Do Differences in Financial Systems Lead to Financial Crises?

Published by Ecosodes team on

It is common knowledge that the developed countries of the West are very different from their counterparts in the Eastern and Southern hemispheres. These differences are not only in terms of culture and inherent social structures but also extend to far more modern and technical parameters such as governance, industrial orders, and financial systems. The present context focuses on the distinct financial structures and whether one is more likely to bolster a financial crisis over the other.

The Western nations that pioneered the Industrial Revolution were also the first ones to develop the idea of a free market. This idea was extended to apply to financial institutions and contracts as well, which translated to transparency, availability of accurate information, and easy enforceability. Since these systems were based on the assumption that parties to a contract had no other relationship amongst themselves beside the transaction at hand, they were also referred to as “arm’s length” systems. Such systems were further backed by the assurance of a strong court of law ensuring the commitment of both parties, thereby building mutual confidence.

The countries of the east and south that were colonized by the richer industrialized nations were very backward and underdeveloped as long as they served as colonies. At the time that they achieved independence from colonial rule, well into the 20th century, their economies were mired in poverty and had meager means of production. It became essential for these governments to focus on those areas that were necessary for kickstarting economic growth.

Consequently, they were deeply involved in diverting finances to the most crucial sectors and making available easy credit for household consumption. Banks, on the other hand, started to establish close relations with a selected group of corporate firms, and all of their lending practices were based on a sense of good faith and regard for the mutual relationship instead of contractual obligations. This practice was further heightened by the ongoing reality that information was restricted among this group of insiders; outsiders were not privy to complete market information.

Now, in a world of closed economies, this disparity would not have been a matter of concern. Since financial systems originated out of the contemporary situations in the countries, as long as they were operating within national boundaries, they could function without a glitch. However, the status quo would have to change if countries were to engage in bilateral transactions. In fact, this is what happened in the closing decades of the 20th century when countries started adopting the policy of globalization.

Developing countries such as Korea, Thailand, and Malaysia wanted to boost domestic production in order to facilitate economic growth, and this entailed heavy investment into the imports of machinery and equipment. Such high imports, coupled with the infancy of domestic production, led these nations to incur trade deficits. This necessitated borrowing money from other countries. The rich countries of the West were in a position to offer such funds and were in search of new investment avenues. However, the dissimilarities between their financial sectors made this process difficult.

The lack of transparency and information made it difficult for foreign investors to trust the institutions of the developing countries. Therefore, in order to mitigate their risk, they agreed to lend for short periods of time so that they could pull out their money at the slightest sign of trouble. In order to protect themselves from the fluctuations of exchange rates and inflation rates, they demanded repayment in foreign currency.

Lastly, the investors preferred to lend through local banks so that if these institutions face bankruptcy and fail to repay them, the government would step in to bail the banks and save the financial system from economic damage. Since investors effectively lent to the banks, they often did not delve deeper into the kind of activity that their money would be invested in.

Throughout the 1980s and the initial years of the 1990s, investment levels kept soaring in the East Asian countries, funded by heavy capital inflow from the west. However, the joint ignorance of investors and banks in scrutinizing the investment avenues and their profitabilities led to a lot of money being put into doomed projects. In fact, the easy availability of money led to a problem of overinvestment financed by short-term foreign debt.

Once the non-viable projects started to get sour, investors were alarmed and started to withdraw their funds. This panic was further fuelled by the depreciation of the Japanese yen against the dollar, which made high-quality Japanese industrial exports much cheaper than those in Thailand and Malaysia. The latter found their export revenues dwindling, and their backers quickly pulled back their money before their losses aggravated.

The East Asian countries started to run deficits, and their governments had to spend out of the foreign exchange reserves to salvage themselves. This led to a depreciation of their currencies and put borrowers at a greater burden of repayment. The firms failed to repay domestic banks, and the latter was threatened by bankruptcy as they tried to repay their own creditors, that is, foreign investors. Thus, the East Asian Miracle soon turned into a major financial crisis in 1997.

The entire narrative might lead one to claim that financial systems characterized by government and bank intervention do not lead to sustainable growth outcomes, and this conclusion is not wrong. The East Asian countries acknowledged the need for reforms in their financial sectors, but they also learned a more universal lesson.

Growth initiatives funded by large amounts of external debt can never be sustainable, irrespective of the structure of financial institutions. Excessive dependence on foreign debt was more responsible for the East Asian Crisis than regulated financial markets. In fact, differences in the financial systems in the developing and developed countries in a globalized economy can cause more harm than the specific nature of the system. However, having said that, it is irrefutable that a free market with perfect information will always lead to better outcomes.

Written By- Ranjana Sinha 

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