal Reserve Bank

Timothy Geithner placed significant blame for the freezing of credit markets on a

"run" on the entities in the "parallel" banking system.

These entities became critical to the credit markets underpinning the financial

system, but were not subject to the same regulatory controls.

Furthermore, these entities were vulnerable because of maturity mismatch,

meaning that they borrowed short-term in liquid markets to purchase long-term,

illiquid and risky assets.

This meant that disruptions in credit markets would make them subject to rapid

deleveraging, selling their long-term assets at depressed prices.

The shadow banking system In early 2007, asset-backed commercial paper conduits, in structured investment

vehicles, in auction-rate preferred securities, tender option bonds and variable rate

demand notes, had a combined asset size of roughly $2.2 trillion.

Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in

hedge funds grew to roughly $1.8 trillion.

The combined balance sheets of the five largest investment banks totaled $4

trillion.

In comparison, the total assets of the top five bank holding companies in the

United States at that point were just over $6 trillion, and total assets of the entire

banking system were about $10 trillion.

The combined effect of these factors was a financial system vulnerable to self-

reinforcing asset price and credit cycles.

The run on the shadow banking Paul Krugman, Nobel Prize in Economics, described the run on the shadow

banking system as the "core of what happened" to cause the crisis.

He referred to this lack of controls as "malign neglect" and argued that regulation

should have been imposed on all banking-like activity.

The securitization markets supported by the shadow banking system started to

close down in the spring of 2007 and nearly shut-down in the fall of 2008.

More than a third of the private credit markets thus became unavailable as a

source of funds.

According to the Brookings Institution, in 2009 the traditional banking system did

not have the capital to close this gap.

The Brookings Institution also indicated that some forms of securitization were

"likely to vanish forever, having been an artifact of excessively loose credit

conditions”.

The immediate cause of the crisis However, the immediate cause or trigger of the crisis was the bursting of the US

housing bubble, which peaked in 2006/2007.

Already-rising default rates on "subprime" and adjustable-rate mortgages (ARM)

began to increase quickly thereafter.

Easy availability of credit in the US, fueled by large inflows of foreign funds after

the Russian debt crisis and Asian financial crisis of the 1997–1998 period, led to a

housing construction boom and facilitated debt-financed consumer spending.

As banks began to give out more loans to potential home owners, housing prices

began to rise.

Lax lending standards and rising real estate prices also contributed to the real

estate bubble.

Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain

and consumers assumed an unprecedented debt load.

The immediate cause of the crisis As part of the housing and credit booms, the number of financial agreements

called mortgage-backed securities (MBS) and collateralized debt obligations

(CDO), which derived their value from mortgage payments and housing prices,

greatly increased.

Such financial innovation enabled institutions and investors around the world to

invest in the US housing market.

As housing prices declined, major global financial institutions that had borrowed

and invested heavily in subprime MBS reported significant losses.

Falling prices also resulted in homes worth less than the mortgage loan, providing

the lender with a financial incentive to enter foreclosure.

The ongoing foreclosure epidemic, that began in late 2006 in the US and only

reduced to historical levels in early 2014, drained significant wealth from

consumers, losing up to $4.2 trillion in wealth from home equity.

Immediate outcomes of the crisis The high delinquency rates led to a rapid devaluation of financial instruments

(mortgage-backed securities including bundled loan portfolios, derivatives and

credit default swaps).

As the value of these assets plummeted, the buyers for these securities evaporated

and banks who were heavily invested in these assets began to experience a

liquidity crisis.

Freddie Mac and Fannie Mae were taken over by the federal government on

September 7, 2008.

Lehman Brothers filed for bankruptcy on September 15, 2008.

Merrill Lynch, AIG, HBOS, Royal Bank of Scotland, Bradford & Bingley, Fortis,

Hypo Real Estate, and Alliance & Leicester were all expected to follow.

A US federal bailout was announced the following day beginning with $85 billion

to AIG.

Defaults and losses on other loan types also increased significantly as the crisis

expanded from the housing market to other parts of the economy.

Consequences of the crisis In spite of trillions paid out by the US federal government, it became much more

difficult to borrow money.

The resulting decrease in buyers caused housing prices to plummet.

While the collapse of large financial institutions was prevented by the bailout of

banks by national governments, stock markets still dropped worldwide.

In many areas, the housing market also suffered, resulting in evictions,

foreclosures, and prolonged unemployment.

The crisis played a significant role in the failure of key businesses, declines in

consumer wealth estimated in trillions of US dollars, and a downturn in economic

activity leading to the Great Recession of 2008–2012 and contributing to the

European sovereign-debt crisis.

The active phase of the crisis, which manifested as a liquidity crisis, can be dated

from August 9, 2007, when BNP Paribas terminated withdrawals from three hedge

funds, declaring "a complete evaporation of liquidity".

Consequences of the crisis The bursting of the US housing bubble, which peaked at the end of 2006, caused

the values of securities tied to US real estate pricing to plummet, damaging

financial institutions globally.

Questions regarding bank solvency, declines in credit availability, and damaged

investor confidence affected global stock markets, where securities suffered large

losses during 2008 and early 2009.

Economies worldwide slowed during this period, as credit tightened and

international trade declined.

Governments and central banks responded with unprecedented fiscal stimulus,

monetary policy expansion and institutional bailouts.

In the US, Congress passed the American Recovery and Reinvestment Act of

2009.