Hong Kong Case Q1: Explain the mechanism of currency attacks.
Currency attacks in emerging market economies and advanced economies occur by following some similar steps and stages but with some notable differences. Since this case is about an emerging economy so we will be discussing the mechanism of currency attacks in an emerging market. There are three following stages that lead an economy to full financial crisis. 1. Initiation of financial crisis 2. Currency crisis 3. Full-fledged financial crisis
Stage 1: Initiation of Financial Crisis
The reasons that leads an emerging market country towards financial crisis initiation includes the first two basic paths and some additional factors and they all make the problems of moral hazard and adverse selection worsen. A. Mismanagement of financial liberalization B. Severe fiscal imbalances C. Asset price decline D. Increase in interest rate E. Increase in uncertainty
Financial liberalization is the eradication of restrictions from all the domestic financial institutions and markets and allowing them to trade with the financial firms of other nations. It has a benefit of financial development in long run but in short run it lead financial institutions to riskier lending (credit boom) and its mismanagement takes an economy towards a bubble. The financial institutions, regulators of bank, and other lenders in emerging economy do not have much expertise to cope the risk of this business line and hence have a weak credit culture. For attracting the foreign capital and rapidly increasing the lending, domestic banks defray high interest rate. Further, if the policies of government fix the domestic currency value with dollars, it encourages the capital inflow and foreign investors consider investment less risky. A point comes in, when these risky lending starts resulting into high