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2012-11-04 20:41:04

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  1. Barriers to international flows
    Asymmetric information is likely to be a larger problem because foreign investors may not have access to the same quality of information

    • Legal rights of foreign investors are often not as
    • strong, for example, when enforcing rights to a share of the remaining assets when a firm is in bankruptcy

    Government exploitation of foreign investors

    –Peg their currencies at an inefficiently low value

    –Impose excise taxes or limits to international financial transactions

    –Nationalize industries
  2. causes for 1990s boom in international capital flows.
    –Worldwide economic boom in both the industrialized and developing world

    –Government policies worldwide shifted, in general, toward greater economic integration

    NAFTA—The North American Free Trade Agreement is an agreement among Canada, Mexico, and the United States creating a trilateral trade bloc in North America

    World Trade Organization (Expansion of GATT)—Mission is to:

    –Promote/liberalize trade between participating countries

    –Supervise international trade and provide a framework for negotiating and formalizing trade agreements and process for the resolution of disputes

    Emerging economies became pro-trade with an emphasis on export market

    –Advancements in information and computer technology and reduction in transaction costs

    •Reduced costs to screen new investment opportunities and monitor performance

    •Improved information quality

    –Increases accountability of firms

    –Forces governments to maintain fiscal discipline

    –Compels financial systems and economies to become more efficient to compete for capital flows

    •Reduced transaction costs

    •International capital flows are increasingly to emerging economies such as China and India—not just to industrialized countries

    •Commercial banking is increasingly becoming an international business

    • •International bond markets and financial instruments have expanded immensely
  3. Why Promote Free Capital Mobility?
    •Foreign direct investment can increase a country’s GDP

    •Liberalization of capital mobility can have spillover effects

    i.e. transparent financial reporting, knowledge (exposure to technologies), local investor risk falls w diversification (Cost of cap falls), develop housing etc

    •Less Developed Countries that grow the fastest have higher levels of capital flows and higher levels of financial development (credit/GDP) (OECD but more risk in employment and growth))

    **Organization for Economic Cooperation and Development (OECD) – examines, devises, and coordinates policies across 34 relatively wealthy nations to foster sustainable economic growth and employment, rising standards of living, and financial stability
  4. Currency Crisis
    Financial crach within the FX markets typically with fixed exchange rate regimes

    Co-occur with banking crises since Bretton Woods

    can create asset bubble bursting
  5. Currency crises are precipitated by
    Capital flight- large rapid withdrawl of funds by foreign investors

    Speculative attack
  6. The Typical Dynamics of a Currency Crisis
    1.Currency crises begin with foreign investors deciding—for whatever reason—that at the pegged rate, the country’s currency/their investments in that country are overvalued

    • 2.Foreign investors respond by selling their real and financial assets in the country, hence, selling that
    • country’s currency

    3.Governments sell their foreign reserves and buy their own currency to defend the peg

    4.Speculators observe the declining foreign reserves and increase their short positions in the country’s financial assets or currency

    5.Panic selling ensues

    6.The government abandons the peg and devalues the currency—typically by more than would have been required at earlier stages of the crisis
  7. A currency crisis may induce a banking crisis
    •A currency crisis and devaluation can signficantly reduce the net worth of the banking system and lead to widespread bank insolvency

    –Mass withdrawals of foreign deposits/credit investments

    • –Bank liabilities and deposits are often in dollars—not
    • the local currency

    •A wave of bank insolvencies during a currency crisis leads to a collapse in credit to firms and individuals and aggravates the economic contraction

    •The economic contraction escalates the capital flight, amplifies the original currency crisis, and in turn, amplifies the banking crisis
  8. Alternatively, a banking crisis may induce a currency crisis
    • •An asset bubble may burst, weaken the
    • fundamentals (for example, loan portfolio values) of the banking system, and create a banking crisis

    •The devaluation further weakens the fundamentals of banks, amplifies the original banking crisis, and in turn, amplifies the currency crisis
  9. Currency Crises: Triggers
    •Fundamentals-based theories, for example:

    –Exchange rates are misaligned with macro conditions and the government stubbornly maintains the peg. For example, the country may have:

    •High budget deficits implying the government is financing the deficit by increasing money supply

    •Falling foreign reserve holdings

    –Growing current account deficits coupled with falling GDP growth (hence unattractive financial account investments)

    –Imprudent deregulation of the banking sector

    • •Beliefs-based theories
    • –It is often difficult to pinpoint a specific change in fundamentals that is large enough to justify most currency crises

    •East Asian crisis (1997), Russia (1998), Brazil (1998), and Argentina (2000)

    –Many countries with weak fundamentals never suffer currency crises and many countries with exemplary fundamentals do!

    –A self-fulfilling prophesy?

    If speculators/investors come to believe that other speculators/investors believe…… that a crisis is going to take place, speculators/investors withdraw their capital and, indeed, a crisis takes place!

    If speculators/investors do not hold these beliefs, no currency crisis takes place—regardless of the state of fundamentals
  10. A commonly used rule of thumb is: once a country’s current account deficit reaches 5 percent of GDP
    It is in danger of speculative attack and capital flight
  11. Effects of Devaluation
    •Real prices for imports rise

    –Production falls when the economy relies heavily on imported inputs, for example, oil

    –Consumption falls when the country relies heavily on imports for necessities such as food stuffs. Higher prices for necessities means lower disposable income, that is, poverty

    •The banking system is severely weakened (or further weakened)

    –Often, assets (denominated in the home currency) lose value relative to debt (often denominated in a foreign currency in emerging economies)

    –Credit is either rationed or available only at exorbitant rates 

    –Lack of credit causes output to plummet even further!
  12. Tequila effect
  13. Causes of contagion
    • Fundamental based theories
    • Correlated shocks across countries
    • i.e. Raw material price shocks (Oil)

    Trade linkages among countries

    Financial linkages (Common institutional lenders ie bank/hedge funds)

    1.Crisis occurs in Country A

    2.Value of assets in the lender’s portfolio falls

    3.To restore solvency, the lender tightens credit to borrowers in Countries A & B, C, D, … sells assets in portfolio in Countries A & B, C, D, ….

    4.Country B, C, D, ….’s asset prices fall

    5.Capital flight occurs in Country B, C, D, ….

    6.Countries B, C, D, …. suffer a currency crisis

    Beliefs-based theories


    •Fund managers are compensated based on how they perform relative to other fund managers: it is better to fail in good company than to succeed alone!

    –Withdrawal of funds in one country by one fund, may lead other managers to withdraw their funds in geographically or economically similar countries

    Small investors: Because information is costly, small investors find it cost effective to follow large investors with established reputations (and withdraw their funds in geographically or economically similar countries)

    –Wake-up Call

    • •A crisis in one country effectively alerts investors to look for similar weaknesses in other countries
    • •A change in international banking regulations or IMF policy might cause investors
    • to reevaluate their risk exposure across several countries

    –Self-fulfilling prophecy

    •A crisis in one country leads speculators/investors to believe that other speculators/investors are going to attack/flee other counties……

    •Regardless of economic fundamentals, speculators/investors begin to withdraw their funds across a range of countries and the crisis spreads
  14. Capital flight
    Rapid outflow of money/assets in a country
  15. EMS Crisis of 1992
    European Monetary System

    • system of fixed-exchange rates with a
    • band that predated the European Monetary Union

    George Soros noticed looser (expansionary- increase gov't spending) fiscal policies in Britain than Germany implying a future devaluation of the pound

    If speculators realize this they will sell pounds buy marks and therefore britain will need to devalue the pound
  16. East Asian Crisis (why unanticipated?, schedule, results)
    •Between 1997 and 1999, an international twin crisis (currency and banking) swept through East Asia resulting in the largest economic contraction since the Great Depression!

    •Especially hard hit were South Korea, Thailand, Indonesia, and Malaysia

    •Growth in this region prior to the crisis had been exceptional

    • Unanticipated because:
    • No Budget Deficits
    • Low inflation

    • May 1997 Thailandhit with speculative attack
    • Thai Gov't floated baht
    • Days after Malaysian ringgit was attacked
    • Month later spread through Indonesia and they floated rupiah
    • 2 months later attack spread to hong kong korea and Taiwan- who intern devalued Tai dollar 15%
    • Capital outflow 11% inflow 10% throughout region

    Real wages fell by 1/3, unemployment trippled Aggregate income fell by 10%, 22m into poverty
  17. Causes of East Asian Crisis
    A rigidly pegged fixed rate relative to US dollar along with slowing growth--> USD appreciated relative to Jap Yen--- 100 to 150 yen per dollar

    Appreciation of dollar increased already large current account deficit throughout east asia therefore reducing their exports attractiveness

    •These large deficits were only sustainable as long as these countries continued to grow at high rates (and attract capital through the financial account)

    Recent and rapid deregulation of the banking system coupled with dramatic foreign investment flows led to asset bubbles

    EA Countries heavily rely on bank lending (gov't garanteed bonds)

    and deregulation coupled with large capital inflows caused banks to be riskier and offer risky ensured bonds

    Real estate and stock market bubbled formed grew and burst!

    Implicit deposit insurance- People believed gov't or IMF would bail out banks and they therefore viewed deposits in these banks as safe

    •Exchangemrate risk: Foreign dollar liabilities funded domestic investments in domestic currency exposed the financial system to tremendous exchange rate risk

    Foreign currency denominated liabilities grew in domestic currency terms

    •Short-term investment: Much of foreign debt was dollar-denominated and short-term, or hot money

    •Much of the foreign investment was not put to productive use!

    •Concentrated holdings in a few families, corporate groups, and amalgamated banks created a complex web of insider financial flows with minimal due diligence in lending and inadequate corporate oversight 

    •Crony capitalism in Korea

    –In Korea 30 conglomerates known as chaebols lead to high industrial concentration

    –Before the crisis 7 of the 30 chaebols were insolvent; in 20 chaebols , the return on capital was less than the cost of capital

    •By 1998, 31 percent of Korean, 45 percent of Indonesian, and 18 percent of Malaysian corporations were insolvent—all due in part to crony capitalism
  18. Why did a currency crisis in Thailand spread throughout the entire region?
    • Large international hedge funds
    • Trade Linkages- Countries traded amongst themselves
    • Financial Linkages- Credited each other (Japan)
    • Beliefs- Herding and wake up call hypothesis
  19. East Asian Crisis concured with
    Russian Speculative attack- Long Term Cap Mgt. had long on Russian bonds and short on US T bonds thinking they'd narrow- crisis caused a meltdown (Russia defalted on bonds)- they also had holdings in Hong Kong and Brazil!
  20. Possible policies to prevent crises like LTCM?
    •Maintain prudent fiscal and monetary policy

    –Balance budgets and pursue low inflation monetary policy

    •Prudently regulate the banking sector

    Belief Based theories- Stabalize expectations creating a reformed IMF with imediate bailout power

    –Ensure foreign capital is used for productive investment not speculation

    –Provide prudential oversight to prevent excessively risky (moral hazard) lending

    –Impose adequate capital requirements

    • •Promote long-term investment:
    • Crises and contagion typically follow a boom in capital inflows followed by a rapid reversal
  21. Brazilian initiative to combat hot money
    Taxes on equity for foreign purchase
  22. High capital mobility forces emerging market nations to chose btw
    • Free floating Regine
    • -Independent monetary policy and free movement of capital allowed
    • - Increased volatility

    • Currency Board or Dollarization
    • -Independent monetary policy is lost
  23. Argentina's Currency Crisis
    • Adopted a currency board to curb hyperinflation
    • This however introduced austerity (People had no money to spend

    •Argentina's largest trading partner, Brazil, suffered a crisis in January 1999. The ensuing devaluation of the real meant that Brazilians could no longer afford Argentine exports

    Third currency phenomenon- the peso was fluctuating according to the US dollar and not according to Argentina's actual economic position

    • •The effect was to reduce Argentina's competitiveness,
    • weaken demand for its products in Europe and Brazil, and increase its current account deficit (Importing more than exporting)

    • •As a result, the economy stalled and subsequently contracted

    • Lower tax revenue with gov't spending doubled the national debt- increasing international borrowing

    International investors doubted its ability to repay its debt and withdrew their dollar and peso balances converting pesos to dollars-

    To stop this massive capital flight they closed the banks

    Dec. 2001 Arg. suspended interest payments on 155Bn of sovereign debt

    January 6th 2002 repealed Convertibillity Law and devalued Peso to 1.4Ps/$

    Feb 3rd 2002- Free float peso
  24. European Sovereign Debt Crisis
    • newly elected Greek government announces that
    • the country’s 2009 budget deficit is approaching 12.5% of GDP

    Investors started dumping Greek bonds—but in spring 2010, Greece faced daunting debt repayment

    •Under the European Stability Pact  –Fiscal deficits should be no more than 3% of GDP

    •By the beginning of May, French Finance Minister Christine Lagarde stated the euro zone was on the verge of collapse

    •Hours later, Germany and France broke their stalemate and endorsed a bailout—only after faced with calamity, did the leaders put aside their differences and compromise

    •EU and IMF agree to a € 110B bail-out on May 2, 2010

    –€30 billion came from the International Monetary Fund, and the rest from the other euro-zone countries
  25. European Financial Stability Facility
    preserve financial stability in Europe by providing financial assistance to eurozone states in economic difficulty (Short term lines of credit)

    can issue bonds or other debt instruments on the market to provide loans to countries in trouble

    €440 billion lending capacity of the facility is jointly and severally guaranteed by the eurozone countries' governments
  26. European Financial Stabilisation Mechanism
    An emergency funding program reliant upon funds raised on the financial markets and guaranteed by Euro Comission- buys government and private debt securities
  27. Greexe Leave Euro?
    • Benefits:
    • Could devalue currency promoting exports and ease debt burden

    • Costs:
    • Banks would need to close because people would dcramble
    • Lawsuit for pensions and
    • Cut off from foreign credit initially causing trade to suffer
  28. Three Scenerios for a fix
    1. Fiscal Union- Fiscal authority transferred to a central authority- would issue "Euro bonds"--> The government debts of the weaker ones could be financed at low interest rates

    2. Breakup- Weak nations exit euro zone

    • funds to provide liquidity to nations and private banks, restructuring plans
    • for high-debt nations, and measures to avert private-sector banking failures

    3. Muddle through plan could also include some special-purpose bonds backed by the eurozone nations collectively