INTERNATIONAL LENDING AND CRISIS International lending has had recurrent horror stories where regional

financial crises have imposed large losses on lenders. In the 1980s, there was a Latin American debt crisis in which many countries were unable to service the international debts they had accumulated. In 1994 to 1995, there was the Mexican financial crisis, when Mexico devalued the peso dramatically and required a large loan from the IMF and the U.S. Treasury to avoid defaulting on international debts. More recently was

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U.S. banks to lending in each of the crisis areas. The table indicates that the situation from the perspective of U.S. banks was much more dire in the 1982 Latin American crisis than in the more recent cases. The 1980 debtor nations owed so much money to international banks that a default would have wiped out the biggest banks in the world. As a result, debts were rescheduled rather than allowed to default. A debt rescheduling post- pones the repayment of interest and principal so that banks can claim the loan as being owed in the future rather than in default now. This way, banks do not have to write off the debt as a loss—which would have threatened the existence of many large banks due to the large size of the loans relative to the capitalization of the bank. For instance, the Mexican debt to U.S. banks in 1982 was equal to 37 percent of U.S. bank capital. Banks simply could not afford to write off bad debt of this magnitude as loss. By rescheduling the debt, banks would avoid this alternative.

In contrast to the heavy exposure of international banks to Latin American borrowers in 1982, the Asian financial crisis of 1997 involved

a much more manageable debt position for U.S. banks. Many international investors lost money in the Asian crisis, but the crisis did not threaten the stability of the world banking system to the extent the 1980s crisis did. However, the debtor countries required international assistance to recover from the crisis in all recent crisis situations. This recovery involves new loans from governments, banks, and the IMF. Later in this chapter, we consider the role of the IMF in more detail. First, it is useful to think about what causes financial crises.

Table 11.1 U.S. Bank Loans in Financial Crisis Countries as a Percentage of U.S. Bank Capital

Latin America in 1982 Argentina

37% Mexico in 1994

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The causes of the recent Asian financial crisis are still being debated. Yet, it is safe to say that certain elements are essential in any explanation, including external shocks, domestic macroeconomic policy, and domestic financial system flaws. Let us consider each of these in turn.

1. External shocks. Following years of rapid growth, the East Asian economies faced a series of external shocks in the mid-1990s that may have contributed to the crisis. The Chinese renminbi and the Japanese yen were both devalued, making other Asian economies with fixed exchange rates less competitive relative to China and Japan. Because electronics manufacturing is an important export industry in East Asia, another factor contributing to a drop in exports and national income was the sharp drop in semiconductor prices. As exports and incomes fell, loan repayment became more difficult and property values started to fall. Since real property is used as collateral in many bank loans, the drop in property values made many loans of question- able value so that the banking systems were facing many defaults.

2. Domestic macroeconomic policy. The most obvious element of macroeconomic policy in most crisis countries was the use of fixed exchange rates. Fixed exchange rates encouraged international capital flows into the countries, and many debts incurred in foreign currencies were not hedged because of the lack of exchange rate volatility. Once pressures for devaluation began, countries defended the pegged exchange rate by central bank intervention—buying domestic currency with dollars. Because each country has a finite supply of dollars, countries also raised interest rates to increase the attractiveness of investments denominated in domestic currency. Finally, some countries resorted to capital controls, restricting foreigners access to domestic currency to restrict speculation against the domestic currency. For instance, if investors wanted to speculate against the Thai baht, they could borrow baht and exchange them for dollars, betting that the baht would fall in value against the dollar. This increased selling pressure on the baht could be reduced by capital controls limiting foreigners’ ability to borrow baht. However, ultimately the pressure to devalue is too great,

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devaluation. To aid in the repayment of the debt, countries turn to other governments and the IMF for aid.

3. Domestic financial system flaws. The countries experiencing the Asian crisis were characterized by banking systems in which loans were not always made on the basis of prudent business decisions. Political and social connections were often more important than expected return and collateral when applying for a loan. As a result, many bad loans were extended. During the boom times of the early to mid-1990s, the rapid growth of the economy covered such losses. However, once the growth started to falter, the bad loans started to adversely affect the financial health of the banking system. A related issue is that banks and other lenders expected the government to bail them out if they ran into serious financial difficulties. This situation of implicit government loan guarantees created a moral hazard situation. A moral hazard exists when one does not have to bear the full cost of bad decisions. If institutions or individuals taking the risk are assured of not being held liable for losses, then it creates excessive risk taking. So if banks believe that the government will cover any significant losses from loans to political cronies that are not repaid, they will be more likely to extend such loans. Considerable resources have been devoted to understanding the nature

and causes of financial crises in hopes of avoiding future crises and forecasting those crises that do occur. Forecasting is always difficult in economics, and it is safe to say that there will always be surprises that no economic forecaster foresees. Yet there are certain variables that are so obviously related to past crises that they may serve as warning indica- tors of potential future crises. The list includes the following:

1. Fixed exchange rates. Countries involved in recent crises, including Mexico in 1993 to 1994, the Southeast Asian countries in 1997, and Argentina in 2002, all utilized fixed exchange rates prior to the onset of the crisis. Generally, macroeconomic policies were inconsistent with the maintenance of the fixed exchange rate. When large devalua- tions ultimately occurred, domestic residents holding unhedged loans

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steadily over time, that is a good indicator that the fixed exchange rate regime is under pressure and there is likely to be a devaluation.

3. Lack of transparency. Many crisis countries suffer from a lack of transparency in governmental activities and in public disclosures of business conditions. Investors need to know the financial situation of firms in order to make informed investment decisions. If accounting rules allow firms to hide the financial impact of actions that would harm investors, then investors may not be able to adequately judge when the risk of investing in a firm rises. In such cases, a financial crisis may appear as a surprise to all but the “insiders” in a troubled firm. Similarly, if the government does not disclose its international reserve position in a timely and informative manner, investors may be caught by surprise when a devaluation occurs. The lack of good information on government and business activities serves as a warning sign of potential future problems. This short list of warning signs provides an indication of the sorts of

variables an international investor must consider when evaluating the risks of investing in a foreign country. Once a country finds itself with severe international debt repayment problems, it has to seek additional financing. Because international banks are not willing to commit new money where prospects for repayment are slim, the IMF becomes an important source of funding.

INTERNATIONAL LENDING AND CRISIS International lending has had recurrent horror stories where regional