The Sequence of Events in the Financial Crises of Mexico and East Asia

If an explanation of financial crisis is to be convincing, it must begin at the beginning and go on to the end. But what event should serve as the beginning of the crises in east Asia and Mexico? Macroeconomic fundamentals are not a likely

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candidate. Inflation and budget deficits were low. The record of currency appre- ciation was mixed, and did not seem sufficient to bring on a crisis. Substantial current account deficits were a feature of the economies that were later to expe- rience a crisis and thus may have had some role. The large net capital inflows were also accompanied by lending booms and a deterioration of bank balance sheets. The consensus from many empirical studies, as discussed in the survey by Kaminsky, Lizondo and Reinhart (1997), is that current account measures do not have predictive power for financial crises, while illiquidity and problems in the banking sector do. Therefore, it makes sense to begin with influences on the domestic financial and banking sectors of these countries.

The First Stage: The Run-up to the Currency Crisis In the late 1980s and into the 1990s, Mexico and the countries of east Asia

carried out a financial liberalization, which involved lifting restrictions on both interest rate ceilings and the type of lending allowed. Lending increased dramat- ically, fed by inflows of international capital.

Of course, the problem was not that lending expanded, but rather that it expanded so rapidly that excessive risk-taking occurred. This excessive risk-taking occurred for two reasons. First, banks and other financial institutions lacked the well-trained loan officers, risk-assessment systems, and other management expertise to evaluate and respond to risk appropriately. This problem was made even more severe by the rapid credit growth in a lending boom which stretched the resources of the bank supervisors. They failed to screen and monitor these new loans appropriately. Second, Mexico and the crisis countries in east Asia were notorious for weak financial regulation and supervision. (In contrast, the noncrisis countries in east Asia—Singapore, Hong Kong and Taiwan— had very strong prudential supervision.) When financial liberalization yielded new opportunities to take on risk, these weak regulatory/supervisory systems could not limit the moral hazard created by the government safety net, and excessive risk-taking was one result. Even as government failed in supervising banks, it was effectively offering an implicit safety net that banks would not be allowed to go broke, and thus reassuring depositors and foreign lenders that they did not need to monitor these banks, since there were likely to be government bailouts to protect them.

A dangerous dynamic emerged. Once financial liberalization was adopted, foreign capital flew into banks in these emerging market countries because they paid high yields to attract funds to increase their lending rapidly, and because such investments were viewed as likely to be protected by a government safety net, either from the government of the emerging market country or from international agencies such as the IMF. The capital inflow problem was further stimulated by government policies of keeping exchange rates pegged to the dollar, which prob- ably gave foreign investors a sense of lower risk. Indeed, one lesson that emerges from the financial crises of the last few years is that pegging exchange rates has a hidden cost because it may encourage excessive risk-taking and capital inflows

Frederic S. Mishkin 13

(Mishkin, 1998b). As noted earlier, across Mexico and east Asia capital inflows averaged over 5 percent of GDP in the three years leading up to the crisis. The private capital inflows led to increases in the banking sector, especially in the emerging market countries in the Asian-Pacific region (Folkerts-Landau et al., 1995). The capital inflows fueled a lending boom which led to excessive risk-taking on the part of banks, which in turn led to huge loan losses and a subsequent deterioration of balance sheets in banks and other financial institutions.

This deterioration in bank balance sheets, by itself, might have been sufficient to drive these countries into a financial and economic crisis. As explained earlier, a deterioration in the balance sheets of banking firms can lead them at a minimum to restrict their lending, or can even lead to a full-scale banking crisis which forces many banks into insolvency, thereby nearly removing the ability of the banking sector to make loans. The resulting credit crunch can stagger an economy.

Stock market declines and increases in uncertainty were additional factors precipitating the full-blown crises in Mexico, Thailand and South Korea. (The stock market declines in Malaysia, Indonesia and the Philippines occurred simulta- neously with the onset of the crisis.) The Mexican economy was hit by political shocks in 1994 that created uncertainty, specifically the assassination of Luis Donaldo Colosio, the ruling party’s presidential candidate, and an uprising in the southern state of Chiapas. By the middle of December 1994, stock prices on the Bolsa (stock exchange) had fallen nearly 20 percent from their September 1994 peak. In January 1997, a major Korean chaebol (conglomerate), Hanbo Steel, collapsed; it was the first bankruptcy of a chaebol in a decade. Shortly thereafter, Sammi Steel and Kia Motors also declared bankruptcy. In Thailand, Samprosong Land, a major real estate developer, defaulted on its foreign debt in early February 1997, and financial institutions that had lent heavily in the real estate market began to encounter serious difficulties, requiring over $8 billion of loans from the Thai central bank to prop them up. Finally, in June, the failure of a major Thai finance company, Finance One, imposed substantial losses on both domestic and foreign creditors. These events increased general uncertainty in the financial markets of Thailand and South Korea, and both experienced substantial declines in their securities markets. From peak values in early 1996, Korean stock prices fell by 25 percent and Thai stock prices fell by 50 percent.

The increase in uncertainty and decrease in net worth as a result of the stock market decline increased asymmetric information problems, for the reasons given earlier. It became harder to screen out good from bad borrowers, and the decline in net worth decreased the value of firms’ collateral and increased their incentives to make risky investments because there is less equity to lose if the investments are unsuccessful. The increase in uncertainty and stock market declines that occurred before the crisis, along with the deterioration in banks’ balance sheets, worsened adverse selection and moral hazard problems and made the economies ripe for a serious financial crisis.

In industrialized countries, when a financial crises occurs and the financial

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system threatens to seize up, domestic central banks can address matters with expansionary monetary policy to make credit more broadly available and with a lender of last resort operation to limit the degree of instability in the banking system.3 However, in emerging markets, where the credibility of the central bank as an inflation-fighter may be in doubt and debt contracts are typically short-term and in foreign currencies, the combination of expansionary monetary policy and lender of last resort becomes a double-edged sword—as likely to exacerbate the financial crisis as to alleviate it.

In emerging economies, since the central bank rarely has much of an inflation- fighting reputation, using expansionary monetary policy is likely to cause expected inflation to rise dramatically, thus pushing nominal interest rates up and causing the domestic currency to depreciate sharply. In turn, this leads to a double- whammy in which interest payments on foreign debt are higher both because of the higher short-term nominal interest rates and because of the currency deprecia- tion—all of which leads to a further deterioration in firms’ and banks’ balance sheets. Thus, in an emerging economy, expansionary monetary policy may amplify the adverse selection and moral hazard problems in financial markets caused by a financial crisis.

For similar reasons, a central bank in an emerging market economy which attempts to serve the lender of last resort function may not be as successful. When the U.S. Federal Reserve has engaged in a lender of last resort operation, as it did during the 1987 stock market crash, there was almost no sentiment in the markets that the action would lead to substantially higher inflation. However, for a central bank with less inflation-fighting credibility, central bank lending to the financial system in the wake of a financial crisis— even under the rhetoric of lender of last resort—may well arouse fears of inflation spiraling out of control, with the atten- dant effects of higher nominal interest rates, currency depreciation, and still greater deterioration of balance sheets.

The known weakness of the central bank in responding to a financial crisis creates vulnerability for a currency crisis. A weak banking system makes it less likely that the central bank will take the steps to defend a domestic currency, which means that expected profits from selling the currency have now risen. For example, the central bank in a country with a weakened banking system will fear raising interest rates, because any rise in interest rates to keep the domestic currency from depreciating has the additional effect of weakening the banking system, as ex- plained earlier. Thus, when a speculative attack on the currency occurs in an emerging market country (in which speculators sell large amounts of the domestic currency for foreign currency), if the central bank raises interest rates sufficiently to defend the currency, the banking system may collapse. There is also the fear that

3 See Mishkin (1991) for a discussion of how expansionary monetary policy and a lender of last resort operation in industrialized countries can work to keep asymmetric information problems from getting out of control, thereby promoting economic recovery.

Global Financial Instability: Framework, Events, Issues 15

the cost of bailing out the insolvent banking sector could produce substantial fiscal deficits that will lead to future currency depreciation (Burnside, Eichenbaum and Rebelo, 1998).

The weakened state of the banking sector, along with the high degree of illiquidity in Mexico and east Asian countries before the crisis, then set the stage for the currency crisis. With these vulnerabilities, speculative attacks on the currency could have been triggered by a variety of factors. In the Mexican case, the attacks came in the wake of political instability in 1994 such as the assassination of political candidates and an uprising in the state of Chiapas. Even though the Mexican central bank intervened in the foreign exchange market and raised interest rates sharply, it was unable to stem the attack and was forced to devalue the peso on December 20, 1994. In Thailand, the attacks followed unsuccessful attempts of the government to shore up the financial system, culminating in the failure of Finance One. Eventually, the inability of the central bank to defend the currency, because the required measures would do too much harm to the weakened financial sector, meant that the attacks could not be resisted. The outcome was therefore a collapse of the Thai baht in early July 1997. Subsequent speculative attacks on other Asian currencies led to devaluations and floats of the Philippine peso and Malaysian ringgit in mid-July, the Indonesian rupiah in mid-August and the Korean won in October. By early 1998, the currencies of Thailand, the Philippines, Malaysia and Korea had fallen by over 30 percent, with the Indonesian rupiah falling by over 75 percent.

The Second Stage: From Currency Crisis to Financial Crisis Two particular features of the typical debt contracts in Mexico and east Asia

helped turn the currency crisis into a full-fledged financial crisis: the short duration of debt contracts and their denomination in foreign currencies. These features of debt contracts generated three mechanisms through which the currency crises increased asymmetric information problems in credit markets, thereby causing a financial crisis to occur.

The first mechanism involved the direct effect of currency devaluation on the balance sheets of firms. As discussed earlier, the devaluations in Mexico and east Asia increased the debt burden of domestic firms which were denominated in foreign currencies. This mechanism was particularly strong in Indonesia, the worst hit of all the crisis countries, which saw the value of its currency decline by over 75 percent, thus increasing the rupiah value of foreign-denominated debts by a factor of four. Even a healthy firm is likely to be driven into insolvency by such a shock if it had a significant amount of foreign-denominated debt.

A second mechanism linking the financial crisis and the currency crisis arose because the devaluation of the domestic currency led to further deterioration in the balance sheets of the banking sector, provoking a large-scale banking crisis. In Mexico and the east Asian countries, banks had many liabilities denominated in foreign currency which increased sharply in value when a depreciation occurred.

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On the other hand, the problems of firms and households meant that they were unable to pay off their debts, also resulting in loan losses on the assets side of the banks’ balance sheets. Thus, bank balance sheets were squeezed from both the assets and liabilities sides. Moreover, many of the banks’ foreign currency denom- inated debt was very short term, so that the sharp increase in the value of this debt led to liquidity problems for the banks because this debt needed to be paid back quickly. The result of the further deterioration in bank balance sheets and their weakened capital base is that they cut back lending. In the case of Indonesia, these forces were severe enough to cause a banking panic in which numerous banks were forced out of business.

The third mechanism linking currency crises with financial crises in emerging market countries is that the devaluation can lead to higher inflation. The central bank in an emerging market country may have little credibility as an inflation fighter. Thus, a sharp depreciation of the currency after a speculative attack that leads to immediate upward pressure on import prices, which can lead to a dramatic rise in both actual and expected inflation. This happened in Mexico and Indonesia, where inflation surged to over a 50 percent annual rate after the currency crisis. (Thailand, Malaysia and South Korea avoided a large rise in inflation, which partially explains their better performance relative to Indonesia.) The rise in expected inflation after the currency crises in Mexico and Indonesia led to a sharp rise in nominal interest rates which, given the short duration of debt, led to huge increases in interest payments by firms. The outcome was a weakening of firms’ cash flow positions and further weakening their balance sheets, which then in- creased adverse selection and moral hazard problems in the credit market.

All three of these mechanisms indicate that the currency crisis caused a sharp deterioration in both financial and nonfinancial firm balance sheets in the crisis countries, which then translated to a contraction in lending and a severe economic downturn. Financial markets were then no longer able to channel funds to those with productive investment opportunities, which led to devastating effects on the economies of these countries.

Policy Issues

Promoting safety and soundness of the financial system is crucial to preventing future financial instability. When a financial crisis does occur, the financial system needs to be restarted so that it can resume its job of channeling funds to those with productive investment opportunities. But what policy measures might governments adopt either to limit the risk of future financial crises or to cope with them after they arise? At the international level, there is the question of how an international institution might help cope with these crises, and prevent them from spreading. At the domestic level, a government might reform the regulation and supervision of its banking system to reduce the risk of lending that disregards prudent risks.

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