What is currency crisis (or financial crisis)?\' What are the major stages of a

Question

What is currency crisis (or financial crisis)?' What are the major stages of a financial bubble? Use one example (Mexican peso crisis. Asian financial crises. Argentine financial crisis, or 2008 financial crisis) to illustrate these stages. What major causes can you identify for the financial crises during the last decade? How does the "Mundel Trilemma'' (or the "unholy trinity", pp 255-257) create challenge to policy options? Facing a financial crisis, what can the IMF and the affected state do to alleviate the crisis? What lessons can be learned from the past financial crises?

Explanation / Answer

Currency Crisis

A currency crisis is when, serious doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate. The crisis is often accompanied by a speculative attack in the foreign exchange market. A currency crisis results from chronic balance of payments deficits, and thus is also called a balance of payments crisis. Often such a crisis culminates in a devaluation of the currency.

Major stages of a Financial Bubble

1. Displacement:-This is the stage where investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low. A classic example of displacement is the decline in average U.S. housing prices had declined by over 20% from their mid-2006 peak, in 2008 financial crisis

2. Boom

Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase.

3. Euphoria

During this phase,caution is thrown to the wind, as asset prices skyrocket. The "greater fool" theory plays out everywhere.

4. Profit Taking

By this time, the smart money – heeding the warning signs – is generally selling out positions and taking profits.

5.Panic:

In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate them at any price. As supply overwhelms demand, asset prices slide sharply.

One of the most vivid examples of global panic in financial markets occurred in October 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac and AIG almost collapsed.

Major Causes for Financial Crisis

The major causes for financial crisis happened over last decade are as follows:

1. Leverage. Excess leverage is at the center of all banking crises, by definition. Leverage goes beyond balance sheets. Leverage is embedded in off-balance-sheet instruments such as derivatives.

2. Liquidity. Similar to leverage, liquidity mismatches (lending long, borrowing short) must be dramatically curtailed.

3. Conflicts of Interest. In no other profession are such blatant conflicts of interest tolerated. Even the asset management industry within finance is aghast, as are many “old school” bankers. Forcing the financial industry to pick a line of business and customer type to serve will solve the conflict problem while improving system resiliency due to the increased diversity of firms

4. Taxes and Subsidies.  Tax policy has a significant impact on the cost and flow of capital and the current tax code as it affects finance needs an overhaul.

5. Governance. We must recognize that the financial system has expanded and interconnected to the point that it is now effectively a “commons”, impacting all citizens.

What can be done by IMF and affected State to alleviate crisis

1. Correction of lending discourse

2. Adjusting interest rates

3. Ensure the prices remain stable

Lessons learned from the past financial crises

First, we need to finalize a common set of accounting principles across borders. In global markets, you cannot have global institutions abiding by differing standards of accounting and disclosure simply because they are headquartered in different countries.

Second, the financial regulatory regimes in the world's major markets need to be structured along broadly the same lines. Each country needs a finance minister at the political level, a central bank and one single financial services regulator with a very broad mandate.

Third, you need full transparency for financial statements. Nothing should be eliminated. Off-balance-sheet vehicles that suddenly return to the balance sheet to wreak havoc make a mockery of principles of disclosure.

Fourth, you need full disclosure of all financial instruments to the regulator. No regulator can do its job of assessing risk and systemic soundness if large parts of the financial markets are invisible to it. A regulator must be able to monitor all derivatives, including, for example, $60 trillion in credit default swaps.

Fifth, the regulator should have oversight over all financial institutions that participate in the markets, regardless of their charter, location or legal status. For example, it makes no sense if you are worried about leverage in the system to exclude major categories of borrowers, such as hedge fund

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