EC 380: Lecture 13

.title[
# EC 380: Lecture 13
]
.subtitle[
## Global Finance: International Crises
]
.author[
### Philip Economides
]
.date[
### Winter 2024
]

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# Prologue

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# Global Finance

### Upcoming Topics

* Broad look at international financial crises

* Understanding Balance of Payments in National Accounting

* Exchange Rate Dynamics

This will comprise the third and last stage of .hi-pink[EC 380]

---

# Today

### International Financial Crises

* Defining types of international financial crises

* Vulnerabilities, Triggers and Contagion

* Crisis Control

* Post-Crisis Reform

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# Types

* Banking Crisis

> e.g. domino of bank collapse due to insolvency

* Exchange Rate Crisis

> e.g. unexpected collapse in value of developing country currency

* (Sovereign) Debt Crisis

> e.g. EU debt crisis following public bailouts

* Balance of Payments Crisis

> e.g. foreign currency reserves drying up

---

# Banking Crises

The primary role of a bank is to provide intermediation between .hi-pink[savers] and .hi-pink[borrowers].

* Pooled deposits saved in banks used as collateral to hedge loans for major businesses

* A functional banking systems is necessary to bolster investment by firms and homeowners

Some percentages of businesses fail, banks must compensate for these bad debts through gains made elsewhere, through elevated interest rates.

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# Banking Crises

Banking systems are reliant on interbanking lending channels

* No bank in particular has enough money to redeem every $ of deposits it maintains

* Some % of bank's liabilities returned to depositors every day

* In cases where a bank lacks cash, it can engage in .hi-pink[interbank lending]

A bank is considered .hi-pink[insolvent] if even after completely liquidizing its assets, it cannot repay its outstanding liabilities owed to creditors.

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# Banking Crises

During a .hi-pink[banking crisis], an abnormally large % of borrowers fail to meet debts.

* Banks assets may suddenly deteriorate

* Depositors may trigger a .hi-pink[run on banks]

If numerous banks struggle meeting obligations to their savers, major loss of savings.

Remaining savings can be lost, causing households to reduce consumption. This can lead to ripple effects throughout the economy.

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# Exchange Rate Crises

If seeking to peg another global currency, lack of foreign reserves may break fixed exchange rate.

Devaluation similar to .hi-pink[bank run], international currency holders sell their holdings ASAP.

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# Exchange Rate Crises

* Equivalent to available currency demand dropping significantly

* Suddenly foreign debt obligations hard to meet payments for `$\implies$` potential knock-on bank crises

* Imported goods become expensive for local economy

* Indutries reliant on foreign credit suddenly see loss of liquidity, resulting in market price falls (e.g. housing market collapse)

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# Debt Crises

* Can be public or private debtors that begin struggling to meet requirement debt repayments

* In exceptional cases out of borrower's control, debt forgiveness, interest rate and term length adjustments can be applied

* .hi-pink[External debt] is debt linked to a foreign lender/borrower. International exchanges of funds result in these forms of linkages.

If debt held in a specific currency, that country presides over legal matters related to payment arrears and bankruptcy.

---

# Debt Crises

If a party fails to honor their debt, these losses can permuate throughout the rest of the economy.

Widespread cases of failures to honor debt can lead to service providers declaring bankruptcy.

.hi-pink[Spread can occur] in insolvency, in which other individuals go into bankruptcy because an intial set of individuals do.

---

# Debt Crises

Suppose economy is split into three groups;

* __Group A__ is heavily indebted and holding risky portfolio of assets it investment in

* __Group B__ holds relatively correlated assets to group A but maintains low debt level

* __Group C__ holds unrelated assets and maintains low debt level

If __A__ experiences a shock in which it cannot service its debts, it may be forced to sell all of its assets to meet as much of debt as possible.

__B__ sees .hi-pink[assets fall in value] as supply on market suddenly increases.

__B__ assets fall in value `$\implies$` becomes insolent too. Group C unaffected.

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# Debt Crises

Governments can also fail to obligate their debts. The EU debt crisis saw repeated episodes of .hi-pink[Greece] almost defaulting on debt, following major economic collapse.

* Normally international lending agencies such as the .hi-pink[IMF] step in

* Bailouts are heavily politicized, often the distressed country is at the mercy of its neighbors

* Steep requirements can be placed on the burdened economy, extending the length of downturn to ensure bailout is provided

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# BoP Crises

Deficit is financed through selling financial assets, which includes currency reserves, as a way to generate .hi-pink[capital account net inflow] that offsets .hi-pink[current account net outflow].

* Foreign bankers extend loans, buy bonds, stocks or invest directly in deficit country's real estate market

* These flows must cover current accout deficit

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# BoP Crises

If .hi-pink[deficit country] capital investments/purchases appear too risky, capital inflows ease.

As .hi-pink[Forbes and Warnock] reveal, patterns have emerged of these flows acting as sudden stops and surges

This can put great pressure on domestic reserves, causing them to dwindle.

Ability to purchase goods abroad using their denominated currency now faces a limit and may need to stop all together.

Ability to convert local currency into foreign debt repayment transfers also kicks in, furthering stress on .hi-pink[deficit country].

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# BoP Crises

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# BoP Crises

Help from allies and IMF act as stopgaps to slow decline. Deficit must shrink until confidence in the country is restored.

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# Vulnerabilities

Could be due to:

* Macroeconomic imbalances

* Capital flow volatility

Long-run underlying issues for domestic economy may lead to over-reliance on foreign debt and over-leveraged credit status across households.

Can be the result of either of these two scenarios.

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# Economic Imbalances

Macroimbalances can be attributes to: large budget deficits, large current account deficits, overinflated exchange rates, unsustainable private sector debt, speculative property bubbles.

Normally these issue occur simultaneously, further complicating matters of unravelling macroeconomic imbalances.

Doubt in government ability may result in government bond yields needing to rise to continue accessing foreign debt. Limits ability of government to service the economy.

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# Volatile Capital Flows

As .hi-pink[Warnock & Forbes (2012)] highlight, there is an ebb-and-flow to capital investment.

During good times, capital is situated in developed economies and accruing returns based on strong economy performance and high interest rates.

When developed economies enter recession, central banks .hi-pink[lower interest rates] and domestic economies see slump in consumption.

Capital investors .hi-pink[migrate] to low-income/emerging countries until resurgence in developed country economy.

These volatile movements of large sums of capital within these transition periods can be .hi-pink[highly costly for the emerging host countries].

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# Contagion

.hi-pink[This aspect of crises determines the scale of how 'international' or 'cross-country' a given crisis will be.]

Particularly strong cases of interbank lending across countries make these spillovers of domestic shocks into foreign countries become amplified.

As the world becomes more globalized, financial interlinkages become stronger.

Local shocks are increasingly likely to trigger worldwide reprecussions due to greater degree of .hi-pink[financial interdependence.]

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# Crisis Control (CC)

The financial sector has always been a concern for policymakers, due to the .hi-pink[too big to fail mindset].

* Bailouts of banks can protect economy, but greater risks offer greater returns

* Encourages banks to become large enough to .hi-pink[force bailouts] in between episodes of them over-leveraging themselves

This is defined as the .hi-pink[moral hazard problem] in which bankers are able to transfer high risks to the government and taxpayer.

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# CC: Exchange Rate Policy

Avoidance of a .hi-pink[crawling peg exchange rate system] is often recommended.

* Regular devaluation of currency to stabilize .hi-pink[real exchange rate] in country with higher inflation than foreign partner

* If .hi-pink[domestic inflation higher than foreign], nominal devaluation keeps `$R_r$` constant

* Requires monetary authority to restrict money creation, making it .hi-pink[anti-inflationary]

* Often leads to severe overvaluation of .hi-pink[real exchange rate], increasing vulnerability to crisis

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# CC: Capital Controls

Capital volatility can be addressed by limiting how much capital enters and exits the country.

These .hi-pink[capital controls] are a popular policy tool in countries such as China.

Can be attributed to reduced exposure to economic turmoil.

.hi-pink[Malaysia] enacted this policy during the Asian Financial Crisis in late 90's but failed to experience much of the warnings surrounding losses from poorer investor confidence.

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# CC: Policies

A budget deficit reduction may stem reserve losses and lower financial exposure.

Interest rate appreciation may boost demand for domestic currency, further helping.

Political feasibility of these moves is up for question, hard to implement during economic strife.

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# International Reform

As a .hi-pink[lender of last resort] on the international scene, IMF is intervenes when countries reach crisis points and risk defaulting on international loans.

A great deal of focus has shifted to the .hi-pink[role of the IMF] and the .hi-pink[conditions it imposes] for bailout fund access. Issues include

* Moral Hazard Problem

* Limits to borrowing for countries

* Loans conditional on economic conditions

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# Three Crises

* 1990s East Asian Financial Crisis

* 2008 Great Recession (Ireland)

* 2009 European Debt Crisis

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# East Asian Crisis

__Leading Up__

* Private current account deficits in .hi-pink[Thailand, South Korea and Indonesia]

* Fixed exchange rate policy `$\implies$` significant .hi-pink[external borrowing]

* US interest rate increases as period of pronounced growth began, USD value up

* Currency peg to USD `$\implies$` suddenly exports are less competitive

* Huge capital drain to meet elevated .hi-pink[current account deficit]

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# East Asian Crisis

__Crisis__

* Market panic, large withdrawal of credit from the crisis countries

* Triggered .hi-pink[series of bankruptcies] which would accelerate more capital flight

* Temporary policies to maintain peg were quickly exhausted (interest rate hike, domestic currency purchases)

* .hi-pink[Higher interest rates] further pressured these economies

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# East Asian Crisis

__Response__

* The IMF offered bailout funds conditional on economic reforms, known as the .hi-pink[structural adjustment package]

> Required countries to reduce government spending and deficits, allow insolvent banks and financial institutions to fail, and aggressively raise interest rates.

* Critics noted the contractionary nature of policies

* In a recession the expected response was to increase government spending and yield greater liquidity through lower interest rates

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# Great Recession (Ireland)

__Leading Up__

* In the early 2000's various EU member states at different points in business cycle

* .hi-pink[Portugal, Italy, Greece, Spain] all experience boom periods

* A large proportion of interbank lending was channeling excessive Germany savings into these peripheral countries

.hi-pink[Irish banks became highly reliant on foreign borrowings] and offered excessive amounts of subprime mortgage loans

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# Great Recession (Ireland)

__Crisis__

* Multiple property bubbles popping simulatenously across countries

* .hi-pink[Global lending channels] froze, channels Irish banks had become particularly reliant on

* Irish housing prices tanked, as did employment in construction sector

* .hi-pink[34,500 people] left the country from April 2009 to 2010, the .hi-pink[largest net emigration since 1989]

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# Great Recession (Ireland)

__Response__

* Public bailout of banks, some failed others nationalized

* Irish .hi-pink[debt-to-GDP] rose rapidly to 120%

* Government required to implement .hi-pink[austerity measures] to receive bailout packages

* Macroprudential policy measures introduced to stabilize housing market

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# EU Debt Crisis

* Widespread requirement of austerity plans

* International assymetry in business cycles combined with lax macroprudential rules prior to the crash

* More recently, countries are now held to macroeconomic monitoring with penalities imposed if countries allow their current account balances, inflation or GDP to get out of control

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# EU Debt Crisis

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