Alesya Sharipova

Group 501

Financial Crisis

Plan 

• Financial crisis                                      

• Underlying causes                             

• Crisis in Different Countries           

• Consequences for Belarus            

• Process of Financial Crisis           

• Signs of a Future Financial Crisis          

• What measures are to be taken?                            

• Conclusion         

Financial crisis

     The world has entered a very dangerous period. There is big danger that some leading circles — including in and around the Bush Administration in the U.S. — will react to the unfolding crisis with desperate and incalculable actions, that could plunge the world into chaos and war. Even apart from this, the tendency of governments to try to adapt to the situation in a purely pragmatic way, rather than addressing the real nature and long-term origins of the crisis, would make a chaotic disintegration of the world economy and political situation virtually inevitable. Before examining the background of the crisis and directions of solution we should stress the following:

1. Present crisis is in nature, not simply the USA. Although the crisis is centered in the U.S., its devastating effects will by no means be restricted to the dollar system alone, but will affect every important currency. This crisis endangers the economic and political security of every nation on Earth, without exception.

2. The present collapse process of the global financial system did not arise just in recent years, but is the result of a long-term process going back over 30 years, and which is connected with fundamental errors of economic thinking and economic policy.

3. There is no purely financial-technical solution. Any successful actions must be based on a long-term policy of cooperation among nations, to the rebuild the world's physical economy via large-scale infrastructure projects, high-technology industrial projects and other projects, and corresponding long-term trade agreements.

Underlying causes

      Financial instability is defined in as a failure of the financial intermediaries to perform their basic function of channeling funds from saving to investment and consumption in order for modern economy to function efficiently.  The lack of needed information to make sound decisions in order to grant loans will push financial instability into financial crisis.   The causes of financial crisis are lack of proper information, decline of credit availability, loans denominated in foreign currencies, depreciation of exchange rate, current account deficit, and lack of effective regulations. 

Lack of Proper Information:           

Market failure as a result of asymmetry of information is larger in asset markets than in goods and services markets.  The asymmetry of information is pronounced in the international capital markets due to differences in cultural and legal frameworks. The asymmetry of information leads investors to react in panic to any sign of economic trouble by withdrawing their financial capital, pushing the country into financial crisis.  The cost of acquiring information on a particular company in a given country reduces the rate of return on investment and, therefore, leads investors to behave like a herd in investing or withdrawing producing a boom-bust cycle.  Investors are aware of the fact that the longer they hold their assets during the financial crisis, the larger their losses will become, so they tend to overreact and produce market failure which may not be justified based on the actual fundamentals of the economy.             

Asymmetric information is where the borrower has superior information compared to the lender.  This asymmetry of information allows for the selection of high risk projects due to the willingness of the borrower to pay higher interest rates relative to less risky projects on the loan.  This may prove to be the wrong strategy. The selection of high risk projects to finance and moral hazard problems lead lenders to lend less than what is optimal to be able to protect themselves.  A moral hazard occurs if the borrower spends the loan, not for its original purpose but on activities that make the ability of the borrower to pay back the loan less likely. Also, imposing restrictions on loans are costly to monitor and enforce by the lender.  Financial intermediaries’ ability to cut future lending to a given borrower may improve the borrowers’ behavior.  International financial institutions and foreign banks use this method to impose restrictions on developing countries to change their fiscal, monetary, trade and investment policies.           

High interest rates and access to long-term loans are problems constraining small and medium sized enterprises’ (SME) ability to expand.  While global corporations finance higher percentage of their investment from commercial banks relative to SME, global corporations have the ability to access credit in many countries and the ability to borrow at a lower interest rate than SME as well as the access to long-term loans.  Also, lack of modern legal and financial development in a country may lead local firms to choose global banks for their services as in the case of Eastern European.  Banks, especially foreign banks, are hesitant to supply credit to SME because of a lack of information needed to assess the risk.

Credit Conditions, Illiquidity and Loans Denominated in Foreign Currency:

     Developing countries under the pressure of financial flight typically adopted drastic measures to stop the dramatic decline in exchange rates.  One of these measures is a higher interest rate.  The higher interest rate and depreciation of the currency increases the burden of local firms with debt denominated in foreign currencies and consequently leads to financial crisis and recession.  One would expect that a high interest rate would require expansionary fiscal policy to offset some of the negative impact of contractionary monetary policies.  This option was not viable for developing countries to use in order to avoid speculative attacks and maintain credibility with the market as was the case in SEA, Mexico, and Brazil.  Contractionary fiscal and monetary policy in the face of recession will increase unemployment and induce a severe recession.             

Increased uncertainty about the future economic conditions due to recession or failure of large corporations or the direction of fiscal and monetary policies may tend to reduce the lending activities of financial institutions.  Stock market decline or deflation will reduce the market valuation of the net worth of the firms or the collateral which will reduce lending and, consequently, economic activities.     

Illiquidity measure is the ratio of short term debt in foreign currencies to total foreign currency reserve in the hands of the central bank.  A high illiquidity ratio is an indication of a central bank’s inability to easily cover short-term foreign debts using its foreign currency reserve.  The other measure of illiquidity is the ratio of money supply to the central bank reserve of foreign currency. The high ratio of money supply to the central bank reserve of foreign currency indicates a potential problem if residents become concerned with the stability of their currency and want to convert their local currency into foreign currency.  The high ratio of money supply to the reserve of the central bank would make it impossible for the central bank to honor that demand at the going rate before the panic.  A high degree of illiquidity can make countries vulnerable to financial crisis. 

Current Account Deficit:

     This deficit played an important part in creating the crises.  Most developing countries face chronic current account deficit.  Current account deficit without surplus capital account will create a depreciation of the currency under floating exchange rate or balance of payments crisis under fixed exchange rate.

Exchange Rate and Speculation:

     Unexpected depreciation of a currency, which has little impact on the balance sheet of the local firms in industrialized countries, has a significant impact in precipitating financial crises in developing countries. The expectation of depreciation of the currency led speculators to sell the local currency in exchange for foreign currencies.  The government tried to support their currency by buying it up with their foreign reserves. The depletion of official reserves or central bank actions to reduce interest rates can produce an abandonment of the fixed exchange rate.  The reduction of interest rates would reduce the cost of public debt, strengthen the banking sector, and reduce the possibility of having to bail out the weak financial institutions. 

Lack of Effective Regulations:

      Lack of effective regulations and premature financial liberalization before the establishment of proper regulatory body was the reason behind financial crisis in developing economies. Interest rates on deposits should not exceed the treasury bill rates to prevent banks from competing for deposits to finance risky ventures, especially when the banks are on the verge of collapse. 

Crisis in Different Countries 

The United States

     The Federal Reserve, Treasury, and Securities and Exchange Commission took several steps on September 19 to intervene in the crisis. To stop the potential run on money market mutual funds, the Treasury also announced on September 19 a new $50 billion program to insure the investments, similar to the Federal Deposit Insurance Corporation (FDIC) program. Part of the announcements included temporary exceptions to section 23 A and 23B (Regulation W), allowing financial groups to more easily share funds within their group. The exceptions would expire on January 30, 2009, unless extended by the Federal Reserve Board. The Securities and Exchange Commission announced termination of short-selling of 799 financial stocks, as well as action against naked short selling, as part of its reaction to the mortgage crisis.