FINANCIAL

CRISIS
International Financial Crises
Currency Crises Loss of credibility of fixed
exchange rate system.
Banking Crisis Sudden collapse of the
domestic banking system.
Systemic Financial Crisis/Sudden Stops
Breakdown of system of international capital
flows.
Sovereign Debt Crisis Govt unable to pay-off
debts

IMF World Economic Outlook, 1998
Devaluation/Revaluation
Devaluation of the currency occurs when
central bank operating an exchange rate peg
increases the number of domestic dollars
needed to purchase one foreign dollar.
Revaluation is a decrease in domestic currency
price of foreign dollars.
Currency Crises
Market believes that exchange rate will be
devalued in the near future.
Lenders demand higher interest rates to lend in
domestic dollars to compensate for loss of
value after devaluation.
Central bank must use its foreign reserves to
buy domestic currency and prop up exchange
rate.
If pain of interest rates is too painful or loss of
reserves too severe, central bank may be forced
to devalue.
ERM Crisis
In 1980s, European economies constructed a
system of linked currencies called the
Exchange Rate Mechanism.
Inflationary German fiscal policy following re-
unification led to high DM interest rates.
To maintain link, other Euro currencies needed
to have interest rates too high for their own
situation.
In Sept. 1992, markets expected a
delinking/devaluation of currencies.
Go for the Jugular
Currency Crisis
Speculation against the
pound forced Bank of
England to raise interest
rates and buy pounds in
forex markets.
Pain of interest rates
was viewed as too
severe and B of E was
forced to abandon the
peg.
Principal Global Indicators Database
Roles of Banking System
Why Not Finance Corporate Sector w/ Stocks and Bonds?
Banks accept deposits from retail customers and
make larger, longer-term loans.
Information: Banking institutions study credit-
worthiness of borrowers.
Monitoring: Banks can enforce covenants and
conditions on lending.
Liquidity : Deposits easily used for necessary
transactions
Link
Banking Crises
Bank Runs Sudden withdrawal of deposit base
forcing bank closures or govt assistance.
Solvency Crisis: Banks have substantial amounts of
loans gone bad and thus have insufficient funds to
repay depositors.
Swedish Banking Crisis, 1991 Link
Liquidity Crisis: Sudden deposit withdrawal requires
liquidation of otherwise sound assets.
Bank of East Asia,
2008 Link
Systemic Crisis
Bank failure can be contagious
1. Interbank Lending
2. Panic conditions

Link
Lender of Last Resort
Banking system sufficiently important that govts will
usually protect depositors and prevent mass
bankruptcies.
Liquidity Crisis: Lend at penalty rates against good
collateral. Walter Bagehot, 1840s.
Solvency Crisis: 1) Containment: Administrative
intervention, temporary closure, nationalization. 2)
Resolution. Recapitalize banks through govt purchase of
equity, diluting or destroying shareholder value.
Moral Hazard: Banks creditors and (sometimes
owners) are protected from consequences of risky
behavior.
Link
Banking
Crisis
Currency
Crisis
Fragile banking system makes high interest rates untenable and
can lead to fears of devaluation (especially if central bank funds
used to bailout banking system)
Exchange rate devaluation can damage balance sheets if balance
sheets (deposits or borrowings) are dollarized.
Sudden Stops
International hot money (short-term lending) is
subject to herding behavior from international
financial market.
Rapid inflows and rapid outflows.
When capital inflows stop, either those can be
replaced with forex reserves, or domestic
borrowers will face bankruptcy.
Domestic firms can no longer finance investment
Demand, GDP, and employment fall.
Devaluation of currency.
Link
Link
Current
Account
Sudden stop?


Net
Capital Outflows


Net
Capital Outflows


Financial Crises
Sudden Stops: Foreign investors herding behavior and
short-termism lead them to move in and out of countries
rapidly.
The greatest concern I have is that capital account
convertibility would leave economic policy in a
typical emerging market hostage to the whims and
fancies of two dozens or so thirty-something country
analysts in London, Frankfurt, and New York. Dani
Rodrik, 1998
East Asian Crisis
IMF World Economic Outlook Database
East Asian Crisis
Link
Dealing with Hot Money
Short-term Money Flows
Zero-Interest Reserve Requirements
Tobin Tax
Administrative Controls

Buildup Foreign Reserve Assets
IMF Financial Statistics
Foreign Reserves
Measures of Adequate Reserves
Import Coverage: Reserves > Imports for 2-3
Months
Greenspan-Guidotti Rule: Reserves exceed
100% of debt due within one year.
Link
Korea
Dealing with Sudden Stops
Modern Approach
Swap lines Link

Link
Chiang Mai Initiative Multilateralization
ASEAN+3 has a pool of US$120billion
(financed mostly by +3) in reserve swaps
available for liquidity in a crisis to allow for
region-wide insurance
In size, amount seems reasonable. IMF-led
programs in Thailand and Indonesia were
about $20billion and $40 billion through 9-
1998
Link