What are the five major forces that can lead to financial crises? Explain each of these forces in depth.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: The five different forces that may lead to financial crises are listed below.
Overlending and overborrowing: In the late 1970s and mid-1990s foreign lenders were lending excessively to some countries. This often results from excessive expansionary policies in the borrowing country. These policies lead to governments borrowing to finance growing budget deficits. Further loans to private borrowers may be guaranteed by the government to finance the growing current account deficits. The governments have an incentive to default when they realize they borrowed too much. When foreign lenders realize that too much has been borrowed, they have an incentive to stop lending and demand repayment quickly. When all cannot be paid quickly, financial crisis occurs. 
Exogenous international shocks: A decline in export earnings due to a decline in the world price of a country's key export commodity may constitute such a shock. In such a situation, the country may find it difficult to service its foreign debt, and therefore default. A change in the U.S. real interest rates in the early 1980s and in the 1990s was another major exogenous shock. When interest rates in the U.S. increase, new funding flows to developing countries decrease because it is harder to find projects that offer a rate of return greater than the already high interest rates in the United States. 
Exchange-rate risk: Borrowers can take on excessive debt denominated in foreign currency and back these with assets valued in local currency. Liabilities are not matched by the same currency assets, and therefore exposure to exchange-rate risk occurs. This mostly occurs because private investors expect the government to successfully defend its fixed exchange rate. Another name for this type of uncovered borrowing is "carry trade" where investors borrow dollars or yen at low interest rates and lend in the borrowing country at a higher rate. As long as the exchange value of local currency is steady, this is a profitable investment. However, when the probability of devaluation increases, borrowers sell local currency, increasing the pressure on the local currency to devalue. When the government has no option but to devalue, borrowers suffer a loss. 
Fickle international short-term lending: Foreign debt that is due to be paid off soon can cause a major problem when foreign lenders refuse to refinance it. Tesobonos were a major contributor to the December 1994 Mexican economic crisis. In the Asian crisis, large amounts of short-term borrowing by banks were coming due, creating a policy dilemma. The country's government could raise interest rates to attract foreign capital but hurt local borrowers or the government could guarantee or take over the banks' foreign borrowings. However, the governments may not have sufficient foreign exchange reserves to pay off the debts, risking a financial crisis when foreign lenders demand repayment. A shift from one state of equilibrium to another occurs more rapidly under short-term borrowing than long-term borrowing. 
Global contagion: Contagion occurs when a crisis hitting one country spreads to other countries. Contagion may be the result of close trade ties between affected countries. A downturn in one country like Argentina can affect another country like Uruguay. Contagion may also result from overreaction by foreign lenders as they struggle to exit. Herding may occur when investors are not provided full information. The high cost of obtaining accurate information may contribute to contagion. Recognition of real problems in a neighboring country (wake-up call) similar to those in the crisis country can cause contagion. Crisis in Thailand led to a wake-up call in Indonesia and South Korea. Some common problems were a weak banking sector, declining quality of domestic capital formation and a slowdown in export growth.