Topic 10: Financial Crises in Emerging Market Economies

Questions and Answers

1. Why would emerging market economies survive a financial crisis, like the 2007–08 crisis,
better than developed economies?

Emerging market economies seem to have weathered the global recession better than
advanced economies, though there is a degree of variation between the resilience shown
by different emerging economies during the financial crisis. It has been noted that better
macroeconomic policies put in place in most emerging market economies have, over the
past decade, reined in inflationary pressures through combined fiscal and monetary
policies. The emerging market economies are less dependent on international finance
and changes in the structure of external debt may have reduced their vulnerability to
volatile capital flows.
Emerging market economies have large foreign exchange reserves and are diversified in
their production and export trends with wider trade and financial networking. Such
economies have experienced higher per capita income levels.

2. Distinguish between how the global financial crisis affected emerging economies and
developed economies. Which economies were more affected and took longer to recover?

The global financial crisis had hit developed economies around the world harder as the
banks in these developed economies were trading with exotic financial instruments,
which were not available in the emerging economies as their financial markets were not
as developed as the western (developed) economies. Therefore, it was more damaging
and took longer to recover for the Western economies compared to the emerging
markets.

3. What is financial globalization? How would it fuel a financial crisis in an emerging market
economy?

One of the ways in which a financial crisis starts developing in an emerging market
economy is through mismanaged financial globalization. This is a process through which
an emerging economy opens up its markets to flows of capital and financial firms from
other nations.
This process allows domestic banks to borrow from financial institutions situated abroad
and banks look to rapidly increase their lending by attracting foreign capital. This lending
boom would end with a lending crash, and add to a financial crisis, if there is an
institutional weakness that prevents the emerging market economy from navigating the
entire process.

4. How would a rise in interest rates play a role in initiating a financial crisis in an emerging
market economy?
 A rise in interest rates can be considered as a precipitating factor for certain emerging
market economies as high-risk firms are most willing to pay such rates. This creates an
adverse selection that worsens an existing financial crisis. The high-interest rates would
also reduce cash flows of businesses in the emerging economy. This would compel the
businesses to look for funds in foreign capital markets that may be facing a greater
financial crisis. Thus, the increase in foreign market interest rates causes domestic rates
to increase and create an adverse selection problem along with moral hazard issues.

5. The currency crisis in Southeast Asia in 1997 did not spread to the developed
economies. Discuss.
The currency crisis in Southeast Asia in 1997 did not spread to the developed economies
as only the Asian currencies were being speculated against and such occurrences
cannot spread to the Western economies as the Western currencies were still trading
very strongly against the Asian currencies. First and foremost, financial markets in the
developed world were much more mature and regulation stricter than Asian countries.
Regulatory changes proposed for Asian economies were designed to make financial and
banking regulation more like that in the developed world. A second set of differences
stems from the fact that mature financial markets that had been through the Great
Depression and the collapse of the Bretton Woods global monetary system were much
more resilient to shocks, due to their depth and sophistication, and their supervisory and
insurance systems. Thirdly, developed world financial systems had proved to be capable
of rebounding from external one-time shocks. The Russian/Long-Term Capital
Management crisis of the fall of 1998 and the September 11, 2011, terrorist attacks are
two cases in point. These events precipitated large temporary declines in asset price,
especially in the United States. But they did not grow into widespread financial market
freezes like the one that occurred in the fall of 2008 after the collapse of investment bank
Lehman Brothers.

6. What is a currency crisis? How do emerging market economies reach a state of currency
crisis? Explain your answer with examples.

A currency crisis, usually accompanied with speculative attacks in the foreign exchange
markets, refer to situations that raise doubts about whether an economy’s central bank
has adequate foreign exchange reserves to meet its fixed exchange rate. The currency
crisis faced by South Korea was a part of the Asian Financial Crisis experienced in most
emerging markets in 1997. During this period, the Asian currency was being traded in the
global currency market and was heavily speculated upon by foreign currency traders. It
was not totally the emerging market’s negligence of monitoring their financial market or
the fact that there was an issue of deregulation of the financial services industry in Asia.
The speculative attack was made on a basket of Asian currencies that were bought in
large quantities by rogue traders and sold off simultaneously to create loss in value
situations, which resulted in these currencies being devalued greatly.

7. How had fiscal imbalances caused one of the emerging market economy’s best-
supervised and strongest banking systems to lose its deposits?

The banking system in Argentina had once been regarded as a well-supervised system
that seemed to be in a good shape before the crisis had begun. However, with the federal
 government being left as the primary unit responsible for raising the revenue, the
provinces had sufficient reasons to spend beyond their means and request the federal
government to uphold their responsibility for the debt. This led Argentina to incur a deficit.

The situation worsened with the 1998 recession—declining tax revenues and an
increasing gap between government expenditures and taxes—causing a severe fiscal
imbalance. This created problems for the government, who had trouble getting domestic
and foreign players to buy sufficient bonds. Eventually investors began to reduce their
reliance on the government of Argentina to repay its debt, causing debt prices to fall
drastically and leaving holes in the banks’ balance sheets.

8. How does currency pegging solve the currency crisis problem and to what extent should
it be used?

A currency peg provides exchange rate stability during a period of great uncertainty.
When a currency peg is in place, traders and investors would be relatively certain of the
foreign exchange value to the pegged currency. Currency pegging also facilitates trade
and foreign direct investment. Additionally, it improves current account surplus and
foreign reserves and allows a country to carry out financial reforms to strengthen the
financial sector without being impacted by external factors. A currency peg however
should be only used to the extent of riding out a crisis period. Prolonged use of a
currency peg may discourage traders and investors from assessing foreign exchange
risk. It also prevents a country from being fully integrated into the global economy. If the
peg is sustained for too long, it may prevent the natural growth of the economy after the
crisis period has passed. Autonomy in monetary policy would also be compromised
because of dependence on the country whose currency it is pegged to.

9. How can emerging market economies avoid the problems of currency mismatch?

Emerging market countries can adopt regulations or impose taxes that restrict
businesses from borrowing in foreign currencies. Prudential regulation and supervision
of banks can limit them from borrowing in foreign currencies. Moving to a flexible
exchange rate system reveals the risk of borrowing in foreign currencies and so less
foreign-currency borrowing may then result. Monetary policy that promotes price stability
will make it more desirable to borrow in domestic currency, making currency mismatch
less likely.

10. What should policy makers in emerging market economies keep in mind to avoid financial
crises while liberalizing financial systems?

In the long run liberalization of an emerging market economy would prove to be very
beneficial. However, without putting in place a proper bank regulatory system,
supervisory structure, and disclosure requirements the constraints on risk-taking and
liberalization will be extremely weak.

It is crucial for policy makers in emerging economies to ensure the implementation of