Financial Crises in Mexico, 1994 1995; East Asia,1997 1998; and Argentina, 2001 2002 APPLICATION

When emerging-market countries opened up their markets to the outside world in

the 1990s, they had high hopes that globalization would stimulate economic

growth and eventually make them rich. Instead of leading to high economic

growth and reduced poverty, however, many of them experienced financial crises

that were every bit as devastating as the Great Depression was in the United States

and other countries.

The most dramatic of these crises were the Mexican crisis, which started in

1994; the East Asian crisis, which started in July 1997; and the Argentine crisis,

which started in 2001. We now apply the asymmetric information analysis of the

dynamics of financial crises to explain why a developing country can shift

dramatically from a path of high growth before a financial crisis as was true in Mexico

and particularly the East Asian countries of Thailand, Malaysia, Indonesia,

the Philippines, and South Korea to a sharp decline in economic activity.2

Before their crises, Mexico and the East Asian countries had achieved sound

fiscal policies. The East Asian countries ran budget surpluses and Mexico ran a

budget deficit of less than 1% of GDP, a number that most advanced countries

would be thrilled to have today. The key precipitating factor driving these crises

was the deterioration in banks balance sheets because of increasing loan losses.

When financial markets in these countries were liberalized and opened to foreign

capital markets in the early 1990s, lending booms ensued. Bank credit to the pri-

vate nonfinancial business sector accelerated sharply, with lending expanding at

15% to 30% per year. Because of weak supervision by bank regulators, aided and

abetted by powerful business interests (see the Global box, The Perversion of the

Financial Liberalization/Globalization Process: Chaebols and the South Korean

Crisis) and a lack of expertise in screening and monitoring borrowers at banking

institutions, losses on loans began to mount, causing an erosion of banks net

worth (capital). As a result of this erosion, banks had fewer resources to lend. This

lack of lending led to a contraction of economic activity, as outlined in the previ-

ous section.In contrast to Mexico and the East Asian countries, Argentina had a well-

supervised banking system, and a lending boom did not occur before the crisis.

The banks were in surprisingly good shape before the crisis, even though a severe

recession had begun in 1998. This recession led to declining tax revenues and a

widening gap between government expenditures and taxes. The subsequent

severe fiscal imbalances were so large that the government had trouble getting

both domestic residents and foreigners to buy enough of its bonds, so it coerced

banks into absorbing large amounts of government debt. Investors soon lost con-

fidence in the ability of the Argentine government to repay this debt. The price of

the debt plummeted, leaving big holes in banks balance sheets. This weakening

led to a decline in lending and a contraction of economic activity, as in Mexico

and East Asia.

Consistent with the Canadian experience in the nineteenth and early twentieth

centuries, another precipitating factor in the Mexican and Argentine (but not East

Asian) financial crises was a rise in interest rates abroad. Before the Mexican cri-

sis in February 1994, and before the Argentine crisis in mid-1999, the Federal

Reserve in the United States began a cycle of raising the federal funds rate to head

off inflationary pressures. Although the Fed s monetary policy actions were suc-

cessful in keeping U.S. inflation in check, they put upward pressure on interest

rates in both Mexico and Argentina. The rise in interest rates in Mexico and

Argentina added to the already increased adverse selection and moral hazard

problems in their financial markets. As discussed earlier, it was more likely that the

parties willing to take on the most risk would seek loans, and the higher interest

payments led to a decline in firms cash flows.

Question:

Q)Summarize how the financial crisis arose and Identify Moral Hazard & Adverse selection from this case study.