Why Financial Crises have Different Causes in Emerging Economies Compared to Developed Economies

Why Financial Crises have Different Causes in Emerging Economies Compared to Developed Economies Financial crises can have a considerable impact on both developing and rising economies, but their causes frequently vary greatly. Although emerging economies have special difficulties since they are in transition, mature economies have sound financial institutions.

Highlights:

Financial crises have different causes in emerging economies compared to developed economies because of:

• Structural vulnerabilities in emerging economies, including underdeveloped financial markets, weak institutions, inadequate regulations, and shallow capital markets.
• The impact of external shocks and greater volatility experienced by emerging economies, such as fluctuations in global commodity prices, sudden capital outflows, currency devaluations, or changes in global interest rates.
• Political instability, weak governance, corruption, and inadequate rule of law as factors that can amplify the risk of financial crises in emerging economies.
• Limited access to financing and shallow capital markets in emerging economies, which increase vulnerability to external shocks and difficulties in managing liquidity.
• Currency mismatches, where liabilities are denominated in foreign currencies while assets are primarily in domestic currency, and fragile banking systems with high levels of non-performing loans and inadequate risk management practices.

Why financial crises have different causes in emerging economies compared to developed economies?

Below, we examine and give examples of how financial crises in emerging economies differ from those in industrialized nations in terms of their root causes.

1. Structural Vulnerabilities: Emerging economies typically exhibit structural vulnerabilities that contribute to their susceptibility to financial crises. These vulnerabilities may arise from factors such as underdeveloped financial markets, weak institutions, inadequate regulations, and shallow capital markets. For instance, insufficient regulatory frameworks and lax supervision in emerging economies can lead to speculative bubbles and excessive risk-taking by financial institutions, resulting in a crisis. The Asian Financial Crisis of 1997, which originated in Southeast Asia, exemplifies this scenario. The crisis was fueled by high levels of foreign debt, weak financial regulation, and inadequate transparency in the affected countries.
2. External Shocks and Volatility: Emerging economies are often exposed to greater volatility and external shocks compared to developed economies. These external factors can include fluctuations in global commodity prices, sudden capital outflows, currency devaluations, or changes in global interest rates. The Russian financial crisis of 1998 is an illustration of how external shocks can trigger a crisis in an emerging economy. The crisis was precipitated by a sharp decline in oil prices and investor confidence, causing significant capital flight and a collapse of the Russian ruble.
3. Political and Governance Factors: Political instability and weak governance can amplify the risk of financial crises in emerging economies. Unstable political environments, corruption, inadequate rule of law, and governance deficiencies can erode investor confidence and hinder effective policy implementation. The Latin American debt crisis of the 1980s serves as an example where poor governance and political factors contributed to financial turmoil. Mismanagement of public finances, excessive borrowing, and political instability led to a debt crisis that affected several countries in the region.
4. Limited Access to Financing and Capital Markets: Emerging economies often face challenges in accessing financing and have limited depth in their capital markets. This limited access can result in increased vulnerability to external shocks and difficulties in managing liquidity. The Global Financial Crisis of 2008 highlighted this issue when emerging economies experienced difficulties in refinancing their debt due to reduced global liquidity. Countries heavily reliant on external borrowing, with limited domestic sources of funding, faced severe repercussions during this crisis.
5. Currency Mismatches and Fragile Banking Systems: Emerging economies may face currency mismatches, where their liabilities are denominated in foreign currencies while their assets are primarily in domestic currency. Such mismatches can expose these economies to exchange rate volatility and make them vulnerable to financial crises. Fragile banking systems, with high levels of non-performing loans and inadequate risk management practices, further exacerbate the risks. The 1994 Mexican Peso Crisis illustrates these issues, where a sudden devaluation of the peso led to a banking crisis and severe economic downturn.

Wrap up

Due to their distinctive characteristics and difficulties, financial crises in emerging nations and those in industrialized ones have different causes. The unique characteristics of financial crises in emerging economies are a result of structural weaknesses, external shocks, political and governance concerns, limited access to funding, and currency mismatches. For policymakers and stakeholders to put effective safeguards in place and reduce the risks associated with financial crises in each setting, they must understand these distinctions.

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