What is currency crisis (or financial crisis)? What are the major stages of a fi

Question

What is currency crisis (or financial crisis)? What are the major stages of a financial bubble? Use one example (Mexican peso crisis, Asian financial crises, Argentine financial crisis, or 2008 financial crisis) to illustrate these stages. What major causes can you identify for the financial crises during the last decade? How does the “Mundel Trilemma” (or the “unholy trinity”, pp. 255-257) create challenge to policy options? Facing a financial crisis, what can the IMF and the affected state do to alleviate the crisis? What lessons can be learned from the past financial crises? (note- plz dont give to long or to short answers )

Explanation / Answer

While financial crises have common elements, they do come in many forms. A financial crisis is often associated with one or more of the following phenomena: substantial changes in credit volume and asset prices; severe disruptions in financial intermediation and the supply of external financing to various actors in the economy; large scale balance sheet problems (of firms, households, financial intermediaries and sovereigns); and large scale government support (in the form of liquidity support and recapitalization). As such, financial crises are typically multidimensional events and can be hard to characterize using a single indicator. The literature has clarified some of the factors driving crises, but it remains a challenge to definitively identify their deeper causes. Many theories have been developed over the years regarding the underlying causes of crises. While fundamental factors—macroeconomic imbalances, internal or external shocks—are often observed, many questions remain on the exact causes of crises. Financial crises sometimes appear to be driven by “irrational” factors. These include sudden runs on banks, contagion and spillovers among financial markets, limits to arbitrage during times of stress, emergence of asset busts, credit crunches, and firesales, and other aspects related to financial turmoil.

The term bubbles refers to large, sustained mispricings of financial or real assets. While definitions of what exactly constitutes a bubble vary, it is clear that not every temporary mispricing can be called a bubble. Rather, bubbles are often associated with mispricings that have certain features. For example, asset valuation in bubble periods is often explosive. Or, the term bubble may refer to periods in which the price of an asset exceeds fundamentals because investors believe that they can sell the asset at an even higher price to some other investor in the future. In fact, John Maynard Keynes, in his General Theory, distinguishes investors, who buy an asset for its dividend stream (fundamental value), from speculators, who buy an asset for its resale value. Ultimately, bubbles are of interest to economists because prices affect the real allocation in the economy. For example, the presence of bubbles may distort agents’ investment incentives, leading to overinvestment in the asset that is overpriced. Real estate bubbles may thus lead to inefficient construction of new homes. Moreover, bubbles can have real effects because the bursting of a bubble may leave the balance sheets of firms, financial institutions, and households in the economy impaired, slowing down real activity. Because of these repercussions on the real economy, it is important for economists to understand the circumstances under which bubbles can arise and why prices can deviate systematically from their fundamental value

five stages in a typical credit cycle – displacement, boom, euphoria, profit taking and panic. Although there are various interpretations of the cycle, the general pattern of bubble activity remains fairly consistent.

Valuations reach extreme levels during this phase. For example, at the peak of the Japanese real estate bubble in 1989, land in Tokyo sold for as much as $139,000 per square foot, or more than 350-times the value of Manhattan property. After the bubble burst, real estate lost approximately 80% of its inflated value, while stock prices declined by 70%. Similarly, at the height of the internet bubble in March, 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations.

During the euphoric phase, new valuation measures and metrics are touted to justify the relentless rise in asset prices.

Note that it only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot "inflate" again. In August, 2007, for example, French bank BNP Paribas halted withdrawals from three investment funds with substantial exposure to U.S. subprime mortgages because it could not value their holdings. While this development initially rattled financial markets, it was brushed aside over the next couple months, as global equity markets reached new highs. In retrospect, this relatively minor event was indeed a warning sign of the turbulent times to come.

Example of Mexico

Whereas the financial crisis in Mexico in 1982 had to do with external debt and took a long time for recovery the peso crisis of 1994 had little to do with external but instead was due to a short-term foreign exchange problem that was handled relatively quickly. In part, this quick recovery was due to the quick response of the U.S. government and the IMF in providing loans or loan guarantees. Some of the financial aid packages were prepared even before the peso crisis occurred as part of the structure associated with the North American Free Trade Alliance (NAFTA).

At the time NAFTA was approved in 1993 the economic future of Mexico looked bright.

As a result of the recovery program from the 1982 financial crisis the Government of Mexico had reduced its deficit even though it had also undertaken many program to alleviate problems of public health and education. Although conditions looked good for Mexico in 1993, 1994 was a very bad year for Mexico in many ways. On New Year's Day a radical activist from Mexico City launched the rebellion in the State of Chiapas which he and his associates had been organizing for a number of years. Chiapas has many problems and many legitimate complains against the central government in Mexico City but probably the last thing the people of Chiapas needed was a leftist rebellion. The more complete story of Chiapas is told elsewhere.

A presidential election was due in August of 1994 and that resulted in political considerations taking precedence over economic policy considerations. The outgoing president, Miguel Salinas de Gotari had selected Luis Donaldo Colosio as the candidate of the Party of Institutional Revolution (PRI) which had dominated the politics of Mexico for more than sixty years. Although he was virtually assured of a victory Colosio started campaigning throughout Mexico. In March Colosio was assassinated. Mexico has had assassinations of politicians before but generally only after they were in office or after they were in office. The last assassination of a major candidate had been in 1928. The assassination of the major candidate before the election creates a political crisis. Ernesto Zedillo, a relatively unknown candidate, was chosen to replace Colosio. Zedillo was elected President of Mexico in August of 1994 without much trouble. Then in September José Francisco Ruiz-Massieu, the Secretary General of the PRI, was assassinated. The world public interpreted Ruiz-Massieu's assassination as evidence of the political instability of Mexico and those with funds invested in Mexico began to withdrawn them. In fact, the assassination of Ruiz-Massieu had to do with vengence within his extended family, but that was not known at the time.

The outgoing president did not want to devalue the peso during his term of office and the devaluation was postponed until it was unavoidable. The attempt to maintain an overvalued peso created economic problems for Mexico in that discouraged foreign buyers from buying Mexican products but it encouraged Mexicans to buy foreign products. Furthermore, those with funds held in Mexico, Mexican and otherwise, could see that a devaluation was likely and began converting their peso assets into dollar assets.

A country supports the value of its currency by using up its hard foreign currency holdings to buy its own currency. Very quickly multibillion dollar reserves can be used up wastefully supporting an exchange rate that cannot be sustained.

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