Over the past few decades, the liberalization of financial systems and globalization of capital markets have improved how financial services are provided and resources are allocated, and have opened up a new pool of financial resources for developing countries. But this has gone hand in hand with increased financial instability in some cases, with swings in asset prices amplifying economic instability and sometimes culminating in banking and exchange market crises. Developed and developing countries alike have borne the costs, but emerging market countries have taken the heaviest hit.
How do these financial cycles begin? Typically, a wave of overoptimism underpinned by favorable developments in the real side of the economy contributes to an underestimation of risk, overextension of credit, excessive asset price inflation, overinvestment by businesses, and a boom in consumer spending. But once expectations realign with fundamentals, imbalances can adjust abruptly, with sentiment swinging from too optimistic to too pessimistic, triggering costly disruptions to both the financial system and the real economy.
Moreover, recent research shows that these cycles can be amplified by the procyclical character of bank credit. The property market plays a key role here because rising real estate prices tend to boost banks’ willingness and ability to lend. With financial markets more globally integrated, large capital inflows can intensify these credit cycles. When a surge in capital flows combines with lax regulation of the financial sector, the resulting credit cycle can end in severe financial crisis.
The Asian crisis of the late 1990s followed this general pattern, observe Collyns and Senhadji, who note that key features of the buildup to the crisis included heady optimism in the mid-1990s that the “east Asian miracle” would be capable of delivering continued rapid economic growth over an extended period; capital account and financial market liberalization that contributed to heavy capital inflows, intermediated largely through the banking system; and high rates of investment and rapid rises in asset prices, especially in the property sector, as poorly regulated banking systems expanded domestic credit at a fast pace. Once the bubble burst, economic growth fell off, asset markets reversed, and both financial and corporate balance sheets began to deteriorate. Eventually, investor sentiment declined sharply, unleashing a cascading series of banking and exchange crises across the region.
What were the differences in experience across the Asian crisis countries? Thailand and, to a lesser extent, Malaysia suffered pronounced property price cycles, while Korea’s property cycle was much more subdued. Other economies—such as Singapore and Hong Kong SAR—experienced fairly dramatic booms and slumps in property prices, yet were able to weather the crisis without major exchange and banking crises. So property price cycles were neither necessary nor sufficient causes of a subsequent exchange and banking crisis.
Following their examination of the links among lending booms, asset price cycles, and financial crises across east Asia, Collyns and Senhadji conclude that the countries’ varying experiences underline the critical importance of strong bank regulation. Certain steps reduce the risk of asset price bubbles and contain the disruptive impact when bubbles burst: strengthening credit assessment, reducing moral hazard, applying a comprehensive approach to bank regulation, and encouraging other nonbank sources of financing for the real estate sector. The Asian experience also shows that sound macroeconomic and related policies help avert bubbles and limit their disruptive impact.
One difficulty, the authors warn, is to judge correctly whether a hike in asset prices is caused by overly optimistic expectations or policy distortions, on the one hand, or genuine structural shifts in demand or gains in long-term productivity, on the other. Reflecting on the potentially huge costs from judgment mistakes, however, they conclude it would be better to err on the side of caution.
Copies of Working Paper 2/20 are available for $10.00 each from IMF Publication Services. See page 72 for ordering information.
Photo credits: Denio Zara, Padraic Hughes, Pedro Marquez, and Michael Spilotro for the IMF, pages 65-70, 74, and 78; Jack Dabaghian for Reuters, pages 65-66; Mohamed El-Dakhakhny for AFP, pages 75-76; Heriberto Rodriguez for Reuters, page 79; and Daniel Aguilar for Reuters, pages 79-80.
The countries’ varying experiences underline the critical importance of strong bank regulation.
—Charles Collyns and