International Lending and Financial Crises There has been remarkable growth in the gross and net external positions and international capital flows in the last two decades. This represents growth of nearly three times among industrialized or developed countries and has led to large effects on the valuation of asset price and exchange rates have also changed considerably with these countries having larger external assets and liabilities. This increase in international capital flows has led to increased interest in understanding the concepts and forces that drive capital flows and their effects on the economy, especially at macro level. Most of what is known about these international capital flows is within risk-free bond trading only. By presenting an analysis of the empirical reasons for the international financial crisis and the role of the International Monetary Fund using what is known about international capital flows, it is possible to understand why these crises are recurrent.

International capital flows

International trade has its financial implications in international capital flow. In most international trade deals, the net trade balance, which is the difference between the amount paid out in international transactions and that which is received from international transactions is almost always not zero. This creates a current capital account balance from the net financial flow and can be an asset or a liability for the country. When the trade balance represents a surplus, the country has an asset in terms of being able to offset future transactions using this balance. When it represents a deficit, the country has a liability that they can offset using strategies such as currency variations or securities. Snoy (1989)

states that the bulk of international capital flows are for transactions that occur between the industrialized or developed nations, particularly the richest ones.

International capital flows can help a country support their long-term income growth through better allocation of savings and investment. On the other hand, they can also make macroeconomic management difficult for the country as seen in the challenges facing developing countries and other emerging economies. This is because these economies that are less strong have to bear the effects of abrupt capital inflow reversals, faster international transmission of shocks, asset price boom-bust cycles, and increased risk of credit.

The international monetary fund

The international monetary fund (IMF) is an international organization that was formed in 1944 at the Bretton Woods Conference. It had 29 member states at the time of formal initiation in 1945. The purpose of the IMF is to promote global stability of currencies and exchange, to facilitate expansion and growth of international trade and to assist in establishing multilateral payment systems for transactions. To fulfil its purpose, the IMF provides financing and policy advice to its members who contribute funds through a quota system to a pool. The IMF has provided advice and loans to countries in economic crisis in order to aid balance-of-payments. Particularly the IMF was instrumental during the Second World War and the great depression.

International lending and borrowing between industrialized countries

Industrialized countries often exhibit well-behaved international lending and borrowing. This is because they have similar macroeconomic characteristics and are able to increase their wealth considerably. Without international borrowing, these countries would only have as much wealth as its domestic investment opportunities, which would create a negative balance-of-payments. Without international lending, countries whose domestic investment opportunities are limited would only enjoy a limited return on their investment and have low interest rates Cecco, 1974.

Therefore industrialized countries gain through both international lending and borrowing though the benefit to each country is limited to whether they are lending or borrowing.

International lending by industrialized countries to developing nations

There has been increased lending to developing countries over the years. Majorly this is because there were several defaults in the 1930s in international lending and borrowing between industrialized countries. In the 1970s, industrialized countries thus had to look for other investment avenues. Four major events led to increased lending to developing countries. First is that oil-exporters deposited petrodollars in large amounts in banks after oil prices increased. These banks did not see good prospects of lending this money to industrialized countries. At the same time, developing nations resisted direct foreign investment from multinational corporations in industrialized countries. Therefore, increased international capital flows to developing nations were only possible through loans. The last event in the chain was that banks exhibited herd behavior and increased the total amount they lent to developing countries.

However, crises began in the 1980s when several developing nations were unable to repay their loans as a result of increased interest...

During this period, the cost of servicing loans increased considerably and export earnings for industrialized nations also decreased considerably as these countries were facing recession, which in turn reduced quantitative demand for their products Jain, 1986.
Mexico was first to declare their inability to repay the loan. Many organizations and banks that issued loans to these countries also issued conditions to be met that worsened the situation. In the mid-1990s, however, these crises were finally resolved through the Brady Plan and intervention by the IMF that reduced debt and converted them to bonds. At the same time, low interest rates in the United States resulted in lenders seeking better returns in other channels. Therefore, developing countries once again became more attractive investment channels by implementing policies that were more market-oriented.

Reasons behind international financial crisis

Over-lending and over-borrowing: the Asian Crisis of 1997

The Asian financial crisis of 1997 started in Thailand in July 1997 when the Thai baht collapsed after the government was forced to float the baht because the government lacked foreign currency to support its fixed exchange rate. Thailand had also acquired a huge debt burden from other countries that made it bankrupt even before their currency collapsed. The crisis spread to South Korea, Indonesia, which were among the most affected countries. Most other countries in Southeast Asia were also affected. One major cause of the Asian crisis was an economic bubble fueled by huge foreign debt. As the bubble grew in size, more debt was required to finance the country. The crisis was also caused by huge conditions for quick profit placed by lending countries. Southeast Asia governments also had weak regulations for their banks, which led to increased borrowing from other countries. The funds that they borrowed were also lent to risky borrowers locally. These weak regulations distorted normal lender-borrower relationships and led to over-borrowing and over-lending Kathryn M.E. Dominguez, 2009()

Exogenous Shocks

Developing countries are often at risk of exogenous shocks such as export demand, volatile international financial flows, sharp swings in trade, and natural disasters. These shocks often have greater effects in developing countries compared to industrialized countries. They lead to negative effect on demand for exports by developing nations, negative balance-of-payments and governments often have their fiscal position disrupted by these shocks Jun-Koo Kang & Rene M. Stulz, 2000()

Exchange rate risk

Unexpected changes in exchange rates between two currencies create exchange rate risk. During this period, the country receives less in their domestic currency in international trade transactions. Often developing countries are at greater risk of exchange rate losses because their currencies are often weaker than those of industrialized countries are Lone Christiansen, Alessandro Prati, Luca Antonio Ricci, & Thierry Tressel, 2009.

Currency crises as a result of exchange rate risk began in the 1990s and went on to the early 2000s. The Mexican peso crisis, 1997 Asian currencies crisis and 1998 Russian currency crisis, and Argentine peso crises are due to substantial losses attributed to foreign exchange.

Large increases in short-term debt to foreigners

In the 1990s, there was a boom in short-term lending by international banks to other countries. This growth lasted until the Asian Crisis of 1997, which is partly attributed to short-term capital flows caused by large increases in short-term debt. During the period of noteworthy short-term international lending, there was a vicious cycle of taking more short-term debt to finance their existing debt. This created increased short-term liabilities to foreign banks that exceeded the reserves of their local banks. When the situation of decreased international demand occurred, more severe consequences followed since capital flows reversed.

Contagion

Contagion is the only reason for financial crises in which only one country can be affected but in turn can affect other countries. Contagion is majorly caused by herd behavior whereby investors rush to cash in on one opportunity and create supply that exceeds their demand. Investors rushing in on an opportunity where they only have partial information can also feed contagion. This creates problems when creditors are unable to repay their loans. Contagion serves as a "wake-up call" for investors and other countries when the crisis hits the first country since the effects could spread to other countries Geert Bekaert, Campbell R. Harvey, & Angela Ng, 2005.

Currency crises also creates financial contagion since when one currency dips, often other currencies experience vulnerabilities that may cause them to experience a similar dip in value.

Resolving the crisis

Rescue package

Rescue packages issued by the International Monetary Fund (IMF) are the first major international effort for resolving financial crises. These rescue packages…