The Roots of Financial Crises During the 1990 - Coursework Example

ROOTS OF THE FINANCIAL CRISIS OF 1990’S AND THE ROLE OF INTERNATIONAL FINANCIAL S IN RESOLVING THE CRISIS Introduction This report discusses the financial crisis that hit many emerging markets during the time fame of 1990s. The report evaluates the crisis and identifies the various roots that aggravated the crisis. The financial slump that surfaced during the time period of 1990s affected many countries at different time frames depending on the domestic economic idiosyncrasies of these countries. These include Mexico crisis of 1994 – 1995, Thailand’s, South Korea’s and Indonesia’s financial slump of 1997, Russian default of 1998, and Brazilian Crisis of 1998 – 1999. The pre-crisis domestic idiosyncrasies in these countries included brisk liberalization of financial sector in late precedent decade of 1980, issues with exchange rate policies, mismanagement of foreign capital, and absence of appropriate financial regulatory prerequisites. It also discusses the role of international financial institutions in relieving the crisis affected countries. Sources of the Financial Crisis of 1990s Before discussing and evaluating the effect of antecedents of the crisis of 1990s, it is vital to first understand a generalized phenomenon of a financial crisis as appeared in emerging economies. The financial crisis, as onset during 1990s, is characterized by an abrupt turnaround of capital flows back to the lending sources which determined withdrawal of short term foreign debts; break out of portfolio resources and cross country running off by local investors (Eichengreen, & Temin, 1992). All these exacerbated the financial crisis by curbing the affected countries access to foreign capital, limiting foreign creditors’ interest in lending, lacking of financial reserves and assets in paying off the already generated foreign short term liabilities, depressing value of domestic currencies relative to the international economies and respective currencies; all resulted in domestic financial resources crunch within the economic and financial setup of the affected countries (Temin, 1993). Reasons behind the Surfacing of Sources There are many reasons prevailing behind the financial crisis of 1990s, which showed up as antecedents of the crisis. These briefly included the following: 1. Abrupt Liberalization of Financial Sector 2. Over investment 3. Financial Chaos Amongst Creditors 4. Exchange rate deflation Evaluation of the Sources and the Reasons Moderating the Crisis This part of the report evaluates how the different factors establish themselves as reasons that moderated the actual sources of the financial crisis in emerging economies during the phase of 1990s. Flawed National Economic Makeup and Absence of Non-Indulgent Financial Systems The individual national economic structure and the financial system of the affected countries had inherent flaws associated with their domestic policies, regulations and management (Mishkin, 1992). The financial market collapse in these affected countries is linked back to their adoption and implementation of financial liberalization policies in abrupt and nonsystematic manner. Such a widespread immediate execution of liberalization policies focusing establishment financial market were designed to create a pool of foreign resources to finance domestic strategic structural operations, manufacturing and trade (Coe, 2002). However, the rapid alleviation practices of financial markets had flawed foundations of a financial system and its prerequisites that are required for efficient and effective functioning of financial markets. Unlike trade and business transactions, financial contracts and commercialism of finance instruments is rigorously regulated and monitored across the world. But, unfortunately the emerging markets hastily operated financial markets without establishing an appropriate regulatory system for supervising the issues associated with financial dealings, portfolio management, and bankruptcy laws to safeguard creditors and guide debtors of the pitfalls that had already been surfaced in the defective functioning of a frail financial system of emerging countries (Calomiris, 1993). The easement of financial policies in the emerging economies provided rooms for establishment of new banking systems which leveraged their capacity to draw funds and financing from foreign lenders. This commercialization of foreign financing increased the credit growth in two channels; one from increasing foreign borrowing and second from mounting domestic lending. This phenomenon, in absence of financial regulatory systems, later resulted in non performing debts and short term loans by these banks, as these panic out of the inability to manage the distribution of the escalating inflow of funds effectively amongst the most suitable fund seekers; rather these banks lend a large proportion of the funds to their affiliate companies (Temin, 1991). The crisis affected countries deliberately maintained large proportion of short term foreign debts in their financial portfolio, to create huge foreign capital inflows in a short period of time to boast their financial activity and liquidity of their domestic financial markets. These short term debts are very risky instruments, which require superfluous regulations. As a result of this faulty structuring, the short term foreign liabilities accrued beyond the foreign asset reserves. Thus, the mounting liabilities created credit vacuum and financial crunch situations which compelled these countries to consume the foreign asset reserves for settlement of the liabilities accrued (Eichengreen, & Mitchener, 2004). On the other hand, the inflow of foreign exchange resulted in overvaluation of the currencies of emerging countries, which in turn lead to overinvestment in these countries. Due to the lack of ability of the domestic banking system and withholding of funds, the growing investment did not get allocated at optimized levels which resulted in cronyism of funds. This affected the export performance of these countries, consequently, the competitiveness of export firms decreased. Thus, the prices and volumes of export commodities reduced which further shrunk the export revenues (Obstfeld, & Taylor, 1999). Risk Seeking Tendency of Affected Countries The overinvestment, which was a result of short term currency overvaluation, by foreign creditors in emerging economies was misinterpreted by domestic banks and other financial counterparts as boom in the local financial market, which they perceived to be continued for a longer period of time. Surprisingly, during the short span of late 1980s to the mid 1990s, the IMF, World Bank and other international economic outlooks evaluated these markets as profitable and healthy. Accordingly, foreign lenders were confident that they would be paid off against their investments. On the other hand, on behalf of government guarantees the local banking sector along with the other financial equivalents began to put in foreign resources in highly risky financial instrument and loans; such as short term loans. (Bernanke, 2000). Abrupt Financier Withdrawal The financial crisis began to show up as the financial bubble burst, as the creditors began to pool out their financial resources from the domestic financial markets of the emerging countries. Eventually, the short term foreign liabilities went beyond the short term foreign asset reserves of the affected countries (Cooper, & Corbae, 2002). The reasons behind the phenomenal withdrawal of foreign resources by overseas lenders are discussed below: Creditor Panic As the export performance declines, the reasons behind the overvaluation of currency unfold and resulted to eventual currency depreciation and foreign reserve depletion. The overseas lenders got panic of the possibility of being bankrupt and left unpaid against the funds lent. Accordingly, the creditors decided to cash their financial securities by converting the instruments into foreign exchange, as a result rapid withdrawal of funds or bad equilibrium of creditors takes place which lead the domestic economies to liquidity crisis and short of on hand reserves to pay off their liabilities generated against financiers of short term debts. Limited Access to Foreign Capital This phenomenal withdrawal of funds from the affected countries’ financial markets limited their access to foreign financing resources for that much period of time until the foreign creditors’ confidence is restored into the domestic financial market, economic functioning and establishment of financial framework that safeguard creditors against bankruptcy and economic failures (Calomiris, 1993). Role of International Financial Institutions in Adjudicating the Financial Crisis 1990s International financial institutions primarily, the IMF and the World Bank, took immediate measures to assist the crisis affected economies recover from the financial slump. The intent of these measures was to protect domestic borrowers from defaulting against the foreign debts, control currency depreciation, maintain a balance in fiscal and monetary policy components, recover foreign reserve, and restore creditor confidence into these emerging economies (Robbins, 2009). To attain the aforementioned objectives IMF designed strategic framework of actions that are elaborated below: Fiscal Policy The IMF directed all the crisis affected countries to maintain a strict fiscal policy that in the initial phase required 1 percent fiscal surplus target, this added to the budget shrinking force prevailed as a consequence of the crisis. Later in the next phase IMF required the countries to sustain a fiscal deficit of 1 percent to ensure a balanced budget. Monetary Policy The IMF initiatives required the crisis affected countries to maintain a stiff monetary policy to ensure sustainability of higher interest rate targets and restricted credit targets for domestic central banks. This was undertaken to defend the exchange rates of the domestic countries, to restore a pool of funds, and protecting those funds from being consumed as non-performing debts by the domestic banks (Hamilton, 1987). Banks Termination The IMF recovery measures required termination of malfunctioning banks whose operations are costly and ineffective to the crisis affected economies. But the banks closure process increased the financial crunch in the affected countries and overburdened the performance of operating banks. On other hand it also reduced the foreign lenders inflow to the operating banks (Rajan, & Zingales, 2003). Banks Recapitalization IMF initiatives proposed diverse recapitalization programs tailored to individual economic situation and financial needs of the crisis affected countries. These range from giving deadlines for restoring the initial levels of capital, establishment of targets for undercapitalized domestic financial institutions, imposition of regulations for bank restructuring, and leverage time frames for complete execution of resources adequacy standards. Conclusion The report thoroughly discusses individually the roots of the financial crisis of 1990s and the consequent role of international financial institutions in resolving the crisis. References Eichengreen, B., & Temin, P. (1992). The Gold Standard and the Great Depression. New York. Coe, P. J. (2002). ‘Financial crisis and the great depression: a regime-switching approach’. Journal of Money, Credit, and Banking, vol. 34, no. 1, pp. 76-93. Calomiris, C. W. 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(2009). The great depression. Transaction Pub. Rajan, R. G., & Zingales, L. (2003). ‘The great reversals: the politics of financial development in the twentieth century’. Journal of financial economics, vol. 69, no. 1, pp. 5-50. Bernanke, B. S. (2000). Essays on the great depression. New Jersey, Princeton University Press. Eichengreen, B., & Mitchener, K. J. (2004). The Great Depression as a credit boom gone wrong. Available from http://elsa.berkeley.edu/users/eichengr/research/bisconferencerevision5jul30-03.pdf [Accessed 5 January 2013] Read More