Research Paper: International Financial Crises

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[. . .] In the beginning, the Bank of Thailand tried to curb the capital inflows by buying back the baht they sold in foreign exchange markets by issuing bonds (Krug, 2000). The problem was that this activity drove the local interest rates up, pushing borrowers to continue to seek funds in the more attractive overseas markets (Krug, 2000). Credit kept growing, and the Thai considered this situation beneficial at the time since it kept their imports competitive (Krug, 2000). But the Thai could not control the actions of other Asian nations, and trade slowed anyway since with the devaluation of the Chinese in 1994 (Krug, 2000). But in the years prior to 1994, Thai affluence brought up wages causing imports to surge and an enormous trade deficit to be generated (Krug, 2000). In classic economic theory, the Asian markets were working -- the trade deficit was a demonstration of the net capital inflows and was the result of decisions in the private sector. One of the critical variables was that the Asian markets were crippled by deep and dysfunctional cronyism (Krug, 2000). The market began to grow increasingly soft, the vortex changed direction -- it was like crossing the equator and watching water begin flowing down a drain in the opposite direction. Despite the failure of the more questionable investments, the Thai market still sought foreign goods. Dollars and yen were exchanged for baht until the supplies of baht grew substantively thin. With the first markings of a recession showing, there was no incentive for the Bank of Thailand to reduce the supply of baht in circulation or see an increase in interest rates (Krug, 2000). But a falling baht did create motivation to sell baht for dollars and yen by foreign investors, local businessmen, and international hedge funds (Krug, 2000). So, the inevitable currency crisis occurred as the central bank tried to keep the baht from a free fall by buying baht with the rapidly diminishing supply of foreign currency. The cyclic pattern of financial crisis entails these basic steps: Financial difficulties for banks, companies, and households; loss of confidence in the banking system and financial services; and a plunging currency, rising interest rates, and a worsening economy (Krug, 2000).

4.2. Exogenous Shocks

In October 1973, when the price of oil increased, the floating exchange rates permitted economies to adjust to the change ("International Monetary Fund," 2012). Countries have continued to be able to adjust to the external shocks in this way ("International Monetary Fund," 2012). The oil price shocks prompted the IMF to change its lending instruments ("International Monetary Fund," 2012). Two oil facilities were established to help oil importers deal with inflation and current account deficits generated by expensive oil ("International Monetary Fund," 2012).

4.3. Exchange Rate Risk

4.4. Large Increases in Short-Term Debt to Foreigners

4.5. Contagion

The cyclic pattern of financial crisis entails these basic steps: Financial difficulties for banks, companies, and households; loss of confidence in the banking system and financial services; and a plunging currency, rising interest rates, and a worsening economy (Krug, 2000). While economists largely appreciate and understand the realities of the vicious circle of a financial crisis, according to Krugman (2000, p. 95), "nobody realized how explosive the circular logic of crisis could be."

5. Resolving the Crisis

The International Monetary Fund recommends policies designed to liberalize capital flows and manage outflows (Brockmeijer, et al., 2011). The past decade has informed economists about the issues, but gray areas remain (Brockmeijer, et al., 2011). The IMF suggests that certain principles and dynamics are clear, however, and those are consist with the recommendations that are summarized here (Brockmeijer, et al., 2011). Liberalization of capital flows should differ across countries depending on their circumstances, particularly with regard to achievement of relevant financial development thresholds (Brockmeijer, et al., 2011). The increased risk associated with capital flows has been made salient by the financial crisis, and this awareness drives the need for better international cooperation and stronger fiscal policies (Brockmeijer, et al., 2011). There may be a need for capital flow management measures (CFMs) to be reimposed for a period when conditions suggest that the overall liberalization of capital flows will not be compromised (Brockmeijer, et al., 2011). Moreover, liberalization in India and China should occur according to a comprehensive and sequenced plan as there is potential for substantive multilateral and domestic effects (Brockmeijer, et al., 2011). The recommendations specify that further liberalization is likely to be beneficial, particularly if financial sector reforms can progress more quickly (Brockmeijer, et al., 2011). Finally, there is recognition that the usefulness of renewed CFMs is strongest when conditions are near crisis or in crisis (Brockmeijer, et al., 2011). It is important to hold to the use of CFMs as adjunct to policy adjustments that are more fundamental in nature (Brockmeijer, et al., 2011).

5.1. Rescue Package

Several decades ago, even advanced countries experienced double-digit inflation and foreign exchange control resulted in extensive economic distortions and corruption ("Global Development Finance," 2009). The establishment of currency convertibility and supports for price stability were steps in the right direction ("Global Development Finance," 2009). But further steps needed to be taken to permit zero inflation and capital controls ("Global Development Finance," 2009). Otherwise, people's fears of economic collapse would easily crate the downward spiral of a self-fulfilling prophecy ("Global Development Finance," 2009). Deposit-taking institutions must experience prudential regulation such that their conduct is supervised and requirements are established that limit the risk-taking behavior of the institutions ("Global Development Finance," 2009). Naturally, the objective of prudential regulation is the overall stability of financial systems and the protection of depositors' funds ("Global Development Finance," 2009).

5.2. Debt Restructuring

The purpose of debt restructuring, which is commonly understood to include both debt reduction and debt rescheduling, is to enable the stream of payments for the debt service to be more manageable than it previously was. The tendency of lenders is to demand full repayment of their own loans to borrowers while delaying payment to their own creditors, in the hope that other creditors will initiate restructuring in the interim -- this situation is termed the free rider issue. In the 1980s debt crisis, The Brady Plan addressed free rider difficulties, and in the 1990s, debt owned to foreign banks was restructured with relative ease. A contemporary problem with debt restructuring occurs with bonds since bondholders can legally obstruct or resist restructuring.

6. Conclusions

In 1930, John Maynard Keyes wrote "we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand" (Krug, 2000, p. 167). The relevance of Keyes' statement to the fiscal crises that have since transpired is indeed high. A problem with economic models is that the thread of economists' thinking is often aimed at attempting to justify models that no longer fit. The beauty of economic analysis is that enables the cobbling together of the old and new to craft models reflect the world in flux. To do otherwise is to "value the appearance of sound economic policy over the reality" (Krug, 2000, p. 167).

References

Brockmeijer, J., Marston, D., and Ostry, J.D. (Eds.) (2011, March 13 ). Liberalizing capital flows and managing outflows. International Monetary Fund.

____. (2012). International Monetary Fund. Retrieved http://www.imf.org/external/about.htm

____. (2011). Getting the Most Out of International Capital Flows (Chapter 6). OECD Economic Outlook, Volume 2011/1.

Krugman, P. (2000). The Return of Depression Economics. New York, NY W.W. Norton & Company, Inc.

Magud, N.E., Reinhart, C.M., and Rogoff, K.S. (2011). Capital Controls: Myth and Reality -- A Portfolio Balance Approach. NBER Working Paper No. 16805 Cambridge, MA: National Bureau of Economic Research.

Pugel, T. (2012). International Economics (15 ed.) Chicago, IL: Irwin.

Ostry, J.D., Ghosh, A.R., Habermeier, K., Chamon, M., Qureshi, M.S., and Dennis B.S. Reinhardt, D.B.S. (2010, February). Capital Inflows: The Role of Controls, IMF Staff Position Note SPN/10/04.

Ostry, J.D., Ghosh, A.R., Habermeier, K., Laeven, L., Chamon, M., Mahvash S. Qureshi, M.S., and… [END OF PREVIEW]

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International Financial Crises.  (2012, September 25).  Retrieved July 18, 2019, from https://www.essaytown.com/subjects/paper/international-financial-crises/9040402

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"International Financial Crises."  Essaytown.com.  September 25, 2012.  Accessed July 18, 2019.
https://www.essaytown.com/subjects/paper/international-financial-crises/9040402.