Bäckström: Some reflections on financial crises
A matter that observers are discussing these days is the ways in which the problems in Asian countries may affect economic developments in the rest of the world. In the brief time available this evening I shall be considering some aspects of the phenomenon of financial crises which have to do with this matter. At the same time one must not lose sight of the fact that other factors are also affecting demand and price tendencies.
The Asian countries with financial problems display a number of fundamental similarities with the situation in Mexico a couple of years ago, as well as with the crisis in Sweden at the beginning of this decade. A common feature is that increasing financial vulnerability coincides with an economic boom. Some of the problem's ingredients are a rapid expansion of credit, inflated asset prices and current-account deficits with the resultant external debt.
Sooner or later the boom falters and asset prices turn downwards. A process of consolidation is initiated among indebted households and firms. A period of weak economic activity is then usually inevitable; the adjustment process will be exacerbated by the extent to which asset prices were pushed up and credit grew in the preceding period.
One aspect of major importance for the economic consequences is how the crisis affects confidence in the financial system and this system's ability to function properly. This includes the ability of the banks to maintain an efficient payment system and an adequate supply of credit. If these two functions are impaired, the adjustment problems may develop into a full-blown financial crisis, with more general macroeconomic consequences that also spread more markedly to other countries.
Traditional banking involves accepting deposits from the non-bank sector and converting these short-term savings into longer loans to households and firms. The economy usually benefits from this transformation of maturities. By borrowing short and lending long, however, banks incur a balance-sheet mismatch, which entails certain risks. Moreover, as banks tend to have a high debt-equity ratio compared with other enterprises, leverage is relatively marked.
If a bank's position is perceived to be so uncertain that deposits are withdrawn and the bank is unable to maintain its liquidity in other ways, it will have to suspend payments and may fail completely. It then ceases to function as a component of the payment system and a provider of credit. When this happens to a single bank, the economic effects need not be negative. But if it involves the whole of the banking system, economic activity is liable to be seriously weakened.
In extreme situations the central bank can perform its classic function as lender of last resort, which amounts to providing liquidity in the event of a threat to the financial system's stability. In this way it is possible to avoid graver economic setbacks and, provided the crisis's underlying problems are tackled, the situation in banking and the economy becomes more stable. In time, the crisis is resolved.
Under normal circumstances, however, a central bank provides liquidity only in the domestic currency. If a country is running an external deficit and export revenue does not cover expenditure on imports, the difference has to be covered with foreign-currency loans. If these loans are short term, sizeable and arranged via banks for long-term capital projects, the situation becomes more vulnerable. If banks in the country in question have problems in renewing the external loans, the central bank's function as lender of last resort is of no avail. In that case a financial crisis may arise and also coincide with an exchange rate crisis.
That was what happened in Sweden. The situation in many of the Asian countries is much the same. Current-account deficits have been financed with short-term loans mediated via the banking system in connection with rapidly growing credit. Weakening economic activity, falling asset prices and rising lending losses have eroded confidence in the banking system and spread uncertainty among foreign creditors. This has resulted in tendencies towards a shortage of foreign liquidity in the banking system, capital outflows and downward pressure on exchange rates.
Sweden managed to establish confidence in the management of the banking problems by taking vigorous measures with broad political backing and presenting the problems openly. Economic stability was gradually restored, though this did require a good deal of after-care, including the consolidation of government finances. Sweden's way of handling the crisis meant that foreign loans could be arranged by the State even during the most acute phase. Consequently Sweden had no need to turn to the International Monetary Fund in order to obtain external liquidity.
The situation in many of the Asian countries has developed differently. The international community, with the IMF in the lead, has provided external liquidity in various forms at the request of the country in question. Private banks have also been engaged in this work, as is virtually self-evident considering that they are the banks with exposed positions in these countries. In return, the countries have been required to take the measures that are need for a restoration of confidence. In other words, the underlying problems must be tackled. Action to support liquidity is not sufficient.
The requisite measures include an orderly wind-up of insolvent banks, a clearer presentation of the problems, a reduction of current-account deficits, a consolidation of government finances in order to meet the costs of restoring the financial sector, and a direction of monetary policy that stops the outflow of international liquidity. One cannot hope for a painless adjustment with no need for difficult decisions.
When a country finds itself in problems of this type, consequences for short-term growth are unavoidable and their effects may also spread to other countries. The currency depreciation likewise affects foreign trade and thus the level of economic activity in other countries. What matters most, however, is that the financial crisis is overcome and macroeconomic stability is restored. This is a question of enhancing confidence both in economic policy and in the ability of economic policy's decision-makers to tackle the problems resolutely. Otherwise the economic consequences for the countries involved will be greater, particularly if the payment system and the supply of credit are impaired.
It is thus quite clear that economic activity in the world in general will be somewhat affected by what is happening in Asia. It now looks as though this effect will be somewhat greater than expected earlier. The crucial factor in this respect, however, is how the problems are managed. The way in which the crisis is handled and how soon international confidence is restored will accordingly determine how the problems in Asia will impinge on economic developments in other parts of the world, including Sweden. The current fluctuations in asset prices, for instance in the relevant exchange rates as well as in international stock exchanges and bond markets, would seem to mirror different assessments of various probabilities concerning the management of the crisis in each country.
Sooner or later, the problems in the Asian countries will subside. These are economies with a fundamentally favourable production potential. When that happens, if not before, it will be high time to consider a number of questions in earnest. How could this happen, not just in the Asian countries that are currently in difficulties but also in countries that have previously faced corresponding problems? What can be done to avoid similar problems in the future? And if problems do arise, what is the best way of tackling them? Discussions on these matters have in fact already begun in various international contexts but they will have to be given a unified content.
