Do you know why Financial Crises reoccur?

Do you know why Financial Crises reoccur?

Currency crises and debt crises have plagued the Latin American countries since 1980s. In East Asian economies, it is primarily the debt crises in the 1990s that led to tapering of the gains that had been made over the years in trade and currency management through various modes that can be used for keeping a currency afloat. A currency can be pegged against the dollar, and a fixed exchange rate can be maintained. In other cases, it is possible to maintain a floating rate wherein people can trade in the currency through buy and sell transactions against standard international currencies like the Dollar, the Euro and the British Pound. Even in case of a fixed exchange rate, maintaining a one to one ratio of the currency against the Dollar was tried in Latin American countries but it is not possible to maintain a stable currency with such a peg as the country in question in that case needs to have foreign currency reserves that allow it to pay a Dollar against the domestic currency should an investor want to move it out of the country. In simpler terms, for every one unit of the domestic currency you could buy one US Dollar in case of a one to one peg of the two currencies.

In the Latin American context, purely from the point of view of a learner, it is to be realized that a full-fledged crisis is a combination of multiple kinds of crises that do not occur in isolation. These may happen one after the other but  these in combination can lead to a bigger financial crisis. For a student interested in pursuing MBA or a career in the banking or Government sectors, basic knowledge of financial crises involves  an understanding of not just what emerges at the end but even the constituents that are by themselves crises that afflict a particular aspect of the economy, for instance, the banking crises that have in recent times affected the European and American economies.

Currency Crisis

Foreign funds flowing into an economy is not always good news. This holds especially true if a balance of payments crises leads to immediate and extensive outflow of funds, which are generally termed as ‘hot money’ coming from investors that have a short-term investment outlook and the currency peg is such that the central bank cannot maintain the exchange rate by buying or selling the domestic or the foreign currency as required in the scenario playing itself out.

Debt Crisis

This was observed in the Mexican & Argentine economies in the 1980’s and the 90’s. The Argentine economy still continues to suffer from the recurring nature of the crisis that continues to make its presence felt in one form or the other, for instance the bond market in Argentina is perennially crisis prone. The settlement with the holdouts from among those having invested in its bond market took a long time to come about while the rest agreed to a shave in the interest rate. The term ‘holdouts’ refers to those who refuse to take the deal on offer coming from the bond issuers. A haircut, which means  taking a cut on the face value of the bond was also a part of the restructuring exercise in the early 2000’s.

Banking Crisis

A combination of banking and debt crises marked the period of instability in the Mexican economy during the fag end of the 80’s decade and in the earlier part of the 90’s. The Thai economy also experienced the same as foreign currency denominated loans were easily available but the domestic currency underwent a rapid slide in its value.

In the last decade, crisis afflicted economies have found it difficult to escape unscathed from the effect of the crises that have for long affected the world economies. Therefore, a look at the factors that caused these and what led to these being restricted to one of a specific kind, viz. banking, debt or currency; and a country rather than it having a cascading affect on the region or it spilling over into other aspects of the economy

Also read: Understanding Basel norms and its implementation

Understanding Greek debt crisis