Capital Account Liberalization, Currency Float, and Twin Crises
After the collapse of the Bretton Woods system in early 1970s, a new breed of financial crisis emerged. Three quarters of the IMF’s member countries suffered some form of banking crisis between 1980 and 1996, and their study did not include the subsequent Asian financial crisis in 1997. In many of these crises, banking panics in the traditional sense were avoided either by central bank intervention or by explicit or implicit government guarantees. But the advent of financial liberalization in many economies in the 1980s, in which free capital in- and out-flows and the entrance and competition from foreign investors and financial institutions follow in the home country, has often led to “twin” banking and currency crises. A common precursor to these crises was financial liberalization and significant credit expansion and subsequent stock market crashes and banking crises. In emerging markets this is often then accompanied by an exchange rate crisis as governments choose between lowering interest rates to ease the banking crises or raising them to defend the home currency. Finally, a significant fall in output occurs and the economies enter recessions.
The entrance of China to the WTO (World Trade Organization) potentially introduces cheap foreign capital and technology, but large scale and sudden capital flows and foreign speculation significantly increase the likelihood of a twin crisis. The first key question is, when and to what extent should a country open its capital account and financial sector to foreign capital and foreign financial institutions? The prevailing view is that success or failure of this policy hinges on the efficiency of domestic financial institutions, while others have promoted reforming the financial sector as a precondition to liberalizing. This latter view assumes that financial liberalization does not alter the efficiency of domestic financial institutions. But this policy change affects both the supply and price of capital, two important determinants of lending contracts. A model of endogenous financial intermediation demonstrates that an efficient financial sector prior to liberalization is neither necessary nor sufficient for a successful financial liberalization. Read more
Financial Crises
Financial crises often accompany the development of a financial system. Conventional wisdom says that financial crises are bad. Often they are very bad, as they disrupt production and lower social welfare as in the Great Depression in the US. Hoggarth et al. (2002) carefully measure the costs of a wide range of recent financial crises and find that these costs are on average roughly 15-20 percent of GDP. It is these large costs that make policymakers so averse to financial crises.
It is important to point out, however, that financial crises may be welfare improving for an economy. One possible example is the late nineteenth century US, which experienced many crises but at the same time had a high long run growth rate. In fact, Ranciere et al. (2003) report an empirical observation that countries which have experienced occasional crises have grown on average faster than countries without crises. They develop an endogenous growth model and show theoretically that an economy may be able to attain higher growth when firms are encouraged by a limited bailout policy to take more credit risk in the form of currency mismatch, even though the country may experience occasional crises (see Allen and Oura (2004) for a review of the growth and crises literature and Allen and Gale (2004a) who show that crises can be optimal).
In this section, we consider financial crises in China. Given China’s current situation with limited currency mismatches any crisis that occurs is likely to be a classic banking, currency or twin crisis. It is perhaps more likely to be of the damaging type that disrupts the economy and social stability than of the more benign type that aids growth. The desirability of preventing crises thus needs to be taken into account when considering reforms of China’s financial system. First, we examine how China can prevent traditional financial crises, including a banking sector crisis and a stock market or real estate crisis/crash. We then discuss how China should be better prepared for new types of financial crises, such as the “twin crises” (simultaneous foreign exchange and banking/stock market crises) that occurred in many Asian economies in the late 1990s.
Government ownership
Many countries in the world neglected one of the important aspects of financial sector - the government ownership of banks. The attitude toward government ownership of banks was different across time. In 1960s and 1970s government ownership of banks was strongly supported by economists. But recent economic views support benefits of private ownership of banks.
Supportive views consider banking sector as ‘strategic economic sector’ along with utilities, education, etc. (Hawtrey, 1926) and point out that the government can improve the functioning of this sector, since the government can overcome market failures, exploit externalities and invest in socially desirable projects.
The supportive view includes three more narrow views:
1. The Social view argues that government plays the important roles in compensating of market imperfections that leave the socially desirable investments under-financed (Atkinson and Stiglitz 1980; Stiglitz 1994).
2. The development view focuses on the necessity of financial development for economic growth and stresses governments’ development goals. This view is associated with Alexander Gerschenkron (1962). He argues that in some countries private banks can channel funds for economic growth, but there are some countries where private banks are not able to attract sufficient funds to engage in financing profitable investment projects, because of public distrust to banking sector and absence of honest business practices. He stresses that government has sufficient information and incentives to promote socially desirable investments and in such countries it can help the development of lending to the private sector or simply subsidize private banks. As a consequence government ownership of banks promote the development of institutions of lending and the whole banking sector. Read more
Banking Auditing
From the perspective of the regulatory institutions market discipline can exist only under the supervision of efficient regulatory bodies. One of the changes that occurred in the institutional environment of the financial system was the separation of the supervision and regulatory functions of the Central Bank of Argentina by re-creating the Superintendency as a semi-autonomous unit within the Central Bank
The availability of the information is not the only important factor determining the efficiency of market principles. The quality of information determines the quality of market reaction on changes in the financial environment and behavior of institutions. To ensure reliable and qualitative information, in Argentina was introduced the system of compulsory auditing of financial institutions and their rating. Auditing ensures the validity of the published information. To have reliable auditing procedures, the Central Bank of Argentina has set guidelines for minimum auditing requirements. The Superintendency adopted a system similar to CAMEL banking rating used mainly for capital requirement regulations. According to this system, the banks with a lower rating were subject to higher capital requirements. Market participants used this information as a signal about the sanity of the financial institutions. Besides institutional rating system Argentina introduced Credit Rating requirements. This measure meant to allow less sophisticated investors to have access to decision-making reliable information. Credit rating was a good measure to ensure market-discipline. The problem is that it did not function too well for Argentina. Credit rating system was criticized because different financial institutions were rated by different agencies, and there was no comparability between them. Economists argue that some credit rating institutions gave higher rates then others did and because of this it could lead to false signals for the market.
