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THE GLOBAL CAPITAL MARKET: Market Failures and the Policy Response 5

Similar patterns can be seen in east Asia. As the IMF observes concerning Thailand (Folkerts-Landau et al., 1997, p. 46):

While banks are believed to have hedged most of their net foreign liabilities, the opposite is believed to be true for the corporate sector. The combination of a stable exchange rate and a wide differential between foreign and (much higher) domestic interest rates provided a strong incentive for firms to take on foreign currency liabilities . . . . Hence, in addition to their own foreign exchange exposure, banks may have a large indirect exposure in the form of credit risk to firms that have borrowed in foreign currencies.

The Thai authorities intervened extensively in exchange markets after the crisis started in May 1997, by committing to contracts under which the government would assure future trades of dollars for baht (the Thai currency) near current spot prices. This policy allowed many of those short on dollars to cover their liabilities relatively cheaply. As a result, the Thai government was stuck with billions in foreign exchange liabilities after the baht was floated in July, and these additional debts fueled the crisis further.

When currency crises struck Europe in 1992, its governments’ credit did not come seriously into question. Europe’s exchange-rate crises therefore did not balloon into more damaging default crises as in Mexico and Asia, capital market access was not interrupted, and there was no need to seek emergency support from foreign governments or the IMF.

The recent east Asian episodes again underline the need for more effective monitoring and regulation of the asset and liability structures of financial institutions. The recent episodes also underline the often weak political will to carry out such supervision, the lack of local expertise, and the difficulty in discerning the true risk characteristics of institutions’ assets and liabilities. Particularly when borrowing is short-term, capital inflows may quickly reverse course and turn into outflows, squeezing liquidity and ultimately draining official reserves. This is what happened, on a global scale, in 1982. Such events are familiar from the record of bank failure in a purely domestic context, but the emerging-market setting combines an additional risk — currency risk -with the lack of a well-defined lender of last resort, transparent accounting practices and legal systems, and (often) adequate prudential supervision. (Even in many industrial countries financial deregulation in the 1980s led to massive banking problems in the early 1990s.)