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

Understanding Financial Crises

Franklin Allen and Douglas Gale

Clarendon Lectures in Finance

June 9-11, 2003


Lecture 2

Lecture 2

Currency Crises

Franklin Allen

University of Pennsylvania

June 10, 2003

http://finance.wharton.upenn.edu/~allenf/


Introduction

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


Understanding financial crises

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

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


Understanding financial crises

  • 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


Understanding financial crises

Ln P(t)

Ln Pc

Ln P(0)

T

t


Understanding financial crises

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


Understanding financial crises

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


Understanding financial crises

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


Understanding financial crises

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

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

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


Understanding financial crises

  • 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


Understanding financial crises

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)


Understanding financial crises

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)


Understanding financial crises

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

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


Understanding financial crises

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

Unique

Peg fails

CL

CU

Unique

Peg holds

Multiple


Understanding financial crises

With lack of common knowledge

  • Major advance over sunspots

  • Empirical evidence?

Unique

Peg fails

C*

Unique

Peg holds


Twin crises

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


Understanding financial crises

  • 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

    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


    Understanding financial crises

    • 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

    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

    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

    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


    Understanding financial crises

    • 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


    Understanding financial crises

    • 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

    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

    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)?


    Understanding financial crises

    • 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

    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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