04. Exam - International Financial Crises

Question 1

What is a financial crisis?

Answer 1

Usually involves a banking crisis, a debit crisis and/or an exchange rate crisis. They result in disintermediation and a slow down in economic activity that may be severe.

Question 2

What is a banking crisis?

Answer 2

Occurs when banks fail and disintermediation spreads.

Question 3

What is an exchange rate crisis?

Answer 3

Collapse of country’s currency

Question 4

What are contagion effects?

Answer 4

The spread of a crisis from one country to another. This may happen through trade flows, currency and exchange rate movements or a change in the perceptions of foreign investors.

Question 5

What is the international financial architecture?

Answer 5

It is the complex of institutions, international organisations, governments and private economic agents that make up the international financial system.

Question 6

What do many of the international financial architecture reforms revolve around?

Answer 6

A set of proposed changes to the IMF and other multilateral institutions with a role in international finance relations.

Question 7

What is intermediation?

Answer 7

The role of the banks as institutions that concentrate savings from many sources and lend money to investors.

Question 8

What is disintermediation?

Answer 8

A failure on the part of the banking system that prevents savings from being channeled into investment.

Question 9

What is a debt crisis?

Answer 9

A financial crisis brought on by unsustainable levels of debt. The debt may be either privately or publicly funded.

Question 10

How does an exchange rate crisis occur (for each different type of currency exchange)?

Answer 10

• Under a fixed exchange rate system, crisis entails the loss of international reserves and devaluation.
• Under a flexible exchange rate system, crisis means an uncontrolled, rapid depreciation of the currency.
• Countries with a pegged exchange rate may be more vulnerable to a crisis.

Question 11

What are the two origins of international financial crisis?

Answer 11

1) Macroeconomic imbalances such as large budget deficits caused by overly expansionary fiscal policies; and
2) volatile flows of financial capital that move in and out of a country quickly.

Question 12

Crises caused by macroeconomic imbalances are often accompanied by what

Answer 12

An exchange rate system that intensifies the country’s vulnerability.

Question 13

Explain how the 2007 crisis partially fits with a macroeconomic imbalance scenario?

Answer 13

Investment was facilitated by global imbalances where countries with high savings rates and large current account surpluses lent to countries with large current account deficits and significant demand for investment.

• In 2007 the housing bubble collapsed
• Banks were unable to lend (becoming insolvent)
• Resulted in steep decline in customer / business spending

Question 14

What is sovereign debt?

Answer 14

A debt crisis in which the government cannot pay back its loans.

Question 15

What is the fundamental cause of a crisis caused by volatile capital flows?

Answer 15

• the financial capital is highly volatile and technological advances have reinforced this volatility. A weak financial sector also intensifies these problems.

Question 16

When banks take on short-term international debt to fund long-term domestic loans, what are the three unsettling possible scenarios?

Answer 16

1) there are multiple possible outcomes (multiple equilibria)
2) A self-fulfilling crisis
3) The crisis affects banks that are fundamentally sound, but have mismatches between maturities of assets and debts - they are illiquid but not insolvent.

Question 17

What is Moral Hazard?

Answer 17

It is the incentive to act in a manner that creates personal benefits at the expense of the common good - ie. banks have an incentive to make riskier investments when they know they will be bailed out.

Question 18

What is a way to avoid moral hazard in banks?

Answer 18

Increasing the capital requirements, so that banks have more capital available. Basel accord 1989 & updated in 2010 (Basel III) have made banking systems more robust by setting new standards for bank supervision, information disclosure and stress tests.

Question 19

What are the three best practices to reduce the problem of moral hazard?

Answer 19

• capital requirements
• supervisory review
• information disclosure requirements

Question 20

What is a crawling peg exchange

Answer 20

An exchange fixed to a major world currency or a basket of currencies.

Question 21

Why does the crawling peg increase vulnerability to a financial crisis (2)?

Answer 21

• requires monetary authorities to exercise discipline in issuing new money; anti-inflationary tendencies are exacerbated by international slow deflation; a sever overvaluation of the real exchange rate may result;
• Exiting crawling peg is also difficult - a government leaving it may lose the confidence of investors.

Question 22

What are capital controls?

Answer 22

They are controls which may be imposed to prevent capital movements in the financial account. The control inflows and outflows.

Question 23

What are the inflow restrictions (capital control)

Answer 23

They reduce the inflow of short-run capital which would add to the stock of liquid, possibly volatile capital. These tend to work better than outflow restrictions.

Question 24

What is the impact of outflow controls and when are these best used?

Answer 24

They may help reduce the impact of a crisis when it occurs.

Question 25

What are possible domestic policies for crises management?

Answer 25

• Cutting the deficit
• Raising the interest rates to help defend the currency
• Letting the currency float.

Question 26

What are the problems with implementing domestic policies to manage a crisis?

Answer 26

• they may not be politically feasible
• sudden capital flight is hard to cure
• collapsing currency may be defended by raising interest rates, but this may cause other issues such as bankruptcy.

Question 27

There are new international policies in the reform of the international architecture to avoid and manage a financial crisis, the great variety of the reform proposals tend to focus on what two issues?

Answer 27

1) the role of an international lender of last resort
2) conditionality - ie the changes in economic policy that a borrowing nation must meet in order to receive loans from the lender of last resort.

Question 28

What is a lender of last resource?

Answer 28

A source of loanable funds after all commercial sources of lending become unavailable - this includes the central bank (domestically) and the IMF with the support of high-income countries (internationally).

Question 29

What do opponents and proponents of the lender of last resort say?

Answer 29

• opponents - cite moral hazard issues

- proponents - lender can reduce moral hazard by requiring increased financial sector regulations

Question 30

Debate on the IMF’s role as a lender of last resort and moral hazard centres on two areas?

Answer 30

• the rules for IMF loans depend on the size of the loan. Countries pay a subscription (quota) to join. The quota depends on the size of the economy & its strength.
• loan size is up to 300% of their quota unless extraordinary circumstances (eg Mexico)

Question 31

What are the conditions that the IMF requires?

Answer 31

• Changes to monetary & fiscal policies - financial sector
• changes to exchange rate policies - international trade
• Change to structural policies - public enterprises

Question 32

How does the IMF go about making the loans to countries?

Answer 32

In tranches (installments of the total loan) with each tranche hinging on the completion of reform targets.

Question 33

What two points do critics of the IMF’s conditionality state?

Answer 33

1) the need to comply with conditionality’s may intensify the recessionary effects of a crisis; and
2) Conditionality may entail high social costs on the poorest in society.

Question 34

What do supporters of the IMF’s conditionality state (2) and how do critics respond to this?

Answer 34

• Crises could be avoided by a pre-qualification criteria;
• Assistance conditional on sound financial sector policies
  However critics respond by saying that pre-qualification will not deter speculative attacks on a country’s currency and that the IMF cannot ignore countries who fail to qualify.

Question 35

There is a need for greater transparency to make a country’s financial standing clearer to potential lenders - what are two ways that this is occurring?

Answer 35

1) Basel Capital Accord includes issues of transparency and data reporting
2) Data dissemination standards by the IMF for data reporting are under development.

Question 36

What are two options for resolving a conflict between lenders (eg the private sector insist they are paid first)

Answer 36

• Standstills - IMF’s recognition that a country in crisis temporarily stop making repayments on its debt
• Collective action clauses - lenders agree on collective mediation among themselves and the debtor in the event of a crisis.

Question 37

After the Asian crises financial reform was at the top of the world’s agenda - what progress has been made and why?

Answer 37

Little - and attention is being focused on security, terrorism, energy and climate change.

Question 38

The first visible stage of the financial crisis of 2007 was the subprime crisis - explain this.

Answer 38

Housing loans were made in the US to borrowers with less than prime ratings. Banks and other non-bank entities packaged these loans and sold shares in the entire package. This securitisation allowed buyers to receive a return based on the interest the borrowers paid.

Question 39

What is sovereign wealth funds?

Answer 39

savings held by governments.