Abstract

This section seeks to shed light on the association of financial liberalization with financial crises.

This section seeks to shed light on the association of financial liberalization with financial crises.

Channels of Transmission

The recent literature (reviewed in Appendix III) features a profusion of models designed to elucidate the dynamics of currency and banking crises. What is relevant here is how domestic and international financial liberalization, if not supported by consistent and rigorous prudential supervision and regulation and appropriate domestic macroeconomic policies, heightens the risk of crises. Domestic liberalization, by intensifying competition in the financial sector, removes a cushion protecting intermediaries from the consequences of bad loan and management practices. It can allow banks to expand risky activities at rates that far exceed their capacity to manage them. It can allow banks gambling for redemption to pursue risky investment projects and use expensive interbank funding. By granting banks access to complex derivative financial instruments, it can heighten the difficulty of evaluating bank balance sheets and stretch the capacity of regulators to monitor, evaluate, and limit risks.50

External financial liberalization, operating through parallel channels, can have an even more dramatic tendency to amplify the effects of policy distortions and agency problems. By allowing the entry of foreign banks, external liberalization, like its domestic counterpart, can squeeze margins and remove domestic banks’ cushion against loan losses. Like domestic financial liberalization, it can facilitate gambling for redemption, in this case by offering access to elastically supplied offshore funding and by allowing access to risky foreign investments.51 A currency crisis or unexpected devaluation can undermine the solvency of banks and bank customers who have been allowed by external financial liberalization and lax regulation to accumulate large unhedged foreign exposures.52

These are all channels through which asymmetric information and policy distortions can give rise to crises—with special violence and force when the financial system has been liberalized. But two points about these dangers require special emphasis. First, the mechanisms through which internal and external financial liberalization can expose threats to financial stability are largely the same. Both internal and external liberalization squeeze margins and leave less leeway for poor loan and management practices. Both give banks and other intermediaries additional access to risky investments. Both give banks gambling for redemption access to additional sources of expensive funding. There is nothing unique or different about external financial liberalization in this context.

Second, it is not the financial liberalization that is at the root of the problem but rather the inadequacy of prudential supervision and regulation, whose consequences are simply magnified by liberalization. The goal of prudential regulation is to get banks (and other participants in financial markets) to recognize the risks they are taking.53 It is the inadequacy of prudential regulation that allows financial institutions to expand risky activities faster than they are able to manage them. It is the inadequacy of prudential regulation that allows banks and bank customers to accumulate dangerous unhedged exposures. It is the inadequacy of prudential regulation (and the absence of a coherent exit policy) that encourages distressed banks to gamble for redemption.54 It is the inadequacy of prudential regulation that permits banks to neglect to put aside the reserves necessary to cope with events that suddenly interrupt their access to foreign funding, including external events such as a change in the level of world interest rates, for example, or a crisis in a neighboring country. The problems created by gaps in the framework for prudential supervision and regulation are themselves indicative of more fundamental distortions. Financial liberalization in general and international financial liberalization in particular can increase the scope for undertaking these socially counterproductive activities and magnify their costs, but it is the inadequacy of prudential supervision and regulation that permits those activities to be undertaken in the first place.

The Special Problem of Short-Term Debt

Financial problems can result from the mismanagement of virtually any financial transaction. They can be associated with any entry on the asset or liability side of the balance sheet. But recent experience suggests that short-term debt poses special problems for the maintenance of financial stability.

The most serious problems with international capital movements occur when capital suddenly flows out of a country, precipitating a crisis. Although the sudden capital outflows associated with a crisis can in principle affect all forms of capital—debt, portfolio equity, and even direct investment and real estate investment—the macroeconomic consequences are most disruptive when they involve debt, especially debt of the sovereign and of the banking and financial system. Outflows from sovereign debt markets that precipitate a sovereign default disrupt the international financial relations of the entire economy. Default by much of the banking system is also disruptive, given that the banking system is at the center of a country’s payment and financial system. The threat of such disruptions in turn impels the sovereign to jump in and guarantee bank debt, thus raising the risk of sovereign default. Although defaults by individual enterprises on foreign currency debts are not generally a problem (except for the enterprises concerned), large-scale defaults by much of the corporate sector—which tend to be triggered by a large devaluation—can be very disruptive, especially insofar as they threaten the stability of the banking system. In contrast, outflows of equity capital have their most immediate impact on asset prices and only indirect effects on bank balance sheets, the government budget, and the financial position of the corporate sector.55

The risks from short-term debt are best controlled at the source. The sovereign can, and should, control its own borrowing. The financial system should be soundly managed and regulated. Corporate borrowers need to recognize and manage risks appropriately, and a strong system of corporate governance will strengthen the incentives for management to do so. While there may be a case for policies designed to avoid excessive reliance on short-term debt denominated in a foreign currency, at the core of an effective strategy to address this problem should be sound financial management and prudential regulation.

Flexibility in the exchange rate can also discourage excessive reliance on short-term foreign borrowing. Recent experience points to a series of episodes where both lenders and borrowers perceive an exchange rate peg as a link in a chain of implicit guarantees. In these circumstances, the high nominal interest rates characteristic of emerging markets can lead to very large short-term capital inflows.56 The exchange risk associated with greater nominal exchange rate flexibility can play a useful, if limited, role in moderating the volume of these short-term flows. It can encourage banks and firms to hedge their short-term foreign exposures, insulating them from the destabilizing effects of unexpectedly large exchange rate movements. However, greater exchange rate flexibility is no panacea; if introduced without advance planning and in a setting where banks and corporations have heavy debts denominated in foreign currency, its effects can be destabilizing. But if the authorities take advantage of a period of capital inflows to introduce greater flexibility so that the rate begins its more flexible life by strengthening, the beneficial effects are likely to dominate.57

50

The willingness and capacity of banks to undertake excessive risks may be exacerbated by the existence of explicit or implicit government guarantees.

51

The Korean banks’ investments in Russian GKOs and Brazilian Brady bonds spring to mind.

52

Moreover, capital account liberalization, by tightening the link between domestic and foreign interest rates, can force the authorities to hike interest rates even more dramatically to defend a currency peg under attack, something that they may be unwilling to do when the condition of the banking system is already fragile. Thus, external financial liberalization increases the scope for lack of confidence in the banking system and lack of confidence in the currency peg to feed on one another in a vicious spiral.

53

And to allow the authorities to gather information on threats to systemic stability and on the need to take appropriate corrective measures (see Section VI).

54

In addition to the ongoing task of supervision and regulation, measures to address financial and organizational restructuring of major banks may be needed in some cases to remove the incentive to gamble for redemption.

55

These links are not inconsequential, especially when universal banks hold equity stakes in the firms to which they extend loans or provide considerable quantities of margin credit to stock market investors, and when the government relies on income and capital gains taxes for a significant share of its revenue. The impact of declining equity prices on bank balance sheets and the fiscal position will be less immediate than the effects of a shift in sentiment against short-term foreign currency debt.

56

The operation of these forces is evident in the 1992–93 European currency crisis, in the literature in which they were labeled “convergence trade.” See Goldstein and Folkerts-Landau (1993). In the literature on the Asian crisis they are referred to as the “carry trade.” See Adams and others (1998).

57

On exit strategies for countries seeking greater exchange rate flexibility, see Eichengreen and Masson (1998).

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