The Globalization of Financial Markets - Pros and Cons - Term Paper Example

 FINANCIAL CRISIS INTRODUCTION To understand financial crisis that have become such a common occurrence in the past decades, it best to understand what caused these crises which started in Thailand, engulfed Malaysia, Indonesia and South Korea, and then continued to influence Russia, Brazil, and Argentina, and some would say now seems to been influencing financial actions in Europe? The Asian crisis was the outcome of a typical asset bubble--over leverage and a boom-bust approach by investors. For instance, in 1996 the whole bank debt in East Asia was around $2.8 trillion, or 130% of gross domestic product; nearly double that from a decade before. By 1996, power for the median firm had arrived at 620% in South Korea, 340% in Thailand, and averaged 150% to 200% crossways other East Asian countries (Mcinish, 2000, 92-112, 326). This chaos was financed with wealth inflows from new countries, which rapidly flowed away in the start in 1997. In order to avoid financial crisis, it is first critical to understand the ones that have occurred in the past. Forces should be in place that would diminish the likely for such crises and diminish their crash when they do take place (Valdez, 2000, 62). Well-built financial systems perform as stabilizers when the domestic economy is worn out. But weak systems turn out to be magnifiers, making a terrible situation worse. AIM OF THE PAPER In this paper I shall provide a critical overview and reflection on the financial crisis. It is a known fact that financial crises have become more frequent in the last three decades as they were before 1970s. In order to examine the reasons behind it I will first look in to the definition of financial crisis and its categories along with its causes and preventive measures. After that I will look in to the details of the phenomenon of financial liberalization that, according to most analysts, is the root cause of frequent financial crisis. I will look in to as to why it causes the crisis. FINANCIAL CRISIS Financial crisis occurs when the demand of the money increases sharply as compared to the money supply. The financial crisis can take many forms which include 1. Banking crisis 2. Currency crisis 3. Credit crunch 4. External debt crisis (Markus, 2005, 77-81, 110-5) Financial crisis occurs when investors loses their confidence in the assets of that country and decides to stop or withdraw their money from that country. The best approach is to first examine briefly some forms of financial crisis and their causes. CURRENCY CRISIS: Currency crisis occurs when a value of the currency is very unstable and people find it to be less reliable to serve as a medium of exchange. This type of crisis usually hits severely small open economies; large economies tend to handle this instability through their foreign reserves by decreasing the excessive demand of a currency in the market. (Ansoff, 1965, 62) THEORIES THAT EXPLAIN CAUSES OF SUCH CRISIS There are many models that explain the currency crisis phenomenon; we will look at some of them briefly: CANONICAL MODEL: The model starts with the premise that investors will hold an exhaustible resource if and only if they hope that its price would rise quickly enough to offer them a rate of return more than or equal to that on other assets. This is the fundamental logic for the famous Hotelling model of exhaustible resource pricing: the price of such a resource should rise over time at the rate of interest, with the level of the price path determined by the requirement that the resource just be exhausted by the time the price has risen to the "stop point" at which there is no more demand. (Mcinish, 2000, 92-112, 26-8) Now assume that stabilization board has announced its willingness to buy or sell the resource at a fixed price. As long as the price is more than the price without the board, speculators will sell off their resources, reasoning that they can no longer expect to realize capital gains. Thus the board will be acquiring a large stockpile initially (Ansoff, 1965, 63-7). Finally, however, the price that would have been without the stabilization that is the “shadow price” will rise above the board's goal. At that point speculators will regard the commodity as a desirable resource, and will begin buying it up; if the board continues to try to stabilize the price and it will quickly find its stocks exhausted (Benn, 2000,44). Salant, the pioneer of this model, said that a huge wave of speculative buying had in effect forced the closure of the open market in gold in 1969. The logic of currency crisis was the same as that of speculative attack on a commodity stock. Suppose speculators were to wait until the reserves were exhausted in the natural course of events. At that point they would know that the value of foreign exchange, fixed up to now, would begin jumping; this would make holding foreign exchange more lucrative than holding domestic currency, leading to an increase in the exchange rate (Markus, 2005, 77-81, 84). But investors, realizing that such a jump was in prospect, would sell domestic currency just before the exhaustion of reserves - and in so doing advance the date of that exhaustion, leading investors to sell even more quickly, and so on ... The result would be that when reserves fell to some alarming level - perhaps a level that might seem large enough to finance years of payments deficits - there would be an unexpected speculative attack that would quickly drive those reserves to zero and will force the withdrawal of the fixed exchange rate. (Miarka, 2000, 92) HERDING: Herding is common in inefficient markets and it has a great impact on the currency crisis phenomenon. There are two reasons as to why herding can take place. One is the mob mentality/ Bandwagon effect that involves the private information that investors have. For example, Investor A has some private information regarding oil/gas sector and investor B has some private information regarding Government policies (Benn, 2000, 39). If investor A has some negative information, he would sell his stocks. Investor B, even if he has a neutral info will tend to sell since investor A has sold. Other investors would also tend to sell their stocks as they assume that investor A and B must have heard some bad news. The other rationale is that most investments in developing countries are handled by agents and not principals and a normal fund would prefer to loose via a general route like other people have (may be an unexpected financial crash in UK) rather than in an expected devaluation of Baht in Thailand (Markus, 2005, 77-81, 21-7). CONTAGION Contagion effects are due to real linkages between different countries and a crisis in one country can trigger a recession or crisis in its trading partner country as well. For example the South Asian countries are selling similar type of products in export market and devaluation in Thai currency would impact the exports of Malaysia as well which may result in financial crisis in Malaysia (Benn, 2000, 62-4). MARKET MANIPULATION Market manipulation refers to an intentional effort to interfere with the free and fair dynamics of the market and create false or misleading appearances with respect to the price of a security or currency. Suppose that a country is weak in its own currency and investors are expecting that either it will break its peg or will compete with others and will cause a stampede of its own currency. In such case an investor may make money by first selling that country’s currency (short) and then intentionally trigger a crisis which he could do by public statements through influential people. The ideal example is that of George Soros who broke pound sterling in 1992 (Black Wednesday). (Mcinish, 2000, 92-112) CASE STUDY OF EUROPEAN CRISIS - 1992 In mid 1992 huge capital fleet led to the exit of Britain, Italy, and Spain from the exchange rate mechanism of the EMS (European Monetary System). In 1993 another wave of crisis led to a decision to widen the exchange rate bands of that system, the purpose of which was to allow franc to depreciate without exiting (Carmen, 2000, 44-9). Interesting thing is why there was a need of devaluation of Pound sterling. The Government had foreign/domestic market access. They didn’t have limitation on their reserves and also had low level of inflation. What, then, provided the purpose for devaluation? There were two reasons: One was unemployment due to less demand, and the other was pressure on authorities to undertake expansionary steps - steps that could not be pursued as long as the country had a fixed exchange rate regime. The basic reason behind the unemployment phenomenon was unique circumstances generated due to the fall of Berlin Wall and the position of Deutsche Mark as primary currency of the EMS. After the fall of Berlin wall, West Germany had an expansionary monetary policy for its East part and the Federal Reserve replied with a tight monetary policy. Because of this the other European countries who were pegged to Mark (DM) also had match the tight monetary policy which pushed them in to crisis. DEBT CRISIS OF 1980s In 1980s, many of the developing countries and Latin American countries were hit by a debt crisis in which these countries announced their incapability to make their international debt payments to IMF, World Bank and global banks. But the question is how these crises originated? So let us discuss the causes briefly. In late 1970s, worldwide economy was making a transition from inflation to small depression. In order to avoid a recession, US started an anti-inflation campaign and decreased the supply of money. This resulted in increased interest rates that made the interest payments costly for the developing countries. There was a recession prevailing in the world that decreased the exports of developing countries and its prices as well. These circumstances caused the problem of BOP (Balance of payments) for the indebted countries and forced them to declare their insolvency to fulfill their debt commitments. Now the next question that comes to mind is how the Latin American countries could have avoided these crises. Comparatively, Asian countries handled the debt crises and external shocks well than the others through better macroeconomic and microeconomic policies. The elements of their strategy that enabled them the Asian countries to perform better and people are: More export oriented policy When recovery phase began in 1982, there was a quick growth in manufacturing sector which Asian countries were able to leverage. This outward strategy leads to foreign competition that enhances efficiency and productivity and also leads to diversification among imports. Thus Latin countries could have avoided the debt crisis through outward oriented strategy. Fiscal policy Expansionary fiscal policies have been held responsible for debt crisis in case of many development countries. Government and the debt guarantee most of the long-term debts, as a percent of GNP should not be greater than difference between interest rate and GNP growth. But in most Latin country’s case, it exceeded. What the Asian countries did was that they introduced expansionary policies for very short span, only in times of extreme shocks, unlike Latin countries. Asian countries kept the public savings positive and never let the budget deficits reach an alarming figure. Exchange Rate: Overvalued exchange rate in case of Latin countries resulted in the losses of production and competitiveness. For e.g. Malaysia’s currency Ringitt was quite stable during the last 25 years, its just recently that it has appreciated due to heavy capital inflows. Industrial and trade policies The focus of Asian countries’ industrial policies has been to increase the internal competition and increase the amount of exportable by maintaining the real exchange rates. Asian countries also tried to increase import competition by decreasing tariffs and remove market inefficiencies like price controls and subsidies. Productive use of domestic savings Hence the debt crisis for Latin countries was a result of their inward-oriented strategy, poor macroeconomic policies and bad investment decisions. The key to avoid them is to have consistent macroeconomic policies and good economic policies. PREVENTIVE MEASURES OF CURRENCY CRISIS It is very difficult to prevent currency crisis in such a world where on average a currency crisis occurs at every 19 months (Thomas, 2000, 87). There are some possibilities to prevent them but none of them is perfect and have its own pros and cons: Take extensive capital controls and go back to 1960s where the movement of hot money is prevented. Another could be that countries should follow sound policies and be persistent with it so that speculators don’t attack them. For e.g. the policies of UK were correct for exchange rate mechanism were correct but when it came to choosing between unemployment and exchange rates, George Soros and other speculators knew that UK would select unemployment. (Thomas, 2000, 87) Thus in order to avoid such things, Government should not change its policies but may be its preferences. The other way not to have your currency speculated against, is not to have your own currency but go for a true monetary union. (Markus, 2005, 77-81) The countries with fixed exchange rate can give speculators a run for their money by not giving them easy goals in fixed rates and infact have a floating exchange rate. Thus a speculator will face a real risk when he is betting on a currency rather than on a single speculation of fixed exchange rate. (SHLEIFER, 2000, 11-7) BANKING CRISIS A bank run is a type of financial crisis in which a large number of investors withdraw their deposits at a time as they have lost confidence in investment in that country. The banks only have a fraction of their liabilities deposited at central bank in the form of Reserve ratio. All the remaining is invested in long term and short term projects (in the form of loans and securities). Thus when they are unable to give back the investors they are declared as bankrupt. If many banks in a certain country declare themselves bankrupt then the country goes into an economic recession. (Carmen, 2000, 44-9) CAUSES: There can be many factors which causes the banking crisis. It includes: Macroeconomic factors Regulatory factors Individual strategy of banks & Operational failure Corruption/fraud (Fahey, 2003, 21-7) MACROECONOMIC FACTORS: The macroeconomic factors instability has a huge impact on the probability of banking crisis. A huge change in exchange rate, slump in real estate sector, certain period of deflation, law and order situation or a sharp increase in interest rates; they all contribute to the loss of confidence of investor in that country’s assets and tend to withdraw his money from the bank in order to put his money in some other stabilized country (Fahey, 2003, 21-7). MICROECONOMIC/REGULATORY FACTORS: These are those policies which are under the supervisory control of the central bank or Government. It includes the supervisory role of the central bank, inadequate infrastructure of the bank in accounting and law issues, deregulation, interference of the Government and no transparent processes. OPERATIONAL FAILURE: There can be many reasons for a bank to fail operationally. Some of them are: Bad assessment of credit Excessive exposure to interest rate and exchange rate fluctuations. Low quality of staff and management. (Markus, 2005, 77-81) FRAUD: Many employees in a bank are susceptible to corruption and fraud. A bank can be in crisis just because of one fraudulent transaction (like the French bank, Societe Generale in January 2008. PREVENTION OF BANKING CRISIS: Different countries use several methods to avoid bank runs across the economy, while still allowing some individual financial institutions to vanish in order to avoid the problem of moral hazard. Some of the steps are: Deposit insurance systems insure each investor a certain capital so that his savings are protected up to some extent even if the bank goes bankrupt. This eliminates the bandwagon effect and people wont withdraw their money just because others are doing so. State bank or the central bank should be the last entity from which one bank should take loan. The central bank says that it would be giving enough money to the bank at high interest rate so that it remains economically stable and they will have enough cash to honor its commitments (Fahey, 2003, 21-7). Although in some cases it could act against the bank’s favor. For e.g. When the Northrock bank said that Bank of England will provide them this facility, many depositors became skeptical and withdrew their money. A suitable proportion of capital should be kept as Reserve Ratio with the central bank in order to avoid a bankruptcy situation and keep a ceiling on the amount that a bank can loan out. (Tyge, 1999, 55-8) . CREDIT CRUNCH Another form of financial crisis that an economy can face is credit crunch. In this situation, the loan from banks suddenly become unavailable or their costs becomes very high. It is just opposite to the situation of “loose credit”. (Mcinish, 2000, 92-112) CAUSES: 1. It may happen after a phase of loose credit when loans were sanctioned on very easy terms and to those people who were unable to cover the cost of the loan i.e. interest payments. So after a series of bad loans, the capacity of financial institutions decreases to extend credit and the interest rates go up. (Lewis, 2004, 31) 2. It can also happen due to the decrease in the asset price which were overinflated and takes form of those crises which happen after a price collapse. SUB-PRIME MORTGAGE CRISIS Subprime lending refers to the loans sanctioned at a higher interest rates (greater than prime interest rate) because the applicant does not satisfy the general guidelines for loan qualification like his income is low or his down payment or his employment status etc. So when the housing and real estate prices starts to decrease, the interest rates increase and default rates increases and so the activity of foreclosures. This category of credit crunch is currently faced by USA as the default rates have increased by 79% in 2007 (Lewis, 2004, 31). ROOT CAUSE OF ANY TYPE OF FINANCIAL CRISIS Why the financial crises were rare before 1973 and now have become so frequent in the last two decades. It was because of financial liberalization; when the financial markets all around the world changed dramatically. Fixed exchanged rates were replaced by flexible exchange rates and open capital markets replaced closed ones. So let us first take a look at the term “financial liberalization” (Miarka, 2000, 77) Financial liberalization means the actions taken to remove or reduce the regulatory control over financial institutions and their activities and let the market mechanisms decide the dynamics of market like interest rates and capital inflows. Such regulatory actions could be either internal or external. INTERNAL FINANCIAL LIBERALIZATION Internal financial liberalization includes the following actions that a Government can take: Interest Rates: Reducing control over the interest rates charged by the financial institutes. This usually involves the removal of interest rate ceilings and encourages the competition between financial institutes like banks. (Markus, 2005, 77-81) This competition reduces the spread of the banks as they have to attract borrowers with low interest rates and attract depositors with high deposit rates. Privatization: The state stops interfering in the activities of financial intermediation and converts development banks in to normal banks and privatizes the state owned banks (Lewis, 2004, 31). The rationale behind this action is that the government thinks their presence is impeding the process of efficient allocation of capital on the basis of market signals. Stock market: Relaxing conditions on listing issues in Stock market so that both investors and firms actively participate (Mcinish, 2000, 92-112). These issues include pricing of new securities Investments: Reducing controls on the investments made by different financial institutions and diluting the boundaries between banking and non-banking investments. In a regulated financial sector, agent of a banking sector was not allowed to invest in a non-banking sector like insurance as conflicts in interests may arise (Naderah, 2000, 33). Constraints regarding the type of securities that can be issued and purchased are relaxed EXTERNAL FINANCIAL LIBERALIZATION External financial liberalization usually includes actions regarding exchange control. Foreign residents are allowed to invest and hold financial assets (including debt) in local market. It can also include actions like allowing entry of foreign banks in to local market which may increase competition. This increased competition after some years might result in consolidation process as well (Lewis, 2004, 31). Local people are allowed to invest in foreign markets. This is great liberalization as it increases the probability of capital flight. This step is usually taken by a country, which has excessive foreign exchange reserves and wants to decrease the pressure on exchange rate. Foreign currency assets are allowed to be traded in the local market. This is an extreme case of financial liberalization, which is very rare (Lewis, 2004, 31). GOVERNMENT MOTIVES BEHIND LIBERALIZATION The people in the Government of a developing country want to liberalize because they believe: The basic determinants of growth in a developing economy are factors of production which includes capital, labor, land and its productivity. Moreover the supply of money does not have any impact on economic activities and rate of growth of output. The decreasing the growth rate of money supply can control inflation (Lewis, 2004, 31). Moreover the requirement to eradicate financial repression justifies financial liberalization. Financial repression affects savings rate badly and thus it results in shortage of capital and it adversely affects growth. (Sorin , 2000, 102) In addition to this, riskier projects, which may be essential for the development of the country, are ruled out as the proper risk premium cannot be charged on them because of the caps on interest rates. CONCLUSION The globalization of financial markets had its own pros and cons. Finally, it is generally argued among economists that, by far, the major cause of financial crisis is an unstable economy. This results in deteriorating asset quality, asset price bubbles, and wide swings in asset prices and exchange rates that can lead to system wide problems. Thus, it is not surprising that the effectiveness of monetary policy was raised as an issue. But it is true that it is the root cause of the frequent financial crisis. The globalization have set the environment more conducive to crisis by taking the economic decision making power from the individual countries. If one country sets the interest rates higher then world market then large capital inflow that sets the financial market volatile (SHLEIFER, 2000, 11-7). If a country sets the exchange rate above equilibrium then account deficit and if below then capital fleet. Thus, if a country has an unregulated free market then it cannot control its development. Thus countries are left with duties but they don’t have the proper parameters to handle it. As a result, a developing country ignores the limitations on its autonomy imposed by international free market dynamics and gets in to financial crisis. Thus globalization is important and more important for developed countries like USA and UK but it makes developing countries more susceptible to financial crisis. REFERENCES ANSOFF, H. I. (1965) Corporate Strategy: An analytic approach to business policy for growth and expansion, New York: McGraw Hill BENN, ALEC. The unseen Wall Street of 1969-1975: And its significance for today. Westport, Conn. and London: Greenwood, Quorum Books, 2000. CARMEN. M. Assessing financial vulnerability: An early warning system for emerging markets. Washington, D.C.: Institute for International Economics, 2000. Carosso, Vincent P (1987). The Morgans: Private International Bankers, 1854-1913. Cambridge: Harvard University Press. FAHEY, L. 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