- Catherine Pattillo, Andrew Berg, Gian Milesi-Ferretti, and Eduardo Borensztein
- Published Date:
- January 2000
This appendix provides a selective review of the economic literature on currency crises, focusing on the explanations that have been advanced of the determinants and the processes leading to crises.37
In his seminal paper on balance of payments crises, Krugman (1979) considers a small open economy with a pegged exchange rate where domestic credit expands continuously, typically to finance a budget deficit. The peg is sustained by a positive stock of foreign exchange reserves, but reserves are gradually depleted as agents continuously buy foreign currency as a result of the imbalance between the expanding domestic credit and the stable money demand. Krugman shows that reserves will eventually be wiped out by a speculative attack once they have reached a sufficiently low level, even though there is no change in policies to trigger the attack. With well-informed, rational speculators assessing the situation, the currency attack will take place only when the transition from the pegged exchange rate to its successor system (presumed to be a float) yields the required return to speculators. Although the policy inconsistency that condemns the exchange rate system is well recognized in advance, and the eventual demise of the peg is known to be unavoidable, it is not profitable to launch an attack too early (or to wait too long). In fact, the determination of the timing of the attack is the main analytical question that first-generation models attempt to answer.
Although Krugman's model is very stylized, and may seem artificial, other models have extended his framework to capture the features usually present in balance of payments crises. With some degree of price sluggishness or the introduction of nontraded goods, the buildup to a crisis features an appreciating real exchange rate and widening current account deficits (Calvo, 1987). Introducing some degree of uncertainty, the timing of the devaluation cannot be exactly predicted and a “peso problem” emerges, that is, a persistent divergence between nominal domestic and foreign interest rates owing to the expectation of an impending devaluation (Krasker, 1980; Penati and Pennacchi, 1989).
Several empirical studies of devaluations have found common features that are consistent with the framework of first-generation models. Indeed, large devaluations in developing countries have often been preceded by expansionary fiscal and monetary policies, interest rate premia, real exchange rate appreciations, and widening current account imbalances (Edwards, 1989). Analyses of individual country experiences have also found a link between excessive credit growth and subsequent crises in a number of case studies of devaluations including in Mexico, Argentina, Italy, and France.38
The breakdown of the exchange rate mechanism (ERM) of the European Monetary System (EMS) in 1993 and the Mexican crisis of 1994 spurred a reconsideration of the explanations of exchange rate crises offered by the economic literature. Some aspects of those crises were hard to reconcile with traditional models of speculative attacks for two reasons. First, as underscored by Obstfeld and Rogoff (1995) among others, the decision to abandon an exchange rate peg in the context of the ERM crises was not due to the exhaustion of foreign exchange reserves, but to the reluctance of governments to fight prolonged speculative attacks with high interest rates. In this regard, the second-generation models explain speculative attacks in a context in which the government decisions take into account the costs and benefits involved in abandoning the peg. In contrast, first-generation models provide no explicit rationale for government policy actions.
The second reason for reassessing theories of currency crises was the unexpected and apparently inexplicable nature of some of these crises, which led several observers to suggest the possibility that self-fulfilling expectations may have played a prominent role (see Eichengreen and Wyplosz (1993) for an interpretation of the EMS crisis along those lines, and Sachs, Tornell, and Velasco (1996b) and Cole and Kehoe (1996) for such an interpretation of the Mexican crisis). For example, France was subject to repeated speculative attacks that led to a widening of the fluctuation band vis-à-vis the deutsche mark, even though traditional “fundamentals” were not visibly out of line—France had modest fiscal imbalances, its real exchange rate had not appreciated, and it was running a current account surplus.
But how can self-fulfilling crises occur? The key feature is the link between the government's assessment of the costs of maintaining the peg and the private sector's expectations. If private investors expect that the peg might be abandoned, the cost to the government of maintaining a fixed exchange rate becomes higher, and this may indeed lead it to devalue the currency, thus validating market expectations. Obstfeld (1994) provides several examples. One is based on the impact of high government debt. When expectations of an impending devaluation are built into nominal interest rates, maintaining the peg will raise the real debt burden significantly. Under the circumstances, the government might find it too costly to keep the exchange rate unchanged. Conversely, if no devaluation is expected, the cost for the government of maintaining the peg is reduced and the peg will be maintained (see also Bensaid and Jeanne, 1997).39
It is important to underscore that the possibility that crises can be self-fulfilling does not imply that the likelihood of an attack is unrelated to fundamentals. Indeed, in second-generation models, there is typically a range of “strong” fundamentals in which a speculative attack would not occur, that is, the government would never find it advantageous to validate market expectations and devalue the currency. Under these circumstances, it would indeed not be rational for market participants to expect a depreciation. Similarly, there is a range of “weak” fundamentals where the cost of defending the peg (the temptation to devalue) is so high that a speculative attack forcing the abandonment of a peg is inevitable. Finally, there is an intermediate “vulnerable” range of fundamentals, in which a peg could survive if expectations were favorable but would be abandoned if an attack were to materialize (Obstfeld, 1996). A shortcoming of these models is that they do not explain what reasons determine whether the attack takes place or the peg is maintained (see the discussion in Masson, 1998).
Second-generation models suggest that crises may be inherently difficult to predict because the currency attacks may or may not materialize rather than being the inevitable and predictable outcome of a progressive deterioration in fundamentals. Yet, although these models and the various country experiences suggest a number of additional indicators of vulnerability to a currency crisis, they do not differ sharply from those suggested by first-generation models. Both kinds of models of speculative attacks have a similar implication: attacks always occur in countries with weak (or “vulnerable”) fundamentals in the macroeconomic sense. In fact, it is usually hard to distinguish whether fundamental policy inconsistencies or self-fulfilling attacks provide the best explanation for a certain episode.40
Role of Asset Markets
The models reviewed so far focus squarely on macroeconomic policy. A peg can be abandoned either because of a policy inconsistency or because of a government policy decision that weighs costs and benefits of maintaining the peg. However, some aspects of the Mexican crisis and, especially, the more recent crises in several Asian countries seem to be related to market failures in asset markets or distortions in the financial system, rather than resulting from clear macroeconomic imbalances or an exchange rate misalignment. In all of these episodes, investors refused to roll over short-term debt (Tesobonos in the case of Mexico) and redeemed the proceeds in foreign currency. Authors such as Calvo (1997) have stressed taking a broader view of asset markets rather than focusing exclusively on the evolution of international reserves. For example, if the government is running an unsustainable deficit but resorts to bond financing rather than monetization of the deficit, international reserves may be stable, rather than declining, in the period leading to an attack. The speculative attack essentially occurs in bond markets, as agents refuse to roll over short-term government paper and convert the proceeds into foreign currency.
Although the linkage between financial sector problems and balance of payments crises received prominent attention only after the Mexican crisis in 1994 and, especially, after the Asian crisis, it had played an important role in previous episodes (see Diaz-Alejandro (1985) for an insightful discussion). For example, the 1982 crisis in Chile was preceded by a period during which the conduct of fiscal policy was conservative, but the private sector borrowed extensively on international markets. The presence of explicit and implicit government guarantees created a severe moral hazard problem, and external shocks precipitated a crisis that resulted in a costly bailout of the banking system and a “socialization” of private external liabilities. With this experience in mind, Velasco (1987) presents a model of currency and banking crises where a negative external shock reduces the value of banks' assets, but because of the deposit guarantee banks do not liquidate bad loans, relying instead on external borrowing to cover their losses. Once access to external borrowing is curtailed, the government has to intervene and bail out the banks. The costs of the bailout and the “socialization” of banks' external liabilities leads to a depletion of foreign exchange reserves and a collapse of the peg. More generally, in situations in which the banking system is fragile because of maturity or currency mismatches, crises can occur because the role of the central bank as lender of last resort comes into conflict with the need to defend the exchange rate peg.
In the Chilean crisis of 1982, self-fulfilling expectations played no role as the crisis was essentially inevitable given the deposit guarantee scheme and the banks' behavior. In contrast, Goldfajn and Valdes (1997) and Chang and Velasco (1998) highlight the role of banking fragility in making a country more vulnerable to speculative attacks. Bank runs based on self-fulfilling expectations can cause the collapse of a solvent but illiquid domestic banking system, as foreign investors refuse to extend credit or roll over existing loans, in a framework similar to that of the well-known banking model of Diamond and Dybvig (1983). Even such purely speculative financial crises can generate large output costs, because banks may be forced to liquidate potentially profitable but illiquid long-term assets to face a liquidity squeeze. A number of factors can make an economy more vulnerable to this type of “run,” among them, a large share of short-term external debt and a lowering of reserve requirements. Empirical evidence presented by Kaminsky and Reinhart (1999) indeed shows that banking crises tend to precede balance of payments crises.41
In addition to underlining the importance of asset market problems, the recent Asian crisis has drawn attention to the moral hazard generated by implicit government guarantees of private sector external liabilities. In Krugman (1998), government provision of (implicit) bailout guarantees leads to private sector overinvestment and asset price inflation.42 If the bailout guarantee is not unlimited, asset prices will eventually collapse as the bubble bursts.43 Corsetti, Pesenti, and Roubini (1998) tell a similar story. In their model, the existence of (implicit or explicit) government guarantees leads firms to “overborrow” from abroad. The guarantees, however, are not unlimited. Under these circumstances, it can be shown that a period of overborrowing can be followed by a sudden withdrawal of external funds once doubts surface over the ability or willingness of the government to cover existing losses. These interpretations of crises do not necessarily emphasize self-fulfilling expectations—rather, they rely on the existence of a fundamental distortion that leads to a gradual buildup of imbalances. One interesting aspect is that the contingent nature of these government liabilities implies that fiscal imbalances will emerge expost, but may not be detectable ex ante.44
Recent experience has also focused attention on distortions generating large capital inflows and their later reversal. A model by Dooley (1997) postulates that governments provide insurance against external shocks to the private sector, which is thus enticed to borrow at above-market rates.45 This attracts capital to the country. However, the available resources of foreign exchange reserves for paying “insurance claims” are limited. This implies that the degree of insurance is declining over time, and therefore the rates of interest that the private sector can afford to pay must also be declining, making the reversal of capital flows eventually unavoidable. When foreigners withdraw their funds, the government steps in to bail out the private sector, but in so doing it depletes its foreign exchange reserves and a crisis occurs. Dooley underlines that if one includes in the government's “war chest” funds made available by international organizations then the moral hazard problem that leads to the capital inflow-crisis sequence is worsened. He also notes that the model provides a simple explanation for contagion: namely, a large bailout by, say, the IMF or the international community may reduce the resources available for similar bailouts in other developing countries.
Role of Contagion
A feature shared by all the major financial crises of the 1990s—the EMS, the Mexican peso and its tequila effects, Asian currencies, and the Russian ruble—is the spreading of difficulties from one country to another, generally referred to as “contagion.” In practice, many factors can account for this phenomenon. First, a crisis in one country may be triggered by a large shock common to several countries—for example, an increase in interest rates on world markets—in which case the crisis can be expected to affect other countries particularly vulnerable to this type of shock.46 Second, devaluation by one country can affect other countries through “spillover effects.” These can occur through several channels. For example, countries that either trade intensively with the country in question or compete with it in third markets will experience a loss in competitiveness and a fall in external demand.47 The recent crises in East Asia and Russia also highlighted the importance of spillover effects that work through the capital account. For example, the Russian crisis affected the profitability and risk appetite of hedge funds, banks, and other investors, leading to portfolio adjustments that spread difficulties to other markets.48 Russia's crisis may have led to a revision in expectations concerning the possibility that the IMF would act as a lender of last resort.
Contagion effects proper, in Masson's (1998) taxonomy, occur when crises spread even in the absence of changes in macroeconomic fundamentals. This may occur because of incomplete information and herd behavior on the part of private investors so that a small shock may trigger a massive outflow of capital from several emerging market countries. For example, Calvo and Mendoza (1997) present a model in which investment fund managers choose to “follow the herd” if they are evaluated based on their relative performance vis-à-vis other managers.49 This type of “collective action” problem increases the likelihood of large swings in capital flows even in the absence of correspondingly large changes in fundamentals. A crisis can also act as a “wake-up call.” For example, Goldstein (1998) argues that after the Thai crisis investors reassessed the economic and financial situation of other countries in the region and found them to be less creditworthy than previously believed.
Empirical work on contagion is still at a preliminary stage. The most basic contagion studies assess whether the existence of speculative attacks elsewhere in the world increase the probability of a currency crisis, controlling for a country's macroeconomic, financial, and external sector factors. Studies use either a simple zero/one variable indicating whether there was a crisis elsewhere in the world, or a measure of the number of recent crises in other countries that gives more weight to the most recent crises (see Eichengreen and others, 1996b) and J.P. Morgan, 1998). There is also some evidence that contagion may have a regional dimension (Krueger and others, 1998). However, this finding may be due to the fact that countries within a region often have strong trade ties. In fact, some studies suggest that trade linkages are an important factor of contagion: countries that have strong trade links or compete in an export market with a country experiencing a crisis are themselves more likely to have a crisis (see Eichengreen and others, 1996b and Glick and Rose, 1998). For some episodes, however, it seems difficult to argue that trade links were the only, or even an important, channel of transmission (for example, the pressure on Brazil following the collapse of the Russian ruble in August 1998). Partly for this reason, some analysts have focused on similarities across countries in macroeconomic policies and conditions. However, the hypothesis that contagion spreads more easily to countries with similar macroeconomic fundamentals has not found much empirical support. Testing more directly the importance of financial market spillovers is inherently more difficult, because it would, inter alia, require information on the positions of financial institutions on a global scale.
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176. Back to the Future: Postwar Reconstruction and Stabilization in Lebanon, edited by Sena Eken and Thomas Helbling. 1999.
175. Macroeconomic Developments in the Baltics, Russia, and Other Countries of the Former Soviet Union, 1992–97, by Luis M. Valdivieso. 1998.
174. Impact of EMU on Selected Non-European Union Countries, by R. Feldman, K. Nashashibi, R. Nord, P. Allum, D. Desruelle, K. Enders, R. Kahn, and H. Temprano-Arroyo. 1998.
173. The Baltic Countries: From Economic Stabilization to EU Accession, by Julian Berengaut, Augusto Lopez-Claros, Francoise Le Gall, Dennis Jones, Richard Stern, Ann-Margret Westin, Effie Psalida, Pietro Garibaldi. 1998.
172. Capital Account Liberalization: Theoretical and Practical Aspects, by a staff team led by Barry Eichen-green and Michael Mussa, with Giovanni Dell'Ariccia, Enrica Detragiache, Gian Maria Milesi-Ferretti, and Andrew Tweedie. 1998.
171. Monetary Policy in Dollarized Economies, by Tomas Balino, Adam Bennett, and Eduardo Borensztein. 1998.
170. The West African Economic and Monetary Union: Recent Developments and Policy Issues, by a staff team led by Ernesto Hernandez-Cata and comprising Christian A. Francois, Paul Masson, Pascal Bouvier, Patrick Peroz, Dominique Desruelle, and Athanasios Vamvakidis. 1998.
169. Financial Sector Development in Sub-Saharan African Countries, by Hassanali Mehran, Piero Ugolini, Jean Phillipe Briffaux, George Iden, Tonny Lybek, Stephen Swaray, and Peter Hayward. 1998.
168. Exit Strategies: Policy Options for Countries Seeking Greater Exchange Rate Flexibility, by a staff team led by Barry Eichengreen and Paul Masson with Hugh Bredenkamp, Barry Johnston, Javier Hamann, Esteban Jadresic, and Inci Otker. 1998.
167. Exchange Rate Assessment: Extensions of the Macroeconomic Balance Approach, edited by Peter Isard and Hamid Faruqee. 1998
166. Hedge Funds and Financial Market Dynamics, by a staff team led by Barry Eichengreen and Donald Mathieson with Bankim Chadha, Anne Jansen, Laura Kodres, and Sunil Sharma. 1998.
165. Algeria: Stabilization and Transition to the Market, by Karim Nashashibi, Patricia Alonso-Gamo, Stefania Bazzoni, Alain Feler, Nicole Laframboise, and Sebastian Paris Horvitz. 1998.
164. MULTIMOD Mark III: The Core Dynamic and Steady-State Model, by Douglas Laxton, Peter Isard, Hamid Faruqee, Eswar Prasad, and Bart Turtelboom. 1998.
163. Egypt: Beyond Stabilization, Toward a Dynamic Market Economy, by a staff team led by Howard Handy. 1998.
162. Fiscal Policy Rules, by George Kopits and Steven Symansky. 1998.
161. The Nordic Banking Crises: Pitfalls in Financial Liberalization? by Burkhard Dress and Ceyla Pazarbasioglu. 1998.
160. Fiscal Reform in Low-Income Countries: Experience Under IMF-Supported Programs, by a staff team led by George T. Abed and comprising Liam Ebrill, Sanjeev Gupta, Benedict Clements, Ronald McMorran, Anthony Pellechio, Jerald Schiff, and Marijn Verhoeven. 1998.
159. Hungary: Economic Policies for Sustainable Growth, Carlo Cottarelli, Thomas Krueger, Reza Moghadam, Perry Perone, Edgardo Ruggiero, and Rachel van Elkan. 1998.
158. Transparency in Government Operations, by George Kopits and Jon Craig. 1998.
157. Central Bank Reforms in the Baltics, Russia, and the Other Countries of the Former Soviet Union, by a staff team led by Malcolm Knight and comprising Susana Almuina, John Dalton, Inci Otker, Ceyla Pazarbasioglu, Arne B. Petersen, Peter Quirk, Nicholas M. Roberts, Gabriel Sensenbrenner, and Jan Willem van der Vossen. 1997.
156. The ESAF at Ten Years: Economic Adjustment and Reform in Low-Income Countries, by the staff of the International Monetary Fund. 1997.
155. Fiscal Policy Issues During the Transition in Russia, by Augusto Lopez-Claros and Sergei V. Alexashenko. 1998.
154. Credibility Without Rules? Monetary Frameworks in the Post-Bretton Woods Era, by Carlo Cottarelli and Curzio Giannini. 1997.
153. Pension Regimes and Saving, by G.A. Mackenzie, Philip Gerson, and Alfredo Cuevas. 1997.
152. Hong Kong, China: Growth, Structural Change, and Economic Stability During the Transition, by John Dodsworth and Dubravko Mihaljek. 1997.
151. Currency Board Arrangements: Issues and Experiences, by a staff team led by Tomas J.T. Balino and Charles Enoch. 1997.
150. Kuwait: From Reconstruction to Accumulation for Future Generations, by Nigel Andrew Chalk, Mohamed A. El-Erian, Susan J. Fennell, Alexei P. Kireyev, and John F. Wilson. 1997.
149. The Composition of Fiscal Adjustment and Growth: Lessons from Fiscal Reforms in Eight Economies, by G.A. Mackenzie, David W.H. Orsmond, and Philip R. Gerson. 1997.
148. Nigeria: Experience with Structural Adjustment, by Gary Moser, Scott Rogers, and Reinold van Til, with Robin Kibuka and Inutu Lukonga. 1997.
147. Aging Populations and Public Pension Schemes, by Sheetal K. Chand and Albert Jaeger. 1996.
146. Thailand: The Road to Sustained Growth, by Kalpana Kochhar, Louis Dicks-Mireaux, Balazs Horvath, Mauro Mecagni, Erik Offerdal, and Jianping Zhou. 1996.
145. Exchange Rate Movements and Their Impact on Trade and Investment in the APEC Region, by Takatoshi Ito, Peter Isard, Steven Symansky, and Tamim Bayoumi. 1996.
144. National Bank of Poland: The Road to Indirect Instruments, by Piero Ugolini. 1996.
143. Adjustment for Growth: The African Experience, by Michael T. Hadjimichael, Michael Nowak, Robert Sharer, and Amor Tahari. 1996.
142. Quasi-Fiscal Operations of Public Financial Institutions, by G.A. Mackenzie and Peter Stella. 1996.
Note: For information on the title and availability of Occasional Papers not listed, please consult the IMF Publications Catalog or contact IMF Publication Services.