BY: MARIO VERA, MBA
CONTENTS
INTRODUCTION
THE CHANGING ENVIRONMENT OF THE FINANCIAL SYSTEM
DETERMINANTS AND RECOMMENDATIONS
- Domestic Factors:
- Rapid Capital Market Liberalization
- Deficit Issues
- Currency Issues
- Lack of Transparency and Supervision
- Political Uncertainty
- External Factors
a) Spillover effects
b) Risk Assessment
Market Risk
Credit Risk
Liquidity Risk
Operational Risk
Settlement Risk
c) Capital Outflows and Financial Panic
CONCLUSIONS
REFERENCE LIST
INTRODUCTION
Less than ten years ago, economists would not even imagine that countries considered
the new key players on a globalized economy were going to experience the worst financial
crisis in the postwar era. With their careful fiscal policies and impressive rates of
growth and private savings, these countries were the models to follow for emerging
economies.
However, financial crises, such as the Asian, Russian, and Mexican crises few years ago
are challenging some of the most important paradigms in recent economy. Nowadays,
economists and financial analysts are questioning the real effects of global integration,
the sustainability of the linkages between emerging capital markets and more developed
ones, and the management of risks associated with surges of capital inflows. (Stiglitz
1998 a) In addition, due to the increasing interdependence of global financial
markets, the effects of financial turmoil are now a vital concern to developed countries,
which currently have considerable risk exposure in the countries in turmoil.
It is impossible to reliably predict financial crises. However, history can become a
tool to avoid making the same mistakes again. Financial analyst must take advantage of
past misjudgments in order to minimize the probability of financial turmoil in the future.
For this reason, the purpose of my research has two primary objectives. First, to analyze
the several factors and kinds of weaknesses that contributed to the deterioration of the
financial systems of the countries in turmoil. Secondly, to provide a set of guidelines
that can evade future financial crises of this nature.
THE CHANGING ENVIRONMENT OF THE FINANCIAL SYSTEM
The financial system is the key player in either developing a financial crisis or
avoiding it. Therefore, before analyzing the determinants of financial crises, it is
necessary to examine the recent development of the financial system.
The liberalization of domestic capital markets has been the primary factor steering a
global financial system. Nowadays, firms in most countries can access diverse financial
services across the world. Consequently, the rapid integration of national financial
systems has resulted on diversified investment portfolios with no boundaries.
Investors, motivated by the new opportunities that the global financial system offers,
have been excessively focused on exploiting arbitrage situations around the world.
Investors yield-seeking behavior across national borders has increased
significantly. To illustrate, since 1970, the growth of international portfolio flow has
increased almost 200 times. (IMF Staff. 1998 b, 186)
The banking system has also moved the integration of the financial system. It has
experienced four major events that have altered its traditional approach. First, the
traditional banking institutions have been transformed into new financial services firms,
taking on new business lines. Moreover, deregulatory banking policies in many countries
have encouraged banks to diversify their source of revenues, offering several services
overseas. Second, non-bank financial institutions are competing with banks in many areas;
consequently, the financial service industry is being consolidated into one large segment.
Third, bank disintermediation has allowed corporations to raise funds directly issuing
debt and equity overseas. For instance, companies issuing equity in international markets
have risen six times during the nineties. (IMF Staff. 1998 b, 180-183) Finally,
the fourth event is the technological development improving global networks across
domestic financial markets. Technology has allowed investors to consider regions of the
world formerly ignored.
In conclusion, financial liberalization, modern global reach, and the changing banking
environment has encouraged financial integration. Moreover, some countries were so easily
persuaded by the apparent benefits of global integration that engage in a dangerously fast
financial liberalization risking severely their financial stability.
DETERMINANTS AND RECOMMENDATIONS
Current financial crises have demonstrated that common policies to integrate emerging
financial markets into the global financial system have been partially unsuccessful. These
policies recommended by international organizations such as the IMF have showed initial
good results followed by extreme financial crises. In addition, IMFs emergency plans
have contributed to moral hazard issues within the countries in turmoil (Radelet and Sachs
1998, 70). Therefore, I firmly believe that traditional policies can be detrimental to
achieve sustainable financial progress.
Countries that have not applied a financial integration strategy have a significant
advantage. They can learn from others mistakes to minimize the probabilities and their
exposure to financial crises. In addition, financial investors and multinational
corporations must be aware of their exposure and relative probability of experiencing a
financial crisis. The following factors can be used by financial analyst to forecast
future financial crises.
- Domestic Issues:
Financial crises have discovered the negative effects of financial integration.
Nowadays, it is very hard to separate domestic factors from external factors contributing
to financial crises because of its synergistic interrelations. However, the following
issues are the most directly related with internal aspects a country. Consequently, the
great majority of the following issues are experienced by the countries although financial
investors and multinational corporations are concerned about these issues as well.
- Rapid Capital Market Liberalization
Several East Asian economies experienced a rapid buildup of short-term external
debt into their weak financial systems, made possible because of their good history
attracting foreign credit and aggressive financial liberalization. Consequently, their
financial markets were intrinsically unstable because they relied heavily on short term
borrowing from abroad. (IMF Survey. 1998) On the other hand, countries such as Chile,
which do not rely on short-term foreign investment, have been less affected by financial
crises. (Corbo 1998) Therefore, swift policies toward fully open capital markets can be
unfavorable for emerging economies where the necessary preconditions for a safe financial
liberalization do not exist.
There is no doubt that countries should globally integrate their financial systems.
However, the pace of the integration must be gradual in order to overcome further
financial shocks. In regards of term preference, emerging economies should encourage
long-term capital flows especially foreign direct investment in order to strengthen their
financial systems. Current financial crises have proved that heavy reliance on short-term
debt increases the probability of an external financial shock.
- Deficit Issues
:
Prior to integrate financial systems, emerging countries must restore their budget
deficits. Countries like Brazil, carrying huge budget deficits are more likely to
experience a financial crisis than countries with smaller budget deficits. These countries
will be forced to use incorrectly their monetary policy to ease their budget deficit,
increasing the likelihood of a financial crisis even more.
- Currency Issues:
Korea is a good example of the significance of the currency issue on financial
crises. In 1997, several big Korean companies went under, leaving 5.8 billion in debt.
Consequently, merchant banks, which had borrowed offshore to lend many East Asian
conglomerates began to concern about the strength of Asian companies and the stability of
its currencies. Speculative forces of the market forced overvalued Asian currencies to
float and to reduce its liquid foreign exchange reserves.
Since the Koran currency was nearly pegged to the dollar, the abrupt depreciation was
the first step of their financial crisis. As exchange rates depreciated and the cost of
maintaining foreign debt increased, foreign creditors become more reluctant to extend new
loans or maintain existing investments. Foreign investors, who had not hedged their
investments, purchased foreign exchange derivatives to try to close their positions,
putting even more pressure on exchange rates and spreading financial panic throughout the
region. The issue of financial panic, capital outflows, and spillover effects are
discussed later on the research paper. (Radelet and Sachs 1998, 23 25)
In conclusion, because of the dependence on foreign capital, several countries
now in turmoil had to use inflexible and in some cases, pegged exchange rates
in order to attract foreign capital. The extended use of pegged exchange rates at
unsustainable levels built negative pressures that encouraged external borrowing and
lending with excessive exposure to foreign exchange risk.
- Lack of Transparency and Accountability
The excessive confidence in emerging markets based on past performance has been one
of the main factors encouraging a lack of transparency and accountability within the
countries in turmoil. After the crises, financial investors and multinational corporations
recognize the need for reliable, comparable, and understandable information disclosed by
the private and public sector. (IMF Working Group. 1998 a)
Nowadays, international organizations such as the IMF are demanding to needing
countries more transparency and accountability in order to meet their emergency loan
requirements. (IMF Working Group. 1998 c) Hopefully, these requirements will
encourage governments to improve their transparency and accountability. Likewise,
financial investors and multinational corporations must enforce better accounting
procedures in order to improve their exposure on emerging markets lacking transparency
- Political Uncertainty
Highly unstable political environment means higher risk, reducing the investors
confidence in the country. Consequently, risk-averse investors will cancel their
investments in emerging markets creating a downward pressure on currencies and stock
markets. For instance, in 1997, Ecuador experienced severe political problems ending up
with a government overthrown. Nearly two years has passed and this country can still not
recover the investors confidence. In the case of financial investors and
multinational corporations, they must be aware of the political environment regardless of
earlier economic performance.
- External Issues
As I stated earlier in the research paper, separating internal from external issues
regarding financial crises is very difficult in a globally integrated financial market.
Some of these issues can be considered either internal or external issues, depending on
the point of view of the party involved with the issue. Anyway, the following issues are
determinants somehow related with the external environment of financial crises.
- Spillover effects
Contagion or spillover effects from a country experiencing a financial crises to
other countries have been very common in the last financial crises in Asia and Latin
America (Tequila Effect). To illustrate, when a country experiences sudden depreciation,
countries that trade with that country or are direct competitors in other markets will
suffer from a price disadvantage and will put depreciating pressure on its currency.
Another type of contagion effect occurs when investors reassess their view and risk
perspective of the specific country in turmoil, causing a sudden capital outflow that will
lead to financial panic among other investors. Capital outflows and financial panic will
be discussed later on the research paper.
The last type of contagion effect involves the financial linkages between countries.
The best example of this effect could be the links between the financial crises of Korea,
Brazil, and Russia. Korean banks bought significant amounts of high-yielding Brazilian and
Russian government debt. When Korean banks experienced severe liquidity problems, they
began to sell off desperately their Brazilian and Russian financial assets, decreasing
their price. Consequently, Korean problems worsen the already adverse economic conditions
of Brazil and Russia.
- Risk Assessment
The issue of risk assessment is relatively experienced only by financial investors and
multinational corporations. For this reason, based on past events, they must be aware of
the following types of risks that they will experience in case of financial turmoil.
- Market Risk
:
Market risk involves the risk of movement in prices. In the case of the recent
financial crises, foreign and domestic investors have been unable to measure precisely the
emerging market risks. The value-at-risk (VAR) methodology, an adjustment of portfolio
theory, was used to measure statistically the probability of losses. Nevertheless, the
Asian crises proved many investors that these models were not efficient because they did
not consider the correlation between market risk and credit risk. (IMF Staff. 1998 b,
193)
- Credit Risk:
Credit risk refers to the potential nonpayment of one party to another. In addition
to the previous issue regarding credit risk and market risk, the greatest problem for
credit risk has been the lack of reliable data in emerging economies. Default statistics
are required to analyze credit risk; consequently, unreported default loans affect the
effectiveness and reliability of credit risk assessment. In fact, default loans reports in
emerging markets have been traditionally unreliable and deceitful.
- Liquidity Risk
:
Liquidity risk means the risk that the holder of a financial instrument may not be able
to sell or transfer that instrument and at a reasonable price. The VAR model cannot
measure precisely liquidity risk too because of the instability and unreliability of
emerging exchange markets.
- Operational Risk
:
Operational risk involves the risk of improper operation of trade processing or
management systems that will result in financial loss. Recent reports by the Basle
Committee on Banking Supervision and the International Organization of Securities
Commissions (IOSCO) have stressed the significance of operational control. In fact, both
agencies have implied that a lack of an adequate control environment has been the main
cause of the financial loss of companies, such as: Barrings, Daiwa, Kidder, Peabody, and
NatWest. Moreover, the IOSCO has recommended the following policies to reduce operational
risk: "through proper management procedures including adequate books and record and
basic internal accounting controls, a strong internal audit function which is independent
of the trading and revenues side of the business, clear limits on personnel, and risk
management and control policies." (IMF Staff. 1998 b, 195)
- Settlement Risk
:
Settlement risk is the risk of nonpayment through a settlement system. Considering the
rapid integration of emerging countries in the global financial market, foreign exchange
settlement systems have been a big concern. In order to minimize settlement risk, in 1996,
17 large banks agreed to set up a new clearing bank (CLS) that will reduce significantly
settlement risk by continuously linking two parts of the transaction.
- Capital Outflows and Financial Panic
In an emerging market financial crisis, en economy that has been the recipient of large
amounts of short-term capital inflows can stop receiving such inflow, facing sudden
demands for the repayment of outstanding loans. Consequently, countries may default their
short-term obligations, rescheduling their debt payments.
The following countries have experienced dramatic reversals of capital flows: Mexico,
Turkey, and Venezuela in 1994; Argentina in 1995; East Asian countries in 1997; and
finally Russia and Brazil in 1998. These countries experienced similar events throughout
their financial crises. They experienced unanticipated shifts in financial flows, which
created a strong economic contraction as well as losses to equity investors. Many
financial analysts argued that abrupt changes in international market conditions,
affecting the country to repay outstanding loans, have been the primary reason for capital
outflows and financial panic.
The role of the government to cease the financial panic is essential. For instance, the
Thais government reaction to the financial panic can be considered "too little
too late". Thais obstructive perseverance on defending their pegged currency
led to a massive loss of reserves. When they decided to float their currency, they had
already spent considerable foreign exchange reserves in defense of their currency and had
committed large amounts of foreign exchange to forward purchases of their currency.
(Radelet and Sachs 1998, 26 29) In conclusion, I firmly believe that the financial
panic and capital outflows could have been in part avoided with a prompt and precise
government intervention.
CONCLUSIONS
Most of the issues examined in the research show that economic and financial
mismanagement is one of the most important factors for financial crises. Uncontrollable
financial liberalization teamed with fictitious exchange rates has made the allocation of
investment funds within the countries in turmoil even worse. In addition, the lack of
supervision and adequate capitalization worsen the whole situation.
Several distinguished economists and financial analysts agree that financial
liberalization without a necessary set of preconditions in place may be extremely risky,
provoking financial crises, especially in emerging economies. (Stiglitz 1998
a) I firmly believe that multinational corporations and financial investor must
identify the following preconditions, which must be in place to ensure a safe financial
integration and sustainable growth, before making big investments in emerging economies.