Financial Crisis: How And Why It Happens
...developing countries (Latin America and Africa)
1992: European Exchange Rate Mechanism (especially UK and Sweden)
1994-95: Mexico (Tequila crisis) and Argentina
1997-98: Asian financial crisis (Thailand, Indonesia, Korea, Philippines, Malaysia)
1998: Russia
1999: Brazil
2000-02: Turkey
2001-02: Argentina (again)
Nature of Financial Crises
Exchange rate crises
Sudden, drastic depreciation of the country's currency
Banking crises
Depositors lose confidence (disintermediation)
Banks can't perform lending function
Effects
Severe recession, due to:
Collapse of bank loans
Reduction in consumer demand
Higher interest rates
Inflation, due to:
Higher import costs
Causes of Financial Crises:
1. Macroeconomic Imbalances
Where: Russia 1999, Brazil 1999, Turkey 2000, Argentina 2001
Characteristics of imbalances:
Causes of Macroeconomic Imbalances
High government spending (G) due to:
Public subsidies for businesses
Infrastructure spending
Lack of fiscal discipline
Insufficient tax revenues (T) due to:
Poorly developed tax systems
Lack of tax enforcement
Money supply (M) growth too high due to:
Lack of independence of central bank
Political pressure on central bank to accommodate fiscal deficits
Pressure on Exchange Rates
CA deficit and inflation cause pressure in forex markets on currency to depreciate.
Government does not want that due to:
Higher import costs
Loss of prestige
Government tries to keep currency from depreciating too fast:
By raising interest rates domestically
By using foreign reserves to buy its currency back
But this creates problems:
Higher interest rates slow the domestic economy
Loss of foreign reserves
Loss of Confidence
Foreigners stop lending
Speculators think the currency will depreciate...
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