Financial Markets and Institutions (2-downloads)

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Part 3 Fundamentals of Financial Institutions

C A S E

Financial Crises in Mexico, 1994–1995;

East Asia, 1997–1998; and Argentina,

2001–2002

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.

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 dynam-

ics 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.

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

fiscal policy. The East Asian countries ran budget surpluses, and Mexico ran a bud-

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

the United States, would be thrilled to have today. The key precipitating factor driv-

ing 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, a lending boom ensued. Bank credit to 

the private 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 on “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 along the lines outlined in the previous section.

In contrast to Mexico and the East Asian countries, Argentina had a well-super-

vised 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 expenditures and taxes. The subsequent severe fiscal imbalances were so

large that the government had trouble getting both citizens and foreigners to buy

enough of its bonds, so it coerced banks into absorbing large amounts of govern-

ment debt. Investors soon lost confidence in the ability of the Argentine govern-

ment to repay this debt. The price of the debt plummeted, leaving big holes in banks’

balance sheets. This weakening helped lead to a decline in lending and a contrac-

tion of economic activity, as in Mexico and East Asia.

Consistent with the U.S. experience in the nineteenth and early twentieth cen-

turies, another precipitating factor in the Mexican and Argentine (but not East Asian)

financial crises was a rise in interest rates abroad. Before the Mexican crisis, in

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

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Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?