World Financial Crises - Example

World financial crises have been a major issue in analysis of the world economy. People have different views on the financial failure in markets throughout the world. These views have led to development of movements such as occupy Wall Street to fight against major banks and other multinational corporation’s power in the economy of the world. This essay addresses the 1997-1998 Asian financial crises, role of financial institutions in the economy of the world, and areas of inadequate financial regulation in the financial system. It also discusses the recommendations on changes in financial regulation, how the changes have closed the regulation and supervision gap and finally it, addresses the lessons for economic policy. Asian financial crisis The financial crisis in Asia began with Thailand’s currency devaluation on July 1997, a devaluation of 15-20% that happened two months after Thailand’s currency began to suffer due to a speculative attack and about a month after Finance One’s bankruptcy which is largest finance company in Thailand. Thai currency first devaluation was soon followed by the currencies of Philippine, Malaysia and Indonesia and Slightly on Singaporean currency. These series in devaluation led to beginning of financial crisis in Asia. The currency crisis underwent two sub-periods where the first one happened between July and October in 1997. The second sub-period of the crisis in currency began in early November in 1997 after the Hong Kong’s stock market collapsed after a loss of 40% in October. The effects of the collapse were also felt in Latin America’s stock markets. In addition, the developed countries such as US also experienced the shock wave by experiencing 7% loss which was the largest point loss ever. These crises in financial and asset price also set the stage for large depreciations on currency in the second sub-period. During this time, not only the four countries’ currency that were affected but also the Taiwan and South Korean currencies suffered (Garay 2003). Due to a sharp depreciation of Korea’s currency that took place in the early November, there was addition of a new dimension to the crisis which became more troublesome owing to the Korea’s significance as the world’s number eight largest economy; the magnitude of its currency depreciation that happened in a span of less than two months; and the success of the central bank of Korea in maintaining the peg since first devaluation in Thailand’s currency. This second sub-period also had another essential component which was the complete Indonesian currency collapsing that began about the same time with issues in Korea (Nanto 1998). In order to understand the Asian financial crisis, it is important to study the evolution of the inflow of money into Asian economies and the stock markets. The investments on net equity in economies of the four countries and sound Korea amounted to 12.2 in 1994, 15.5 in 1995, 19.1 in 1996, and 4.5 in 1997 in US billion dollars. This show a reversal in 1997 which is attributed to the financial crisis that began in Thailand. This later added pressure to the five Asian countries discussed in this essay. Research show that for the five Asian countries, the correlation between the weekly returns on stock market and the changes in currency between the first weeks of July in 1997 and May in 1998 is approximately –0.63 at 1 percent level of significance. The closeness in correlation shows that the severe downturn of stock markets in Asia in the financial crisis period can be associated with devaluations in currency of South Korea, Thailand, Philippine, Malaysia and Indonesia whose currencies were in the verge of sharp depreciation experiences during the financial crises (Bailey, Chan & Chung, 2002). In the beginning of January in 1998, these countries’ currencies regained what was seen as part of what they lost when crisis began. Also, after the first eruption of crisis, Hong Kong managed to maintain its peg but through incurring great costs. This called for rising of interest rates in order to fend-off the currencies from speculative attacks that were repeated (Forbes & Rigobon 2002). Role of financial institutions The purpose of international architecture which was developed after the Second World War through the World Bank, world trade organisation what was then the IMF was mainly to address the issue of globalization, the trade disputes and to specialise on the dreams of all the countries of rising economic powers. The monetary fund, World Bank, and other sister institution were established early in 1944 with the main aim of securing international economy. These purpose of the bank was rebuilding Europe and also to reduce poverty all over the world with loans and grants. The purpose of the monetary fund was trying to avert the meltdowns in finance through monitoring of economic policies of different countries throughout the world. Trade organisation was developed in 1947 through the general agreements on trade and traffic was supposed to make sure there is a smooth flow in distribution of goods and services which are responsible for keeping the economy of the world growing. Another role of financial institutions is the stabilization strategies in the areas hit by financial crisis. This is done through addressing issues that are pressing which include weak sectors of finance, poor governance and lack of transparency in corporate sectors and weaknesses in the management of the external liability. This assists much in restoring confidence for both domestic and foreign investors. Financial institutions support these goals through provision lending money to address the financial crisis (Lévy-Lang 2011). Areas of inadequate financial regulation One of the areas where there is inadequate financial regulation in the financial system is lending. The result of most crises especially the financial crisis in Asia was inadequate regulation which permitted most of the banks to make risk loans excessively without making adequate monitoring. This problem was due to financial liberalization which was too rapid and excessive without any adequate strengthening of supervision and regulation. This can be explained in the cases of Korea and Thailand before occurrence of Asian financial crisis. A decade before the crisis, Thailand made reductions in reserve requirements, made expansion on the scope allowable activities of capital market which include permitting the banks to finance purchases on equity on margin, they eased the rules which governed the financial institutions that were non-bank, and made an increase in accessing off shore borrowing. Earlier in Korea before the Asian financial crisis, they eliminated a lot of controls on interest rates; they scrapped the restrictions that were present in cross boarder flows and corporate financing on debt, and also allowed an intensified competition the financial services. Although these two countries praised the benefits of these changes, there was no adequate emphasis on the necessary increase in safeguards (Stiglitz 1998). Financial liberalization that is excessively rapid is usually inadequate as it can lead to undermining of the financial systems’ strength which results to reduction in growth. The increases in the severity and frequency of financial crises mostly in developing countries can be attributed to how financial liberalization is carried out. This can be explained through inadequate regulation in finance in East Asia which was evidenced by overbuilding of commercial real estates. Thailand used to impose restrictions on real estate bank lending due to realization of such lending dangers and also to direct credit enhancing investments which Thailand saw it as more growth. Bu due to pressure emerging from the claims that these restrictions interfered with the efficiency of the economy, Thailand liberalized and eliminated these restriction leading to the crisis. The exposure of the banks and the risks originating from the commercial vacancies are much great in East Asia as compared to other countries (Johnston 2005). The reason why there was inadequate regulation in lending is because in addition to the advantages resulting to eliminating restriction on lending, there was no adequate emphasis in making necessary increments in safeguarding. Recommendations on changes in financial regulation The recommendations are based on policies of achieving best financial regulation systems. Though it is difficult to come up with good regulation, we cannot always expect elimination of all fluctuations. Building of a financial system that is robust is a long and difficult process. This long process involves reforming of the existing policies in developing countries. First, we need to recognise that most of developing countries have greater shocks vulnerability and very low capacities for regulations in finance. There is a need to put into consideration policy recommendations in every area particularly sequencing and timing in financial sector liberalisation and opening up markets to foreign investors. There is also recommendation on designing a policy regime that is robust as it will minimise long term effects of expected economic fluctuations. This means that there is a need to design a financial system which will buffer the country’s economy against the shocks instead of making these shocks much greater. Domestic economic reforms are very effective in the achievement of these goals but also, there is a need to incorporate in international efforts (Wilson & Purushothaman 2003). Closing the gap between regulation and supervision The changes in the regulatory system in finance will link the regulators with policy makers thus preventing macroeconomic issues which originate from the disconnection of policy makers from regulation. The financial regulators main tasks include ensuring transparency, authorising entries into market, enforcing guidelines on regulation and the prosecution of the transgressors. As regulators visualise the market as the summation of parts, the regulated and authorised companies develop a contagion effect as things go astray. This leads to issues that lead to collapsing. Connection of policy makers and regulation will solve disastrous outcomes of financial markets thus, preventing collapsing. Also, a robust financial system will ensure that the regulation and supervision is strong enough before excessively introduction of rapid financial liberalization. This will ensure that there is adequate emphasis on increased safeguards for any country to enjoy the advantages of controlled services that leads to ease of lending in banks. Failure to coordinate supervision and regulation in rapid financial liberalization will expose the country to more financial crisis. The changes will also lead to promotion of transparency where lack of it may be the main source of financial crisis. Lack of supervision may make one think that many firms are strong as they really are. This will lead to lack of information in differentiating bad firm from a pool of firms where it may lead to raising risk premiums for all these firms. Due to lack of transparency, it will lead to gradual development of crisis to end up realizing it at a late stage (Bernanke 2009). Lessons for economic policy Another issue to be put into consideration relevant to broad topic is the lessons for economic policy. One of the lessons is that there is a need for sensitivity on the relationships between macro-economy (the trade balance, output, interest rates and exchange rates) and micro-economy (particularly the financial system). For instance, after a financial crisis, how do we restore confidence or persuade investors to place their capital in the country after crisis? We also need to first ask ourselves why people are pulling out their money out of the country’s economy. Higher rates of interests can promise a return but it may lead to financial strains, bankruptcy and increasing the probability of defaults. Another lesson is financial restructuring most likely the need to maintain the system of payments and credit in financial reform process. This has proved to be very difficult. In developing countries, the process of restructuring becomes even more difficult due to various reasons. First, legal, technical, and institutional capacities for various tasks such as asset resolution are very low. Second, there is very large fraction of the system of banking with insolvencies and bad assets; weak banks are so many and they cannot be overtaken the few healthy banks. Third, the systems of banking are more complex due to a mixture of private and state banks. The key issue in financial structure strengthening is making it strong in a way that it will fulfil effectively its role of the promotion of economic growth (Nicolas 2011). References Bailey, W., Chan, K., and P. Chung, 2002, “Depositary Receipts, Country Funds, and the Peso Crash: The Intraday Evidence,” The Journal of Finance, v55, no. 6, pp. 2693-2717. Bernanke, BS 2009, Financial Regulation and Supervision after the Crisis: The Role of the Federal Reserve. Retrieved on 25 February from: http://www.federalreserve.gov/newsevents/speech/bernanke20091023a.htm Forbes, K., and R. Rigobon, 2002, “No Contagion, Only Interdependence: Measuring Stock Market Co-movements,” The Journal of Finance, v57, no. 5, pp. 2223-2261. Garay, U 2003, The Asian Financial Crisis of 1997 - 1998 and the Behavior of Asian Stock Markets. Retrieved on 25 February from: http://www.westga.edu/~bquest/2003/asian.htm Johnston, DJ 2005, ‘Importance of Financial Literacy in the Global Economy’ Financial Education Summit, pp. 1-5 Lévy-Lang 2011, Financial Regulation: Facing a Global Challenge. Retrieved on 25 February from: http://yaleglobal.yale.edu/content/financial-regulation-facing-global-challenge Nanto, DK 1998, CRS Report: The 1997-98 Asian Financial Crisis. Retrieved on 25 February from: http://www.fas.org/man/crs/crs-asia2.htm Nicolas, J 2011, ‘A Critique of the Basel Committee on Banking Supervision’ Revue Analyse Financière, p.72 Stiglitz, J 1998, The Role of International Financial Institutions in the Current Global Economy Retrieved on 25 February from: http://www.worldbank.org/html/extdr/extme/jssp022798.htm Wilson, D & Purushothaman 2003, ‘Dreaming With BRICs: The Path to 2050’, Global Economics, vol. 99. Read More