Financial Crisis, Contagion, and Containment

Financial Crisis, Contagion, and Containment: From Asia to Argentina

Padma Desai
Copyright Date: 2003
Pages: 318
https://www.jstor.org/stable/j.ctt9qh03n
  • Cite this Item
  • Book Info
    Financial Crisis, Contagion, and Containment
    Book Description:

    This book provides a sweeping, up-to-date, and boldly critical account of the financial crises that rocked East Asia and other parts of the world beginning with the collapse of the Thai baht in 1997. Retracing the story of Asia's "Crisis Five"--Indonesia, Malaysia, South Korea, the Philippines, and Thailand--Padma Desai argues that the region's imprudently fast-paced opening to the free flow of capital was pushed by determined advocates, official and private, in the global economy's U.S.-led developed center. Turmoil ensued in these peripheral economies, the Russian ruble faltered, and Brazil was eventually hit. The inequitable center-periphery relationship also extended to the policy measures that the crisis-swept economies implemented under International Monetary Fund bailouts, which intensified the downturns induced by the panic-driven outflows of short-term capital.

    Financial Crisis, Contagion, and Containmentexamines crisis origin and resolution in a comparative perspective by combing empirical evidence from the most robust economies to the least. Why is the U.S. relatively successful at weathering economic ups and downs? Why is Japan stuck in policy paralysis? Why is the European Central Bank unable to achieve both inflation control and stable growth? How can emerging markets avoid turbulence amid free-flowing speculative capital from private lenders of the developed center? Engaging and nontechnical yet deeply insightful, this book appears at a time when the continuing turmoil in Argentina has revived policy debates for avoiding and addressing financial crises in emerging market economies.

    eISBN: 978-1-4008-6537-6
    Subjects: Economics

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-viii)
  3. Preface
    (pp. ix-xii)
    Padma Desai
  4. 1 Introduction
    (pp. 1-12)

    The global economy experienced extraordinary changes in the nineties that affected the economic prospects of both developed and less developed countries when the decade ended.

    One of its alarming features was the widespread and massive borrowing in both groups. In the U.S., the government budget deficit was being energetically brought down during the Clinton administration, but American households and businesses borrowed freely during the unprecedented economic boom of the second half of the decade. Japanese corporate and financial sectors borrowed heavily and invested unwisely in land and real estate, burdening Japanese banks with a mountain of nonperforming loans when the...

  5. 2 The U.S. Economy in Transition
    (pp. 13-45)

    Domestic ups and downs of economic activity characterize the U.S. economy. It manages, however, to overcome these self-generated fluctuations via resilient responses of its households and businesses to policy signals. The special features of a highly mobile labor force, a less intrusive government, a weakening welfare system, increasingly deregulated markets, and the Schumpeterian drive of its corporate sector for creative destruction drive this process. The interaction between policy incentives and private sector behavior is not only facilitated by these structural features but also by the underlying institutions, which continuously renovate themselves. The U.S. financial institutions, including the banks and the...

  6. 3 The Euro: Teething Troubles and Faltering Responses
    (pp. 46-69)

    In early may 1998, eleven of the fifteen European Union (EU) member countries (figure 3.1), linked by common agricultural, trade, and environmental policies, agreed to take a giant step forward by forming an economic and monetary union and creating a single capital market. From its inception, however, it faced difficulties in functioning as a single unit, raising doubts about its potential to compete with U.S. growth performance and about the euro’s rapid emergence as an effective rival to the dollar. These problems, which I analyze in this chapter, appeared from several directions. Trapped in structural bottlenecks, the eurozone trailed the...

  7. 4 Japan: The Lost Decade of the Nineties amidst Policy Paralysis
    (pp. 70-85)

    The Japanese economy’s prolonged decline in the nineties turned into a recession toward the end of 2000 marked by mounting price deflation. During this period, attempts to revive the economy via fiscal pump priming led to resource misuse into pork barrel projects. Monetary easing failed to stimulate consumer demand by households or capital spending by industry. A softening of the yen in late 2001 calculated to boost exports raised protests from Asian neighbors and the U.S. treasury. The prolonged policy paralysis, which I analyze in this chapter, arose from the leadership’s failure to enforce a cleanup of banks that were...

  8. 5 The Asian Financial Crisis
    (pp. 86-98)

    The asian financial crisis that originated in Thailand in the summer of 1997 caught everyone off guard by its unpredictability and scale as it spread in the neighborhood to Indonesia, Malaysia, and South Korea. It came as a shock because the affected economies had chalked up impressive private sector–led economic performance marked by high growth and low inflation rates, public sector balanced budgets, and economy-wide savings. Despite their evident strengths leading up to 1996, however, these economies displayed disturbing features, which I analyze in this chapter. I argue that the sudden and destabilizing reversals of short-term capital inflows, affecting...

  9. Block 1 What Are Fundamentals? What Are Structural Issues?
    (pp. 99-106)

    Fundamentals refer to macroeconomic indicators, the choice depending on the analyst’s concern. Gross domestic product (GDP) growth and unemployment rates, government budget deficit, and the economy’s current account deficit, both in relation to GDP, top the list. The choice also includes a second tier of macroeconomic measures affecting the health of the economy’s current account balance. Among these are the ratios of external debt to GDP, of the short-term debt to total debt, and of export earnings to total debt liability. These reflect the economy’s potential to continue growing while meeting its external debt obligations. However, trade-related problems in the...

  10. Block 2 The Current Account and the Exchange Rate
    (pp. 107-109)

    Mulling over the lessons of the Mexican financial crisis of 1994, U.S. Treasury Secretary Lawrence Summers, then a major player in handling the crisis as the country’s deputy treasury secretary, noted that a current account deficit of over 5 percent of gross domestic product (GDP) was a cause for concern. What is a current account?

    The elementary distinction, often overlooked in journalistic accounts, is that the current account differs from the trade account: the latter includes only exports and imports of goods. If a country imports more goods than it exports, it runs a trade deficit. The current account additionally...

  11. Block 3 Financial Liberalization, Capital Account Decontrol, and the Regulatory Framework
    (pp. 110-116)

    Until the mid-eighties, the Asian tigers were reined in by financial and capital account controls marked by regulated banks and financial institutions.

    Thus, domestic credit flows were regulated via ceilings on interest rates and state-directed credits in prescribed areas. Foreign direct and portfolio investments faced limits on repatriation of principal, interest, and dividends. Indeed, foreign investors were denied opportunities to acquire a stake in certain types of companies and in real estate. Domestic banks and residents could not borrow abroad without a permit from the central bank. At the same time, the rules governing the activities of banks and financial...

  12. Block 4 The East Asian Crisis: A Crisis of Over-Investment or Unregulated, Premature Capital Flows?
    (pp. 117-118)

    Why did the East Asian miracle of unprecedented growth over three decades suddenly turn into an unexpected debacle?

    According to Krugman (1998), the miracle, the result of escalating investments, was bound to lead to diminishing returns and growth rates: as more capital is combined with a slower growing labor force, the marginal product of capital declines. This argument was further buttressed by the lack of measured factor productivity as a source of growth in East Asia (Young, 1995).

    These exercises drew a parallel from painstaking analysis by economists, among them Desai (1976, 1987) and Weitzman (1970) who sought to explain...

  13. 6 The Asian Crisis Chronology
    (pp. 119-135)

    The Asian crisis was set in motion in Thailand, Indonesia, Malaysia, and South Korea by highly leveraged local banks, financial institutions, and companies that had borrowed short term abroad and lent long term at home to questionable investors in real estate and other dubious ventures. As these borrowers missed debt payments and declared bankruptcies, foreign creditors withdrew funds aggravating the finances of these borrowers and dragging with them the values of currencies they dumped. The financial crisis became a currency crisis. In response, East Asian central banks raised interest rates with a view to stemming the outflows by nervous currency...

  14. 7 The Ruble Collapses in August 1998
    (pp. 136-155)

    Russia, marked by a fragile economy in the midst of continuing political instability, was an exception among emerging market economies. Its fundamentals were weak, its institutional underpinning was inadequate for the challenges of a market economy, and its politics were volatile. These three features coalesced into a financial meltdown when the government of Prime Minister Sergei Kiriyenko devalued the ruble on August 17, 1998, defaulted on the government’s domestic debt, and declared a moratorium on payments by Russian commercial banks to foreign creditors. As a result, inflation control, a stable ruble, and a fragile turnaround of gross domestic product (GDP)...

  15. Block 5 The Ruble: Premature Capital Account Convertibility
    (pp. 156-161)

    The ruble that traded at 6 rubles for a dollar in the first half of 1998 exchanged for 26 to 28 rubles toward the end of 1999. What went wrong?

    The ruble’s course spanned two phases: the first one from 1992 to August 17, 1998, when it was sharply devalued, witnessed its liberalization from a variety of exchange controls operated by the Central Bank of Russia. Some exchange controls were restored subsequently. The rules governing current account transactions for exporters and importers were simplified and relaxed gradually in the first phase.

    Foreign exchange auctions, which appeared in Moscow in early...

  16. 8 Contagion from the Ruble to the Real
    (pp. 162-171)

    Toward the end of 1997, the Brazilian government of President Fernando Henrique Cardoso sought to ward off pressure on therealas nervous investors reacted to the Asian crisis by pulling out of the Brazilian currency: the central bank raised the basic lending rate to 43 1/2 percent and the government cut back budget outlays by 2.5 percent of gross domestic product (GDP). After a temporary respite, the old pressures on therealresurfaced following the meltdown of the Russian ruble in August 1998 and the declaration of debt moratorium by Minas Gerais, one of Brazil’s largest constituent states. Further...

  17. 9 Beyond Bangkok: Crisis Erupts in Buenos Aires and in the Bosphorus
    (pp. 172-196)

    The economies of the Crisis Five in East Asia and of Russia and Brazil revived in 1999 and 2000 leaving behind them the worst consequences of capital outflows and plunging currencies. Toward the end of 2000, the circumstances marking a financial crisis emerged elsewhere in debt-ridden Argentina and Turkey, raising fears about the collapse of their currencies, testing once again the firefighting skills of the International Monetary Fund (IMF), and setting off speculation about the likelihood of a new financial contagion. These concerns intensified after the terrorist attacks on U.S. territory on 9/11.

    The origins of the crisis in each...

  18. 10 The Contagion
    (pp. 197-211)

    The asian crisis originating in Thailand in July 1997 hit Brazil in November 1998, devastating Russia’s fragile finances in August 1998 along the way. The crisis originating in Asia became global. By contrast, the financial and currency problems of Argentina, unrelated to those in Turkey, remained largely confined to the neighboring economies of Latin America. The conceptual and empirical analysis of this chapter provides three important insights with regard to crisis transmission.

    First, excessive and indiscriminate short-term capital inflows from financial institutions of the developed center, including banks as well as mutual and hedge funds with linked global operations, not...

  19. 11 International Monetary Fund to the Rescue: How Did It Fare? Badly
    (pp. 212-241)

    As the Asian financial crisis spread from Thailand to the neighboring countries and beyond to Russia and Brazil with a speed and on a scale not encountered before, the International Monetary Fund (IMF) found its financial resources and negotiating skills, its technical expertise and public posturing, and above all, its policy relevance tested to the hilt. Three years later in late 2000, the IMF faced a debt and currency turmoil in Argentina in the midst of a recession that arose from an antiquated policy framework tying the peso to the dollar under a currency board straightjacket. After the debt default...

  20. Block 6 Was There Moral Hazard in the Asian Financial Crisis?
    (pp. 242-246)

    Moral hazard is invoked in situations involving human responses that tend to be reckless if their consequences are guaranteed not to be penalized.

    If divorce were automatic, people might choose to get married at the drop of a hat. Since 911 has no more than a minimal charge for individual callers to seek help in emergencies, they tend to use it in seemingly trivial situations. American teenagers behave recklessly because they expect to be bailed out by parents. In other words, if people have a guarantee that they will not bear the costs of the outcomes of an activity that...

  21. Block 7 How Much Corruption? Does Corruption Matter?
    (pp. 247-252)

    Corruption, like adultery, exists across cultures but is difficult to measure.

    It is equally difficult to define. Recently several French chefs, some of the best in the culinary profession, were fined in amounts ranging from $10,000 to $12,000 for having “bribed” their wholesale fish suppliers. But according to Manuel Martinez, one of the best chefs in the business, “nobody got rich. We spread it around among the staff. It was a kind of tradition in the business to create good will. It’s not as if it was public money and these were kickbacks” (New York Times, July 14, 1999, p....

  22. Block 8 Chilean Capital Inflow Tax
    (pp. 253-255)

    Emerging market economies tend to have poor credit rating because creditors find it difficult to assess their loan risks. The necessary information about the viability of banks and corporate businesses for the purpose is missing; often, the information is misleading because the accounting system is different. Again, managers are still coping with problems of risk management. The supervisory system is lax. Governments often rush in to bail out failing banks and corporate units. Above all, a loan contract may not be enforced. Creditors therefore prefer to loan short term, choosing to move their cash in and out speedily in order...

  23. Block 9 Capital Account Convertibility in China and India: A Cautionary Tale of Two Countries
    (pp. 256-262)

    China and India fitfully progressed from exceedingly regulated and painstakingly bureaucratized arrangements of direct controls of activities (involving foreign exchange transactions by residents and nonresidents)to current account convertibility of their currencies. They have however quite a distance to travel in order to reach full capital account convertibility. Policy makers in both countries implemented a liberalization progression marked by encouragement of foreign direct investment inflows followed by their outflows by resident companies culminating in the final phase of regulated freeing of inflows of private equity and bonds and their outflows by residents. (I outlined the steps relating to a desirable progression...

  24. 12 Crisis Prevention and Containment: The Next Steps in Financial Reform
    (pp. 263-284)

    The aftermath of the East Asian financial turmoil was followed by calls for redesigning the international financial architecture with a view to preventing and containing future debacles.¹ The Argentine and Turkish economic turmoil resurrected the pressure for reforming the global financial system in 2001. It became acute after 9/11 as the synchronization of economic recession in the U.S., the eurozone, and Japan threatened the economic prospects of emerging markets via reduced trade and capital flows.

    Despite the new urgency, analysts and policy makers disagree on measures for preempting the recurrence and containing the impact of financial crisis. The advisability of...

  25. References
    (pp. 285-292)
  26. Index
    (pp. 293-306)