financial crises in mexico 1994 1995 east asia 1997 1998 and argentina 638256

Financial Crises in Mexico, 1994–1995; East Asia, 1997–1998; and Argentina,

2001–2002 When emerging market countries opened up their markets to the outside world in the 1990s, they had high hopes that globalization would stimulate economic growth and eventually make them rich. Instead of leading to high economic growth and reduced poverty, however, many of them experienced financial crises that were every bit as devastating as the Great Depression was in the United States. The most dramatic of these crises were the Mexican crisis, which started in 1994; the East Asian crisis, which started in July 1997; and the Argentine crisis, which started in 2001. We now apply the asymmetric information analysis of the dynamics of financial crises to explain why a developing country can shift dramatically from a path of high growth before a financial crisis—as was true in Mexico and particularly the East Asian countries of Thailand, Malaysia, Indonesia, the Philippines, and South Korea—to a sharp decline in economic activity. Before their crises, Mexico and the East Asian countries had achieved a sound fiscal policy. The East Asian countries ran budget surpluses, and Mexico ran a budget deficit of less than 1% of GDP, a number that most advanced countries, including the United States, would be thrilled to have today. The key precipitating factor driving these crises was the deterioration in banks’ balance sheets because of increasing loan losses. When financial markets in these countries were liberalized and opened to foreign capital markets in the early 1990s, a lending boom ensued. Bank credit to the private nonfinancial business sector accelerated sharply, with lending expanding at 15% to 30% per year. Because of weak supervision by bank regulators, aided and abetted by powerful business interests (see the Global box on “The Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean Crisis”) and a lack of expertise in screening and monitoring borrowers at banking institutions, losses on loans began to mount, causing an erosion of banks’ net worth (capital). As a result of this erosion, banks had fewer resources to lend. This lack of lending led to a contraction of economic activity along the lines outlined in the previous section. In contrast to Mexico and the East Asian countries, Argentina had a well supervised banking system, and a lending boom did not occur before the crisis. The banks were in surprisingly good shape before the crisis, even though a severe recession had begun in 1998. This recession led to declining tax revenues and a widening gap between expenditures and taxes. The subsequent severe fiscal imbalances were so large that the government had trouble getting both citizens and foreigners to buy enough of its bonds, so it coerced banks into absorbing large amounts of government debt. Investors soon lost confidence in the ability of the Argentine government to repay this debt. The price of the debt plummeted, leaving big holes in banks’ balance sheets. This weakening helped lead to a decline in lending and a contraction of economic activity, as in Mexico and East Asia. Consistent with the U.S. experience in the nineteenth and early twentieth centuries, another precipitating factor in the Mexican and Argentine (but not East Asian) financial crises was a rise in interest rates abroad. Before the Mexican crisis, in February 1994, and before the Argentine crisis, in mid 1999, the Federal Reserve