Glamor Economics

Chapter 114

Chapter 15 Section 5 The Domino Effect in the Financial System - Currency Crisis

In the 20s, with the end of World War I, the world economy entered a period of recession, and the currencies of European countries were faltering.During this period, the French government staged a splendid and successful defense of the franc.

The franc crisis also started with the First World War.The French government spent a large amount of military expenditure in World War I, which was twice the military expenditure of all major participating countries in 1913-1914.After the end of World War I, there was a gap of 62 billion francs in the French finances, and there were huge loans. In 1926, the exchange rate of the franc began to decline.It is believed that the franc will face the same fate as the Deutsche mark.At that time, the French government cabinet was helpless, prices kept rising, and the franc continued to depreciate.At this time, Prime Minister Raymond?Ngale came to power.He converted short-term borrowing into long-term borrowing by raising short-term interest rates, raising taxes and cutting government spending. At the same time, he borrowed a huge loan from JPMorgan Bank of the United States to supplement the cash exchange of French banks.A series of measures restored people's trust in the franc. Since then, the value of the franc has stabilized, and the French economy and political situation have gradually stabilized.

The concept of currency crisis can be divided into narrow sense and broad sense.A currency crisis in a narrow sense corresponds to a specific exchange rate system (usually a fixed exchange rate system), which means that a country that implements a fixed exchange rate system, under special circumstances (such as in the case of deterioration, or in the case of a strong speculative attack) ), adjust the country’s exchange rate system and switch to a floating exchange rate system, so that the exchange rate level determined by the free market is much higher than the original official exchange rate. This situation is a currency crisis.Currency crisis in a broad sense refers to the range of exchange rate fluctuations beyond a country's tolerance, usually manifested as a sharp depreciation of the country's currency.

An isolated currency turmoil rarely occurs in the contemporary international economic society.In the era of globalization, due to the increasingly close connection between the national economy and the international economy, a country's currency crisis often affects other countries.

With the development of market economy and the acceleration of globalization, the stagnation of economic growth is no longer the main cause of currency crisis.A large number of studies by economists have shown that overvalued exchange rates, huge current account deficits, declining exports, and slowing economic activities are all precursors to currency crises.In terms of actual operation, a currency crisis is usually caused by the bursting of the bubble economy, the increase in bank bad debts, a serious imbalance in the balance of payments, excessive foreign debts, financial crises, political turmoil, and distrust of the government.

1. Improper exchange rate policy
Economists generally agree with the conclusion that the fixed exchange rate system is not feasible under the conditions of large-scale and rapid international capital flows.A fixed exchange rate system can nominally reduce the uncertainty of exchange rate fluctuations, but since the 20s, currency crises have often occurred in countries with fixed exchange rates.Therefore, in recent years, more and more countries have abandoned the fixed exchange rate system they once implemented, such as Brazil, Colombia, South Korea, Russia, Thailand and Turkey.However, most of these countries were forced to abandon their fixed exchange rates due to the outbreak of the financial crisis. Exchange rate adjustments are often accompanied by loss of confidence, deterioration of the financial system, slowdown in economic growth, and political turmoil.There are also some countries that have successfully transitioned from a fixed exchange rate system to a floating exchange rate system, such as Poland, Israel, Chile and Singapore.

2. The banking system is fragile
In most emerging market countries, including those in Eastern Europe, a reliable precursor to a currency crisis is a banking crisis.Undercapitalized and not strictly regulated banks borrow heavily from abroad, and then lend to domestic problematic projects, due to currency mismatch (banks often borrow in US dollars, and lend out in local currency) and maturity mismatch (bank Borrowing is usually short-term funds, and lending is often for construction projects that take several years), so bad and bad debts have accumulated.For example, a few years before the outbreak of the East Asian financial crisis, the annual growth rate of the credit markets in Malaysia, Indonesia, the Philippines and Thailand was between 20% and 30%, far exceeding the growth rate of industry and commerce, and the resulting economic bubbles became more and more serious. The bigger the banking system, the more fragile it will be.

3. Heavy foreign debt burden

Currency crises in Thailand, Argentina, and Russia are closely related to the huge scale and irrational structure of foreign debt owed.For example, Russia has absorbed a total of 1991 billion US dollars of foreign capital from 1997 to 237.5, but in the total foreign capital, direct investment only accounts for about 30%, and short-term capital investment accounts for about 70%.In October 1997, before the outbreak of the currency crisis, foreign capital had already controlled 10% to 60% of stock market transactions and 70% to 30% of treasury bond transactions. After mid-July 40, the Ministry of Finance of the Russian government issued the "August 1998 Joint Statement", announcing that "the transaction and payment of national debt due before the end of 7 would be stopped", and the bond market collapsed, directly triggering the ruble crisis.

4. The fiscal deficit is serious
In countries where currency crisis occurs, more or less fiscal deficits exist, and the larger the deficit, the greater the possibility of currency crisis.The fiscal crisis directly triggered the collapse of the bond market, which in turn led to the currency crisis.

5. Crisis of government confidence
The trust of the public and investors in the government is the prerequisite for currency stability, and winning the support of the public and investors is the basis for the government to effectively prevent and respond to financial crises.Much of the Mexican peso crisis has been blamed on its political fragility, with the assassination of a presidential candidate in 1994 and unrest in Chiapas putting Mexico in socio-economic turmoil.The indecision of the new government on economic policy made foreign investors believe that Mexico might not take its government expenditure and balance of payments seriously, and the crisis of confidence led to a financial crisis.

6. Weak economic foundation
A strong manufacturing industry and a reasonable industrial structure are a solid foundation for preventing financial turmoil.Serious flaws in the industrial structure are one of the reasons for the economic crisis in many countries.For example, Argentina has always had serious structural problems. Although neoliberal reforms were implemented in the 20s, the adjustment of industrial structure lagged behind. Exports of agricultural and animal husbandry products accounted for 90% of total exports, while manufacturing exports accounted for only about 60%. .After the price of primary products in the international market fell and some countries increased barriers to Argentina's agricultural products, Argentina lost its competitive advantage and its exports suffered setbacks.

7. Cross-border transmission of crisis
Due to trade liberalization, regional integration, and especially the facilitation of cross-border capital flows, currency trends in one country can easily cause financial market turmoil in neighboring countries, especially in emerging markets.The domino effect of Thailand to East Asia, Russia to Eastern Europe, and Mexico and Brazil to Latin America have been repeatedly confirmed.

[links to related words]

Contagion Effect The spread of currency crises in the international community is called the contagion effect.

(End of this chapter)