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Refers to exchange rate crises, banking crises
or some combination of the two.
These are often the variables through which
the contagion effects are spread from one
country to another
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Economic integration = opportunities for
growth and development but also =
Easier for crises to spread from one country
to another
e.g. 1992 currency speculation against British
pound and other European currencies = near
collapse of monetary arrangements in Europe
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A banking crisis occurs when
The banking system becomes unable to
perform its normal lending functions and
some or all of a nation’s banks are threatened
with insolvency. (net worth is negative =
assets are less than liabilities)
If banks cannot pay its creditors (depositors)
because its debtors (businesses, loans) have
gone under or defaulted = Disintermediation
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When depositors lose their money (unless
they have deposit insurance), Consumption
drops, new investments slows down,
economy falls into deep vicious circle of
recession.
Sudden and unexpected collapse in the value of
a nation’s currency.
 May occur in either fixed or flexible regimes
but research shows that countries with fixed
regime are more vulnerable to this type of crisis
 Result is steep recession
e.g. A country borrows large amounts in
international capital markets.
Country’s currency collapses value of debt
increases
Many banks fail capital outflow and no new I
economy goes into deep recession
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Banking system is the channel for
transmitting recessionary effects
Prior to the Asian crisis, banks borrowed
dollars in capital markets.
When home country currency collapsed,
dollar value of debt increased.
Many banks failed. Disintermediation took
place and economies slid into deep recession
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1994, speculation against the Mexican peso
= its collapse and spread of “Tequila effect”
through out South America.
1997 several East Asian economies were
thrown into recession by a wave of sudden
capital outflows
Contagion effect = not a single pattern =
different rules of behavior
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2 Sources
1. Macroeconomic imbalances
2. Volatile flows of financial capital that quickly
move in and out a country (sudden changes
in investor expectations may be the
triggering factor)
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Macroeconomic Imbalances
-Best example is Third World Debt crisis (1980)
-Overly expansionary fiscal policies creating
large government deficits financed by high
growth of money supply
-potential problems of government spending
are compounded by inefficient and unreliable
tax systems
 Tax revenue may be insufficient for
government expenditure
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-Governments resort to selling bonds
to finance expenditures but capital
markets are underdeveloped
-So governments require central
banks to buy the bonds
-Money supply increase
-Inflationary pressure
-currency becomes overvalued
-everyone tries to sell domestic assets
and convert them to foreign
exchange
-Government begins to run out of
international reserves
-pressure on currency to depreciate
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If exchange rates are fixed serious
repercussions on real value of the exchange
rate
Capital flight if people begin to think
exchange rate is overvalued and correction is
likely in future
In addition to large budget deficits and
inflationary pressures is a large and growing
current account deficit.
People try to sell their domestic assets and
acquire foreign ones  run on a country’s
international reserves
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Portfolio managers look at actions of each
other for information about the direction of
the market
Herd mentality
A small trickle of funds can be fueled by
speculations which can lead to a huge capital
flight.
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When this happens, international reserves
disappear, exchange rates tumble and
weakens the financial sector
A weak financial sector intensifies the
problems
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Steps Countries can take to minimize
likelihood of crises and damage they
cause when they happen
-maintain credible and sustainable fiscal
and monetary policies
-engage in active supervision and
regulation of the financial system
-provide timely information about key
economic variables such as central bank
holding of international reserves
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Elements of macro imbalances, volatile
capital flows and financial sector weakness.
Overvalued real exchange rates, current
account deficits because domestic savings
could not support investments
In 1990 – 1993 capital inflows of $91B
made up of private investment, direct
investment and bank loans
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In 1994, interest rate movements led to
large losses for banks and investors
Investors called for reducing level of
exposure to Mexico
Dec. 1994, newly elected president, Zedillo,
announced a 15% devaluation
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Currency speculators had expected a 20 –
30% devaluation Zedillo’s announcement
sent financial markets into turmoil
More capital fled the country
Dollar reserves shrank.
Though 2 days after the announcement,
Mexico said it would move to a flexible
exchange rate, the damage had already
been done
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Both domestic and foreign capital
continue to leave the country
By March 1995, peso had lost more than
50% of its value
NAFTA and IMF helped in the form of line
of credit and loans with conditions of
decreasing G and increasing T
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Began in Thailand in July 1997 and spread to
Malaysia, Philippines, Indonesia and South
Korea
Symptoms of crisis were fairly similar across
countries
-currency speculation and steep
depreciation
-capital flight
-financial and industrial sector
bankruptcies
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Countries had large trade deficits (on average
5.2% of GDP, Thailand had a deficit of 8% of
GDP) the year before the crisis
Large current account deficits = large capital
inflows
Because for last 30 years these countries
averaged 5% growth in GDP and foreign
investors had no reasons to believe
otherwise
Also, Japan and Europe were losing grounds
in growth and investors were looking
elsewhere
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Exchange rates in the region were pegged
to the dollar  dollar appreciating in the
90s meant many exchange rates
appreciating as well.
Exchange rates were harder to sustain
because it became more difficult to export.
CA deficits increased
Financial sector problems because of family
ties
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Investors lost confidence in Thailand to keep
its exchange rate pegged
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People began to suspect devaluation and
refused to hold Thai baht
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Many loans to the Thai financial sector were in
dollars so this raised the cost of devaluation
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Thailand served as a wake-up call to investors
in the region
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Others think the devaluation in Thailand made
exports from other countries less competitive
which led them to devalue as well.
Whatever the case, the Thailand experience had
a contagion effect
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Effect spread to countries as far as Brazil and
Russia
With the exception of Singapore and Taiwan,
every country affected by the crisis experienced
a recession in 1998
Singapore and Taiwan had had large surpluses
so they concentrated on domestic economies
rather than defending their currencies
IMF helped with loans and conditions of interest
rate hikes. Capital controls were implemented
in some countries
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In the 1980s, high interest rates and an
appreciation of the US dollar caused the burden of
dollar denominated debts in Argentina, Mexico,
Brazil and Chile to increase drastically.
A worldwide recession and a fall in many
commodity prices also hurt export sectors in these
countries.
In August 1982, Mexico announced that it could
not repay its debts, mostly to private banks.
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After liberalization in 1991, Russia’s economic laws
were weakly enforced or nonexistent.
◦ There was weak enforcement of banking regulations, tax
laws, property rights, loan contracts, and bankruptcy laws.
◦ Financial markets were not well established.
◦ Corruption and crime became growing problems.
◦ Because of a lack of tax revenue, the government financed
spending by seignoirage.
◦ Interest rates rose on government debt to reflect high
inflation from seignoirage and the risk of default.
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The IMF offered loans of official international
reserves to try to support the fixed exchange rate
conditional on reforms.
But in 1998, Russia devalued the ruble and
defaulted on its debt and froze financial asset
flows.
Without international financial assets for
investment, output fell in 1998 but recovered
thereafter, partially due to the expanding
petroleum industry.
Inflation rose in 1998 and 1999 but fell thereafter.