Volatility and Contagion in a Financially Integrated World: Lessons from East Asia's Recent Experience

63 Pages Posted: 20 Apr 2016

See all articles by Pedro Alba

Pedro Alba

World Bank

Amar Bhattacharya

World Bank

Stijn Claessens

Bank for International Settlements (BIS)

Swati Ghosh

World Bank

Leonardo Hernandez

Central Bank of Chile

Date Written: December 1993

Abstract

Recent events in East Asia highlighted the risks of weak financial institutions and distorted incentives in a financially integrated world. These weaknesses led to two sources of vulnerability: East Asia's rapid buildup of contingent liabilities, and overreliance on short-term foreign borrowing.

The buildup of vulnerabilities in East Asia is shown here to be mainly the result of weaknesses in financial intermediation, poor corporate governance, and deficient government policies, including pro-cyclical macroeconomic policy responses to large capital inflows.

Weak due diligence by external creditors, fueled partly by ample global liquidity, also played a role but global factors were more important in triggering the crises than in causing them.

The crisis occurred partly because the economies lacked the institutional and regulatory structure to cope with increasingly integrated capital markets. Trouble arose from private sector decisions (by both borrowers and lenders) but governments created incentives for risky behavior and exerted little regulatory authority. Governments failed to encourage the transparency needed for the market to recognize and correct such problems as unreported mutual guarantees, insider relations, and nondisclosure of banks' and companies' true net positions.

Domestic weaknesses were aggravated by poorly disciplined foreign lending. The problem was not so much overall indebtedness as the composition of debt: a buildup of short-term unhedged debt left the economies vulnerable to a sudden loss of confidence.

The same factors made the crisis's economic and social impact more severe than some anticipated. The loss of confidence directly affected private demand-both investment and consumption - which could not be offset in the short run by net external demand.

The effect on corporations and financial institutions has been severe because of the high degree of leveraging and the unhedged, short-term nature of foreign liabilities, which has led to a severe liquidity crunch. Domestic recession, financial and corporate distress, liquidity constraints, and political uncertainty were self-reinforcing, leading to a severe downturn.

This paper - a joint product of the Economic Policy Unit, Poverty Reduction and Economic Management Network and the Central Bank of Chile - was presented at the CEPR/World Bank conference Financial Crises: Contagion and Market Volatility, May 8-9, 1998, London, and at the PAFTAD 24 conference, Asia Pacific Financial Liberation and Reform, May 20-22, 1998, in Chiangmai, Thailand. Pedro Alba may be contacted at palba@worldbank.org.

Suggested Citation

Alba, Pedro and Bhattacharya, Amar and Claessens, Stijn and Ghosh, Swati and Hernandez, Leonardo, Volatility and Contagion in a Financially Integrated World: Lessons from East Asia's Recent Experience (December 1993). World Bank Policy Research Working Paper No. 2008, Available at SSRN: https://ssrn.com/abstract=597217

Pedro Alba (Contact Author)

World Bank ( email )

1818 H Street, N.W.
Social & Economic Development
Washington, DC 20433
United States
202-458-2246 (Phone)

Amar Bhattacharya

World Bank

1818 H Street, N.W.
Washington, DC 20433
United States

Stijn Claessens

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Swati Ghosh

World Bank ( email )

1818 H Street, N.W.
Washington, DC 20433
United States

Leonardo Hernandez

Central Bank of Chile

Agustinas 1180
Santiago
Chile

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