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 – Gov’t 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 1980’s, 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 SystemWhy 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

transactionsLink

Banking Crises• Bank Runs – Sudden withdrawal of deposit base

forcing bank closures or gov’t 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 contagious1. Interbank Lending2. Panic conditions

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Lender of Last Resort• Banking system sufficiently important that gov’ts will

usually protect depositors and prevent mass bankruptcies.– Liquidity Crisis: Lend at penalty rates against good

collateral. Walter Bagehot, 1840’s. – Solvency Crisis: 1) Containment: Administrative

intervention, temporary closure, nationalization. 2) Resolution. Recapitalize banks through gov’t purchase of equity, diluting or destroying shareholder value.

• Moral Hazard: Banks creditors and (sometimes owners) are protected from consequences of risky behavior.

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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.

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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.

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Korea

Dealing with Sudden Stops

• Modern Approach Swap lines Link

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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

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