Listener: 10 April, 1999.
Keywords: Macroeconomics & Money;
The worldwide trend of financial liberalisation since the early 1980s seems to have resulted in more financial crises. These include currency crises, where the foreign exchange market is disrupted, forcing the government to change its exchange rate regime (frequently either changing the peg of the fixed exchange rate, or shifting to some sort of floating regime). New Zealand had a currency crisis in July 1984 when there was a fixed exchange rate, and so much conversion of New Zealand into foreign denominated financial assets that the Reserve Bank (which funded the conversion) became short of foreign currency.
There are banking crises, where the banking system is under stress, typically when the balance sheets of assets and liabilities of a number of banks are awry. It may be they are illiquid and are short of the cash to pay their immediate bills (but have enough assets in the long run to do so), or they are insolvent and their liabilities exceed their assets, so they could never pay all their bills. There has been no banking crisis here, unless one so treats the upheaval beginning with the collapse of the overseas Bank of Glasgow in 1878 (before the Reserve Bank was established in 1934). The resulting credit contraction led to our long depression of the 1880s.
There are bank crisis, where a single bank is illiquid or insolvent (There is a danger one could undermine public confidence in the entire banking system precipitating a systemic banking crisis). The illiquidity of the Bank of New Zealand at the end of 1990 was a bank crisis. There have been other bank crises, most famously in the nineteenth century.
Even if some politicians panicked, the BNZ bank crisis was a tiddler, costing less than 1 percent of GDP. The banking crisis in Mexico (1994-7) cost about 15 percent, in Israel (1981-84) 30 percent, and in Chile (1981-84) 41 percent, while the Argentinean crisis of 1980-82 cost a whopping 55 percent of GDP. Most countries have had a bank or banking crisis in the last twenty years. (Note the list does not include sharemarket or property collapses. Such a collapse can cause a banking crisis, when banks have too many of their assets in devalued shares or property.)
Currency crises can cause banking crises. Banks usually have some liabilities denominated in overseas currencies (they borrow overseas). If the value of the currency falls, the value of the banks’ liabilities rise, and the equity on the assets side may be wiped out, so the banks becomes insolvent. Prudent banks do not greatly expose themselves to foreign currency risk. However, when a government has been successfully maintaining a fixed exchange rate, the temptation is to assume that it will always be successful. That is what happened in East Asia, so when the various currencies devalued, the banks found themselves in difficulties. Worried investors subjected them to greater scrutiny, and there was a growing realisation that many of their assets were overvalued too.
The Thai baht collapsed in mid 1997 (see below). Currency ructions followed in other East Asian countries later in the year. The Russian rouble collapsed in August 1998, and the Brazilian real joined in a couple of months ago. None of these economies have yet really recovered, although some may have bottomed out. We are told that the current world financial crisis is over. Perhaps. I would wait at least a year after the last collapse before I was confident.
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MEXICO 1994
Between 1988 and 1993 economic stabilization and reform in Mexico led to a sharp reduction in the rate of inflation, although it depended on a real appreciation of the exchange rate so import prices rose more slowly that domestic production prices. Not surprisingly, the current account deficit widened as exporters found the going more difficult and importers found it easier. There were huge inflows of speculative capital attracted by favourable interest rates. In early 1994 the flows reversed. Accounts mention the First Chiapas uprising and the assassination of presidential candidate Luis Colosio. Various economic and financial indicators looked weak before then, so the political events may have drawn attention to problematic fundamentals. International reserves fell rapidly. Interest rates rose. But the external deficit expanded to over 7 percent of GDP. Reserves continued to fall. By late December the authorities’ ingenuity defending the currency peg was exhausted, capital flight was severe, and the exchange rate collapsed from around 3.5 pesos to the US Dollar to 5.5 pesos. Banks depending on foreign loans were in trouble.
THAILAND 1997
Again there was a fixed exchange rate, and a real appreciation as Thailand inflated faster than its trading partners in the mid 1990s, in this case complicated by the baht being primarily fixed to the US dollar, which appreciated relative to the Japanese yen in whose area Thailand had important markets. The current account deficit widened – to about 8 percent of GDP in 1996. Speculative pressures built up from December 1996. Foreign reserves began to run down. Defensive measures proved ineffective, the baht was floated, and fell 42 percent against the dollar (after being stable since 1984). At which point Thai banks found they had too many liabilities denominated in US dollars.