International Lending and Financial Crises
Past instances of international lending have demonstrated that there is a strong co-relation between lending and financial crises. For instance, increased lending in the 1970s is believed to have led to the debt crisis that began in 1982. Several proposals have been made to reduce the number of financial crises associated with international lending. These include ensuring that the borrowing country has sound macroeconomic practices, and minimizing short-term debt. They should also have stricter controls over their banks to ensure that these institutions do not over-borrow. The following paper attempts to explain international capital flows, observe the differences in lending between industrialized nations and between industrialized nations and developing countries, as well as looking to some of the causes and solutions to financial crises.
International Capital Flows
Well-structured international lending otherwise referred to as international capital flows is similar to international trade because they wield the same kind of welfare. International capital flows are the financial flows of credit occurring on an international platform between different countries. The international capital claims can be broken down into government versus private international capital flows and long-term versus short-term international capital flows. In international economics, there is no difference between debt and equity except the belief that equity claims are usually long-term while debt can both be short and long-term.
International capital flows add to the total world product and results in net gains for the two nations involved in the transaction i.e. the borrowing and lending nations. Through this transaction, some groups in each country will lose well-being. The country with the higher market power (the one that can influence world interest rates) can impose taxes on international lending known as the national optimum tax to increase its welfare. However, if the other nation establishes its own national optimum tax then both countries can lose well-being or be worse off before the transaction and the imposition of tax took place.
The International Monetary Fund
· International Lending and borrowing between industrialized countries
International lending and borrowing between industrialized countries is usually well behaved and non-predatory in nature. The reason behind this could be that even though one country may have dominance over lending, the other industrialized nations have other areas that they may dominate. Thus, the industrialized nations may be afraid of retaliation in other markets if they become predatory in lending. In addition, the lending and borrowing between industrialized nations is well behaved because these countries’ economies present minimal default risks.
· International Lending by industrialized countries to developing nations
According to Leddy (1988), international capital flows between industrialized nations and developing countries/emerging markets have fueled global economic progress for more than two centuries. International capital flows have had a significant impact on the development of emerging nations. The funds borrowed are used for a variety of purposes but the purpose is to develop the comparative advantages of the borrowing countries.
There is an asymmetry between how industrialized nations utilize borrowed funds and how developing nations use these funds. International lending by industrialized nations to developing countries is very political, risky, and in most instances predatory. For many years, developing nations have been using the borrowed funds incorrectly. The reasons for this include extreme corruption inherent in these countries, political instability, wars, and institutional problems. This has resulted in a situation whereby such countries continue to have increasing deficits in their balance of payments and a significant decline in their productivity.
Furthermore, international borrowing poses a big problem for developing countries’ abilities to protect their environments and natural resources. Exogenous shocks to the developing markets make it impossible for such markets to manage effectively their natural resources. The increased difficulty in servicing foreign debt and decreased capital flows put too much pressure on such markets leading to environmental deterioration and the depletion of resources. Therefore, sustainable development is disregarded for short-term financial needs.
Reasons behind International Financial Crises
1. Over-lending and over-borrowing: the Asian crisis of 1997
Over-lending and over-borrowing can occur in many ways. The government might over-borrow in order to fund expansionary policies, lenders might over-lend to the country in order to gain better returns, and banks might over-borrow for profit-seeking purposes as well. There are also some instances where the lending can be excessive for a borrowing government with a sovereign debt because the benefits of defaulting on the debt far outweigh the costs of repaying it (Summers, 2000).
The Asian crisis of 1997 showed the world that over-borrowing and over-lending could occur with private borrowers and not just the government (Chinn and Kletzer, 1999). The participants saw rising stock and land prices as the perfect opportunity to over-invest and over-borrow. This led to debt-overhang, which is the amount by which the debt obligations exceed the current value of the resource that has been transferred. This means that the borrowers cannot make enough returns to meet their loan obligations.
2. Exogenous Shocks
Exogenous shocks such as swings in export demand, volatile financial flows, and in terms of trade can lead to financial crises in both developing and developed nations. This is especially the case when there is a dramatic decrease in trade volume due to lower demand. The country whose trade volume has decreased significantly will experience lower income making it harder for the country to repay its foreign debts in the face of rising interest rates on these debts (Dabla-Norris & Gunduz, 2012).
The same thing happens when the foreign interest rates increase. The increase in interest rates leads to flows moving away from the borrower making the re-servicing of the loan difficult leading to a financial crisis. Exogenous shocks in the international market causes anxiety in the investors who begin to shun risky investments and unwind any risky transactions that they may have in a country (Deutsche Bundesbank, 2010).
3. Exchange rate risk
Domestic banks are prone to taking unhedged foreign currency liabilities in such a large volume that it becomes next to impossible to pay off the debt when the borrower’s local currency depreciates suddenly. Because the foreign investors are afraid that the country will default, they withdraw their investments from the country leaving the country reeling in an economic and financial crisis.
4. Large increases in short-term debt to foreigners
Countries have continued to structure their debt, relying too heavily on short-term debts. They accumulate too much of these debts that usually have very high interest rates and shorter repayment periods. The volume of these debts might be too much for the borrower to repay in the short term leading to an increase in deficits. The borrowers might also face a financial crisis if the lenders refuse to refinance the debt or roll it over.
When a financial crisis occurs in a country or in one part of the region, then chances are that that financial crisis will spread across the region. This is usually because of herding behavior, social psychology, information asymmetry, and generalizing notions. Once a country in a region experiences a financial crisis, investors’ confidence in the entire region becomes shaky. Due to information asymmetry, the investors will pool their funds from the entire region crumbling the financial and economic systems of the region.
A classic example of contagion causing financial crises in other markets in a region is the Asian Financial Crisis. The crisis began in Thailand when its currency market failed because of its government’s refusal to peg its currency to the U.S. dollar. Information asymmetry and investor speculation led to anxiety amongst investors who began to doubt the stability of the entire Asian market. Consequently, they sold off the shares they had in the Asian markets leading to a currency decline of major currencies in the region. The countries affected included Thailand, Indonesia, South Korea, Philippines, Hong Kong, Malaysia, Laos, and China and Singapore to a lesser extent (Delhaise, 1998).
Resolving the crisis
· Rescue Package
Governments that are debtors and find it difficult to repay their debt can receive temporary assistance through a rescue package. Such a package helps to boost foreign investor confidence in the country as well as limiting the chances for a contagion to occur in the region. However, many economists believe that a rescue package can exacerbate the issue because lenders will continue to over-lend while ignoring the risks because they know that a rescue package can bail them out. This creates a situation commonly referred to as moral hazard and it incentivizes the lender to engage in low quality and high-risk investments knowing they are insured from loss.
· Debt Restructuring
Debt restructuring aims at making the overwhelming debt more manageable to service for the borrowing country. Two possibilities are outlines as part of the restructuring of a debt. These options are debt lowering and debt rescheduling. The former seeks to reduce the amount to be paid by the borrowing government while the latter pushes forward the repayments of the debt into the future to make it easier for the borrowing government to repay (Summers, 2000).
The problem with debt restructuring is the incentive created by such a program for lenders to free ride. They free ride with the hopes that the rest of the creditors will also restructure their debts while simultaneously demanding that the debtor services the loan fully as quickly as possible. During the debt crises that have occurred during the 1990s, debt restructuring was easy and effective. However, the problem arises when it comes to restructuring bonds because bondholders have the legal power to stop the restructuring of the debts owed to them.
As seen above, there is a strong co-relation between international lending and financial crises. International lending is often predatory between industrialized nations and developing countries. Developing countries are wallowing in debt because of the predatory nature of these lending relationships. We have also seen that there are several reasons behind a financial crisis including exchange rate risk, contagion, over-borrowing and over-lending, large increase in short term debt to foreigners, and exogenous market. There are various ways that the IMF and other international players use to resolve the financial crises caused by international lending. These methods include debt restructuring and providing the borrower with a rescue package. Each of these solutions pose their own problems including creating moral hazard among lenders/ investors.
Chinn, M.D. & Kletzer, K.M. (1999). International capital inflows, domestic financial intermediation, and financial crises under imperfect information.
Dabla-Norris, E. & Gunduz, Y.B. (2012). Exogenous shocks and growth crises in low-income countries: A vulnerability index. IMF Working Paper 12-264.
Delhaise, P.F. (1998). Asia in Crisis: The implosion of the banking and finance systems.
Deutsche Bundesbank (2010). Nominal and real exchange rate movements during the financial crisis. Retrieved on 20/1/2016 from https://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Monthly_Report_Articles/2010/2010_07_financial_crisis.pdf?__blob=publicationFile