Poorly managed capital funds and investments, uncontrolled international capital flows, and incorrect resources chosen by lenders and investors are the main reasons for the development of a financial crisis. To comprehend the value of such economic situations and the steps that could be taken to investigate and avoid financial crises, terms such as “international capital flows,” “the International Monetary Fund,” “overlending” and “overborrowing,” “exogenous shocks” and “exchange rate risks,” “contagion,” and “debts” have to be identified and explained with real-world examples. Understanding the causes of financial crises and evaluating past examples should help policymakers and leaders predict or even eradicate similar situations in the future.
International Capital Flows
International capital flows are defined as the exchange of financial claims between the representatives of the two countries. These flows are characterized by the stock of wealth, and they give countries with low rates the chance to lend to countries with high economic rates. Capital flows remain a crucial economic process of globalization, and they are usually divided into inflows and outflows. Inflows of foreign capital destabilize the economies of developing and transitional countries, influence macroeconomic stability, and change the level of competitiveness. The main reasons for capital inflows are unexpected changes in the domestic money demand, the domestic productivity of capital, and changes in international interest rates (Magud, Reinhart, & Vesperoni, 2012).
Capital outflows, on the other hand, occur when domestic assets leave a country without any kind of equitable return that could be generated over time. In general, the main cause of such capital outflows is an unstable political condition in which investors cannot be confident in the safety of their money within their home country. The South African experience after the sanctions of the 1980s could be used as a prime example to describe capital flows (Rangasamy, 2014).
The International Monetary Fund
To avoid negative outcomes of capital flows in different countries, it is necessary to promote capital control and monitoring. The International Monetary Fund (IMF) is one of the leading international organizations that aim at fostering global monetary cooperation, improving the conditions of international trade, promoting sustainable economic growth, and reducing global poverty (International Monetary Fund, 2016).
However, even if the representatives of the IMF take all necessary precautionary steps, the possibility of a financial crisis can still occur. For example, the global crisis of April 2009 could be explained by the poor financial support offered by the IMF to developing countries. However, today, the representatives of the IMF are actively trying to prevent the development of the same crisis and have reported the possibility of the global output being cut by 4% over the next five years (Elliott, 2016).
International Lending and Borrowing between Industrialized Countries
Being a powerful economic entity, the IMF takes responsibility for such events as international lending and borrowing between industrialized countries, which is usually well organized. The success of such international lending is explained by the fact that all industrialized countries have certain assets, capital, and resources that can be borrowed. International lending offers the possibility for these countries to diversify assets and achieve certain financial benefits. On the one hand, the diversification of resources is good for a country’s economy.
On the other hand, the foreign capital that comes to a country improves its economy as well. In this instance, the example of the relations developed between the United States and China could be used. China lends money to the United States; as a result, the United States gets new ideas, and China earns from investing. From international lending, both countries get guarantees and lay the foundation for the successful development of the relationship.
International Lending by Industrialized Countries to Developing Nations
The process of lending that is offered by industrialized countries to developing countries differs from the previous activity due to the inherent risks, which include unstable political conditions, possible economic challenges, and unpredictable debts. The default of developing countries may lead to the inability of those countries to acquire new loans. Though developing countries may attract the attention of industrialized countries, representatives of the developing countries are not always ready to cooperate with individual investors from industrialized countries but rather prefer to take loans from their own banks. The results of such uncertainty lead to new financial crises and the inability of developing countries to pay loans back. An example of this situation is the cooperation between the United States and countries in Southern Africa and the intentions of the Americans to help Africans gain profits in different spheres.
Reasons behind the International Financial Crisis
International financial crises occur when the value of financial assets drops in a short period of time without any evident reasons or the ability to forecast the problem. There are many ways to analyze the current situation and introduce explanations, including the predictions of Steve Eisman regarding the crash of 2007-2008 (Collinson, 2016). The causes of financial crises vary, but the most common reasons are introduced below.
Overlending and Overborrowing: The Asian Crisis of 1997
Overlending and overborrowing happen regularly in different countries around the world. Such situations occur when governments make a decision to borrow and lenders to invest without considering the possible risks. Overborrowing in foreign currencies led to the development of the crisis in Asia in 1997 (Schonhardt, 2015). The ability to borrow created the conditions for debt overhang, where debt obligations were bigger than the value of payments that could be offered by a country. A lack of appropriate financial coordination and control resulted in incorrect decisions and financial crises.
Exogenous shocks should be regarded as another contributor to the development of financial crises. These shocks lead to the unpredictable behavior of representatives who could change the current economic flow. Well-known examples of exogenous shocks include fast exchange rate changes and shortages in import resources. Export prices fall without any explanation, and the rise of foreign liabilities in the country promotes the denomination of the local currency. Asian countries were not ready for such changes and were shocked by their inability to gain control over the situation.
Exchange Rate Risk
A financial crisis may also be developed due to the inability to control interest rates on loans. Changes in exchange rates lead to risks in developing countries. The point is that there are different conditions under which one currency may be changed for another. A higher (foreign) currency reduces the value of a lower (local) currency. In 1996, Asian currencies depended on the US dollar considerably (Schonhardt, 2015). In 1997, the currencies of many Asian countries lost their value in regards to the US dollar. The US Federal Reserve raised interest rates so that the local currencies of the Asian countries could not keep the rates the same. Many Asian countries suffered because of this policy change.
Large Increases in Short-Term Debt to Foreigners
Asian countries also had low ratios of external debts compared to GDP. Therefore, the countries believed they could use their short-term external loans to stabilize their economies (Schonhardt, 2015). However, short-term borrowing, also known as “hot money,” created the dilemma under which banking systems and repayment abilities were weakened, and interest rates continued to grow. The rise of such short-term debts to foreigners created a new risk for the financial crisis. Instead of searching for new alternatives to deal with short-term debts, Asian countries promoted transparency and focused on fiscal policies. These mistakes could not be neglected, and the crisis began.
Finally, international contagion has to be introduced as one of the possible reasons for a financial crisis. Contagion is a situation in which an economic shock influences other, even non-economic, fields of one country and touches upon the economic sphere of other countries. Price movements, the inability to avoid close trade relations, and economic mobs were the main characteristics of the Asian crisis in 1997. A kind of spillover effect occurred when it became impossible to control the economic situation of one country and avoid changes in other countries. The Asian region was doomed to face the resulting challenges.
Regarding the possibility of analyzing and understand the reasons for a financial crisis, sometimes even professional organizations like the IMF cannot avoid the development of the crisis. Therefore, it is necessary to learn what steps to take when a financial crisis hits a country or even several countries at once. Resolving a financial crisis is a time-consuming and difficult task that requires the investigation of many different economic aspects. It is not enough to make a good start; indeed, it is important to continue taking steps even if certain changes and improvements are observed. There are two crucial factors that should be underlined in the process of resolving a crisis: the presence of rescue packages and the possibility to restructure debts.
The IMF offers rescue packages to compensate for the current lack of private lending and borrowing because it is important to restore conditions under which lending is possible. Besides, these rescue packages are expected to limit the number and effects of contagion and increase the possibilities of improving the country’s macroeconomic situation. The stabilization of the banking system is a crucial step in resolving crises.
These packages can take different forms, including deposit insurances, capital injections, debt guarantees, and numerous asset programs designed to help the country identify its main weaknesses and use its strengths to solve the existing problems. It is possible to address some industrialized countries and their banks in order to ask for loans. Still, each rescue package has to be properly explained and supported in order to prevent just becoming another threat to the country and its economy.
Debt restructuring is another step in the process of solving financial crises. It usually consists of two important aspects: the process of rescheduling and the process of threat reduction. This activity helps control the payments that may influence debt services. Restructuring can become a real challenge for lenders because of the existing free rides and the inability to be confident about the power or intentions of other creditors, who could demand full repayment of all debts in a short period of time. Therefore, effective debt restructuring requires communication between different creditors and the representatives of foreign countries in order to clarify the conditions that are least harmful to the country-debtors.
In general, an analysis of the outcomes of the Asian crisis in 1997 and the relations that can be developed between industrialized and developing countries shows that financial crises continue to happen. It is possible to investigate the reasons for a crisis and the solutions that can be offered to the countries under threat. Still, there is one fact that cannot be avoided: a financial crisis could occur at any time. People may follow the rules and develop business relations in regards to the norms and requirements established at the international level. Financial changes, unpredictable decisions, and uncontrolled political activities may create a solid basis for a new financial crisis. Therefore, countries have to be ready to investigate their possible actions and make the decisions necessary to minimize the number of negative outcomes of financial crises.
Collinson, P. (2016). The Big Short: Is the next financial crisis on its way?. The Guardian. Web.
Elliott, L. (2016). IMF warns of a fresh financial crisis. The Guardian. Web.
International Monetary Fund. (2016). The IMF at a glance. Web.
Magud, N., Reinhart, C., & Vesperoni, E. (2012). Capital inflows, exchange-rate flexibility, and credit booms. VOX: CEPR’s Policy Portal. Web.
Rangasamy, L. (2014). Capital flows The South African experience. South African Journal of Economics, 82(4), 551-566.
Schonhardt, S. (2015). Five things Asian economies learned from the 1997-98 financial crisis. The Wall Street Journal. Web.