Choongsoo Kim: Financial crises and policy responses - a Korean
perspective
Speech by Mr Choongsoo Kim, Governor of the Bank of Korea, at the Bank of Japan's
annual Tripartite Governors' Meeting, Tokyo, 3 August 2010.
* * *
The author wishes to express his gratitude to Dr K H Oh, Dr H J Kim, and Mr H S Shin for their assistance in
drafting the paper. The views in the paper represent those of the author and do not necessarily represent the
views of the Bank of Korea.
1. Introduction
Honorable Governor Masaaki Shirakawa, Members of the Policy Board, Ladies and
gentlemen,
It is a great pleasure for me to have this opportunity to share ideas with you today on the
topic of financial crises and policy responses. The latest US financial crisis hit Asian
countries hard as well, but they have shown remarkable resilience. And now Asia is regarded
as the powerhouse for the growth of the global economy.
However, from this experience, we have come to realize that the interconnected global
economy is highly vulnerable to various shocks. Therefore, the governments and the central
banks of G20 countries are now working hard on designing a new financial architecture to
prevent further crises and to support sustainable and balanced growth.
The topic of today's speech is "Financial Crises and Policy Responses: A Korean
Perspective." In fact, I used to teach a graduate course titled "Economic Crisis Management"
when I was a professor at a university in Korea. Since the 1997 Asian crisis, I have not been
able to get the topic out of mind. I think many policymakers in emerging market countries
have also had a similar obsession.
The plan of my exposition today is as follows. First, I will briefly talk about some theories
regarding financial crisis and secondly I will review the history of financial crises with a
special focus on the period since the 1980s. To understand the situation in which we are
placed, it is helpful to look back and draw some implications from the past. Lastly, I will
discuss the measures under discussion in the G20 to lower the probability of future crises
and mitigate their impact on the world economy.
2. Economics of financial crisis
Leo Tolstoy opened Anna Karenina by asserting, "Happy families are all alike; every
unhappy family is unhappy in its own way."1 It seems this phrase also applies to financial
crises. Each crisis may have its own causes and consequences. Even for a single crisis,
there are many competitive diagnoses and policy prescriptions by researchers and
policymakers. However, it is also true that there are some common elements to many
financial crises. Understanding these common factors is critical for preventing a potential
financial crisis from materializing.
Two key questions facing policymakers are how to reduce the risk of a financial crisis and
how to cope with one when it does occur. Understanding the common elements of crises is
related to the first question and can contribute to reducing the probability of financial crises
even though it is not possible to escape them completely. The second question is related to
identifying the amplification mechanisms behind a crisis. By doing this, we can check the
spread of a crisis and contain the consequences once it has been triggered and a crisis
erupts.
2.1 Causes of financial crises
There are several frameworks to explain the origins or causes of financial crises in
economics. Even though there may be many ways to categorize them, I would like to classify
them into two broad categories: the "fundamentalist view" and the "human nature view."
The first view posits a financial crisis as a rational response of economic agents to
exogenous events. Such external events include changes in fundamentals like the terms of
trade or international financial market conditions which alter rational perceptions of agents as
to future cash flows. Thereby, agents change their attitude toward risk, which is reflected in
leverage limits, risk pricing, and asset prices. Moreover, according to this view, there is a
fundamental intrinsic weakness within the financial system as Douglas Diamond and Philip
Dybvig demonstrated.2 Banks provide liquidity services to the market and thus themselves
take on large liquidity risks. Due to this inherent weakness, there are multiple equilibria:
everyone should stay in if everyone else does, but everyone should pullout if everyone else
does. So, a relatively small exogenous shock can move an economy from one equilibrium to
another one and sometimes provoke a devastating crisis.
The second approach is based on the view that human nature is prone to irrationality.
According to Hyman Minsky, the financial system itself has a tendency to generate economic
instability through endogenous waves of euphoria and anxiety.3 Myopia and herd-like
behavior rather than rational long-term calculations are common and they lead to
endogenous cycles of manias and panics.
From the point of past experiences, both frameworks seem to help explain some causes of
financial crises as these are not only driven by the extent of fundamental weakness even
though agents are rational, but also by the illusion or myopia on the part of policymakers and
investors that "this time is different."4 However, the two approaches still leave some gap to be
filled with other factors like incomplete regulation leading to incentive misalignments, global
capital flows or global imbalances, and so on.
2.2 Amplification mechanisms
When a crisis occurs, the loss of welfare is huge, compared with the size of the initial
problem. For example, according to the estimation of the IMF, the losses on U.S. subprime
loans and securities were estimated at about $250 billion as of October 2007. However, the
expected cumulative losses in world output associated with the crisis for the years from 2008
to 2015 are forecast to run at $4,700 billion, about 20 times the initial subprime loss.5 Then,
the following question is an obvious one: How could such a relatively limited event have
effects of such magnitude on the national or world economy?
To explain this phenomenon, I would like to adopt the explanation put forward by Frederic
Mishkin (1999).6 Financial markets perform the essential function of channeling funds to the
individuals or firms that have productive investment opportunities. However, relevant
information is not free and not always creditworthy. The basic problems in the financial
system are asymmetric information: adverse selection and moral hazard. To address these
problems, various measures are created within the financial system: long-term customer
relationships, credit line arrangements, collateral posting, etc.
However, shocks to the financial system make the adverse selection and moral hazard
problems worse, and then credit tends to dry up, which is termed a "credit crunch." The lack
of credit leads individuals and firms to cut their spending, resulting in a contraction of
economic activities. Four factors exacerbate asymmetric information problems, contributing
to financial instability: the deterioration of financial sector balance sheets, rise of interest
rates, increases in uncertainty, and the deterioration of non-financial sector balance sheets
due to changes in asset prices.
This is why the government and the central bank intervene in financial markets promptly
during a crisis. The central bank provides liquidity by acting as "the lender of last resort." This
helps the payment system work smoothly, and prevents the price of assets from dropping
excessively. This, in turn, helps financial firms keep their balance sheets in better shape. The
government injects public funds into banks for recapitalization and helps financial firms
dispose of their non-performing assets by establishing special agents or bad banks.
Sometimes, the government and the central bank engage in financial markets directly by
taking over banks or buying commercial papers. Another important measure is enhancing
transparency by disclosing key economic, financial and corporate sector information. All
these measures alleviate the asymmetric information problem, helping prevent herd
behavior.
So far, we talked about the causes and amplification mechanisms of crises. Bearing this
theoretical understanding in mind, let us move on to the history of economic crises.
3. A short history of financial crises
Today, I would like to review four major financial crises that have taken place since 1980.
These are the Latin American debt crisis of the 1980s, the Nordic Banking Crisis of the early
1990s, the Asian currency crisis of the late 1990s, and the latest US financial crisis in 2007. I
chose them because they are most relevant for understanding the evolution of the global
economy, although the choice may be somewhat arbitrary. I leave out the crisis which took
place in Japan in the early 1990s and the long-term stagnation afterwards not only because I
would not presume to venture in an area where your expertise is preeminent, but also it does
not have great relevance to today's topic. As we review each crisis, we will find common
characteristics as well as its own particular features.
3.1 Latin America's debt crisis of the 1980s
Let's start by looking at the Latin American debt crisis of the 1980s. In the early 1980s, many
Latin American countries found themselves in a situation where their foreign debt exceeded
their earning power and they were not able to repay it.
Even though quite a few researchers tried to explain the crisis as a result of the economic
development strategy of import substitution industrialization and heavy reliance on raw
material exports, the direct causes were the two kinds of abnormalities. On the one hand, the
governments and public sector typically took a large share of expenditures and investment in
the economies, and thus the scale of the budget increased continuously. On the other hand,
the governments were unable to collect the necessary taxes to pay for the increased
spending.7
The consequence of this double problem was increased budget deficits, which in turn limited
the capacity of the states to finance the deficit through raising debt. When the government
could not resort to tax collection or further debt accumulation, printing money was the only
option left, consequently resulting in hyper-inflation.
The evolution of the international financial environment at the time also played a role in the
process. During the 1970s, oil prices skyrocketed and oil-exporting countries invested their
money in international banks, which recycled a major portion of this as loans to Latin
American governments. However, at the end of the 1970s, the US Fed led by Paul Volcker
raised interest rates to curb inflation. As a result, interest rates in global financial markets
rose and the world economy went into a deep recession. The debt obligations that should
have been met by the Latin American countries increased dramatically and it became much
harder for them to pay back their debts.
Consequently, in August 1982, Mexico declared that it would no longer be able to service its
debt. And international commercial banks reduced new lending to Latin America significantly
or halted it altogether. As much of the Latin American debt was short-term, a crisis followed
when its rollover was refused. Sudden stops and massive capital outflows brought about a
rapid depreciation of the Latin American currencies, thereby further raising the real interest
rate. In terms of per capita real income, Latin America experienced negative growth of almost
9 percent between 1980 and 1985.
After the Latin American debt crisis, the so-called "Washington Consensus" emerged among
economists and Washington, D.C.-based institutions such as the IMF and the World Bank.
The term Washington Consensus was initially coined in 1989 by John Williamson, an economist
of the Institute for International Economics, to describe a set of specific economic policy
prescriptions that he considered constitute the "standard" reform package.8
Later, what was understood as the Washington Consensus came to include more market
oriented policies such as capital account liberalization and was looked upon as a kind of
ideology promoting free market economies. However, after the recent series of global
financial crises, the Washington Consensus has been criticized by both policymakers and
academics, and it no longer seems to have its past aura of "holy writ."
3.2 The Nordic banking crisis of the early 1990s9
A second major international financial crisis we should look at is the Nordic banking crisis.
During the late 1980s and early 1990s, nearly all major banks in the Nordic countries of
Norway, Sweden, and Finland got into difficulties and made huge losses. And the
governments of these countries had to provide public support to their banking systems.
The boom started with financial market deregulation, which led to an explosion of domestic
bank credit. Following financial deregulation, competition between banks led to increased
risk-taking. Another ingredient of the credit expansion was the freeing of international capital
movements. A huge amount of capital flowed into the countries and a significant fraction of
this was denominated in foreign currencies, but not hedged.
On the other hand, the rules and practices in prudential regulation and bank supervision
were left unchanged in spite of the rapid deregulation. Meanwhile, social welfare policies
distorted the market mechanism and prevented the efficient allocation of resources by
placing a high priority on the housing and public sectors. The tax system also contributed to
the credit boom. Full tax deductions for interest payments worked as an incentive to
borrowers under a progressive tax system with high marginal rates.
On the side of real economy, strong external demand for the countries' products and the
positive terms of trade contributed to the domestic boom, rapidly pulling up real assets and
stock prices. For example, the oil price surge in the early 1980s led to a boom in Norway,
and the rise in the world market price of forest products contributed to the overheating of the
Finish economy.
However, the overall run-up of the upswing finally ended with the bursting of asset prices and
a huge loss to the banking system. The bust started with the turnaround of international
economic conditions. The oil price fall in 1986 was a major negative shock to Norway. With
the collapse of the Soviet Union, Finnish trade with Russia quickly decreased in 1991.
Moreover, after German reunification, interest rates rose in Europe as a result of Germany's
combination of an expansive fiscal policy with a tighter monetary policy.
As a result, the three countries plunged into a deep recession for more than three years.
Finland suffered an over 10 percent cumulative fall in GDP. The other two countries
experienced a less severe loss but experienced three and four percent falls in their GDP.
One important feature to note about the Nordic banking crisis is that while the crisis was
caused by excessive liberalization policies without due adjustments for social policies and
regulation settings, it was overcome without resorting to the financial rescue packages of the
IMF.
3.3 The Asian currency crisis of the late 1990s
Now let's move on to the familiar Asian currency crisis of the late 1990s. East and South Asia
had been widely acclaimed as successful models for economic development by international
institutions including the IMF and the World Bank. Outward-oriented growth, high savings
and investment ratio, low inflation and strong fiscal positions were mentioned as the key
elements in the successful development strategy. Each country experienced high GDP
growth rates of 8 to 12 percent in the late 1980s and early 1990s. How then did these
countries fall prey to such severe financial distress?
The causes of the debacle are many and disputed. Huge capital inflows played a crucial role
in the development of internal imbalances in the countries before the crisis. Capital inflows
relative to GDP were very high in all affected countries for the pre-crisis period, ranging from
5 percent to 14 percent of GDP. Moreover, the ratio of short-term debt denominated in
foreign currencies was quite high compared to central banks' foreign reserves. The ratio of
short-term debt to total foreign debt of the affected countries exceeded 50 percent.10
As foreign capital poured into the Asian countries, lending booms emerged in all these
countries before the crisis. If the capital inflows and lending booms had enhanced the
productivity and competitiveness of the economies, there might not have been a crisis.
However, many of the loans were misallocated and eventually turned sour. Before the crisis,
nonperforming loans exceeded 10 percent of total bank lending in those countries. The other
aspect of capital inflows was the current account deficit. For example, Thailand, Indonesia,
and Korea ran current account deficits of 8.0, 3.4, and 5.0 percent of GDP, respectively, in
1996.
The crisis started in Thailand with the collapse of the Thai baht. The crisis spread quickly
around the region. Indonesia and South Korea were particularly hard hit. Hong Kong,
Malaysia, Laos and the Philippines were hurt by the slump, and the rest of the region also
suffered from a loss of demand and confidence.
The Asian financial crisis showed the weakness of an emerging economy against the volatile
international capital markets. Together with inflows of foreign capital, overconfidence or
excessive optimism created credit booms in the economies. Ironically, they were "victims of
their own economic success.11" The input-dependent development strategy, which had
worked very well up until then, itself contributed to the crisis.
After the crisis, Asian countries introduced various measures to tackle the weaknesses that
had led to the crisis. First of all, they enlarged the scale of their foreign reserve accumulation
as the first line of defense. They also shifted to a free floating exchange rate system to
contain the excessive capital flows. The other measures included making financial
surveillance and regulation efficient; improving the functioning of the market by breaking the
links between businesses, banks and the government; and enhancing transparency by
enforcing the duty of disclosure of key financial or corporate sector information.
Controversy has raged over the IMF prescription for the affected countries. For example, the
IMF was criticized as acting in Southeast Asia and Korea in much the same way as it had in
the transitional economies of Eastern Europe. In short, the main criticism was that the same
prescription was applied for different symptoms.12 Especially, in the case of Korea, interest
rates were raised excessively in response to the foreign currency shortage, which resulted in
a severe domestic credit crunch. However, I think that most of the measures during the crisis
were inevitable to a certain extent and can be regarded as having erred more in their degree
of severity rather than in their primary purpose.
3.4 The latest US financial crisis
The final example of a major crisis we will review is the latest US financial crisis. Even though
it is not yet clear whether the crisis has ended or not, it is certain that it will have a profound
impact not only on our economies but also on our economic thought. There is even a saying
that we face not only an economic crisis but also a crisis in economics.13 As you are of
course all too well aware of the evolution of the US financial crisis, I will be brief on the crisis
itself, instead focusing on the mechanism of propagation to emerging economies.
The trigger for the crisis was the decline in housing prices in the United States. But, in the
run-up to it, three elements had been working to bring about a major global crisis. The first
element was credit expansion and asset price increase. During the first half of this decade, a
benign environment of low inflation, low interest rates and sustained growth led people to
have an optimistic attitude with regard to their economies. Some people enjoyed
consumption in excess of their income level for too long a period of time. The second
ingredient was the securitization of financial assets and the interconnectedness between
financial institutions both within and across countries. Basically, securitization should improve
risk allocation and helps absorb shocks. However, in fact, it brought opacity with increasing
complexity, and a large degree of uncertainty about the value of the securities because their
evaluation became much more difficult. And the third ingredient was the increase in leverage.
Financial institutions financed their portfolio with more and more external debt, thus
increasing the rate of return on capital. Underestimation of risk, moral hazard and poor
supervision were the factors underlying this.
Around the end of 2006, US housing prices stopped rising and started declining rather
steadily. Many marginal mortgages, especially subprimes, fell into default. And the shock
reverberated through the securities markets and financial institutions. As asset prices
dropped greatly, financial institutions needed to improve their capital ratio, to satisfy either
investors or regulatory requirements. To do this, they deleveraged by selling part of their
assets or reducing their lending.
Through the deleveraging of financial institutions in the advanced countries, emerging market
countries eventually started to get affected by the crisis that had originated from the former.
Right after the financial crisis, it looked as if emerging markets might be shielded from the
crisis. But things changed dramatically after Lehman's collapse in the fall of 2008. In the
process of deleveraging, banks in advanced countries started to drastically reduce their
exposure to emerging markets, closing credit lines and repatriating funds. The situation was
similar to the Asian crisis of the 1990s.
Since the eruption of the latest U.S. financial crisis, much work for establishing remedial and
preemptive measures has been going on, both in each country and internationally, ranging
from the examination of the rules governing credit rating agencies to constraints on executive
compensation, to new rules for evaluating assets on balance sheets, to the introduction of
new regulatory capital ratios and so on.
Here, I will not go into details of policy responses after the US financial crisis because these
topics are now under discussion at the meetings of the G20, FSB, BIS, etc., and they are too
specific to be discussed here and now. Instead, I would like to move on and touch upon the
global financial safety net, which is one of the most important agenda items for the G20
Seoul Summit.
4. Global financial safety net (GFSN)
We learn more when something goes wrong than when everything hums along smoothly. We
have become more knowledgeable about the global economy through a series of crises.
As the global economy has become more integrated, crises have also evolved in their scope
of influence and propagation mechanism. In the Latin American debt crisis and the Nordic
banking crisis, the influence was more or less restricted within the territorial boundaries. Even
though we name these crises by their region, contagion was not a big issue. However, since
the Asian currency crisis, contagion has come to be understood as a key factor threatening
the stability of the global economy.
4.1 Principles of the GFSN
During the recent crisis, the affected emerging market countries responded through domestic
policy actions by allowing exchange rates to depreciate, and by making use of accumulated
reserves to help cushion the impact of the shock. But this was often only partially effective. In
a number of cases, countries also needed to rely on external cooperation, including central
bank swap lines, precautionary finance from the IMF in the form of the newly developed
Flexible Credit Line (FCL) or traditional IMF lending through a series of Stand-By
Arrangements (SBAs). These measures played a crucial role as a "fire break," limiting the
impact of the crisis and its further feedback.
Based on these experiences, the G20 has recognized increasing capital volatility as a
serious future risk to the global economy. And, as a part of its efforts to pursue sustainable
growth, it has agreed to develop ways to assist countries to deal with such problems.
Notably, the Korean government has put forward the strengthening of the global financial
safety net (GFSN) as a major item on the agenda for the G20 Seoul Summit to be held this
November.
From past experience, we find the GFSN should be constructed under the four principles:
certainty, sufficiency, stigma-free, and minimizing moral hazard. These principles are
important because a truly effective GFSN must work as a forward-looking crisis prevention
mechanism rather than a crisis resolution mechanism. When countries are in need, they
have to be assured of access to funds and the amount available has to be sufficient to cover
problems. And eliminating or reducing the stigma effect is also very important to enable
countries in need to access the resource. If not, an application to the GFSN may create more
problems than it solves, and the GFSN will become useless.
Minimizing the moral hazard problem is also challenging, but must be dealt with in order to
have a workable GFSN. When I emphasized the importance of the GFSN in the annual
international conference of the Bank of Korea this June, some participants raised the moral
hazard problem. I fully understand their concerns. Instead of giving up a system because of a
moral hazard problem, however, we should design the system to minimize it efficiently. In
fact, we have various insurance schemes in our daily lives even though they are not immune
to such problem. A GFSN can cope with it by extending funds only to countries with a strong
track record and sound macroeconomic policies. In this way, it gives countries an incentive to
keep the macroeconomy sound, bringing a virtuous cycle for the global economy.
4.2 Current issues related to the GFSN
To be more specific, let me briefly introduce some instruments of the GFSN which are
currently under discussion. No single facility can meet the various needs of countries
because each country confronts a different situation. A GFSN should be a tightly-woven
multi-layered network of facilities with their respective strengths. The GFSN could have three
layers: bilateral, regional and global.
An example of the bilateral layer is the swap lines between the central banks. The network of
swap lines was highly effective during the last financial crisis. The swap between the BOJ
and the BOK, which contributed greatly to stabilizing the Korean capital market, serves a
good example of a successful bilateral swap. However, the flexible nature of these swap
lines generates a significant degree of uncertainty for potential recipient countries because it
is at the discretion of the issuing central banks.
The second layer is regional financial safety nets. Regional arrangements in Europe were
established quite rapidly in response to the developments in Eastern Europe during the
2008-9 crisis and the more recent euro area financial distress. In the Asian region, the
Chiang Mai Initiative (CMI) of the ASEAN plus three countries has expanded into the Chiang
Mai Initiative Multilateralisation (CMIM). We need to find the most effective way in which the
IMF and the regional arrangements can mesh together through, for example, coordinated
surveillance or co-financing.
Lastly, various liquidity provision facilities of the IMF make up the global level layer in the
GFSN. The Flexible Credit Line (FCL) of the IMF was a critical part of the toolkit in the
response to the latest crisis. This is a precautionary finance facility based on pre-qualification
criteria. However, some countries feel the current FCL is not enough in view of the critical
GFSN principles I mentioned. There are concerns about certainty, sufficiency, and the
stigma-effect. Including the improvement of the FCL, a Global Stabilization Mechanism
(GSM) is now under discussion. The GSM is a comprehensive liquidity-supporting framework
which will be activated by the resolution of the Executive Board in the event of a systemic
crisis. The GSM will allow qualified systemically important countries access to various types
of liquidity line such as the FCL and the Short-term Liquidity Line (SSL).
5. Concluding remarks
In Korea, the Asian crisis is also commonly referred to as the IMF crisis. This term may
indicate the fact that the IMF played a major role in resolving the crisis. But the term also
reflects the bitter emotion felt by the Korean people. In a sense, such emotion has some
reasonable grounds in that the pain might have been much less acute if there had been an
adequate GFSN at the time of the Asian crisis.
The U.S. financial crisis highlighted the risk of sudden reversals of capital flows in emerging
market countries. In the past, these sudden reversals were typically associated with the
problems of emerging market countries such as mismanagement of macroeconomic policies
and a weak financial regulatory system. This time, many of the economies affected by
contagion had strong policy frameworks in place. In this sense, the crisis hit "innocent"
bystanders through financial and trade channels.
Now we are working hard to fix the system in the hope that the next crisis can be prevented
by minimizing systemic risks. However, crises are still likely to happen in the future. It seems
quite natural to think that, even if jurisdictional systemic risks are somehow controlled for,
"global" systemic risks will emerge as a source of future financial crises due to the
everstronger trend toward the inter-connectedness of the world economy.
It remains true that strong national economic and financial policy frameworks provide the first
and most important line of defense for countries facing external shocks. But these are not
enough in a globalized world. The GFSN will help cushion the impact of a crisis and limit its
further propagation.
And there is another issue I would like to raise. The current crisis was caused by systemic
malfunctions within the advanced economies, coupled with contagion effects on the
emerging economies. As the current crisis is to be overcome, we may well find that the
income gaps between the low income countries and the rest of the world have widened
during the course of the crisis. International social instability as well as international financial
instability will be an issue that must be dealt with soon to avoid a new type of crisis. This is
one of the compelling reasons that we are putting a very high priority on "development"
issues at the upcoming G20 meeting in Seoul.
What then should be the role of central bankers in preventing and managing future financial
crises? With the limited policy instruments available, central bankers should establish closer
networking among themselves for active information sharing to cope with the ever-increasing
cross-border transmission of domestic policy actions.
I think there is much more that the Tripartite Governors' meeting and our three central banks
should be doing together in the future than they have in the past. For heightened prosperity
and stability, let us go forward together hand in hand. In this way, I believe, our three
countries can also contribute immensely to the global economy.
Thank you for listening.