Liquidity shocks on the international arena can have a strong negative impact on less developed countries whose access to funding sources is already reduced.
The clearing risk is a specific risk, which combines credit risk, in the sense that it results from a counterparty's inability to meet its liabilities, market risk in the sense that it is caused by market shifts (general and specific market risk) between the time a transaction is executed and the time it is cleared, as well as liquidity and systemic risk." (Casanova, 2000). The clearing risk is assumed by clearing houses, which guarantee the proper settlement of transactions done by the members. These institutions engage themselves to bear potential replacement costs if either one of the trade counterparties can't fulfill its obligations. In international markets this risk is increased as the international arena as mentioned before it more dynamic and volatile and the chance of either one of the trade counterparties to lose ability of fulfilling its obligations is increased.
Case study - the Asian crisis in 1997
The economic internal context before the crisis included good market conditions such as:
Private debt and leverage increased, sometimes in foreign currency and in some instances by local banks
The fixed exchange rate system boosted confidence that international borrowings would be sustainable. However, inflation and increasing budget deficits made pegs (fixed exchange rates relative to other currencies) less sustainable than assumed.
The international context before the same crisis was characterized by" general belief that governments would protect domestic banks, which allowed those to operate in the international interbank market specific belief that there would be a safety net for the Asian markets after the Mexican rescue in 1994
The beginning of the collapse in these markets was marked by cyclical weakening, followed by speculations, which led to the collapse of currency pegs and the effect was felt in multiple countries. Some of the consequences included the shrinking of international lending flows and several bank runs.
Figure 1 shows the fall in effective financing after the crisis compared to the announcements of syndicated credit facilities and securities issues. The last type of funding was almost completely abandoned, whereas bank loans were reduced to almost half of the value announced before the crisis.
FIGURE 1 - POST-CRISIS FINANCING in ASIAN MARKETS
Source: Bank of England, Capital DATA, ISMA, Thompson Financial Securities Data
International lending increases access to funds and better financing conditions for participants in international lending markets as the globalization increased competition on these markets. In an international stable context, international lending is a useful tool to finance growth.
International lending, however, bears more risks than domestic lending as international markets can turn out to be more dynamic and volatile that the domestic ones. Moreover, additional risks attached to international operations, such as foreign exchange risk or country risk are not risks that need to be mitigated when financing is done within the country.
International lending has implications on many players in the international arena, not just the exchange parties as international lending conditions may be considerably changed by some players, but they change for all players and those countries that have reduced access to funds that are crucial for their development (e.g. less developed countries) may be faced with disastrous consequences.
Casanova, J - F. 2000 - Role Played by Risk Management and Clearing Systems in the Economy of Future Exchanges and ECNs. UNCTAD, www.unctad.org
Eichengreen, B. 1990a. Trends and Cycles in Foreign Lending. CEPR - Center for Economic Policy Research. Working Paper N"451.
Eichengreen, B. 1990b, Economic Policy - International Lending, Center for Economic Policy Research. Working Paper N"452.
Investopedia, Accessed October 2008, www.investopedia.com
Moreno, R. 2000. What Explains Capital Flows? FRBSF - Federal Reserve Bank of San Francisco - Economic Research and Data, http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-22.html
Yaghmaian, B. 1997. Industrialization and Developing Countries' Indebtedness: A Theoretical and Empirical Analysis. International Review of Applied Economics, vol. 11(1): pp. 49-64.
Loan - the act of giving money, property or other material goods to an another party in exchange for future repayment of the principal amount along with interest or other finance charges. A loan may be for a specific, one-time amount or can be available as open-ended credit up to a specified ceiling amount.
Bond - a debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. And foreign governments to finance a variety of projects and activities.