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MAS (Economics), MBA (Finance)
Dec 04 - 10, 2000

This article attempts to highlight the major characteristics and the moral hazards associated with the financial crisis of the recent past and seeks to signify the policy issues to be realigned in the light of above attributes. What is required is the structural policies geared to improve the strength and cogency of financial institutions. More emphasis should be given to Demand-Management-Policies.

A common factor in the financial crisis in several countries was the failure of most debtors to hedge the foreign exchange risk of borrowing in foreign currencies. A large part of this borrowing was in US dollars and this constrained the domestic borrowers to undertake the additional cost of hedging the risk of a change in the exchange rate against the dollar because the domestic currency had remained pegged to the dollar for long periods of time. Most borrowers would also have reasoned that authorities held ample foreign exchange reserves to defend the peg against speculative attack. What they would not have known, for instance in the case of Thailand, the epicenter of the crisis, was that the Bank of Thailand had been intervening in the forward exchange market for several months preceding, and that its forward sales had effectively depleted the foreign exchange reserves in a manner that was not shown in the published spot figures of its foreign exchange position. A flexible exchange rate regime and a candid disclosure of the true state of their foreign exchange reserves by the Thai authorities would have produced a better evaluation of foreign exchange risk in dollar borrowing, but in its absence, economic agents has reason to assume that there was an implicit guarantee of an invariant price for the dollar

The lending side of the equation, an incentive for less than one year commitments by foreign banks, since the capital adequacy prescriptions under the Basel Capital Accord required much lower ratios of capital to be reserved against shorter term claims relative to longer term claims. This could also be due to the fact that the financial authorities will not change adversely the rules of the game. For instance, one rule implies that holdings of sovereign bonds are not to be included in any comprehensive debt-restructuring operation. Another rule advocate that NBFI's are not subject to disclosure of their commitments in over the counter markets for contracts in derivatives. Similarly, commercial and investment banks that enter into such contracts on their own account in off balance sheet transactions are not required to reveal them either. But, in fact, the growing range and complexity of financial products, and their continuing innovation, has generated a degree of opaqueness in the working of financial markets. This suggests that very large risks can be taken, which insufficiently known to or fully understood by the monetary authorities of even the major money-center countries, let alone the authorities of the developing countries whose institutions might be holding the other end of such high-risk transactions.

In an emerging market financial crisis, an economy that had been the recipient of the large scale capital inflow stops receiving such inflows and faces sudden demand for repayment of outstanding loans. This abrupt reversal of capital flows leads to the financial embarrassment. In the twentieth century, there have been several dramatic international financial crisis involving developing countries. In l929, Bond financing from USA to Latin America dried up. In August 1982, Mexico was pushed to the brink of default and in the same 80s, Chile, Uruguay and Argentina also experienced financial crisis. More recently Mexico, Turkey and Venezuela in 1994, Argentina in early 1995 and East Asian countries in 1997 are such examples.

These are all those players who comprises of the tale of the borrowers and lenders. All the above shared a common characteristics that was sudden shifts in the financial flows. The capital inflow has a chain of effects the real exchange rates appreciation, which in turn has a negative impact on the recipient economy's competitiveness in international trade and hence, its current account balance. This can be countered through intervention of the central bank in the foreign exchange market, namely buying foreign exchange.

The question is how to overcome these problems. Exchange rates policy should also be employed apart from the direct regulations imposed on foreign capital inflows. The aim should be to discourage short term speculative flows by introducing a greater element of uncertainty into the equation.

According to the World Bank (1997), those countries with highest increase in Bank lending not only were those that later experienced banking crisis, but also were usually those in which macro-economic vulnerability was higher- measured by increase in the current accounts deficit, real exchange rate appreciation, excess consumption and underinvestment. The policies that have been employed to combat the adverse effects of capital inflows involve in the first instance demand-management policies, which include monetary, exchange rate and fiscal policies. The effects of the financial system require structural policies geared to improving the strength and resiliency of financial institutions. The policy implications for less developing countries specifically, is that major reversals in capital flows will continue to be a threat if lack of confidence in domestic macro-economic policies emerges. The crisis of Balance of Payments may arise as a consequence of both financial and macro-economic imbalances. The more important of them is the integration of world; the recent volatility observed with private capital is likely to increase due to the changes in interest rates, stock market returns, international portfolio diversification and hedging phenomena.