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Financial crises, whether in the form of banking collapses or stock market crashes or bursting
of other financial assets bubbles or currency crises or sovereign defaults, have occurred
sporadically virtually every decade and in various locations around the world ranging from
Argentina to Sweden, Russia to Korea, UK to Indonesia, Greece to Dubai, and from Japan to
the US. Although each such crisis has been unique in texture, yet each bears some resemblance
to others. In particular, deregulation and globalization of capital flows without adequate
market monitoring and regulatory oversight, unsustainable macroeconomic policies, relatively
easy monetary policies at major financial centers, overheating of markets, excessive leveraging
of debt, credit boom, miscalculation and mispricing of risk inherent in financial assets,
off-balance sheet operations by banks, and imperfect understanding of new and complex
financial instruments and inexperience in handling the same are some identifiable common
causes of the crises. Financial crisis culminates in a vicious cycle of asset de-leveraging, price
declines, investor redemptions, erosion in corporate profitability, bankruptcy of firms in
distress, dwindling capital flows, huge withdrawals of capital leading to losses in equity market,
pressure on national currencies, high interest rates, depleting currency reserves and downgrade
in sovereign rating. The crisis usually has a ‘domino’ effect and spills over from the financial
to the real sector through the various interlinkages in the economy. The reduced financing of
the economy hinders capacity expansion, leading to supply side pressure, with the concomitant
effects of rise in inflation rate, increasing demand for domestic liquidity, shrink in exports,
increase in unemployment, slowing down of economic growth, thus plunging the economy
into severe downturn. Due to messianic faith in the market forces and deregulation and integration of financial and real sectors among various world economies through trade and
finance, such financial crisis, originating in a particular region, often spreads like wildfire
across countries so that no economy is spared of the global financial contagion.
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