Understanding Financial Crises

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Understanding Financial Crises

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

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literature

• Exchange Rate Dynamics and Currency Crises C.P.
  Hallwood and R. MacDonald - International Money
  and Finance Chs 14-17 (HG3881.H2) M. Obstfeld
  and K. Rogoff - Foundations of International
  Macroeconomics Ch. 8 (except 8.1 and 8.3) and Ch.
  9 (HF1359.O2) P. Krugman - Currencies and
  Crises, 1995 (HG3881.K7) P. Krugman - Currency
  Crises, 2000 (HG3881.C8) R. Flood and P. Garber
  - Collapsing exchange rate regimes some linear
  examples, Journal of International Economics 17
  (1984), 1-13 M. Obstfeld - Models of currency
  crises with self-fulfilling features, European
  Economic Review 40 (August 1996), 1037-47 G.
  Urwin - Currency boards and currency crises,
  Oxford Economic Papers 56 (2004), 64-87 G.
  Kaminsky and C. Reinhart - The twin crises the
  causes of banking and balance-of-payments
  problems, American Economic Review 89 (1999),
  473-500 T. Komulainen and J. Lukkarila - What
  drives financial crises in emerging markets?
  Emerging Markets Review 4 (2003), 248-72 W.H.
  Buiter et al. - Interpreting the ERM Crisis
  Country-Specific and Systemic Issues (1998)
  (HG136.P7/84) R.S. Rajan - (Ir)relevance of
  Currency-Crisis Theory to the Devaluation and
  Collapse of the Thai Baht (2001) (HG136.P71/88)

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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)
t
T
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• If the government pegs price at P, what does
  the price path look like?
• Cant be an equilibrium because of arbitrage
  opportunity

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

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• 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
• 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
• 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
• 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
• 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

CL
CU
Unique Peg fails
Multiple
Unique Peg holds
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• With lack of common knowledge
• Major advance over sunspots
• Empirical evidence?

Unique Peg fails
C
Unique Peg holds
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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