ISSUES IN THE GLOBAL FINANCIAL SYSTEM

Financial contagion refers to the spread of a financial crisis from one country or region to other countries or regions. Economic interdependence, an underpinning of globalization, increases the danger of financial contagion. Economic interdependence is generally viewed favorably because it creates a mutually supportive web of economic opportunities. But interdependence can also create financial instability. Advanced technologies capable of instantaneous cross-border transfers of assets, such as stocks or bonds, have created greater volatility in global financial markets. Financial crises originating in Mexico,

The global financial system facilitates cross-border financial and business activity

The global financial system facilitates cross-border financial and business activity. (Andreblais)

Brazil, Russia, and Thailand destabilized global financial markets in the 1990s, as did the financial crisis of 2007–2008. These crises accented the need for meaningful financial reform at the national and global levels.

Financial Contagion and the East Asian Financial Crisis of 1997–1998

The East Asian financial crisis of 1997–1998 was the world's most serious bout with financial contagion during the 1990s. The seeds of the East Asian crisis were sown in Thailand. In the early 1990s investment opportunities in Thailand caught the eye of foreign investors. Foreign and domestic investors speculated in Thai stocks and other securities, developed and undeveloped real estate, and other assets. Soon asset prices soared to unreasonably high levels.

Beneath the glitter of the investment boom were serious weaknesses in the Thai financial system, however. Inadequate banking supervision, poor assessment models for credit risk, and excessive borrowing in global capital markets spelled disaster for Thailand's financial sector. Complicating the country's financial picture were governance problems, including public corruption, a lack of transparency, and inadequate economic data for informed policy decisions.

Short-term, speculative investments invite periods of boom and bust. In Thailand the bottom fell out of the speculative boom in 1997. Shaken investors stampeded to sell their holdings of Thai securities, properties, and other assets. The panicked sell-off of Thai assets, a type of herd behavior, is characteristic of speculative investment. The financial meltdown weakened Thailand's currency, the baht, and threw the overextended banking system and securities market into chaos. Fears of a regional financial meltdown caused similar asset sell-offs in other East Asian countries, resulting in severe economic downturns, as shown in Table 9.7.[1]

The financial contagion was soon knocking at the doors of Tokyo, New York City, and London. The financial crisis, which slowed business activity and dimmed consumer confidence in East Asia, also reduced Japanese, American, and European exports to Asian markets. Global securities markets, such as the New York Stock Exchange, dipped under the weight of the East Asian financial collapse. Global economic growth slowed.

International financial institutions and governments were forced to intervene. The International Monetary Fund (IMF), Asian Development Bank (ADB), World Bank, and United States orchestrated a $125 billion financial bailout to prevent a total collapse of major East Asian economies. Calls for financial reform centered on stricter supervision

Table 9.7 East Asian Financial Crisis and Real GDP, 1996–2000

Real Gross Domestic Product (percentage change)

Countries

1996

1997

1998

1999

2000

Hong Kong SAR

4.5

5.0

-5.3

3.0

10.5

Indonesia

8.0

4.5

-13.1

0.8

4.8

Korea

6.8

5.0

-6.7

10.9

9.3

Malaysia

10.0

7.3

-7.4

6.1

8.3

Philippines

5.8

5.2

-0.6

3.4

4.0

Thailand

5.9

-1.4

-10.5

4.4

4.6

Source: International Monetary Fund, “Table 2” and “Table 6,” World Economic Outlook, April 2002, 158, 165.

of banks and securities markets, heightened surveillance of countries' macroeconomic policies and performance, and technical support for good governance.[2]

  • [1] International Monetary Fund Staff, “Table 2: Advanced Economies: Real GDP and Total Domestic Demand,” “Table 6: Developing Countries; By Country, Real GDP,” World Economic Outlook April 2002: Recessions and Recoveries, April 2002 (Washington, DC: IMF Publication Services, 2002), 158, 165.
  • [2] IMF Staff, “Recovery from the Asian Crisis and the Role of the IMF,” IMF Issues Brief, June 2000
 
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