Chapter 20: Crises

and Responses

An Introduction to International
Economics: New Perspectives on the
World Economy
Analytical Elements

 Countries
 Currencies
 Financial assets
Introduction
 Unlike markets for most goods and services, financial
markets are characterized by market “imperfections.”
 These imperfections tend to make financial markets
somewhat unstable, with “booms” of one kind or another
being followed by “busts.”
 Various types of crises
Types of Crises
 In order to get beyond popular descriptions of
crises, we need to understand the different types of
crises
 Six types of crises are listed in Table 20.1
1. Hyperinflation
2. Balance of payments and currency crises
3. Asset price deflation
4. Banking crises
5. External debt crises
6. Domestic debt crises
 These can occur one at a time or in combinations
 Table 20.1
Types of crises

Sources: Eichengreen
(1999) and Reinhart and
Rogoff (2009)
Hyperinflation

 Hyperinflation is a period of rapid increases in the

price level of a country, typically defined to be 40
percent or more
 Generally speaking, periods of hyperinflation are
associated with rapid expansions of the money
supply
 The case of Venezuela is presented in Figure 20.1
Figure 20.1 Inflation in Venezuela,
2000–2018 (percentage change in
consumer prices)
Balance of Payments and
Currency Crises
 Balance of payments and currency crises consist
of large devaluations or rapid depreciation in the
value of domestic currencies
 Periods of hyperinflation can contribute to currency
crashes
 Significant degrees of inflation can cause asset owners to
move out domestic-currency-denominated assets in to
foreign-currency-denominated assets to maintain portfolio
values
 This causes a decrease in the demand for the domestic
currency, lowering its value
Asset Price Deflation

 Asset price deflation involves a large and

sustained decline in the prices of financial assets
 This typically follows behind large increases in asset
prices or asset price bubbles
 The last significant episode of international asset
price deflation took place between 2007 and 2009
 A classic case of an asset price deflation is that of
Japan in 1990, presented in Figure 20.2
Figure 20.2: Asset Prices in Japan, 1981-
1992 (¥ trillions)

Source: Noguchi (1994)

Banking Crises

 Banking crises involve the occurrence of bank

runs, mergers, closures,, or government takeovers
of banking institutions
 In general, banking sectors are particularly fragile
components of financial systems
 This reflects their involvement in maturity transformation
 Maturity transformation involves banks borrowing short
term and lending long term
 Bank runs can be set off by asset price deflation,
capital inflows surges and financial sector
liberalization
External Debt Crises

 External debt crises involve sovereign default on

debt obligations to foreign creditors or the
substantial restructuring of this debt.
 The classic case of this is Mexico’s defaulting in
1982 on its foreign debt, setting of a global debt
crisis
 Debt crises tend to follow large capital inflows
Domestic Debt Crises
 Domestic debt crises involve sovereign default on
debt obligations to domestic creditors or substantial
restructuring of this debt
 Reinhart and Rogoff (2009) emphasize that these
events are understudied
 As with banking crises and external debt crises,
preceding capital inflows are often a contributing
factor
 Argentina in 2001 combined a banking crises, a
currency crisis, both external and domestic debt
crises, and asset price deflation
Contagion and Systemic Risk

 Contagion refers to crises beginning in one country

and “spreading” to other countries
 This can occur through a few different mechanisms
 Shifts in expectations and confidence (herding or
informational cascades)
 Asset prices (financial linkage)
 Capital flight (sudden stops)
 Sudden stops, surprise financial announcements
and highly leveraged financial institutions can work
together to cause contagion
Contagion and Systemic Risk

 When contagion takes on global or near-global

characteristics, it becomes what is known as
systemic risk
 These episodes are rare but characterized the Great
Depression of the 1930s and the 2007-2009 crisis
 It is becoming clear that increased financial
globalization has increased the possibility of
systemic risk
 This is indicated by the volume of a number of key
financial markets being multiples of global GDP
Analyzing Balance of Payments
and Currency Crises
 “Old fashioned” balance of payments and currency
crises have their roots in over-valued, fixed
exchange rates and large current-account deficits
 Suppose that Mexico is successful in implementing
an equilibrium exchange rate at e0 (Figure 20.3)
 Requires that the expected future exchange rate must
equal the equilibrium rate
 ee = e
0
 In turn, requires that the interest rate on the peso must
equal the interest rate on the dollar
 r = r
M US
Figure 20.3 A Balance of
Payments and Currency Crisis
Analyzing Balance of Payments
and Currency Crises
 Suppose that we find Mexico in a position of a current
account deficit
 Current account deficit is always financed by a capital
account surplus
 When a large trade deficit is financed by an inflow of
short-term capital problems will soon develop
 The denomination in dollars exacerbates the problem
because any fall in the value of the home currency
inflates the domestic currency value of the debt
 Many domestic investors were aware of these problems
and began to sell pesos during 1994
Analyzing Balance of Payments
and Currency Crises
 If you as Mexican investor feels that the Mexican
government will have to devalue the peso in order to
suppress the trade deficit, then you think that e e >
e0
 If rM = rUS and ee > e0 then
rM  rUS 
ee  e
Expected total return on    e 
peso -denominated assets Expected total return on
dollar-denominated assets

 You will buy dollars and sell pesos, participating in

capital flight
Analyzing Balance of Payments
and Currency Crises
 In response to such changes, in December 1994,
the Mexican government devalued the peso by 15%
 This proved to be too little and fueled speculation of
further devaluations
 The demand for pesos graph in Figure 20.3 shifted
further to the left
 Mexico was forced to let the peso float
 Further and sudden shifts out of peso-denominated
assets sent the peso into a deep fall
Figure 20.4 Balance of
Payments and Currency Crises
The Asian Crisis
 “High-tech” crises typically include some elements
of the balance of payments crises but also include
some less-concrete factors that are often difficult to
predict
 Combine current account deficits with weak financial
sectors (especially in the banking system) and/or
inappropriate capital account liberalization
 This view of crises is summarized in Figure 20.5 and
characterized the Asian crisis of 1997
 This crisis began in Thailand but spread through
contagion effects to Malaysia, Indonesia, the
Philippines, Hong Kong, South Korea, and Taiwan
Figure 20.5 A “High-Tech”
Balance of Payments Crisis
The Asian Crisis
 The Asian crisis of 1997 involved the large
devaluations featured in Figure 20.6
 The high-tech features of the Asian crisis included
 Exposures of financial firms (including banks) to real estate
and equity markets
 Capital account liberalization
 Poor regulation of banks
 The absence of hedging (see Chapter 14)
 The loss of confidence in the financial sectors of the
Asian countries involved was a main culprit in the
crisis
Figure 20.6: Nominal Exchange Rates of Four
Asian Countries, 1995-2005
The IMF Responses
 The IMF’s response to the 1997 Asian crisis and the
1999 Brazilian crisis became a point of serious
contention and debate
 IMF’s response can be characterized with three
elements
 Interest rate increases
 Fiscal austerity
 Structural reforms
 The IMF required the afflicted economies increase their
interest rates, as an increase in the domestic interest
rate tends to increase the equilibrium value of a
country’s currency.
The IMF Response
 However, interest rate increases also tended to
suppress domestic demand and sometimes fed into
a sense of panic
 Fiscal austerity measures ignored the fact that the
Asian crisis was not the result of profligate
governments but profligate private sectors
 Structural reform requirements had two weaknesses
 They were overly broad
 They encroached on the traditional realm of the World Bank
 The specifics of this economic history are still being
debated
The IMF Response: Indonesia

 IMF condition included:

 Dismantling of monopolies in cloves and palm oil owned by
Suharto associates
 Removing government food and energy subsidies
 Particularly controversial was the IMF’s closing of 16
insolvent Indonesian banks
 Critics alleged that this fed into panic and made matters
worse
 Whatever the case, continued rioting in 1998 finally
ended the 32-year reign of President Suharto
The Global Financial Crisis
 Financial crises can and do occur in developed or
high-income countries
 Causes include
 Capital inflows
 Financial liberalization
 Asset price inflation
 Over-borrowing
 The sub-prime crisis emerged in the United States
in 2007 to 2008
 This involved sub-prime mortgages that had been
bundled into mortgage-backed securities (MBS)
The Global Financial Crisis
 Losses in US housing markets were transmitted
around the globe via a pyramid of financial
instruments, include MBS
 Thereby, a crisis originating in one country took on a
global profile through systemic risk described above
 Addressing this crisis had profound fiscal impact for
the United States that have not yet been adequately
addressed
 It also sparked a crisis in Europe to be discussed in
Chapter 21
 The GFC was an example of systemic crisis.
Prudential Regulation and the
Basel Standards
 The most fundamental imperfection in financial markets
is imperfect information, particularly asymmetric
information
 Therefore, financial systems, particularly banking
systems, can benefit from prudential regulation.
 Prudential regulation aims to help support the solvency
of financial intermediaries and limit contagion and
systemic risk.
 In practice, much of the attention in prudential regulation
is on capital adequacy ratios (CARs), which measure
banks’ available capital as a ratio of a risk-weighted
measure of credit exposure.
Prudential Regulation and the
Basel Standards
 The Basel Committee on Banking Supervision was
established in 1974
 In 1988, the Basel Committee introduced a banking
capital measurement standard known as the Basel
Capital Accord and later Basel I (see Table 20.2)
 A new set of standards went into effect in 2004 in
the form of Basel II based on three pillars
 Minimum capital requirements
 Supervisory review
 Disclosure for market discipline
Table 20.2: The Basel Accords

Stage Years of Issue Components

Basel I 1988 Proposed regulatory capital requirements of 8
percent and introduced two tiers of capital.
Basel II 2004 Introduced three pillars of bank regulation
(minimum capital requirements, supervisory
review, and disclosure for market discipline)
and two tiers of capital. Effectively reduced
the capital requirement and allowed asset
measurements to be risk adjusted by banks’
internal models.
Basel III Phased 2010-2017 Improved asset risk adjustment and increased
capital requirements to 7 percent, and allowed
for countercyclical capital requirements.
Basel Standards

 As the Global Financial Crisis testified, Basel II was

insufficient
 Its conditions were simply too lax
 In response, Basel III was announced in 2010
 Basel III tightens up the Basel II standards, for
example, by tightening standards on Tier I and Tier
II and increasing capital requirements from 2 to 7%
 Some observers think that even 7% is too lax
Capital Controls
 Capital controls, aka capital account regulations
(CARs) and capital flow (management) measures
(CFMs)
 The purpose of capital controls is to address the
volatile nature of gross capital flows
 To the extent that such volatility contributes to crises,
capital controls might help with crisis prevention.
 In the wake of the GFC the IMF revisited capital
controls and gave them an endorsement:
 market-friendly capital controls can help countries cope with
surges of capital inflows, which can end in sudden stops and
contribute to crises