CHAPTER Financial Crises and the Subprime Meltdown 217 rise in value in terms of pesos, while the debt does The depreciation of the domestic currency increases the value of debt relative to assets, and the firm s net worth declines The decline in net worth then increases adverse selection and moral hazard problems A decline in investment and economic activity then follows (as shown by the Stage Three section of Figure 9-3) We now see how the institutional structure of debt markets in emergingmarket countries interacts with the currency devaluations to propel the economies into full-fledged financial crises Economists often call a concurrent currency and financial crisis the twin crises The collapse of a currency also can lead to higher inflation The central banks in most emerging-market countries have little credibility as inflation fighters Thus, a sharp depreciation of the currency after a currency crisis leads to immediate upward pressure on import prices A dramatic rise in both actual and expected inflation will likely follow The resulting increase in interest payments causes reductions in firms cash flows, which lead to increased asymmetric information problems since firms are now more dependent on external funds to finance their investment As the asymmetric information analysis suggests, the resulting increase in adverse selection and moral hazard problems leads to a reduction in investment and economic activity As shown in Figure 9-3, further deterioration in the economy occurs The collapse in economic activity and the deterioration of cash flow and balance sheets of firms and households means that many are no longer able to pay off their debts, resulting in substantial losses for banks Sharp rises in interest rates also have a negative effect on banks profitability and balance sheets Even more problematic for the banks is the sharp increase in the value of their foreign-currency-denominated liabilities after a devaluation Thus, bank balance sheets are squeezed from both sides the value of their assets falls as the value of their liabilities rises Under these circumstances, the banking system will often suffer a banking crisis in which many banks are likely to fail (as happened in the United States during the Great Depression) The banking crisis and the contributing factors in the credit markets explain a further worsening of adverse selection and moral hazard problems and a further collapse of lending and economic activity in the aftermath of the crisis A PP LI CATI O N Financial Crises in Mexico, 1994 1995; East Asia, 1997 1998; and Argentina, 2001 2002 When emerging-market countries opened up their markets to the outside world in the 1990s, they had high hopes that globalization would stimulate economic growth and eventually make them rich Instead of leading to high economic growth and reduced poverty, however, many of them experienced financial crises that were every bit as devastating as the Great Depression was in the United States and other countries The most dramatic of these crises were the Mexican crisis, which started in 1994; the East Asian crisis, which started in July 1997; and the Argentine crisis, which started in 2001 We now apply the asymmetric information analysis of the dynamics of financial crises to explain why a developing country can shift dramatically from a path of high growth before a financial crisis as was true in