Finance, as indicated by the Japanese Kanji(金融), means lending and borrowing of money. Money, as well as commodities and services, is exchanged in financial transactions. However, financial transactions spread across time; both present and future. For example, in the borrowing and lending of money, lending is only the first step of the transaction -- the entire financial transaction is not yet completed. A lender gains a right to receive money from a borrower in the future in exchange for lending money, and an obligation for the borrower to repay in the future occurs. This means that the borrower’s future repayment completes the financial transaction. This is very tricky. We do not know what exactly is going to happen in the future, while we are able to know the result of a transaction which is completed in the present. This is why finance is interesting and complicated at the same time.
Exchange of rights for the future is the nature of financial transactions, both domestically and internationally. Today, an enormous amount of financial transactions with this kind of uncertainty are carried out in the world. Also, these transactions are interrelated in a very complicated and layered structure, where a lender for somebody is a borrower for somebody else. This structure has a close relationship with the recent financial crisis, which will be dealt with later.
We have something called exchange rates, because international financial transactions are usually carried out between different regions and countries with different currencies. Exchange rates are, for most people, especially students, something taught in social studies class in junior high school or shown in TV news shows, and is often not known what exchange rates actually do. It’s not so different for economics students in university.
As for Japan, the reason for this lack of exposure lies in the Japanese economy and our currency, the Japanese Yen (JPY). JPY is one of the few international settlement currencies in the world, with which we can directly start international transactions and exchange transactions. Also, we do not need to rely on other countries for financing because our economy is large enough and our domestic financial market is developed. As a result, a vast majority of the population does not need to concern itself with exchange rates in their everyday lives and perhaps have no interest in it.
However, exchange rates are an immediate and serious matter for people in most regions and countries in the world. Developing economies, where domestic financial markets are not well developed, rely on foreign countries with large surplus funds for financing. Those foreign countries also enjoy the opportunities to utilize their surplus funds in a region where economic growth is high and which is attractive to investors. Here we find an obstacle; currency. Currencies used in international financial transactions are usually different. In this case, either lenders or borrowers have to take the risk resulting from exchange fluctuation unless borrowing countries have fixed exchange rates towards their lender countries.
For example, if a lender loans money to a borrower in the local currency, after the money is repaid, the lender needs to exchange the currency back to the lender’s currency to use it in their own country. However, the lender could possibly lose large profits if the exchange rate fluctuates between the time when the money was borrowed and repaid. Also, it is not easy to find a partner who is willing to exchange the local currency for the lender’s currency when the local currency is not an international settlement currency. The value of the currency fluctuates even while they are looking for a partner. This is a setback for investors. This type of difficulty is expressed as low liquidity. Low liquidity itself is a risk for lenders.
Thus, uncertainty for international financial transactions is greater than domestic financial transactions. For this reason, foreign investors prefer to loan in currencies with higher liquidity when they finance developing countries. According to documents of the Bank for International Settlements (BIS), when all exchange transactions carried out in 2013 totaled 200% per say, the US dollar dominated 87% of the share, the Euro took over 33%, and these two currencies alone dominated more than half of all transactions. Moreover, together with the Japanese Yen and the British Pound, the share is as high as 155% of all transactions. What this fact tells us is the high liquidity of these currencies. Without a doubt, lenders choose the US dollar and the Euro if possible. As a result of their choice, developing countries, which are the borrowers, have to take risks resulting from exchange fluctuations. Therefore, exchange rates are a serious matter for developing countries.
I think it is still difficult for people living in Japan to realize why exchange rates are a serious matter. This is because we think that only companies and banks need to be concerned with exchange rates while the common households have nothing to do with it. Although it might be difficult for us to imagine situations where households receive housing loans in foreign currencies, this is the reality for many people in the world. Mega banks in developed countries often build their branches and subsidiaries in developing countries, e.g. Central and Eastern Europe, and make loans to households and companies there in foreign currencies. In another case, just like Eastern Asia has experienced before, developed countries finance in foreign currencies to local banks in developing countries, which then loan households and companies there in local currencies. Similarly in this case, the economy is impacted as a whole from the exchange rate fluctuation which influences the financial conditions and lending attitude of a bank. Therefore, most people in other countries are never ignorant to international financial issues including exchange rate fluctuations.
That being said, households are not always involved in this uncertainty. Governments usually attempt to eliminate or relieve this problem by setting a fixed exchange rate system for a specific currency or similar system. This attempt usually prevents the economy from suffering losses caused by sudden exchange rate fluctuations.
I said “usually” because unusual situations do exist in the world, like a currency crisis or a financial crisis. It is to be noted that, these crises do not necessarily have to occur within one country. This is why today’s international financial market is so volatile. To understand this point we shall look at cases from the Global Financial Crisis in 2008 and the Eurozone debt crisis since 2009 to observe the phenomena outside the country and region.
In these crises, Central and Eastern European countries, as mentioned above, experienced a sharp decline in economic growth rate, high unemployment rate and high non-performing loan ratio, despite that these countries had no direct relations to the crises and had a healthy economy. Especially when their economic growth was supported not only by exports to the Eurozone but also by expansion of domestic demand, the decline of exports was not the only crucial factor to the problems.
The key to understanding this phenomenon lies in financial institutions, especially banks in Europe, which dominate the international financial markets and play a role as international mediating agencies. European banks had financial downturns because their investment destination countries experienced these two crises and were unable to repay. The refusal of financing by the U.S. and Japanese banks made the situation even worse. In order to improve their financial condition, they withdrew capital from the borrowing countries, known as asset reduction for banks. This is called a credit crunch.
Most major banks in Central and Eastern European countries are affiliated with banks in the Eurozone including Austrian banks, and they loaned money to companies and households in the Euro or the Swiss Franc currencies. The household and private sectors experienced the same situation. The expansion of domestic demand, such as household consumption and private sector investment, which supported the high economic growth in Central and Eastern European countries in the 2000’s was actually supported by funds from the Eurozone. Domestic demand, after losing these funds from the Eurozone, rapidly shrunk. Moreover, they needed to excahnge their local currencies for foreign currencies in order to repay. However, their local currencies were depreciated against foreign currencies because of the withdrawal. As a result, rapid outflow of capital caused even more depreciation of the exchange rates, and the debt denominated in local currencies swelled. As an obvious outcome, many households and companies became insolvent.
In fact, the bad debt ratio in this region was only 3% on average before the two crises, but jumped to 12% in 2013. Taking into consideration that the same ratio in EU which was directly related to the crises in 2013 was 7%, it is clear how seriously a credit crunch influences international financial transactions. In today’s world where capital inflow and outflow are globalized, crisis is not only a problem for those who are directly involved but it can become a contagion for others.