FRBSF Economic Letter
2001-07; March 23, 2001
Financial Crises in Emerging Markets
Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Monetary and Economic Studies within the FRBSF's
Economic Research Department.
The causes of the currency crises in emerging markets during the late
1990s have been the subject of much debate—especially considering that,
before the crises, many of the Asian countries involved tended to have
balanced budgets and generally sound macroeconomic performance. Some observers
argue that the generally favorable macroeconomic conditions indicate that
the crises were not caused by incompatibility between fiscal and monetary
policies and exchange rate pegs, but rather by the unexpected and self-fulfilling
panics of foreign investors. Others, in contrast, attribute the crises
to policy mistakes, such as excessive private spending, overvaluation
of real exchange rates, and the buildup of bad loans and bank weaknesses.
This Economic Letter briefly reviews 11 papers that provide analytical
perspectives and new empirical evidence on the causes of these crises
as well as the appropriate policy responses. These papers, prepared for
a conference sponsored by the Federal Reserve Bank of San Francisco's
Center for Pacific Basin Monetary and Economic Studies, have been collected
in Financial Crises in Emerging Markets (edited by R. Glick, R.
Moreno, and M. Spiegel), published in 2001 by Cambridge University Press.
Determinants and propagation of financial
The coincidence of banking and currency problems associated with recent
Asian financial crises has drawn renewed attention to the relationship
between these two phenomena. Reuven Glick (FRBSF) and Michael Hutchison
(U.C. Santa Cruz) examine the link between bank and currency crises in
a broad set of industrial and developing countries between 1975 and 1997.
They find that the "twin crises" phenomenon is primarily concentrated
in emerging-market economies that are financially liberalized. Glick and
Hutchison also find that the occurrence of banking crises provides a good
leading indicator of currency crises in emerging markets. They conjecture
that emerging markets' openness to international capital flows and their
liberalized financial systems combine to make them particularly vulnerable
to twin crises.
Paul Masson (International Monetary Fund) surveys various types of models
that imply the possibility of multiple equilibria in financial markets,
whereby jumps from a "good" equilibrium to a "bad"
equilibrium can be triggered by changes in investor confidence that may
be unrelated to economic fundamentals. These models, he argues, can explain
some of the stylized facts associated with recent events in international
financial markets, including the "excessive" volatility of financial
market prices and the abrupt reversal of capital inflows in emerging markets.
Masson concludes that when arbitrary shifts in market expectations unduly
influence capital flows, countries may be justified in imposing greater
regulation and control of capital flows as well as in slowing capital
Kristin Forbes (Massachusetts Institute of Technology) analyzes the empirical
magnitude of various channels through which shocks to one country can
be transmitted abroad. She uses firm-level information to evaluate the
impact of the East Asian and Russian crises on individual companies' stock
market returns in other countries. This is an innovative departure from
other studies of contagion, which have relied on aggregate macroeconomic
Forbes finds evidence that contagion may spread through a number of channels
simultaneously. or example, she identifies three channels associated with
the Russian crisis: falling demand for foreign firms selling in the crises
countries ("income effect"), increased sales of high-liquidity
corporate stocks in order to meet portfolio rebalancing needs of investors
who suffered losses elsewhere ("liquidity effect"), and the
tendency for investors to re-evaluate firms operating in the same region
("wake-up call effect"). All of these effects, as well as declining
competitiveness for firms exporting similar products ("product competitiveness
effect"), also were significant during the East Asian crises. However,
Forbes finds that the economic magnitudes of these effects vary greatly.
The "wake-up call effect" generally appears to have the largest
Capital flows and reversals
The Asian financial crises have raised questions about the factors underlying
the large surges in capital flows to emerging markets and the reasons
for their abrupt reversals. Joshua Aizenman and Nancy Marion (Dartmouth)
explore the abrupt decrease in the supply of credit to Asian countries
by focusing on uncertainty about the magnitude of these nations' outstanding
foreign debt obligations. They cite the dramatic buildup of foreign debt
in Thailand and South Korea and note that at critical junctures both countries
also announced significant upward revisions in the magnitude of their
They present one theoretical model in which increased uncertainty about
the magnitude of outstanding debt reduces the probability of debt repayment,
which in turn reduces the supply of credit to the debtor country. With
another model, they discuss how increased uncertainty about investment
prospects in Asia may have reduced the expected return on Asian assets,
leading to an escalation of home bias by foreign investors and generating
the observed collapse of foreign investment in the region.
Menzie Chinn and Kenneth Kletzer (U.C. Santa Cruz) highlight the central
role of the banking sector and government bailout guarantees in recent
capital flow reversals. They show that when accumulated foreign borrowing
and other liabilities of the banking system exhaust the maximum available
level of government bailout funds, banks are attacked by creditors, who
remove their assets from the banking system. They cite empirical evidence
in support of their model: the countries that were hit hardest by the
Asian crisis also were the countries that had the greatest rise in foreign
borrowing before the crisis, and loan quality deteriorated before the
crisis in most countries.
A key element of the Chinn and Kletzer model is that financial crises
may result from government guarantees to the private sector that encourage
capital flows to emerging markets. As such guarantees have long been in
place in many emerging markets, Chinn and Kletzer consider what might
have precipitated the occurrence of crises in the 1990s. They suggest
that the culprit may be financial liberalization in the first half of
the 1990s, which lessened restrictions on domestic financial institutions
and opened access to foreign lenders, thus prompting capital to flow into
emerging markets to take advantage of guaranteed ("insured")
Michael Dooley (U.C. Santa Cruz) and Inseok Shin (Korea Development Institute)
argue that financial liberalization in Korea initiated in the late 1980s
was the fundamental factor behind the country's 1997-1998 crisis. In their
view, Korean liberalization reduced the franchise value of the domestic
banking system and exposed already very weak balance sheets to competitive
pressures that promoted risk-seeking, including more short-term lending.
In addition, Dooley and Shin contend that foreign creditors failed to
monitor the individual creditworthiness of Korean banks. This failure
is interpreted as evidence that foreign banks expected to be bailed out
in the event of a crisis. Finally, Dooley and Shin argue that Korean regulatory
authorities failed to manage the risky behavior of commercial banks adequately;
in particular, authorities allowed the foreign branches of Korean banks
to take on uncontrolled levels of foreign debt and to enhance the opportunities
to exploit government insurance.
Institutional factors and financial structure
It is commonly believed that some forms of foreign investment are more
desirable for recipient countries than others. In particular, foreign
direct investments (FDI) are sometimes characterized as "cold"
capital flows, which prove resilient during financial crises, while foreign
portfolio investments are characterized as "hot" capital flows,
ready to turn tail and flee at the first sign of difficulty. While the
empirical foundation for this stylized fact has been questioned, many
still believe that "cold" capital flows should be actively encouraged
by recipient-country governments and that limits on the movements of "hot"
capital flows also may be in order.
Assaf Razin, Efraim Sadka (both at Tel-Aviv University) and Chi-Wa Yuen
(University of Hong Kong) explore why FDI is resilient during crises.
In their model, the foreign operators of a multinational subsidiary have
an inside-information advantage over potential domestic equity buyers;
this advantage acts implicitly as a subsidy to FDI, thus leading to overinvestment.
There is a widespread perception that capital flows to emerging markets
in the 1990s financed excessively risky projects and encouraged greater
corporate exposure to fluctuations in interest rates and exchange rates.
This perception has generated considerable interest in the factors that
influence corporations' exposure to risk. Stijn Claessens, Simeon Djankov,
(both of the World Bank) and Tatiana Nenova (Harvard) find that firms
in countries with civil law (which prevails in countries in continental
Europe and their ex-colonies) and weaker creditor rights display riskier
financing patterns and lower profitability. They also find that firms
operating in more bank-dominated financial systems also display riskier
financing patterns and lower profitability. These results conform to expectations.
Civil law systems tend to provide weaker protection of property rights
than do common law systems (which prevail in Anglo-Saxon countries and
their ex-colonies), lessening the ability of investors to limit risk-taking
by corporations. Finally, banks tend to be dominant in markets with weaker
property rights and poorly developed capital markets, implying riskier
Policy responses to crises
Currency crises in emerging markets typically have been accompanied by
a sharp contraction in output. This presents policymakers with a dilemma.
On the one hand, economic recovery may be imperiled if the currency does
not stabilize. Further depreciation may generate capital losses to foreign
investors, discouraging their return, and cause further bankruptcies in
domestic firms with foreign currency exposure, thus increasing the extent
of economic disruption. These considerations account for the standard
policy prescription calling for a relatively firm monetary policy stance
that raises interest rates in the aftermath of currency crises to stabilize
the exchange rate. On the other hand, the costs of keeping domestic interest
rates high after a currency collapse also may be very large. Raising or
maintaining high interest rates under crisis conditions may so weaken
the economy that it may destabilize the exchange rate, even causing it
to depreciate further, by raising the risk premium or the probability
of default on credit. As either view of the effects of interest rates
on the exchange rate during crisis periods can be supported theoretically,
the disagreement can be resolved only by empirical analysis. Two papers
in the volume addressed this issue.
Robert Dekle, Cheng Hsiao, and Siyan Wang (University of Southern California)
find that, in the short run, the rise in domestic interest rates in countries
experiencing currency crises did appreciate the nominal exchange rate.
However, their estimates imply that such an interest rate defense against
speculative attacks requires extremely high interest rate levels. David
Gould (Institute of International Finance) and Steven Kamin (Federal Reserve
Board), however, find little evidence of any effect (appreciation or depreciation)
of interest rate increases on the exchange rate, even after controlling
for country risk premiums or default risk. While these findings differ
qualitatively from each other, the policy implications of these two papers
are actually quite similar: Policymakers need to exercise great caution
in using an interest rate defense of the exchange rate during a crisis.
Because the effects may be economically insignificant or very small, the
high interest rates needed to restore exchange rate stability are potentially
Capital controls provide an alternative policy response to capital flow
reversals. Proponents argue that curbs on capital outflows, particularly
during crises, could prevent the sudden withdrawal of capital, allowing
policymakers to avoid the uncomfortable choice of raising domestic interest
rates or allowing the currency to depreciate sharply, both of which can
be very costly. The jury is still out on the value and effectiveness of
Hali Edison (Federal Reserve Board) and Carmen Reinhart (University of
Maryland) attempt to shed further light on these questions by comparing
the experiences of Malaysia and Thailand, both of which faced downward
currency pressure from investors in offshore markets taking positions
against the domestic currency as well as from capital flight in the onshore
domestic market. Though each imposed controls on capital outflows, the
authors found that Malaysia's controls were more effective than Thailand's
for two reasons: First, Malaysia's controls were more restrictive than
Thailand's, and second, Thailand imposed its controls as the crisis was
unfolding in May 1997, while Malaysia imposed them much later, in September
1998, just before a regional recovery.
This collection of 11 papers provides a valuable contribution to ongoing
research into understanding the causes and consequences of currency crises
as well as the options available to policymakers.
Vice President and Director
Center for Pacific Basin Monetary and Economic Studies
Glick, R., R. Moreno, and M. Spiegel, eds. 2001. Financial Crises
in Emerging Markets. Cambridge University Press.
Inquiries about ordering the book should be directed to Cambridge University
Press, 40 West 20th Street, New York, NY 10011-4211, or its website, http://www.cup.org.
Opinions expressed in this newsletter do not necessarily reflect
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or of the Board of Governors of the Federal Reserve System. Editorial
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