Financial Liberalisation and Crisis - Essay Example

Financial Liberalisation and Crisis Liberalisation of Financial Markets This paper is a critical examination of the link between financial liberalisation and financial crisis. We begin by defining the concept of financial markets, how and why they go about the process of liberalisation, the recent experience of countries getting into a financial crisis, and how the crisis is linked to the liberalisation of financial markets. A financial market is a place - an actual location such as a stock exchange building or a virtual location such as in a computer - where buyers and sellers agree to buy and sell financial instruments such as stocks, bonds, or derivatives in order to borrow, lend or invest funds for commercial purposes and in a manner that puts financial resources to best use. Transactions in financial markets are affected by the efficiency of intermediaries such as brokers who put buyers and sellers together and professionals who keep the market in operation, ranging from clerks who keep records and financial analysts who allow information to flow within, to, and from the market (Howell et al., 2002). Historically, financial markets evolved under the close supervision, regulation, and protection of governments for the good of market agents (the suppliers and users of funds). Through laws, suppliers of funds such as depositors or lenders were protected from swindlers who ran away with the money, whilst users or funds borrowers had to be protected from usurious lenders. Whilst the government also made it difficult for a small number of market agents to establish an oligopoly, it also saw the need to create monopolies mainly for legitimate reasons such as the regulation of prices, public protection, and to stimulate market competition. However, when governments become too complacent, these legitimate reasons become intertwined with political factors and became illegitimate and burdensome, and instead of improving market efficiency it had the opposite effect: markets became too costly, prices were too high, artificial, and not competitive, and therefore highly inefficient. Inefficiency is tantamount to a lack of freedom in the operations of markets, so the call for market liberalisation is in effect a strategy to "free" the market from government regulations. Liberalisation is the removal of government interference in economic markets and barriers to trade (Stiglitz 2002: 59) and is supposed to improve a nation's economy by forcing resources to move from less to more productive uses, thereby raising efficiency in the use of resources. Liberalisation is not necessarily a bad thing because in fact and intention, it is for the benefit of market agents. However, like most other realities of life, if it is not done well it can end in disaster. Just to give some examples easy to understand: you don't ask a young man who just received his driver's license to race against David Coulthard or expect the Manchester school district's soccer champions to play well against Manchester United. Yet, this is what liberalisation attempts to do: the best way to improve the efficiency of financial markets is to let it free, which usually means allowing competitors both local and foreign to slug it out in open competition. The good ones will adjust, learn, and survive, whilst the poor ones will disappear. The financial markets of Southeast Asia before the crisis shared the characteristics of a market that was not free and of being under the influence of government regulations that stifled competition. The foreign exchange market was protected by a government that intervened in transactions to keep the local currencies artificially high. Bank interest rates were kept artificially low to favour local borrowers, which included local governments and favoured conglomerates. Awash with cheap funds, wanton borrowing and wild lending happened side by side to construct golf courses and buildings and purchase Porsches. How Inefficiency breeds Crisis The Asian financial crisis of 1997-1998 has been one of the well-studied events in the last ten years that choosing the materials for this critical examination can be a dissertation in itself. Approaching the problem necessarily requires a starting point that is within the writer's power to decide; in this case, this would be the notions of financial liberalisation, intervention, and credit rationing (Basu 2002). The introduction discussed the need for financial liberalisation in the face of (government) intervention in financial markets (by pegging exchange rates or keeping interest rates artificially low). What economists call credit rationing was defined by Baltensperger (1978) as a phenomenon that exists when a borrower's demand for credit is turned down although the borrower is willing to pay all the price and non-price elements of the loan contract. He identified two types: Type 1 rationing occurs when there is a partial or complete rationing of all the borrowers within a given group; Type 2 rationing concerns the rationing within a group that is homogeneous from the lender standpoint, so that some borrowers of this group obtain the loan they demand while others are rationed. What are the reasons for credit rationing, which is a sign of inefficiency in the way that banks lend money Stiglitz and Weiss (393-398) linked credit rationing with asymmetric information, adverse selection, and moral hazard. Asymmetric information denotes that one side (borrowers) have much better information than lenders. Borrowers know more about their repayment prospects, or sellers know more than buyers about the quality of the good being sold, so they take advantage of their superior knowledge to get what they want over those who do not have information. This leads to adverse selection, whereby borrowers with weak repayment prospects crowd out everyone else including good borrowers from the market. When a poor borrower gets a loan, the chances the bank's bad loans will increase goes up, and even good borrowers who need money would not get any. This is another form of inefficiency because those who need funds and could put these to better use end up not getting it, whilst those who want funds to pay for profligacy end up getting them. The moral hazard, like adverse selection, is also traced to asymmetric information and can be defined as a mode of behaviour that encourages bad behaviour. This is similar to giving a drug dependent the means to indulge in addiction. It is a form of behaviour where an agent, in this case the bank, encourages another agent, the poor borrower, to perform an action not in keeping with good behaviour, such as not repaying a loan. By making it possible for poor borrowers to get loans, poor borrowers are encouraged to keep a non-viable business alive. Examples are Federal Reserve and International Monetary Fund (IMF) bail-outs of hedge fund Long-Term Capital Management and countries in financial crises, which critics like Tucker (1998) note are measures that encourage excessive risk-taking, profligacy, poor governance, and downright fiscal irresponsibility on the part of governments. Several other causes of financial crises are corruption, poor governance in emerging economies, poorly structured financial systems, and managerial incompetence and greed that existed in the countries affected by the Asian financial crisis (Stiglitz 1075-1086; Radelet and Sachs 1-74; Athukorala et al. 168-194; Eichengreen 185-192). Financial Liberalisation and Efficiency The viewpoint that liberalisation leads to the removal of market efficiencies can be traced to Smith who in his classic book Wealth of Nations (Bartleby 2001) called for the virtue of free markets that suffered minimal government intervention and where prices and quantities of goods bought and sold are determined by market forces of supply and demand. Liberalisation therefore works towards minimising forms of government intervention. There are a thousand and one ways for governments to intervene in markets. Amongst forms of intervention in several Asian countries that were proven to be direct or indirect causes of the financial crisis in 1997-1998 are exchange rates pegged at artificially high rates, high interest rates caused by large government budget deficits that made it difficult for banks to lend to companies who needed them to fund projects, and artificially high tariffs and tax rates that discouraged foreign investments and protected local companies from foreign competition. The objective of liberalisation is to remove or minimise these forms of government intervention that lead to inefficiency, and in the late 1980s to early 1990s, the Asian countries began liberalising their financial markets by drafting laws and regulations that were implemented in record time. As a result, foreign funds flowed into these countries and created an economic boom that by 1993 was called the Asian Miracle, turning almost all the emerging countries in Southeast Asia into roaring tigers and tiger cubs. In early 1997, the euphoria continued as record amounts of funds flowed in, encouraged by low interest rates, artificially favourable exchange rates, and lower tariff rates and barriers to entry. Unfortunately, the boom in these Asian countries encouraged huge volumes of imports and discouraged exports due to the artificial exchange rate, which governments continued to defend through currency market intervention, buying foreign currencies and selling government foreign exchange reserves when needed. If done for a short time, this would not have been a problem, but prolonged over a long period, it was a recipe for disaster. Governments, by wanting to keep exchange rates low to avoid inflation because their economies relied on imported goods such as petroleum, machineries, and raw materials, set the stage for the crisis. Foreign funds continued flowing in and found their way as hot money, speculative investments in the stock markets, the local currency, and property projects. Most of the foreign currency funds were channelled into short-term local currency lending by banks to local companies with long-term property or manufacturing projects (Willet et al. 25-44). Liberalisation and Crisis: South Korea and Malaysia Experience Five countries suffered from the Asian financial crisis: Thailand, South Korea, Malaysia, the Philippines, and Indonesia. We focus this part of the discussion on South Korea, one of the hardest hit, and Malaysia which, like the Philippines, was the least hit. South Korea Events in 1996 led South Korea to the crisis when exports fell significantly and, with it, foreign exchange earnings. The government's current account deficit increased, leading to a massive build-up of short-term debt as both governments and large private companies experienced lower cash flows. The collapse of chaebols Hanbo and Sammi Steel in early 1997 created a perception of possible bankruptcies. The stock market crashed, loan defaults increased, and Korean banks suffered a liquidity crisis as foreign funders refused to roll-over their short-term loans whilst corporate borrowers that lost money were unable to pay their loans. Depositors panicked, and a bad situation became worse as they tried to withdraw their deposits (Choe and Lee 384-508). Liberalisation made it easy for foreign investors to bring in their funds and for Korean banks to source funds from other countries. Investors wanted to take advantage of the economic boom and lent to banks at very attractive rates. Banks were in turn encouraged to lend at low rates to dispose of these funds, thus encouraging companies to borrow for various reasons, hoping to pay the loans from their earnings. When earnings dropped, they had problems paying off their loans. The events in Korea combined information asymmetries, adverse selection, and moral hazard. Poorly performing companies borrowed at low rates because they wrongly assumed they could sustain operations long enough thru loans. Financial liberalisation gave Korea a floating currency before the crisis, so foreign lenders assumed (wrongly, it turned out) that the government would defend the currency to keep Korean banks and exports competitive and avoid inflation. Whilst the government did no such thing, abiding by their commitment to liberalisation, foreign markets pulled out their funds, the government raised interest rates to slow down the funds outflow, and several borrowers defaulted on their loans. It took South Korea two years to get out of the crisis, emerging stronger and more competitive (Burnside et al. 45-60; Borensztein and Lee 5-12). Malaysia Malaysia's case was different. Although investors were concerned about the overheating economy and deficits caused by the increased volume of public sector investments and infrastructure projects in 1995, these worries disappeared in 1996. This led foreign investors to consider Malaysia as an attractive investment opportunity. Liberalised financial markets allowed short-term capital to flow in, increasing bank lending and driving asset and property prices upwards, creating bubbles that could not be sustained. A slowdown in exports beginning in 1995 worsened matters when the currency crisis in Thailand began to spread throughout the region and affected the Malaysian currency (ringgit). Malaysia reacted by raising interest rates and using fiscal policy to bring down its budget deficit. It allowed interest rates to fall by tightening money supply and fiscal discipline. In September 1998, Malaysia imposed wide-ranging capital controls, pegging the ringgit to the dollar and using an exit levy to discourage speculative outflows (Boorman et al. 7-12). Discipline and going against the grain saved Malaysia and allowed its speedy recovery. Lessons from the Crisis: A Crisis of Confidence Knowing the main causes of the financial crises is the key to learning the lessons. Several studies cited identify two main causes: structural weaknesses and liquidity problems. The first concerns poor and inexperienced regulatory and market structures (such as bank supervision) in the affected countries that led to credit rationing and poorly managed government intervention. The experience suggests that financial liberalisation cannot go at a faster pace than the development of adequate regulatory and supervisory institutions, and can only build on a strong financial sector and sound government policies, and not the other way. Liberalisation should also follow a careful sequence: foreign direct investments and long-term capital flows should be encouraged first, while volatile and speculative short-term cross-border funds, also known as hot money, should be tightly controlled (Mishkin 720-723). The liquidity problem resulted from asymmetric information and the moral hazard that allowed poor borrowers to secure loans denied to others that suffered having to go bankrupt even if these could afford to stay healthy only if they secured the needed funds. However, we can identify the trigger to be the value of confidence in the banking sector. After all, foreign investors knew that regulatory frameworks were weak in emerging markets. However, as Solomon (15-31) argued, banking is a confidence game sustained by the trust that lenders have on their borrowers and vice versa, and where loss of confidence breaks up the banking relationship. This triggered the Asian crisis as lenders of short-term funds lost confidence and decided to pull out their funds, starting a vicious cycle. This is why India and China continue to escape from a crisis despite showing the same signs as emerging Asian economies did prior to 1997: regulatory frameworks that are lacking in experience and integrity, huge inflows of speculative funds into the economy, asset price bubbles, decreasing exports, and currencies that are kept artificially undervalued. As long as bankers continue to have confidence in the government's ability to maintain economic stability through prudent intervention, and for as long as these countries continue to have huge foreign exchange reserves (China approaching $1 trillion) and growing (India's GDP growth at 9%), then they are safe for now (Fernald et al.; Corsetti et al.). References Athukorala, Premachandra and Hal Hill (2001). "FDI and Host Country Development: The East Asian Experience" in Bijit Bora (Ed), Foreign Direct Investment: Research Issues London: Routledge (2001): 168-194. Baltensperger, Ernst. "Credit Rationing: Issues and Questions". Journal of Money, Credit, and Banking 10.2 (1978): 170-83. Bartleby. Wealth of Nations. The Harvard Classics.1909-14. Book III. Of the natural progress of opulence. Smith, Adam. Wealth of Nations, edited by C. J. Bullock. Vol. X. New York: P.F. Collier & Son, 1909-14, 2001. Basu, Santonu. Financial Liberalisation and Intervention: A New Analysis of Credit Rationing. Cheltenham: Edward Elgar, 2002. Boorman, Jack, Timothy Lane, Marianne Schulze-Ghattas, Ales Bulr, Atish Ghosh, Javier Hamann, Alexandros Mourmouras, and Steven Phillips. "Managing Financial Crisis: The Experience in East Asia". IMF Working Paper, No. 00/107. Washington DC: International Monetary Fund, 2000. Borensztein, Eduardo, and Jong-Wha Lee. "Credit Allocation and Financial Crisis in Korea." International Monetary Fund Working Paper no. 99/20. Washington, D.C.: International Monetary Fund, February 1999. Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo. "Understanding the Korean and Thai Currency Crises," Federal Reserve Bank of Chicago Economic Perspective Third Quarter (2000): 45-60. Choe, Heungsik, and Bong-Soo Lee. "Korean Bank Governance Reform after the Asian Financial Crisis." Pacific Basin Finance Journal 11 (2003): 483-508. Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. "What Caused the Asian Currency and Financial Crisis Part II: The Policy Debate" NBER Working Paper Series, No. 6834. Cambridge, MA: National Bureau of Economic Research, 1998. Eichengreen, Barry. Financial Crises and What to do About Them New York: Oxford University Press, 2002. Fernald, John and Olivier Babson (1999). "Why Has China Survived the Asian Crisis So Well What Risks Remain" International Finance Discussion Papers, No 633. Washington DC: Board of Governors of the Federal Reserve System, 1999. Howell, Peter and Keith Bain. Financial Markets and Institutions (2nd Ed.). London: Prentice Hall, 2002. Mishkin, Frederic S. "Lessons from the Asian Crisis". Journal of International Money and Finance, 18 (1999): 709-723. Radelet, Steven and Jeffrey D. Sachs. "The East Asian Financial Crisis: Diagnosis, Remedies, and Prospects" Brookings Papers on Economic Activity 1 (1998): 1-74. Solomon, Steven. The Confidence Game New York: Simon and Schuster, 1995. Stiglitz, Joseph E. Capital market liberalization, economic growth, and instability. World Development 4 (2000): 1075-1086. Stiglitz, Joseph E. Globalization and its Discontents. London: Allen Lane, 2002. Stiglitz, Joseph E. and Andrei Weiss. "Credit Rationing in Markets with Imperfect Information." American Economic Review 71 (1981): 393-410. Tucker, Jeffrey. "Mr. Moral Hazard." The Free Market, Ludwig von Mises Institute, 16.12 (1998). 12 March 2007 Willett, Thomas, Aida Budiman, Arthur Denzau, Gab-Je Jo, Cesar Ramos, and John Thomas. "The Falsification of Four Popular Hypotheses about the Asian Crisis." The World Economy 27.1 (2004): 25-44. Read More