Liquidity Crisis - Liquidity Crisis in Emerging Markets

Liquidity Crisis in Emerging Markets

It has been argued by some economists that financial liberalization and increased inflows of foreign capital, especially if short term, can aggravate illiquidity of banks and increase their vulnerability. In this context, ‘International Illiquidity’ refers to a situation in which a country’s short term financial obligations denominated in foreign/hard currency exceed the amount of foreign/hard currency that it can obtain on a short notice. Empirical evidence reveals that weak fundamentals alone cannot account for all foreign capital outflows, especially from Emerging Markets. Open economy extensions of the Diamond – Dybvig Model, where runs on domestic deposits interact with foreign creditor panics (depending on the maturity of the foreign debt and the possibility of international default), offer a plausible explanation for the financial crises that were observed in in Mexico, East Asia, Russia etc. These models assert that international factors can play a particularly important role in increasing domestic financial vulnerability and likelihood of a liquidity crisis.

The onset of capital outflows can have particularly destabilising consequences for emerging markets. Unlike the banks of advanced economies, which typically have a number of potential investors in the world capital markets, informational frictions imply that investors in emerging markets are ‘fair weather friends’. Thus self – fulfilling panics akin to those observed during a bank run, are much more likely for these economies. Moreover, policy distortions in these countries work to magnify the effects of adverse shocks. Given the limited access of emerging markets to world capital markets, illiquidity resulting from contemporaneous loss of domestic and foreign investor confidence is nearly sufficient to cause a financial and currency crises, the 1997 Asian financial crisis being one example.