Financial Crises

by Sylvia Chia Lee Ping

The three most common financial crises that have occurred and impacted the global financial system are debt crisis, currency crisis and banking crisis. In this article, we will be looking at the Latin America Debt Crisis and East Asian Currency Crisis as these two crises were the major ones that occurred in the 1980s and 1990s.

Latin America Debt Crisis in the 1980s

This crisis that started in the 1970s and eventually took effect in the 1980s happened due to advancement in industries and the need to build better infrastructure. This led to borrowing of money from international creditors with countries such as Mexico, Venezuela, Brazil and Argentina having had the most public debt in Latin America.

The reduction of domestic output and consumption caused the increase of resources to repay the debts accumulated. Banks became active in Leverage Buy-out (LBOs) (Simpson, 2012) and had to put an end to central planning and create privatisation. Small and medium sized banks withdrew from the international lending arena while the multinational banks went through transformation in international lending (Mehta and Fung 2004, 222).

Ocampo, J. A. (2009, 14) stated that the economic history of Latin America since the 1970s indicated that the region has been plagued not only by strong pro-cyclical capital flows but also by the predominance of pro-cyclical macroeconomic policies that tend to reinforce rather than smoothen out the transmission of external shocks to the domestic economy.

Meanwhile, Coatsworth, J. H. (2008) stated that for the Americas as a whole and Latin America in particular, this trend has already produced new knowledge about the causes and consequences of economic backwardness, with even some new thinking about possible remedies.

East Asian Currency Crisis in the 1990s

This crisis started in 1997 when Thailand defaulted its non-bank financial institutions on real estate loans financed by foreign debt (Mehta and Fung, 2004, 222). During that period of time, some Asian countries were doing well in its economies with the assistance of foreign capital inflows.

Thailand’s government then decided to eliminate their currency to peg against the American dollar (which resulted from the domestic real estate crisis) and float its currency. This resulted in the country’s bankruptcy. Recovery from this crisis was near impossible as earnings from import of goods in Thailand decreased.

The crisis spread to other nations in the region such as Indonesia, South Korea, Hong Kong, Malaysia, Laos and the Philippines while countries such as China, India, Taiwan, Singapore and Vietnam remained unaffected.

The International Monetary Fund (IMF) was forced to inject funds into a forty billion dollar programme to stabilise the currencies of Thailand, Indonesia and South Korea even though the governments of these countries did not have national debt. The high dependence of private sectors on foreign loans and the failure of economies to control portfolio investment flows caused this East Asia crisis to occur (Dullum and Kulkami, 2011, 9-10).

Shen and Lin (2011, 90) stated that since the occurrence of the Asian financial crisis in 1997, the financial sectors of Asian countries have been experiencing a period of consolidation. However, at the time of the crisis, local currencies and equity prices plummeted, and real estate bubbles burst.

In the 1990s, there were also other crises that occurred during that era and spread from one country to another in the same region. These include the Europe Crisis and Tequila Crisis.

Europe Crisis

A property boom in Sweden and Finland started due to extensive controls as the Nordic countries freed their banks. The European Monetary System crisis triggered a bust and also caused the breakdown of the Soviet Empire while banks in Norway failed due to the Nordic banking and currency crisis (Bordo and Landon-Lane 2010, 7-10).

Leijonhufvud (2009, 746) stated that in the wake of their real estate bubbles (and in Finland’s case, the loss of its Soviet Union export markets) in the early 1990s, both Sweden and Finland fell into depressions deeper than what they had experienced in the 1930s. Both had to devalue, and Sweden in particular, had to climb far down from its lofty perch in the world ranking of per capita real income.

Tequila Crisis

A massive devaluation in 1994 by Mexico may have been triggered due to an inflation scare and constricted Federal Reserve policy. This created the banking crisis and the United States arranged for a rescue package. Other Latin American countries were also hit by debt, banking and currency crises due to the tequila effect. It however had minimal impact on developed countries (Bordo and Landon-Lane 2010, 7-10) (Figure 1).

Differences and similarities

Both crises are similar in excessive dependence on foreign borrowing. This caused the countries affected to accumulate debts (Mehta and Fung, 2004). The difference would be the type of debts in which Latin America suffered from public debts (foreign debts that were accumulated by the government) while East Asia suffered from private debts (crisis from the source of revenue for businesses and households).

According to Candelon and Palm, there are potential connections between currency and banking crises with the possibility of twin crises. If the exchange rate markets suffer from a sudden collapse, it would threaten financial investments where this may lead to liquidity problems and bankruptcy of financial institutions.

According to Bordo, Cavallo and Meissner, currency crises can be generated through both banking crisis and the expectation of a debt crisis. This is where the banking system’s liabilities are drained and it is supported by international reserves. The government’s balance sheet is also threatened.

Figure 1.

Sylvia Chia Lee Ping is a third-year Accounting and Banking student of Curtin Sarawak. She was the Secretary of CPA Australia Student Charter (CPAASC) Curtin Sarawak and was involved in the CPAASC Curtin Undergraduate Business Conference.

Share this