8.4 The frequency of financial crises
Financial crises create large losses for international lenders through defaults, debt rescheduling, debt reduction, and declines in the market prices of bonds, stocks, and loans that are traded in secondary markets.Financial crises also impose large costs on borrowing countries through sudden declines in access to lending and the macroeconomic costs of recessions and slow economic growth that usually accompany the crises.While we have ways of trying to resolve crises once they occur, it would also be great to find ways to prevent financial crises from occurring, or at least to reduce their frequency.
There is no scarcity of proposals for improving the “international financial architecture”.Four proposed reforms enjoy widespread support.First, developing countries should pursue sound macroeconomic policies, to avoid creating conditions in which over-borrowing or a loss of confidence in the government’s capability could lead to a crisis.Second, countries should improve the data that they report publicly, to provide sufficient details on total debt and its components, as well as on holdings of international reserves, and they should report these data promptly.The belief is that with better data lenders would make more informed decisions on lending and investing, making over-lending less likely and also reducing the risk of pure contagion against emerging markets debt.While the call for more information is not controversial, it also has its limits.Developing country governments have the incentive to provide misleading or incomplete data at exactly the times when lenders most need accurate information.Third, developing country governments should avoid short-term borrowing denominated in foreign currencies, to avoid crises that begin with foreign lenders abruptly demanding repayment.In the next part of this section we look more closely at a fourth proposal that enjoys widespread support—better regulation and supervision of banks in developing countries.
Other proposals for reform are more controversial, and in some cases serious competing proposals suggest moving in opposite directions.One proposal is that developing countries should end efforts to fix or heavily manage the exchange rate values of their currencies.Among other possible benefits, the shift to more flexible exchange rates makes the existence of exchange rate risk palpable, and so private borrowers are less likely to build up large un-hedged liabilities in foreign currencies.But a competing proposal is that developing countries should move to nearly permanently fixed exchange rates, with greater use of currency boards and dollarization.Such arrangements may discipline government macroeconomic policies to be more sound.In another set of competing proposals, one is that the IMF should receive more resources so that it can establish large lines of credit to developing countries with sound economic policies.These countries then can use this backing to fight off any financial attacks.The other is that the IMF should be abolished, or at least that its rescue activities be severely limited, because it creates substantial moral hazard with its lending.By encouraging over-lending, it causes crises more likely.
1.International lending can bring two major types of benefits.First, it represents inter-temporary trade, in which the lender gives up resources today but must be willing to pay back more in the future.Second, it allows lenders and investors to diversify their investments more broadly.
2.Five major forces can lead to financial crises: waves of over-lending and over-borrowing, exogenous international shocks, exchange rate risk, fickle international short-term lending, and global contagion.
3.In the crises of the past several decades, the two major types of international efforts to resolve financial crises were rescue packages and debt restructuring.