International Financial Crises and the IMF Research Paper

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International Financial Crises and the IMF

Demand failures are a major economic problem, and one that cannot necessarily be addressed by cutting interest rates as once believed. Small economies, such as those known as the Asian "tigers" are not invulnerable to international speculation. They may, in fact, resist cutting their interest rates -- raising them instead in an effort to keep their currencies from collapse. Failed economies financed poor investments with huge debt, and when the markets turned on their currencies -- causing them to plummet -- the foreign debt value grew astronomically causing an enormous number of companies to fail. The International Money Fund quickly identified the source of the crises as deeply structural and requiring fundamental financial reforms. Some pundits argue that the IMF should have focused more on the panic and less on reforms. Indeed, the variable performance of Korea (which rolled over debt) and Malaysia (which imposed capital controls) after the crisis suggest that the IMF standards overreached and contributed to the panic.

1 Introduction

The intention of international borrowing and lending is the creation of important fiscal gains to the countries engaged in lending and investing, and to the countries that are engaged in borrowing. Lenders and investors stand to gain portfolio diversification from these international financial activities and intertemporal trade is a benefit to the borrowers. Despite these well-intentioned objectives, international lending and borrowing does not always progress in an ordered and benevolent fashion, such that financial crises are known to occur again and again. Intertemporal trade refers to the manner in which current financial decisions impact the availability of financial options in the future.

2 International capital flows

The primary benefit to increasing international capital flows is that improvements to the international allocation of investment and savings can result, and this promotes long-term income growth for participating countries. The flip side is that macroeconomic management becomes harder to accomplish, as is evident in a number of emerging economies. The mechanism is predominantly a speeded up transmission of international shocks. There is an underlying increased risk of overheating and "credit and asset price boom-and-bust cycles and abrupt reversals in capital inflows" ().

3 The International Monetary Fund

With a membership extending to 188 countries, the International Monetary Fund (IMF) is well positioned to promote monetary cooperation across the globe in order to attain several lofty goals: "secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world" ("International Monetary Fund," 2012).

The Bretton Woods system of fixed exchange rates was considered to be overvalued, and with the pressure of the costs of the Vietnam War -- on top of the expenses of Lyndon Baines Johnson's Great Society programs, the system was dissolved ("International Monetary Fund," 2012). Since 1973, IMF members have been able to float their currencies freely against another currency or some basket of currencies, participate in a currency block, form a monetary union, and even adopt another country's currency -- the only stipulation was that currencies could not be pegged to gold ("International Monetary Fund," 2012).

3.1. International Lending and borrowing between industrialized countries

By and large, outflow controls have not been shown to be robustly effective, with the possible exception of the 1998 situation in Malaysia (Magud, et al., 2011). Where outflow controls have been effective, the economies have been more advanced -- and it has been suggested that the strength of the interventions are largely due to the overall higher quality of institutions and regulatory policies in those countries.

3.2. International Lending by industrialized countries to developing nations

The main benefits of capital flows from industrialized countries to developing, low-income countries take the form of foreign direct investment (FDI). These benefits take the form of increased rates of employment, growth, and investment. It is generally agreed that in order to safely absorb capital flows other than FDI, developing, low-income countries must first strengthen their markets and financial institutions. Until the specified thresholds are met, those cash flows hold substantial risks.

In fact and in retrospect, those emerging market economies (EMEs) that experienced inflow surges and had cross-border bank flows were hit with bigger output losses. From their examination of the outcomes of 48 EMEs from the beginning to the fiscal crisis onward, the IMF concluded that "de facto measures of openness (primarily bank intermediated flows) were significant predictors of growth declines." Other pre-crisis indicators were the growth of credit and levels of bank leverage. The IMF also found that the EMEs that had instituted greater capital inflow restrictions -- particularly on debt liabilities -- were impacted less during the global fiscal crisis of 2008 (Ostry et al., 2010; Ostry et al., 2011). When the fiscal crises took place, the EMEs that had instituted higher capital inflow restrictions -- on an economy-wide basis in the years running up to the fiscal crisis -- had substantively smaller declines in growth (Ostry et al., 2011).

4. Reasons behind International Financial Crisis

Following the Great Depression in 1930s, a four-decade period of low lending to developing countries ensued (Pugel, 2012). But in the 1970s, lending to emerging economies took off. This change is attributed to four key drivers (Pugel, 2012). When oil prices increased, so did deposits of petrodollars in banks. Responding to the capital spending of industrialized countries with loans to borrowers did not appeal to banks (Pugel, 2012). Since there was considerable resistance in developing countries to foreign investment by multinational corporations, money flowed to developing countries primarily in the form of bank loans (Pugel, 2012). An increasing number of banks piled on the lending practices to developing countries (Pugel, 2012). In 1982, Mexico became the first of many developing nations unable to repay the bank loans they had accepted (Pugel, 2012). Two variables were key to the defaults: interest rates in the U.S. increased markedly so loan service costs escalated, and earning from exports declined in developing countries as the industrialized countries experienced deep recession (Pugel, 2012). The debt crisis ground along until 1989 when debts began to be reduced and converted to bonds, a process brought into effect by the Brady Plan (Pugel, 2012). Nearly a decade and a half passed before the 1980s debt crisis was ended (Pugel, 2012). Toward the early 1990s, investors began to move to market-oriented policies and developing countries presented attractive investment options (Pugel, 2012). Faced with low interest rates in the U.S., investors sought better returns and fund managers were ready with emerging market portfolios (Pugel, 2012). However, the period could be characterized as just smooth sailing. In concert with a weak banking system and a large current account deficit dominated 1994, Mexico again became a fiscal crisis hot spot (Pugel, 2012). The dollar-indexed Mexican debt (tesobonos) spiked, leading to a deep devaluation and depreciation of the Mexican peso (Pugel, 2012). Foreign investors stayed far away from any new purchases of tesobonos (Pugel, 2012). The resultant contagion was called the tequila effect and it spread rapidly to other countries (Pugel, 2012). The IMF and the U.S. government provided rescue package; the contagion abated and the fiscal crisis was brought to a standstill (Pugel, 2012).

Country variations on the fiscal crisis occurred, but overall, the weak regulation of banks by government was pivotal (Pugel, 2012). Large amounts of foreign currency were borrowed and then lent to local borrowers who posed considerable risk (Pugel, 2012). At the same time, export growth in these developing countries fell off, which led to a weakened current account (Pugel, 2012). The pattern of contagion can be seen in the movement of the Thai crisis in 1997 to Indonesia, South Korea, Malaysia, and the Philippines (Pugel, 2012).

4.1. Overlending and Overborrowing: The Asian Crisis of 1997

According to Paul Krugman, the combined purchasing power of the people of Thailand is no greater than that of the citizenry of Massachusetts (Krugman, 2000). In light of that fact, it seems improbable that the "financial avalanche that buried much of Asia" could have been caused by the 1997 devaluation of Thailand's currency (Krugman, 2000). Yet, that is what occurred. Central banks kept interest rates low, investors wanted higher yields and countries like Thailand became known as emerging markets (Krug, 2000). In 1990, the IMF and the World Bank financed more investment in emerging markets than did all the private investors in the aggregate (Krug, 2000). In just seven years, the amount of private flows to emerging markets rose to $256 billion, with a good portion of the funds going to Asia (Krug, 2000).

Thailand strove to maintain a stable exchange rate, which dictated a work-around of the supply-demand dynamic. Thailand had to increase the supply of the baht in order to offset increased demand: baht were sold and foreign currencies (principally the yen or the dollar) were purchased (Krug, 2000). It followed that the initial loan of yen caused the supply of Thai money and the Bank of Thailand's foreign exchange reserves to rise (Krug, 2000). As banks' provided credit, baht deposits increased, and still more…[continue]

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