The Economics of Money, Banking, and

Financial Markets
Twelfth Edition, Global Edition

Chapter 13
Financial Crises in Emerging
Economies

Copyright © 2019 Pearson Education, Ltd.

Preview
• This chapter applies the asymmetric information theory of
financial crises to investigate the cause of frequent and
devastating financial crises in emerging market economies
• This analysis is then applied to the events surrounding the
financial crises that took place in South Korea and
Argentina in recent years and explore why these events
caused such devastating contractions of economic activity.

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Dynamics of Financial Crisis in Emerging
Market Economies (1 of 5)
• Stage one: Initial Phase
– Path A: Credit Boom and Bust
 Weak supervision and lack of expertise lead to a lending
boom.
 Domestic banks borrow from foreign banks.
 Fixed exchange rates give a sense of lower risk.
 Banks play a more important role in emerging market
economies, since securities markets are not well developed
yet.
 At this stage emerging economies may report “sound
fundamentals.” For example, fiscal positions may be sound.
 Credit boom is associated with deteriorating balance of
payments.
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Key Economic Indicators for Crisis-Stricken
Mexico and Thailand

Source: Adapted from International Monetary Fund. World Economic Outlook Database. www.imfstatistics.org/imf/
Crisis years are indicated in italics.

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Dynamics of Financial Crisis in Emerging
Market Economies (2 of 5)
• Stage one: Initial Phase
– Path B: Severe Fiscal Imbalances
 Governments in need of funds sometimes force banks to buy
government debt.
 When government debt loses value, banks lose and their net
worth decreases.
– Additional factors:
 Increase in interest rates (from abroad)
 Asset price
– Decrease firms' net worth and thus increase adverse
selection problems
 Uncertainty linked to unstable political systems

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Dynamics of Financial Crisis in Emerging
Market Economies (3 of 5)
• Stage two: Currency Crisis
– Deterioration of bank balance sheets triggers currency
crises:
 Government cannot raise interest rates (doing so
forces banks into insolvency)…
 … and speculators expect a devaluation.
 Note difference with advanced economies (where
bank failures do not cause currency crisis)
– Severe fiscal imbalances triggers currency crises:
 Foreign and domestic investors sell the domestic
currency.
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Dynamics of Financial Crisis in Emerging
Market Economies (4 of 5)
• Stage three: Full-Fledged Financial Crisis
– Currency mismatch: another difference from
advanced economies
 Arises out of the denomination of many debt
contracts in a foreign currency (usually a foreign
reserve currency such as the US$)
 At the same time, however, domestic income
denominated in local currency
– With currency crisis, firms face a higher debt
– Net worth decreases and averse selection problems
increases

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Dynamics of Financial Crisis in Emerging
Market Economies (5 of 5)
• Stage three: Full-Fledged Financial Crisis
– Debt burden in terms of domestic currency increases
(net worth decreases).
– Increase in expected and actual inflation reduces firms’
cash flow.
– “Twin crisis”
– Banks are more likely to fail:
 Individuals are less likely to payoff debts (value of
assets fall)
 Debt denominated in foreign currency increases
(value of liabilities increase)
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Figure 1 Sequence of Events in Emerging
Market Financial Crises

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Application: Crisis in South Korea, 1997–98
(1 of 5)

• Financial liberalization and globalization mismanaged

• Perversion of the financial liberalization and globalization
process: chaebols and the South Korean crisis
• Starting point: sound macroeconomic fundamentals
– Rapid growth, low unemployment, and fiscal surpluses
– “Asian miracle”

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Figure 3 Real GDP Growth, South Korea,
1995–1999

Source: Adapted from International Monetary Fund’s International Financial Statistics, www.imfstatistics.org/imf/

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Application: Crisis in South Korea, 1997–98
(2 of 5)

• What happened? Financial liberalization in the 1990s

– Financial de-regulation
– Opening up of capital markets
– Outcome: lending boom fueled by massive foreign borrowing -
especially short term
• Perversion of the financial liberalization and globalization
process: chaebols and the South Korean crisis
– Chaebols: large family-owned conglomerates
– Political ties: too big to fail
– Leading role in borrowing frenzy: very high leverage (but low
profits)
– Facilitating role played by South Korean merchant banks

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Application: Crisis in South Korea, 1997–98
(3 of 5)

• Stock market decline and failure of firms increase

uncertainty
– In early 1997, series of negative shocks to the external
position of (already weakened) chaebols
– First high-profile bankruptcy of one of the largest chaebols
in January, followed by 5 more
– Uncertainty caused by such bankruptcies, and decrease in
chaebols' net worth, cause a sharp decline in stock market
values
• Adverse selection and moral hazard problems worsen, and
the economy contracts

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Figure 5 Stock Market Index, South Korea,
1995–1999

Source: Global Financial Data, available at www.globalfinancialdata.com/.

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Application: Crisis in South Korea, 1997–98
(4 of 5)

• Currency crisis ensues

– Speculative attack against the South Korean currency (won)
– Fueled by
 deterioration financial health of chaebols (associated with high
leverage)
 crisis of confidence affecting other Southeast Asian economies
• Final stage: currency crisis triggers full-fledged financial crisis
– 50% decrease in value of the won increases the value of foreign
debt by 50%
– Increased adverse selection & moral hazard
– Deterioration of banks' balance sheets
– GDP declines by 6%

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Figure 6 Value of South Korean Currency,
1995–1999

Source: Adapted from International Monetary Fund’s International Financial Statistics, www.imfstatistics.org/imf/

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Application: Crisis in South Korea, 1997–98
(5 of 5)

• Economic impact of the crisis

– Declining GDP causes a sharp increase in unemployment
– Inflation increases spurred by increases in import prices
– Central bank increases interest rates...
– ...Which worsen the balance sheet of banks and firms
– Severe socio-economic consequences
• Recovery
– Aggressive policy by South Korean government to restore
financial stability
 In particular, overhaul of financial regulation
– Financial markets stabilize in 1998–99.

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Global: China and the “Noncrisis” in 1997–
1998
• China not affected by the 1997-98 crisis in East Asia.
Why?
• Two key factors:
– Slower, more restricted financial liberalization in China
– No currency instability
 Renminbi pegged to the dollar and not convertible for capital
account transactions

• Impact of the crisis on China's subsequent economic

policies
– Vindicated the policy of “controlled liberalization”
– Encouraged the country to accumulate foreign exchange reserves

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Application: The Argentine Financial Crisis,
2001–2002 (1 of 6)
• Severe fiscal imbalances
• Adverse selection and moral hazard problems worsen
• Bank panic begins
• Currency crisis ensues
• Currency crisis triggers full-fledged financial crisis
• Recovery begins

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Application: The Argentine Financial Crisis,
2001–2002 (2 of 6)
• Severe fiscal imbalances
– Contrast with Mexico (1995) and East Asian crisis
(1997)
– No lending boom, banks had sounder balance sheets
– However, growing fiscal imbalances led the
government to ask banks to buy public debt
– Bank balance sheets deteriorate, while investors
(foreign and domestic) do not regain trust in Argentina's
ability to repay debt

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Application: The Argentine Financial Crisis,
2001–2002 (3 of 6)
• Adverse selection and moral hazard problems worsen
– By 2001, banks start losing deposits and reduce lending
– Increases in adverse selection and moral hazards

• Bank panic begins

– Doubts over sustainability of fiscal imbalances grow throughout
2001
– By October, default becomes real prospect
– Investors lose trust in banks
– In November, deposit withdrawals reach US$1 billion/day
– Restrictions on withdrawals imposed by government fan the
flames of social unrest–30 die in violent riots

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Application: The Argentine Financial Crisis,
2001–2002 (4 of 6)
• Currency crisis ensues
– At the time of the bank panic, currency board was in place
 Currency board: Arrangement in which the Argentine
government fixed the value of one Argentine peso to one U.S.
dollar by agreeing to buy and sell pesos at that exchange rate
– But bank panic clearly questions the ability of the government to
keep interest rates high to preserve the currency board
– Speculative attacks against the peso multiply
– In December, 2001, the government announces the suspension of
external debt repayments
– In January 2002, the government announces the end of the
currency board

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Figure 9 Argentine Peso, 1998–2004

Source: Adapted from International Monetary Fund’s International Financial Statistics, www.imfstatistics.org/imf/

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Application: The Argentine Financial Crisis,
2001–2002 (5 of 6)
• Currency crisis triggers full-fledged financial crisis
– Free fall of the peso, stabilizing at 25% of its value by
the end of 2001
– Rapid increase in capital outflows and decline in
lending
– Increase in inflation through higher import prices (like in
South Korea), compounded by historically poor inflation
performance in the country
– GDP decreases, dramatic increases in unemployment
and poverty
 Worst crisis in Argentina's history

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Figure 10 Inflation in Argentina, 1998–2004

Source: Adapted from International Monetary Fund’s International Financial Statistics, www.imfstatistics.org/imf/

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Figure 12 Unemployment Rate, Argentina,
1998–2004

Source: Adapted from Global Financial Data, available at www.globalfinancialdata.com/.

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Application: The Argentine Financial Crisis,
2001–2002 (6 of 6)
• Recovery begins
– Financial recovery in 2002 together with boom in
demand for Argentinian exports
– Growth resumes at fast pace in 2003: +10% annual
rate

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Global: When an Advanced Economy Is Like an Emerging
Market Economy: The Icelandic Financial Crisis of 2008

• The financial crisis and economic contraction in Iceland

that started in 2008 followed the script of a financial crisis
in an emerging market economy, even though Iceland is a
wealthy nation.
• Financial liberalization led to rising stock market values
and currency mismatch.
• Foreign capital fled the country as a severe recession
developed.

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Preventing Emerging Market Financial
Crises
• Beef up prudential regulation and supervision of banks
• Encourage disclosure and market-based discipline
• Limit currency mismatch
• Sequence financial liberalization

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