Signs of a Future Financial Crisis

The outflow of funds occurred when the crisis started.  Some argued that the outflow of funds was the reason for the crisis rather than the symptom.  The lending activities grew at a rate of 17%-30% annually during the three years before their financial crisis.  These lending activities are a good predictor of future financial crisis.       

There are many signs of financial crisis.  The value of the short-term liabilities (loans) owned by foreigners relative to the total short-term debt, is one measure of vulnerability.  These loans have a maturity of one year or less.  Increased spending, real appreciation of domestic currency, increased current account deficit, and occasional increases in foreign debt are additional good predictors of future financial crisis.  Then small events may trigger panic and financial crisis.           

Another sign, financial liberalization, may provide financial capital inflows, credit and appreciation of the currency.  When the economy enters into recession, banking crises appear and then lead to currency crisis.  Banking problems usually start with a decline of asset quality by bankruptcies of firms in non-banking sectors or by a substantial decline in real estate prices. The probability of currency crisis increases within 24 months of banking crisis.  A weak banking sector reduces the ability of the central bank to defend the currency.  The peak of banking crisis comes after the currency crisis.  The central bank fights off speculative attacks on the currency which leads to higher domestic interest rates and a depletion of foreign exchange reserves. Banking crisis increases the probability of financial crisis and may lead to the devaluation of the currency.  The devaluation usually increases the severity of the banking crisis.  The severity of currency crisis can be measured by the real depreciation of the currency and the losses of foreign reserves.  Financial liberalization, deregulation of the financial system, consequences of boom-bust cycles, and the bubble in asset values are some of the major reasons behind banking crisis.    

Before a currency crisis, one would observe a gradual decline in official reserves and an expansion of domestic credit at noticeably higher rates than the trend.  However, the expansion of domestic credit can be the result of a budget deficit or the bailout of troubled domestic financial institutions by the central bank.  The loss of official reserves would trigger higher domestic interest rates.  The expansion of domestic credit would trigger higher wages.  Also, before any currency crisis there would be a real appreciation of the currency and a deterioration of current account.  Expectation of financial collapse would lead to higher interest rates and the prediction that the government would abandon the fixed exchange rate.       

What measures are to be taken?

     The crisis is global, and leaves no country unharmed. No doubt remains about this. But it is also the first downturn of this magnitude in a multipolar and economically integrated world, at least since 1914. In such a world, the major economies share neither the same political system nor the same historical reference points, which makes coordinated action even more difficult. France's Nicolas Sarkozy repeatedly asserted last autumn that a global crisis demands global solutions. But such solutions are only a last resort as they are likely to be fiendishly difficult both to decide and to enforce. Regional or national responses are preferable wherever possible, including on fiscal stimulus. Any global solidarity is out of reach, as the world is far from cohesive enough to allow it. The urgency of the moment is more modestly about maintaining an open economy in which all players have a chance to succeed. Globalisation has allowed hundreds of millions of households to escape poverty. A new fragmentation of the system would be a massive negative-sum game. All senior policymakers around the world are aware of this. However, fragmentation is exactly what is happening - not because of tariff increases as in the 1930s, but as a result of macroeconomic instability, international competitive distortions, and a breakdown of trust in key intermediaries. These are the key threats to address. Macroeconomic challenges are perhaps the most worrying of all. They are also those for which the most tried-and-tested tools exist. These include IMF intervention and the coordination of central banks, sometimes through the Bank for International Settlements (BIS) and its committees. One of these, the Financial Stability Forum (FSF), has played a constructive role as early as last April to help coordinate national responses to the crisis. The European Union can also be helpful, as it has been with Hungary and Latvia. Alas, tensions on the sovereign-debt market suggest that 2009 will be an active year on this front. Competitive devaluations are another major risk, to which the G7 format is no longer able to respond - if indeed it ever was. Fair global competition entails in the short term a curb on domestic preference policies. The ongoing US debate on 'Buy American' clauses in the stimulus package will set the tone here. It also rests on harmonised international rales in key areas of regulation. The Basel 2 framework for banking supervision has not fared the crisis test well. The Basel committee on banking supervision, under the aegis of the BIS, has now started review it. Progress may be hoped for in the medium term. The crisis has also put international accounting standards, known as JJFRS, in the dock. The IASB, which sets them, was slow off the mark and then overly cowed by political pressure. The prospects for IFRS adoption in the US seem distant once again. Besides, common standards only serve a purpose if their implementation on the ground is consistent, which is currently far from being the case. Finally, trust crucially rests on credible supervision of the clutch of global private intermediaries whose role is paramount for the whole system. For these, self-regulation is no longer enough to foster confidence. The scope includes the big four audit networks, the three largest credit rating agencies, and key clearing and settlement infrastructure (including now for credit derivatives). These are all too globally integrated to be supervised separately in the US, Europe and elsewhere. Investment banks and hedge funds which are active the world over may be added to this list. But their supervision on a global scale would arguably be both less pressing and more difficult. Existing global governance institutions are illsuited to deliver on all these items. Moreover, they all need reform. For high-level summits, a transition is underway in which the G20 format is likely to eclipse the G7.