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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.
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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 Go for the Jugular • 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.
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 transactions Link
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 contagious • Interbank Lending • Panic conditions Link
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. Link
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) Currency Crisis Banking Crisis 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. Link
Sudden stop? Net Capital Outflows Current Account 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. Link
Dealing with Sudden Stops Swap lines Link • Modern Approach Link
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 Link
