1 Understanding Financial Crises Franklin Allen and Douglas Gale Clarendon Lectures in Finance June 9-11, 2003

2 Lecture 2 Currency Crises Franklin Allen University of Pennsylvania June 10,

3 Introduction Major theme of the banking crises literature Major theme of the banking crises literature Central bank/government intervention is necessary to prevent crises Central bank/government intervention is necessary to prevent crises From banking crises were eliminated but currency crises were not From banking crises were eliminated but currency crises were not

4 Many of the currency crises were due to inconsistent government macroeconomic policies Many of the currency crises were due to inconsistent government macroeconomic policies Explanations of currency crises are based on government mismanagement Explanations of currency crises are based on government mismanagement Contrasts with banking literature where central banks/government are the solution not the problem Contrasts with banking literature where central banks/government are the solution not the problem

5 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 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 Designed to explain currency crises like that in Mexico

6 Salant and Henderson (1978): Model to understand government attempts to peg the price of gold Salant and Henderson (1978): Model to understand government attempts to peg the price of gold Market Solution: Earn r on gold holdings Market Solution: Earn r on gold holdings P(t) = P(0) e rt Ln P(t) = Ln P(0) + rt

7 Ln P(t) t Ln P c T Ln P(0)

8 If the government pegs price at P*, what does the price path look like? If the government pegs price at P*, what does the price path look like? Can’t be an equilibrium because of arbitrage opportunity Can’t be an equilibrium because of arbitrage opportunity Ln P(t) Ln P* Ln P c tT

9 Equilibrium: Peg until T’ then there is a run on reserves and the peg is abandoned Equilibrium: Peg until T’ then there is a run on reserves and the peg is abandoned Ln P(t) Ln P* Ln P c tTT’

10 Krugman (1979) realized that the model could be used to explain currency crises Krugman (1979) realized that the model could be used to explain currency crises Government is running a fiscal deficit Government is running a fiscal deficit It can fix the exchange rate and temporarily fund the deficit from its foreign exchange reserves It can fix the exchange rate and temporarily fund the deficit from its foreign exchange reserves

11 There is an exchange rate over time such that the “inflation tax” covers the deficit There is an exchange rate over time such that the “inflation tax” covers the deficit Equilibrium has predictable run on reserves and abandonment of peg Equilibrium has predictable run on reserves and abandonment of peg Ln S(t) Ln S* tT’

12 Problems with first generation models Timing of currency crises is very unpredictable Timing of currency crises is very unpredictable There are often jumps in exchange rates There are often jumps in exchange rates Government actions to eliminate deficits? Government actions to eliminate deficits? E.g. ERM crisis of 1992 when the pound and the lira dropped out of the mechanism E.g. ERM crisis of 1992 when the pound and the lira dropped out of the mechanism

13 Second generation models Obstfeld (1996): Extent government is prepared to fight the speculators is endogenous. This can lead to multiple equilibria. Obstfeld (1996): Extent government is prepared to fight the speculators is endogenous. This can lead to multiple equilibria. There are three agents There are three agents A government that sells reserves to fix it currency’s exchange rate A government that sells reserves to fix it currency’s 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 Two private holders of domestic currency who can continue to hold it or who can sell it to the government for foreign currency

14 Each trader has reserves of 6 Each trader has reserves of 6 Transactions costs of trading are 1 Transactions costs of trading are 1 If the government runs out of reserves it is forced to devalue by 50 percent If the government runs out of reserves it is forced to devalue by 50 percent

15 High Reserve Game: Gov. Reserves = 20 High Reserve Game: Gov. Reserves = 20 There is no devaluation because gov. doesn’t run out of reserves. If either trader sells they bear the transaction costs. There is no devaluation because gov. doesn’t run out of reserves. If either trader sells they bear the transaction costs. The unique equilibrium is (0, 0) The unique equilibrium is (0, 0) Trader 2 HoldSell Trader 1 Hold0,00,-1 Sell-1,0-1,-1

16 Low Reserve Game: Gov. Reserves = 6 Low Reserve Game: Gov. Reserves = 6 Either trader can force the government to run out of reserves Either trader can force the government to run out of reserves The unique equilibrium is (0.5, 0.5) The unique equilibrium is (0.5, 0.5) Trader 2 HoldSell Trader 1 Hold0,00,2 Sell2,00.5,0.5

17 Medium Reserve Game: Gov. Reserves = 10 Medium Reserve Game: Gov. Reserves = 10 Both traders need to sell for a devaluation to occur Both traders need to sell for a devaluation to occur Multiple equilibria (0.5, 0.5) and (1.5,1.5) Multiple equilibria (0.5, 0.5) and (1.5,1.5) Trader 2 HoldSell Trader 1 Hold0,00,-1 Sell-1,01.5,1.5

18 Equilibrium selection Sunspots – doesn’t really deal with issue Sunspots – doesn’t really deal with issue Morris and Shin (1998) approach Morris and Shin (1998) approach Arbitrarily small lack of common knowledge about fundamentals can lead to unique equilibrium Arbitrarily small lack of common knowledge about fundamentals can lead to unique equilibrium

19 With common knowledge about fundamentals e.g. currency reserves C With common knowledge about fundamentals e.g. currency reserves C CLCL CUCU Unique Peg fails Multiple Unique Peg holds

20 With lack of common knowledge With lack of common knowledge Major advance over sunspots Major advance over sunspots Empirical evidence? Empirical evidence? C* Unique Peg fails Unique Peg holds

21 Twin Crises Kaminsky and Reinhart (1999) have investigated joint occurrence of currency and banking crises Kaminsky and Reinhart (1999) have investigated joint occurrence of currency and banking crises In the 1970’s when financial systems were highly regulated currency crises were not accompanied by banking crises In the 1970’s when financial systems were highly regulated currency crises were not accompanied by banking crises After the financial liberalizations that occurred in the 1980’s currency crises and banking crises have become intertwined After the financial liberalizations that occurred in the 1980’s currency crises and banking crises have become intertwined

22 The usual sequence is that banking sector problems are followed by a currency crisis and this further exacerbates the banking crisis 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 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 Important to develop theoretical models of twin crises

23 Panic-based twin crises Chang and Velasco (2000a, b) have a multiple equilibrium model like Diamond and Dybvig (1983) 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 Chang and Velasco introduce money as an argument in the utility function and a central bank controls the ratio of currency to consumption

24 Banking and currency crises are “sunspot phenomena” Banking and currency crises are “sunspot phenomena” Different exchange rate regimes correspond to different rules for regulating the currency-consumption ratio 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 Policy aim is to reduce parameter space where “bad equilibrium” exists

25 Fundamental-based twin crises Allen and Gale (2000) extends Allen and Gale (1998) to allow for international lending and borrowing Allen and Gale (2000) extends Allen and Gale (1998) to allow for international lending and borrowing Risk neutral international debt markets Risk neutral international debt markets Consider small country with risky domestic assets Consider small country with risky domestic assets

26 Banks Use deposit contracts with investors subject to early/late liquidity shocks Use deposit contracts with investors subject to early/late liquidity shocks Can borrow and lend using the international debt markets Can borrow and lend using the international debt markets Domestic versus dollar loans Domestic versus dollar loans

27 Domestic currency debt Risk sharing achieved through: Bank liabilities Bank liabilities Deposit contracts Deposit contracts Large amount of domestic currency bonds Large amount of domestic currency bonds Bank assets Bank assets Domestic risky assets Domestic risky assets Large amount of foreign currency bonds Large amount of foreign currency bonds

28 Government adjusts exchange rate so the value of banks’ foreign assets allows them to avoid banking crisis and costly liquidation 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 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 If portfolios large enough all risk transferred to international market

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

30 Dollar-denominated debt The benefits that a central bank and international bond market can bring are reduced 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 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 Dollar debts and domestic currency deposits: It may not be possible to share risk with the international bond market

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

32 Framework above allows these issues to be addressed Framework above allows these issues to be addressed Case 1: Flexible Exchange rates and Foreign Debt in Domestic Currency – No IMF needed 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 Case 2: Foreign Borrowing Denominated in Foreign Currency – IMF needed to prevent banking crises with costly liquidation and contagion

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