Understanding financial crises
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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/. Introduction.

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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/


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


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


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


  • 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


Ln P(t)

Ln Pc

Ln P(0)

T

t


Ln P(t)

Ln Pc

Ln P*

T

t

If the government pegs price at P*, what does the price path look like?

Can’t be an equilibrium because of arbitrage opportunity


Ln P(t)

Ln Pc

Ln P*

T’

T

t

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


Ln S(t)

Ln S*

T’

t

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


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


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 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


  • 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


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.

  • The unique equilibrium is (0, 0)


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)


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)


Equilibrium selection

  • Sunspots – doesn’t really deal with issue

  • Morris and Shin (1998) approach

    • Arbitrarily small lack of common knowledge about fundamentals can lead to unique equilibrium


With common knowledge about fundamentals e.g. currency reserves C

Unique

Peg fails

CL

CU

Unique

Peg holds

Multiple


With lack of common knowledge

  • Major advance over sunspots

  • Empirical evidence?

Unique

Peg fails

C*

Unique

Peg holds


Twin 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

    • After the financial liberalizations that occurred in the 1980’s currency crises and banking crises have become intertwined


  • 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


  • 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


    • 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


    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


    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


    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


    • 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


    • 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


    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


    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)?


    • 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


    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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