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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

slide4
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
slide6
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

slide7

Ln P(t)

Ln Pc

Ln P(0)

T

t

slide8

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

slide9

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

slide10
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
slide11

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
slide14
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
slide15
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)
slide16
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)
slide17
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
slide19
With common knowledge about fundamentals e.g. currency reserves C

Unique

Peg fails

CL

CU

Unique

Peg holds

Multiple

slide20
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
slide22
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
slide24
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
slide28
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
slide29
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)?
slide32
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
ad