Essay About High Government Spending And Foreign Money

Financial Crisis: How And Why It Happens
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Financial Crises: How and Why and Lessons
Recent Major Financial Crises
1980s:
Debt crisis for developing countries (Latin America and Africa)
1992:
European Exchange Rate Mechanism (especially UK and Sweden)
1994-95:
Mexico (Tequila crisis) and Argentina
1997-98:
Asian financial crisis (Thailand, Indonesia, Korea, Philippines, Malaysia)
1998:
Russia
1999:
Brazil
2000-02:
Turkey
2001-02:
Argentina (again)
Nature of Financial Crises
Exchange rate crises
Sudden, drastic depreciation of the countrys currency
Banking crises
Depositors lose confidence (disintermediation)
Banks cant perform lending function
Effects
Severe recession, due to:
Collapse of bank loans
Reduction in consumer demand
Higher interest rates
Inflation, due to:
Higher import costs
Causes of Financial Crises:
1. Macroeconomic Imbalances
Where: Russia 1999, Brazil 1999, Turkey 2000, Argentina 2001
Characteristics of imbalances:
Causes of Macroeconomic Imbalances
High government spending (G) due to:
Public subsidies for businesses
Infrastructure spending
Lack of fiscal discipline
Insufficient tax revenues (T) due to:
Poorly developed tax systems
Lack of tax enforcement
Money supply (M) growth too high due to:
Lack of independence of central bank
Political pressure on central bank to accommodate fiscal deficits
Pressure on Exchange Rates
CA deficit and inflation cause pressure in forex markets on currency to depreciate.
Government does not want that due to:
Higher import costs
Loss of prestige
Government tries to keep currency from depreciating too fast:
By raising interest rates domestically
By using foreign reserves to buy its currency back
But this creates problems:
Higher interest rates slow the domestic economy
Loss of foreign reserves
Loss of Confidence
Foreigners stop lending
Speculators think the currency will depreciate further
Domestic owners of financial capital move that capital out of the country (capital flight)
Causes of Financial Crises:
2. Capital Flow Volatility
Where: Mexico 1994, Asia 1997-98
Characteristics of capital flow patterns:
CA deficits
Offsetting inflows of capital to purchase assets
Factories
Real estate
Stocks
Many investments were economically doubtful
Over-reliance on bank financing
Short-term borrowing and lending
Using foreign money
Recent Capital Flow Patterns
Capital Flows for Asian Crisis Countries (US $ billions)
Source: IMF, World Economic Outlook, Database tables, December 2001
Short-term Debt Exposure
Country
S.T. Debt as % of Reserves
Q2 1997
Korea
200%
Indonesia
165%
Thailand
145%
Philippines
Malaysia
Taiwan
Source: The Economist, “Global Finance Survey,” January 30, 1999, p. 11
Effects of Dependence on Foreign Capital
Exposure to interest rate risk outside own control
Currency effects
Bank