Chapter 7

International Lending and Financial Crises Tutor: X. Zhang

Topics Covered
Introduction Gains and losses from well-behaved international lending Taxes on international lending International lending to developing countries Financial crises: what can and does go wrong Resolving financial crises Reducing the frequency of financial crises

Introduction
International financial capital flows have grown rapidly in the past several decades. The lenders or investors give the borrowers money to be used now in exchange for IOUs or ownership shares entitling them to interest and dividends later. International flows of financial claims are conventionally divided into different categories by type of lender or investor (private versus official), by maturity (long term versus short term), by existence of management control (direct versus portfolio), and by type of borrower (private or government).

Introduction
Before World War II to early 1980s, the main lender was the United States, joined in the 1970s by the newly rich oil exporters. Since the early 1980s, the US has been the worlds largest net borrower, and the oil exporters have also become borrowers. The dominant lender since then has been Japan. The major type of lending has been private loans and portfolio investments, a shift from the official loans from governments and direct foreign investment that were dominant from the late 1940s to the early 1970s.

Introduction
International lending can bring major benefits of two types.
First, it represents intertemporal trade, in which the lender gives up resources today in order to get more in the future, and the borrower gets 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. The ability to add foreign financial assets to investment portfolios can lower the riskiness of the entire portfolio of investments through greater diversification.

International Lending to Developing countries

International lending and borrowing between industrialized countries generally is well behaved and provides mutual benefits to each other. Financial capital flows from industrialized countries like Japan and Germany, where it is relatively abundant, to countries like the US that offer rich investment opportunities. Both lenders and borrowers benefit from the gains from intertemporal trade, as countries with net savings get higher returns and countries that are net borrowers pay lower costs. Additional gains arise as international financial investments are used to lower risk through portfolio diversification. Conflicts sometimes arise over tax policies, but these are manageable.

International Lending to Developing countries

International lending by industrialized countries to developing countries is another story. It is sometimes not well behaved and there are periodic international crises. In a financial crises the borrowing country experiences difficulties in servicing its debts, and it often defaults that is failing to make payments as specified in the debt agreements. Lenders cut back or stop new lending, as the borrower is viewed as too risky.

The surge in international lending 1974-1982

Before World War I there was a large amount of international lending, with Britain as the main creditor and the growing newly settled countries such as US, Canada, Argentina, Australia as the main borrowers. During the 1920s, a large number of foreign government issued foreign bonds, especially in New York, as the US became a major creditor country. But in the 1930s, the depression led to massive defaults by developing countries, which frightened away lenders through the 1960s. Lending to developing countries remained very low for four decades.

The surge in international lending 1974-1982

The oil shock of the 1970s led to a surge in private international lending to developing countries. Between 1970 and 1980, developing country debt outstanding increased sevenfold, with debt rising from 9.8% of the countries national product in 1970 to 18.2% in 1980. The oil shocks caused recessions and high inflation in the industrialized countries and it also revive the lending. Four forces combined to create the surge:

The surge in international lending 1974-1982

1. The rich oil exporting nations had a high short run propensity to save out of their extra income. They tended to invest them in bonds and bank deposits in the US and other established financial centres. The major international private banks thereby gained large amounts of new funds to be lent to other borrowers. 2. There was widespread pessimism about the profitability of capital formation in industrialized countries. For a time the banks expanded ability to lend was not absorbed by borrowers in the industrial countries, which encouraged banks to shift to developing countries, which had long been forced to offer higher rates of interest and dividends to attract even small amounts of private capital.

The surge in international lending 1974-1982

3.In developing countries, 1970s was an era of peak resistance to FDI. Banks might have lent to multinational firms for additional FDI, but developing countries were generally hostile to FDI. FDI to developing countries from multinational firms had been reduced from 25% in 1960 to less than 10% by 1980. To gain access to the higher returns offered in developing countries, banks had to lend outright to governments and companies in these countries. 4. Herding behaviour meant that the lending to developing countries acquired a momentum of its own once it began to increase. Major banks aggressively sought lending opportunities, each showing eagerness to lend before competing banks did.

The Debt Crisis of 1982

In August 1982, Mexico declared that it was unable to service its large foreign debt. Dozens of other developing countries followed with announcements that they also could not repay their previous loans. The crisis was due to the following factors: 1. Interest rates increased sharply in the US, as the US Fed shifted to a much tighter monetary policy to reduce US inflation. The US and other industrialized countries sank into a severe recession. 2. Developing countries exports declined and commodity prices plummeted while real interest rates remained high. The debtors ability to repay fell dramatically.

The Debt Crisis of 1982

At first responses of the bank creditors depended on how much each bank had lent. Smaller banks (those holding small shares of all loans) headed for the exits and eliminated their exposure by selling off their loans or getting repaid. The larger banks could not extricate themselves without triggering a larger crisis, and they hoped that the problems were temporary. They rescheduled loan payments to establish repayment obligations in the future and they loaned smaller amounts of new money to assist the debtors to grow so that repayment would be possible. However, as large banks reassessed the prospects for developing country debtors, they concluded that it was imprudent to lend more. The net flows of bank loans to developing countries became small in 1985 and remained low until 1995.

The Debt Crisis of 1982

As the debt crisis wore on through the 1980s, it became clear that the debtor countries were suffering low economic growth and lack of access to international finance. In response, US treasury officials crafted the Brady plan. Beginning in 1989, each debtor country could reach a deal in which its bank debt would be partially reduced, with most of the remaining loans repackaged as Brady bonds. By 1994, most of the bank debt had been reduced and converted into bonds. The debt crisis that began in 1982 was effectively over.

The resurgence of capital flows in the 1990s

Beginning in 1990, lending to and investing in developing countries began to increase again. Four forces converged to drive this new lending: 1. The size and scope of the Brady Plan led investors to believe that the previous crisis was being resolved. As each debtor country agreed to a Brady deal, it was usually able to receive new private lending almost immediately. 2. Low US interest rates again led lenders to seek out higher returns through foreign investments. 3. The developing countries were becoming more attractive places to lend as government reformed their policies. Governments were opening up opportunities for financing profitable new investments as they deregulated industries, privatized state owned firms and encouraged production for export with outward oriented trade policies.

The resurgence of Capital flows in the 1990s

4. Individual investors as well as the rapidly growing mutual funds and pension funds, were looking for new forms of portfolio investments that could raise returns and add risk diversification. Developing countries such as Mexico, Brazil, Argentina, China, Indonesia, South Korea and Thailand became the emerging market for this portfolio investment. This type of investments were different from those that drove the lending surge in the late 1970s. Foreign portfolio investors net purchases of stocks and bonds rose from almost nothing in 1990 to one third of total net financial flows in 1996. Bank lending was less important even it increased substantially from 1993 to 1997.

The Mexican Crisis, 1994-1995

Mexico received large capital inflows in the early 1990s, as investors sought high returns and were impressed with Mexicos economic reforms and its entry into the North American Free trade Area. But strains also rose. The real exchange rate value of the peso increased, because the government permitted only a slow nominal peso depreciation, while the Mexican inflation rate was higher than that of the US, its main trading partner. The current account deficit increased to 8% of Mexicos GDP in 1994, although this was readily financed by the capital inflows. Mexicos banking system was rather weak, with inadequate bank supervision and regulation by the government. With the capital inflows adding funds to Mexican banking system, bank lending grew rapidly, as did defaults on these loans. The year 1994 was an election year with turmoil and the peso came under downward pressure. The government used sterilized intervention to defend its exchange rate, so its holdings of official international reserves fell.

The Mexican Crisis, 1994-1995

In the past Mexicos fiscal policy was reasonable, with a modest government budget deficit. However, beginning in early 1994, the government replaced peso-denominated government debt with short term dollar indexed government debt called tesobonos. By the end of 1994, there were about $28 billion of tesobonos outstanding, most maturing in the first half of 1995. The crisis was touched off by a large flight of capital, mostly by Mexican residents who feared a currency devaluation and converted out of pesos. In December, the currency was allowed to depreciate, but Mexican holdings of official reserves had declined to about $6 billion. The financial crisis arose as investors refused to purchase new tesobonos to pay off the coming due because it appeared that the government did not have the ability to make good on its dollar obligations. Each investor wanted to be paid off in dollarsa rush to the exit. As investors reassessed their investments in emerging markets, they pulled back on investments not only in Mexico but also in many other developing countries (the Tequila effect)

The Mexican Crisis, 1994-1995

The US government became worried about the political and economic effects of financial crisis in Mexico, and it arranged a large rescue package that permitted the Mexican government to borrow up to $50 billion mostly from the US government and IMF. The Mexican government did borrow about $25 billion, using the money to pay off the tesobonos as they matured and to replenish its official reserve holdings. The currency depreciation and the financial turmoil caused rapid and painful adjustments in Mexico. The Mexican economy went into a severe recession, and the current account deficit disappeared as imports decreased and exports increased.

The Asian Crisis, 1997

In the early and mid-1990s, foreign investors looked favourably on the rapidly growing developing countries of Southeast and East Asia. In these countries macroeconomic policies were solid. The government had fiscal budgets with surpluses or small deficits; steady monetary policies kept inflation low, and trade policies were outward-oriented. Most of the foreign debt was owed by private firms, not by the governments. However, in Thailand and South Korea, much of the foreign borrowing was by banks and other financial institutions. Government regulations and supervision were weak. The banks took on significant exchange rate risk by borrowing dollars and yen and lending in local currencies. And the lending boom led to loans to riskier local borrowers and rising defaults on loans. The external balance of the countries also showed some problems. The real exchange rate values of these countries seemed to be overvalued, and the growth of exports slowed beginning in 1996.

The Asian Crisis, 1997

Crisis struck first in Thailand. Beginning in 1996, the expectation of declining exports led to large declines in Thai stock prices and real estate prices. The exchange rate value of the Thai baht came under downward pressure. By mid 1997, the pressures had become intense. Banks and other local firms that had borrowed dollars and yen without hedging rushed to sell baht to acquire foreign currency assets. The Thai government could not maintain its defense, and the baht was allowed to depreciate beginning in July 1997.

The Asian Crisis, 1997

Throughout the rest of 1997 the crisis spread to a number of other Asian countries especially to Indonesia and South Korea as foreign investors lost confidence in local bank borrowers and the local stock markets and local borrowers scrambled to sell local currency to establish hedges against exchange rate risk. In response, the IMF organized large rescue packages, with commitments to lend up to $17 billion to Thailand, up to $43 billion to Indonesia and up to $58 billion to South Korea. The currency depreciations and recessions did lead to improvement in the current account balance, largely through decreases in imports. However, those countries also went into severe multiyear recessions.

The Russian Crisis 1998

Russia weathered the Asian crisis in 1997 very well, but its underlying fundamental position was remarkable weak. It had a large fiscal budget deficit, and government borrowing led to rapid increases in government debt to both domestic and foreign lenders. In July 1998, the IMF organized a lending package under which the Russian government could borrow up to $23 billion, and the IMF made the first loan of $5 billion. However, the Russian government failed to enact policy changes included as conditions for the loan. The exchange rate value of the ruble came under severe pressure as capital flight by wealthy Russians led to large sales of rubles for foreign currencies. With substantial debt service due on government debt during the second half of 1998, investor confidence declined, with selling pressure driving down Russian stock and bond prices.

The Russian Crisis 1998

In August 1998, the Russian government announced drastic measures. The government unilaterally restructured its ruble-denominated debt, effectively wiping out most of the creditors value. It placed a 90 day moratorium on payments of many foreign currency obligations of banks and other private firms, a move designed to protect Russian banks. And it allowed the ruble to depreciate by shifting to a floating exchange rate. Russia requested the next instalment of its loan from the IMF, but the IMF refused, because the government had not met the conditions for fiscal reforms.

The Russian Crisis 1998

Foreign lenders were in shock. They had expected that Russia was too important to fail and that the IMF rescue package would provide Russia with the funds to repay them. They reassessed the risk of investments in all emerging markets and rapidly sought to reduce their investments. The selloff caused stock and bond prices to plummet, with a general flight to high-quality investments like US government bonds.

The Brazilian Crisis, 1999

Brazil was among the countries hit hard by the fallout from the Russian crisis. In Nov. 1998, the IMF organized a package that allowed the Brazilian government to borrow up to $41 billion, in an effort to allow Brazil to fight pressures pushing toward a crisis. Brazil had a large current account deficit, and the government was defending its crawling exchange rate with intervention and high domestic interest rate. However, the government failed to enact the fiscal reforms called for in the IMF loan, and capital outflows increased. In January 1999, the Brazilian government ended its pegged exchange rate, and the real depreciated. However, this situation did not escalate into a full crisis because the problems did not spread to the Brazilian banking system, which was sound and well regulated. By April 1999, Brazil and other developing countries were able to issue new bonds to foreign investors. More generally, the market prices of emerging market financial assets began to increase, although the net capital flows to developing countries remained lower than they had been in 1997.

The Turkish Crisis, 2001

Turkeys economy and its government policies had been problematic for decades, and it had borrowed from the IMF continually since 1958. In Jan. 2000 Turkey entered into another borrowing program of $8 billion from the IMF and the World Bank, and committed to reduce its inflation rate, improve its regulation of the banking system and close failing banks, privatize state-owned businesses, end various subsidies, and reduce its fiscal deficit. Turkey adopted a crawling exchange rate. The announcement of the new program brought large capital inflows. Its government were able to borrow foreign currencies at low interest rates to invest the funds in high interest Turkish government bonds.

The Turkish Crisis, 2001

The country grew quickly and inflation was lowered below 50% (original is 100%), but the fiscal deficit remained high, and the current account deficit widened to about 5% of GDP. In Nov. foreign lenders began to pull back. The Turkish government used a large amount of its official reserves to defend the pegged exchange rate. December brought new pressures as several prominent bankers were arrested. Overnight interest rates rose to an annual rate of nearly 2,000 percent to stem the capital outflows. After calming for a while due to a new IMF program of $7.5 billion loans, conditions deteriorated again in Feb 2001 because of legislative delays and political fighting between the president and prime minister about reforms. Overnight interest rates again went into quadruple digits, and the government again used up a large amount of its official reserves defending the pegged exchange rates. Then the government gave up, and the lira lost a third of its value in two days. Turkeys banks incurred large losses.

Financial Crises: what can and does go wrong

1. Waves of overlending and overborrowing: the classic explanation of overlending and overborrowing is that it results from excessively expansionary government policies in the borrowing country. These policies lead to government borrowing to finance growing budget deficits, and the government may also guarantee loans to private borrowers in order to finance the growing current account deficit. Lending to government seems to be low risk, but its not. When the government realizes that it has borrowed too much, it has an incentive to default, and a financial crisis arises.

Financial Crises: what can and does go wrong

The Asian crisis presented a new form of overlending and overborrowing: too much lending to private borrowers rather than to national governments. The capital inflows and lending boom tend to inflate stock and real estate prices. For a while the capital inflows appear to be earning high returns , until the price bubble bursts. Once foreign lenders realize that too much has been lent and borrowed, each has the incentive to stop lending and to try to get repaid as quickly as possible. The excessive lending/borrowing can lead to a financial crisis called a debt overhangthe amount by which the debt obligations exceed the present value of the payments that will be made to service the debt.

Financial Crises: what can and does go wrong

2.Exogenous international shocks: when exogenous international shocks hit a countrys economy, international lenders and the borrower must reassess the borrowers ability to meet its obligations to service its debt. For instance, a decline in export earnings, perhaps due to a decline in the world price of the countrys key export commodity, makes it more difficult for the country to service its debt and thus more likely to default.

Financial Crises: what can and does go wrong

3. Exchange rate risk: in the Mexican, Asian and Turkish crises, private borrowers took on large liabilities denominated in foreign currency while acquiring assets valued in local currency. The borrowers took on these positions exposed to exchange rate risk because they expect that the government would continue to defend the fixed or heavily managed exchange rate value of the foreign currency. A major part of this uncovered foreign borrowing was the carry trade in which financial institutions borrow dollars or yen at a low interest rate, exchange the money to local currency and lend in the borrowing country at a higher interest rate. This is very profitable as long as the exchange value of the local currency is steady (so that local currency can be exchanged back to dollars or yen at the same rate in the future, to repay the foreign borrowings). When the likelihood of devaluation or depreciation becomes noticeable, the borrowers attempt to hedge their exposed positions by selling local currency, but this puts additional pressure on the government defense of the fixed exchange rate. If the government give up the fixed rate, borrowers suffer losses to the extent that their positions are still unhedged. The losses make it more difficult for them to serve their foreign debts. Foreign lenders then may reduce new lending and try to be repaid more quickly, leading to a financial crisis.

Financial Crises: what can and does go wrong

4. Fickle international short term lending: short term debtdebt that is due to be paid off sooncan cause a major problem because foreign lenders can refuse to refinance it. The inability of the Mexican government to refinance the large amount of short term tesobonos that were coming due was a major contributor to the Mexican crisis of 19941995. in the Asian crisis, the large amount of short term borrowings by banks that was coming due created a policy dilemma for the countries governments. The governments could raise interest rate to attract continued foreign financing, but this would weaken local borrowers and hurt the banks loan returns. Instead, the governments could guarantee or take over the banks foreign borrowings, based on the need to prevent the local banks from failing. But the government itself did not have the sufficient foreign exchange to pay off the debts, so they risked setting off a financial crisis on their own if foreign lenders demanded repayment. Short term debt is risky to the borrowing country because international lenders can readily shift from one equilibrium to another, based on their opinion of the countrys prospects. In one equilibrium, the lenders refinance or roll over the short term debt, and this can continue into the future. But a rapid shift to another equilibrium in which lenders demand repayments is also possible. If the borrowing country cannot come up with the payoff quickly, a financial crisis occurs.

Financial Crises: what can and does go wrong

5. Global contagion: the above four forces have explained the caused why a financial crisis could hit a country. But the financial crises since 1980 were more than this. When a crisis hits one country, it usually spreads and affects many other countries. It appears that some kind of global contagion is at work. Some contagion is the result of close trade links between the affected countries; thus a crisis downturn in one country, like Argentina, has spillover effects in another country, like Uruguay. Contagion can be overreaction by foreign lenders as they engage in a scramble for the exits. Herding behavior can occur. Borrowers often do not provide full information to lenders. The high costs of obtaining accurate information on their own can lead some lenders to imitate other lenders who may have better information about the borrowers, or to fear that other borrowing countries are likely to have similar problems as the crisis country. Contagion can also be based on new recognition of real problems in other countries that are similar to those countries with the initial crisis. The financial crisis in one country can serve as a wakeup call that other countries really do have similar problems. The crisis in Mexico led to a more severe tequila effect in countries that had problems similar to those of Mexicocurrencies that had experienced real appreciations, weak banking systems and domestic lending booms, and relatively low holdings of official international reserves. In Asia the crisis in Thailand led to a recognition that Indonesia and South Korea had similar problems, including a weak banking sector, declining quality of domestic capital formation, a slowdown in export growth and fixed exchange rates that may not be defensible for very long. Analysis suggests that the initial reaction to crisis in one country is often pure contagion, as international lenders pull back from nearly all investments in developing countries. Lenders then examine the other countries more closely. International lenders resume lending to those countries that do not seem to have problems. But financial crisis spreads to those countries that seem to have similar problems. Although the spread of the crisis has a basis in the recognition of actual problems, it is still a kind of contagion effect. Without the crisis in the first country, the other countries probable would have avoided their own crises.

Resolving financial crises

A financial crisis has serious negative consequences for the borrowing country and its economy. As new lending to the country dries up, the economy goes into recession. Also a financial crisis in one country can threaten the economies of other countries and the broader global financial system, through contagion effects that reduce capital flows to other borrowers and can send some into their own crises. In the crises of the past several decades, the two major types of international effects to resolve financial crises have been rescue packages and debt restructuring.

Rescue packages
1. When a financial crisis hits a country, that countrys government usually seeks a rescue package of loan commitments to assist it in getting through the crisis. The lenders generally included the IMF, the World Bank, and some national governments. A rescue package can have several purposes: The loans in the rescue package compensate for the lack of private lending during the crisis. The money allows the country to meet its needs for foreign exchange, to provide some financing for new domestic investments, and to cushion the decline in aggregate demand and domestic production. The package can restore investor confidence by replenishing official reserve holdings and by signalling official international support for the country and its government. This can stem the capital outflow, even if it does not immediately restart new private foreign lending to the country. The IMF and other official lenders in the rescue package hope that package will limit contagion effects that could spread the crisis to other countries. The IMF imposes conditions as part of its lending, to require the government of the crisis country to make policy changes that should speed the end of the financial crisis. These policy reforms usually include tighter monetary policy and tighter fiscal policy, and they may include other structural reforms like liberalizing restrictions on international trade or improving regulation of the banking system.

2. 3. 4.

How effective the rescue packages

The rescue package for Mexico in 1995 seemed to be very successful in helping Mexico to resolve its financial crisis. The packages for the Asian countries in 1997 were at best moderately successful. The economies went into surprisingly deep and long recessions and the exchange rate values of the countries currencies declined greatly before stabilizing. Russia was a nontestRussia did not abide by the IMF conditions, so the package never took hold. The package for Brazil did not prevent a currency fall, probably largely because the Brazilian government did not enact the fiscal reforms that it promised. But the package appeared to be helpful in heading off a full financial crisis. The package for Turkey seemed successful mainly in preventing much contagion. The other major question about the rescue packages is whether they actually increase the likelihood of financial crises because they encourage overlending and overborrowing. A large rescue package provides a bailout for lenders and borrowers when a crisis hits. But if lenders and borrowers expect to be bailed out, then they should worry less about the risk of a financial crisis. This leads them to lend and borrow more than is prudentan example of moral hazard, in which insurance leads the insured to be les careful because the insurance offers compensation if bad things happen.

How effective the rescue packages

In Mexican crisis of 1994-1995, the rescue package was used to pay off foreign investors, including full payment to the holders of the tesobonos. The lack of large loses to rescued creditors in the Mexican crisis probably encouraged too much international lending during 1996-1197 because the lenders worried too little about the risks of the lending. In the Asian crisis, lenders to banks in the crisis countries were generally repaid in full, using money from the rescue packages. Still, the scope for moral hazard had its limits. Foreign investors in private bonds and stocks suffered large losses as the market price of these securities declined, an foreign banks suffered large losses on loans to private nonfinancial borrowers. The failure of the rescue package for Russia led large losses for all foreign creditors. Many of these lenders were specifically relying on a rescue to limit their downside risk (moral hazard in action), so they received quite a surprise. Some of the caution in lending to developing countries after the Russian Crisis is probably the result of a reappraisal of the risks of this lending.

Debt restructuring
Debt restructuring refers to two types of changes in the terms of debt: 1. Debt rescheduling changes when payments are due, by pushing the repayments schedule further into the future. The amount of debt is effectively the same, but the borrower has a longer time to pay it off. 2. Debt reduction lowers the amount of debt. When a financial crisis hits a country because the country has more debt than it is willing or able to service, resolution of the crisis often requires debt restructuring. By stretching out payments or reducing debt, the borrowing country gains a better chance of meeting a more manageable stream of current and future payments for debt service.

Reducing 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 on 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. Although there are ways to resolve crises once they occur, it would also be great to find ways to prevent financial crises from occurring, or at least reduce their frequency. Four proposed reforms enjoy widespread support for this issue: Developing countries should pursue sound macroeconomic policies to avoid creating conditions in which overborrowing or a loss of confidence in the governments capability could lead to a crisis. 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 informed decisions on lending and investing, making overlending less likely and also reducing the risk of pure contagion against emerging markets debt. Developing country governments should avoid short-term borrowing denominated in foreign currencies, to avoid crises that begin when foreign lenders abruptly demand repayment. Developing countries should provide better regulation and supervision to their banking system.

1. 2.

3. 4.

Bank regulation and supervision

Banks are considered to have a special role in an economy which are at the centre of the payments system that facilitate transactions in the economy. They acquire deposits from customers based on trust that the banks can pay back the deposits in the future, but if this trust is broken, depositors create a run on the bank as they all try to get their money out quickly. In developing countries banks are often especially important, because bank lending is also the major source of financing for local businesses. Stock and bond markets are often underdeveloped. But government regulations and supervision of banks in developing countries is often weak, which enable banks to engage in more risky activities. Banks can make loans based on relationshipscrony capitalism loans to bank directors, managers, friends of directors and managers, politically important people, and their businesses. Banks take on large exposures to exchange rate risk by borrowing foreign currencies to fund local currency loans (the carry trade). Banks operate with little equity capital, so they are more likely to take risks and require government rescues. In addition, the government often exerts direct influence on lending decisions, to favour some borrowers based on the governments strategy for economic development. With weak supervision and an explicit or implicit guarantee that the government will rescue banks in trouble, banks have incentives to borrow too much internationally (and lenders are comfortable lending so much), and banks are more willing to take the risk of unhedged foreign currency liabilities. A financial crisis becomes more likely.

Bank regulation and supervision

There is a clear need for better government regulation and supervision of local banks in the borrowing countries. Regulators should require banks to use better accounting and disclose more information publicly, to use risk assessment and risk management to reduce risk exposures, to recognize bad loans and make provision for them, and to have more equity capital. The regulators should be willing to identify weak banks, to insist on changes in practices and management at these banks, and to close them if they are insolvent. In addition, the government should probably permit more foreign banks to operate locally because these foreign banks bring better management and better techniques for controlling risks. To reduce the risk of a crisis, the country should solidify its regulation of banks and other financial institutions before it liberalizes its capital account and provides them with easy access to foreign currency exposures. However, implementation for these proposals may be challengeable. There is likely to be political resistance and also shortage of people with the expertise to regulate banks effectively. Therefore, it is a slow process.

Capital controls
A controversial proposal for reducing the frequency of financial crises is to increase developing countries use of controls or impediments to capital inflows. Such controls could take any of several forms, including an outright limit or prohibition, a tax that must be paid to the government equal to some portion of the borrowing, or a requirement that some portion of the borrowing be placed in a deposit with the countrys central bank. There are three ways in which such controls can reduce the risk of financial crisis: 1. The controls can prevent large inflows that could result in overlending and overborrowing. 2. The controls can be used to discourage short term borrowing.

Capital controls
1. The controls can reduce the countrys exposure to contagion by limiting the amount that foreign lenders could pull out of the country. Chile is usually offered the example of a country that used controls on capital inflows successfully during the 1990s. The Chilean government required that a percentage of the value of new lending and investments into the country be placed in an interests-free deposit with the central bank for one year. And the government required that foreign investors keep their investments in Chile for at least one year. These requirements seem to have had their major effect by altering the mix of borrowingless short term debt. The Chilean government also changed the percentage that must be deposited to tune it to changing market conditions over time. It began at 20%, was raised to 30%, then lowered to 10% and to 0 in 1998, as capital inflows fell off following the Russian crisis. In 2000, Chile also removed the one year rule. What are the overall benefits and costs of controls on capital inflows? A major cost of the controls is the loss of the gains from international borrowings, to the extent that they discourage capital inflows. While they can provide benefits by reducing the risk of a financial crisis, they are a second best policy. It would be better if the government of the borrowing country could identify the specific problems that might lead to a crisis and address these directly. For instance, if overborrowing or too much short term foreign currency borrowing occurs because of the excessive risks taken by local banks, the direct policy response is to improve bank regulation and supervision. If bank regulation cannot be improved immediately, then capital controls can be a second best policy response.