Understanding Financial Crises

Franklin Allen and Douglas Gale Clarendon Lectures in Finance June 9-11, 2003

Lecture 2
Currency Crises
Franklin Allen University of Pennsylvania June 10, 2003 http://finance.wharton.upenn.edu/~allenf/
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Introduction
Major theme of the banking crises literature

Central bank/government intervention is necessary to prevent crises

From 1945-1971 banking crises were eliminated but currency crises were not
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Many of the currency crises were due to inconsistent government macroeconomic policies

Explanations of currency crises are based on government mismanagement Contrasts with banking literature where central banks/government are the solution not the problem
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First generation models

Krugman (1979) and Flood and Garber (1984) show how a fixed exchange rate plus a government budget deficit leads to a currency crisis
Designed to explain currency crises like that in Mexico 1973-82
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Salant and Henderson (1978): Model to understand government attempts to peg the price of gold
Market Solution: Earn r on gold holdings P(t) = P(0) ert Ln P(t) = Ln P(0) + rt
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Ln P(t) Ln Pc Ln P(0)

If the government pegs price at P*, what does the price path look like?
Ln P(t)
Ln Pc

Ln P*

Cant be an equilibrium because of arbitrage opportunity

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Ln P(t) Ln Pc

Ln P*

Equilibrium: Peg until T then there is a run on reserves and the peg is abandoned

Krugman (1979) realized that the model could be used to explain currency crises

Government is running a fiscal deficit

It can fix the exchange rate and temporarily fund the deficit from its foreign exchange reserves

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There is an exchange rate over time such that the inflation tax covers the deficit
Ln S(t)

Ln S*

Equilibrium has predictable run on reserves and abandonment of peg

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Problems with first generation models

Timing of currency crises is very unpredictable

There are often jumps in exchange rates Government actions to eliminate deficits?

E.g. ERM crisis of 1992 when the pound and the lira dropped out of the mechanism
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Second generation models

Obstfeld (1996): Extent government is prepared to fight the speculators is endogenous. This can lead to multiple equilibria.
There are three agents A government that sells reserves to fix it currencys exchange rate

Two private holders of domestic currency who can continue to hold it or who can sell it to the government for foreign currency
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Each trader has reserves of 6

Transactions costs of trading are 1

If the government runs out of reserves it is forced to devalue by 50 percent

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High Reserve Game: Gov. Reserves = 20 Trader 2 Hold 0,0 -1,0

Sell 0,-1 -1,-1

Trader 1

Hold Sell

There is no devaluation because gov. doesnt run out of reserves. If either trader sells they bear the transaction costs. The unique equilibrium is (0, 0)

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Low Reserve Game: Gov. Reserves = 6

Trader 2 Hold 0,0 2,0
Sell 0,2 0.5,0.5

Trader 1

Hold Sell

Either trader can force the government to run out of reserves The unique equilibrium is (0.5, 0.5)
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Medium Reserve Game: Gov. Reserves = 10 Trader 2 Hold 0,0 -1,0

Sell 0,-1 1.5,1.5

Trader 1

Hold Sell

Both traders need to sell for a devaluation to occur Multiple equilibria (0.5, 0.5) and (1.5,1.5)

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Equilibrium selection

Sunspots doesnt really deal with issue

Morris and Shin (1998) approach

Arbitrarily small lack of common knowledge about fundamentals can lead to unique equilibrium
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With common knowledge about fundamentals e.g. currency reserves C

Unique

CL

Multiple

CU Unique

Peg fails

Peg holds

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With lack of common knowledge

Unique Peg fails

C*

Unique Peg holds

Major advance over sunspots Empirical evidence?

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Twin Crises

Kaminsky and Reinhart (1999) have investigated joint occurrence of currency and banking crises

In the 1970s when financial systems were highly regulated currency crises were not accompanied by banking crises After the financial liberalizations that occurred in the 1980s currency crises and banking crises have become intertwined

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The usual sequence is that banking sector problems are followed by a currency crisis and this further exacerbates the banking crisis
Kaminsky and Reinhart find that the twin crises are related to weak economic fundamentals - crises when fundamentals are sound are rare

Important to develop theoretical models of twin crises

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Panic-based twin crises

Chang and Velasco (2000a, b) have a multiple equilibrium model like Diamond and Dybvig (1983)
Chang and Velasco introduce money as an argument in the utility function and a central bank controls the ratio of currency to consumption
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Banking and currency crises are sunspot phenomena

Different exchange rate regimes correspond to different rules for regulating the currency-consumption ratio Policy aim is to reduce parameter space where bad equilibrium exists

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Fundamental-based twin crises

Allen and Gale (2000) extends Allen and Gale (1998) to allow for international lending and borrowing

Risk neutral international debt markets

Consider small country with risky domestic assets

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Banks

Use deposit contracts with investors subject to early/late liquidity shocks

Can borrow and lend using the international debt markets Domestic versus dollar loans
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Domestic currency debt

Risk sharing achieved through:

Bank liabilities

Deposit contracts Large amount of domestic currency bonds

Bank assets

Domestic risky assets Large amount of foreign currency bonds

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Government adjusts exchange rate so the value of banks foreign assets allows them to avoid banking crisis and costly liquidation
Risk neutral international (domestic currency) bond holders bear most of the risk while domestic depositors bear little risk If portfolios large enough all risk transferred to international market

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Viable system of international risk sharing for developed countries whose banks can borrow in domestic currency
Many emerging countries banks cannot borrow in domestic currency because of the fear of inflation they must borrow using dollar-denominated debt

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Dollar-denominated debt

The benefits that a central bank and international bond market can bring are reduced

Dollarization: The central bank may no longer be

able to prevent financial crises and inefficient liquidation of assets

Dollar debts and domestic currency deposits: It may

not be possible to share risk with the international bond market

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Policy Implications
Is the IMF important as lender of last resort like a domestic central bank (Krugman (1998) and Fischer (1999) OR It misallocates resources because it interferes with markets (Friedman (1998) and Schwartz (1998)?

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Framework above allows these issues to be addressed

Case 1: Flexible Exchange rates and Foreign Debt in Domestic Currency No IMF needed Case 2: Foreign Borrowing Denominated in Foreign Currency IMF needed to prevent banking crises with costly liquidation and contagion

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Conclusions

When is government the problem and when is it the solution? The importance of twin crises
Interaction of exchange rate policies and bank portfolios in avoiding crises and ensuring risk sharing
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