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. Investor’s 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, IMF’s 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.

1. 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.

1. 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.

2. 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.

3. 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.

4. 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

5. Political Uncertainty

Highly unstable political environment means higher risk, reducing the investor’s 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 investor’s confidence. In the case of financial investors and multinational corporations, they must be aware of the political environment regardless of earlier economic performance.

1. 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.

1. 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.

2. 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.

1. 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)

2. 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.

3. 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.

4. 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)

5. 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.

1. 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 Thai’s government reaction to the financial panic can be considered "too little too late". Thai’s 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.