INTERNATIONAL TRADE

American countries except the largest. In 1995, the.Equivalent Producer Subsidy represented 41 % of theproduction value of these products. This high levelpersisted in spite of the fact that it had decreasedfrom 20% "to 15% in the United States from 1994 to1995 as a result of lower direct payments and higherworld market prices, whereas it had increased in theEuropean Community mainly due to the incorporationof new members.34 It should be noted that this 20%increase in total support occurred during the decadein which the Uruguay Round was,negotiated and inwhich the official discourse focused on statereduction.

Contrarily, support of this kind has been systemat-ically eliminated in Latin American countries becauseof the discourse on globalisation and the pressure ofinternational organisations. Although comprehensiveinformation regarding support to agriculture in thesecountries is lacking, the FAO, based on differentstudies, accepts that this particular tendency isconfirmed in Latin America35 as well as in grainproducing countries.36 As long as industrial countriesmaintain subsidies and developing countries reducethem the asymmetry between these economies will

not only remain, it will become larger. Nor will thisasymmetry abate if Latin America keeps exportingcoffee, oil seeds, tropical and subtropical fruit as wellas fruit juice, meat and animal food or if it continuesfocusing on maquila production based on cheaplabour and inputs that are specifically imported forexportable production.

Evidence leads to the inevitable conclusion that intrade liberalisation there is a gap between what indus-trial countries say must be done and what they do tomake it happen. If the EU continues grantingsubsidies to agriculture and to other sectors andmaintains its protectionist stance, it will be extremelydifficult for negotiations to level out the playing field.Under these conditions, the gap between what LatinAmerica sells to the EU and what it buys from the EUwill continue to expand.

34 FAO: Commodity Market Review, 1996-97, p. 7.

35 A. Va ldes : Surveillance of agricultural price and trade policy inselected Latin American countries at the time of major reform, TheWorld Bank, 1996.

c36 FAO: Review of Cereal Prices Developments in SelectedDeveloping Countries in 1995-96 and Policy Response, Commoditiesand Trade Division, September 1996.

CURRENCY CRISES

Gerhard Aschinger*

Why Do Currency Crises Arise and HowCould They Be Avoided?

In the 1990s currency crises arose in different regions, e.g. in Mexico, East Asia, Russia,Brazil and Ecuador, to mention only the most important ones. What are the main factors

which may trigger such events? How does globalisation and deregulation of financialmarkets influence the emergence of a currency crisis? What forms of crises exist? Arethey driven by fundamental imbalances in a country or are they caused by self-fulfillingmechanisms involving herd behaviour and destabilising speculation? To what extent do

such crises reflect implicit governmental and international guarantees which may cause moralhazard and adverse selection, thereby increasing the risk behaviour of enterprises and banks?

Acurrency crisis is characterised by a suddenattack on a country's currency, which will devalue

accordingly. Although currency crises may also occurunder flexible exchange rates, the pegging of thedomestic currency to a reserve currency (e.g. the US

* Professor of Economics, University of Fribourg, Switzerland.

152

dollar) creates a higher potential for such crises sinceunder flexible exchange rates investors directly bearthe exchange-rate risk. The commitment of agovernment to defending the peg of its currency(falsely) signalises investors that exchange-rate risksare virtually non-existent. It is often believed thatdomestic money could always be exchanged for

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CURRENCY CRISES

foreign currency at par such that the central bank'sforeign reserves would not be exhausted. A loss ofconfidence, however, may exert heavy pressure onthe domestic currency, leading to a currency attackand thereby depleting the foreign currency reserves ofthe central bank even if the amount of these reservesseemed to be sufficiently high. Whatever the reasonfor the increased demand for foreign currency, a fixedpeg would amplify the danger of a currency crisis.

Factors which may Trigger a Currency Crisis

Although different currency crises in emergingeconomies depend on specific constellations andevolutions^ they are driven by important commonfactors as well. Some influential determinants whichmay trigger currency attacks are discussed below.

Introducing a Peg: Many developing countriessuffering from economic imbalances such as highinflation or budget deficits decided to peg theircurrency to a reserve currency as a nominal anchor inorder to stabilise the domestic economy. Under fixedexchange rates a country has ah incentive to disci-pline its economic policy in order not to lose too muchof its foreign currency reserves. While maintaining thepeg, the home country may "inherit" stability from thereserve currency country and gain the confidence ofinvestors. Especially in emerging economies whichneed a high amount of foreign credit to financeeconomiagrowth, a stable exchange rate is a prereq-uisite for attracting substantial capital inflow. Althoughexchange-rate risks seem to be eliminated by intro-ducing a peg, the danger of a currency attack isreinforced in the longer run, given the fact that capitalis highly volatile and susceptible to pessimistic expec-tations. In such situations investors have an incentiveto exchange domestic currency for foreign currency ata given price.

Globalisation and Capital Flows: With the globali-sation of financial markets international capitalmobility has increased enormously. Financial deregu-lation, the elimination of capital controls, the liberali-sation of local markets and the ample creation ofderivatives has intensified competition in the financialindustry and reduced transaction costs. Technologicalimprovements in telecommunication and computerfacilities have led to a widespread financial network.Together with the extension of trading foreign sharesat different stock exchanges, this has constituted aworld market, making possible financial transactions24 hours a day around the globe.

Emerging economies (especially in East Asia)experienced high economic growth over a long periodof time, encouraged by low salaries, skilled labour andattractive investment opportunities especially duringthe recession in industrial countries in the 1990s. Inorder to attract capital, emerging economies liber-alised their financial sectors to facilitate access byforeign investors. Since equity and obligation marketsin such countries are not sufficiently developed,capital inflows usually take the form of bank credits.The lack of efficient institutions and supervision of thebanking system as well as the absence of bindingrules for risk management and bookkeepingstandards enhanced the danger of financial distress.

While foreign direct investment constituted animportant part of capital imports, the share of short-run capital inflows (portfolio investment) increasedsubstantially over time. With globalised financialmarkets, short-run capital became extremely volatile,reacting quickly to changes in investors' expecta-tions. Using short-term capital to finance long-runinvestment augmented the default risk of firms andbanks.

Excessive Credit Creation: Given the peg, strongcapital inflows led to a substantial accumulation ofcentral banks' foreign currency reserves and to anincrease in money supply and domestic creditalthough emerging countries pursued stabilisingmonetary and fiscal policies in order not to run intoinflation. Domestic firms and banks increasinglydemanded credits in foreign currency, due to the factthat foreign interest rates were lower than domesticones and the government was expected to guaranteethe peg. Ignoring exchange-rate risks the interestdifferential seemed to be too high. The accumulationof short-term foreign debt could therefore trigger acurrency crisis. The need to pay back maturatingforeign debt and to make interest payments wouldinduce domestic firms to buy foreign currency fromthe central bank at the given peg. If doubts shouldarise concerning the maintenance of the peg, foreigncreditors would be reluctant to roll over their loans todomestic firms, and if they ever did then only at highercost. Debtors would fear that their foreign exposurewould sharply increase in domestic currency terms inthe case of a devaluation.

Moral Hazard: Abundant liquidity is an incentive forbanks to give easy credits. Implicit governmentguarantees (including the lender of last resort functionof the central bank) give rise to moral hazard and

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CURRENCY CRISES

adverse selection. While granting credits; bankswould earn large profits in the case of positive eventswhereas for negative ones they could burden heavylosses on society. In East Asian countries e.g.domestic banks and firms increased their riskexposure to a large extent, which led to a growingnumber of inefficient investments. Widespreadcorruption and nepotism reinforced this tendency.Overinvestment led to "suffering" credits but banksdid not write them down.

Another source of moral hazard was the expectedfinancial help the IMF (together with other organisa-tions and governments) would offer to countriesexperiencing a currency crisis. The expected bail outinduced private foreign creditors to accept thegrowing accumulation of debts by domestic firms andbanks. In order to reduce moral hazard, implicitguarantees would have to be reduced while privatecreditors should be induced to bail in and bear theirown risks. Implicit government guarantees, however,should not be totally eliminated in order to avoid adisruption of the financial system that would give riseto extreme costs.

Real Estate Bubbles and Bank Runs: In many EastAsian countries domestic credit expansion generateda boom in the real estate sector and equity markets,which gave rise to speculative bubbles. The inflationof real estate prices was nourished by buoyous1

demand but prices began to fall when the saturationof the market and pessimistic expectations increasedthe number of non-performing loans. As bad loanswere not paid back and many depositors withdrewtheir money, banks had to be closed. Bank runs finallyput doubt on the government's ability to defend thepeg. Faced with this situation, the governmentpursued a restrictive monetary policy which causedinterest rates to climb in an unprecedented way. Evenwith rocketing interest rates it was not possible tostop the outflow of capital because devaluation riskswere considered to be too high. The rise in interestrates forced many firms into insolvency.

Contagion of Currency Crises: Besides precedingreal estate and banking crises there are many otherfactors which may contribute to a currency crisis:investors' pessimism about a country's creditwor-thiness, high volatility of short-run capital, liberali-sation of local markets without flanking regulativemeasures and a new institutional framework, a currentrecession, political unrest, corruption and nepotism. Apeg which favours the influx of capital at an earlier

stage will create an incentive for short-run capital toflow out in the case of declining confidence.

Contagion is another important reason for acurrency crisis. Difficulties or crises in certaincountries may place doubt on the economic stabilityof other countries and areas. The more a country islinked with one that is suffering from a currency crisis,either through a similar export structure, or intensivemutual trade, the same culture and language,exposure to the same type of external shocks, asimilar financial market structure etc. the moresusceptible it is to such a crisis. There can be anawakening effect: countries which seem to be similarto a country that actually experiences a currencycrisis are suspected of being prone to run into thesame difficulties. Such generalisations without athorough inspection of a country's specific situationmay trigger a crisis in a country" which in fact hassound fundamentals. There is a tendency towardsherd behaviour.

If some countries devalued their currency to a largeextent, other countries in the region were forced todevalue as well in order not to lose competitiveness.Cumulative devaluations (experienced during the EastAsian crisis) augmented the danger of serious harm tointernational trade as in the 1930s.

IMF Programmes: Rescue programmes forcountries experiencing a currency crisis were offeredby the IMF, and other organisations and countries expost but not ex ante. It is not evident, however, thatpreventive programmes avoid currency crises, nomatter, the amount of financial support, since thedriving forces of such crises are often too powerful tobe stopped. IMF credits were granted on thecondition that stringent stability requirements weremet, involving restrictive monetary and fiscal policy,which led to sharp increases in interest rates andrecession. In certain cases, e.g. in East Asia, the IMFeven bound countries to attain budget surpluses.Such policy measures raised unemployment andaggravated the crisis. The IMF also urged countries tofurther liberalise their financial markets immediatelyfollowing the outbreak of a currency crisis, therebyprovoking the additional outflow of capital rather thanstabilising the situation. As a consequence socialunrest and protests unfolded in countries such asIndonesia and South Korea. In 1998 the IMF acknowl-edged faults in its policy and tried to correct them byslackening the rules. Investors' confidence withrespect to countries experiencing a currency crisiswere not restored by the "medicine" ordered by the

154 INTERECONOMICS, May/June 2001

CURRENCY CRISES

Figure 1Different Stages of the East Asian Crisis

peg of dorrjesticcurrency (with

respect to foreignhard currency)

governmental and international guarantee:

moral hazard

recession in industrialcountries

high economicgrowth'

1high

capital imports

deregulation,

liberalisation ofdomestic markets

cumulativedevaluations

increase in foreign

money reserves ofthe central bank

extension ofdomestic credits

contagion of othercountries

transition to flexibleexchange rates

euphoria anddestabilisingspeculation

real estate andbank crises

changingexpectations:

currency attacks

threateningdepletion of

foreign currencyreserves: currency

crisis

restrictivemonetary policy:

rise in interestrates

IMF. On the contrary, the'"illness" was aggravated.However, it seemed difficult to offer financial helpwithout imposing certain strict conditions on therecipient country.

Figure 1 shows the different stages which led to theoutbreak of the East Asian crisis. The main course ofevents is marked with arrows. The dynamic systemunderlying this scheme involves many feedbacks.

Different Types of Currency Crises

There are obviously different reasons for currencycrises. One type of crisis is caused by unfavourablefundamentals. Persistent budget or current accountdeficits, high inflation, low economic growth or thepresence of specific risks will have an impact on theintrinsic value of a country's currency. A peg cannotbe maintained if fundamental imbalances continue -

sooner or later there will be a transition to flexibleexchange rates forced because foreign exchangereserves will be exhausted. This type of crisis can beexplained by so-called first generation models.1 Insuch models as those of Krugman, and Flood andGarber, a persistent budget deficit financed by printingmoney leads to a reduction in the central bank'sforeign exchange reserves. Under perfect foresight,investors will attack domestic currency and depleteforeign exchange reserves such that the peg has to beabandoned. With perfect arbitrage the currency

1 See e.g. P. K r u g m a n : A Model of Balance-of-Payments Crises,in: Journal of Money, Credit and Banking, Vol. 11, 1979, p. 311-325;and R.P. F l o o d , P.M. G a r b e r : Collapsing Exchange-RateRegimes - Some Linear Examples, in: Journal of InternationalEconomics, Vol. 17, 1984, pp.1-13. See also G. A s c h i n g e r :Wahrungs- und Finanzkrisen - Entstehung, Analyse und Beurteilungaktueller Krisen, Verlag Vahlen, Munchen 2001, for a survey ofdifferent types of models of currency crises.

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CURRENCY CRISES

attack is advanced to the earliest possible time wherethe exchange rate devalues continuously. Thesemodels use the same elements as those ofexhaustible resources, where an attack on theresources takes place whenever the shadow pricemoves over the fixed price. In models of currencycrises foreign exchange reserves are treated asexhaustible resources. It is shown that internal imbal-ances are not consistent with a fixed peg.

Besides unfavourable fundamentals, self-fulfillingexpectations can trigger a currency crisis as well.Second generation models of currency crises showthat if the fundamentals lie within a specific interval acurrency attack may occur or not, depending on theexchange-rate expectations of investors. In suchmodels the optimal mix of government policies isdetermined by minimising a loss-function whichmeasures different policy goals including the choiceof the exchange-rate system. In contrast to firstgeneration models there may be a deliberategovernment decision to abandon a fixed peg if othergoals seem to be more important.

It is sometimes argued that self-fulfilling processesreflect fundamentals and are therefore a rationalexplanation for a currency crisis. Herd behaviour e.g.can be rational if non-informed investors adopt theviews of smart investors when information can beobtained only at high costs. However, a self-fulfillingprocess may be influenced by mass psychologyinvolving irrational behaviour. Kindleberger showed inhis pioneering book "Manias, panics and crashes"that in.speculative crises irrational behaviour occurswhich leads to euphoria and panic.2

According to Kindleberger, speculative crises canbe characterised by different stages:

(1) displacement: an exogenous shock operates on amacroeconomic system,

(2) development of a boom: if positive changespredominate,

(3) expansion of bank credits: increasing liquidityaugments credit supply,

(4) rising speculation: at first stabilising speculationprevails and rational behaviour dominates,

(5) euphoria: irrational behaviour leads to destabilisingspeculation; and exaggerations,

(6) abrupt changes in expectations: instability hasincreased to the extent that continuous adjustment isno longer possible,

(7) panic: mass selling of the speculative good leadsto a crash.

The market efficiency hypothesis, which states thatall public information is instantaneously reflected inprices, is not fulfilled for all financial market events.Many anomalies exist for financial markets that seemto be driven by investors' sentiments and may alsoinclude irrational behaviour. In behavioural financesuch mechanisms are studied. Shiller in his book"Irrational Exuberance" pointed out that mostinvestors base their financial decisions on personalfeelings and random observations rather than onquantitative analyses.3

Concerning currency crises one can distinguishbetween informational and speculative crises. Aninformational crisis explains a currency attack by theappearance of relevant negative news which has animpact on the valuation of the exchange rate. Thedeterioration of a country's fundamentals may e.g.lead to an informational currency crisis. The questionis, whether information is reliable and relevant for theintrinsic value of a currency and will therefore reflectthe rational behaviour of investors. With imperfect andasymmetric information, expectation formation maytrigger a self-fulfilling crisis which, under certaincircumstances, reflects rational behaviour.

Speculative currency crises involve irrationalmotives which may lead to exaggerations. Newrelevant information does not arrive shortly before acurrency attack. At the time just before a speculativecrisis occurs, no change in fundamentals takes place.Such a crisis develops over time while the instabilityof the system grows. The delay rule applies, whichmeans that local continuous adjustments are pursuedup to the last moment when an abrupt move of theexchange rate takes place and corrects the inherentimbalance.

Recent Currency Crises

There have been several important currency crisesin recent years:4

2 C.R K i n d l e b e r g e r : Manias, Panics and Crashes-A History ofFinancial Crises, Basic Books, New York 1978.

3 R.J. Sh i l l e r : Irrational Exuberance, Princeton University Press,Princeton, New Jersey 2000.

4 These currency crises are described and analyzed at length in G.A s c h i n g e r , op. cit.

156 INTERECONOMICS, May/June 2001

CURRENCY CRISES

• The Mexico crisis <(1995): The difficulties arisingfrom the debt crisis of 1982 were consolidated inMexico by stabilisation programmes which involvedrestrictive monetary and fiscal measures, a solidaritypact between employers, employees and thegovernment, and widespread liberalisation. Due to arestriction on government expenditure a balancedbudget was reached in 1990, while average real GDPgrowth amounted to 3% p.a. and the inflation ratewas reduced to 7% p.a. by 1994. Positive economicprospects which were accentuated by Mexico'smembership of NAFTA and the OECD led to amassive inflow of short-term foreign capital. Mexicoused a crawling peg vis-a-vis the US dollar. As deval-uation steps proved to be insufficient to eliminate theinterest differential, the peso revalued in real terms.This led to reduced competitiveness and growingcurrent account deficits. Rising US interest rates atthe beginning of 1994 drained portfolio capital out ofMexico and the government had to issue dollar-indexed obligations {tesobonos) in order to roll over itsforeign debt. Together with political instability andeasy monetary and fiscal policies before the presi-dential election this led to speculative attacks againstthe peso, which devaluated about 30% up to earlyJanuary 1995. Financial markets, however, did notanticipate the currency crisis.

• The East Asia crisis (1997): East Asian countriesexperienced high real GDP growth rates for manyyears and achieved substantial budget surpluseswhile inflation rates remained low. These countriesused a fixed peg with respect to the US dollar. Strongcapital inflows, especially of portfolio capital, broughtabout a high accumulation of credits and a boom inthe real estate and equity markets. Moral hazarddriven by implicit guarantees, poor risk managementand a lack-of supervision of the banking systemproduced a high number of failing credits which led toreal estate and bank crises. Corruption and nepotismtogether with a high degree of monopolisation inindustry accentuated the vulnerability of East Asiancountries. In spring 1997 the currency crisis started inThailand and with the devaluation of the baht itquickly expanded to the Philippines, Malaysia,Indonesia and finally to South Korea. Contagion wasan important factor since all East Asian countriesfaced similar problems. Since the outbreak of thecrisis up to March 1998 the currencies of thesecountries devalued about 50% with the exception ofthe Indonesian rupiah which lost about 80% of itsvalue against the US dollar. Also in this case, financialmarkets did not foresee the crisis.5

• The Russia crisis (1998): With the transition to amarket economy in 1990 Russia experienced seriousdifficulties since many industries and their productsturned out to be obsolete. The deep economic crisiswas marked by high inflation rates, a reduction of realGDP, an increasing budget deficit and decliningcurrent account surpluses. Frequent changes ofgovernment added to incertitude. In 1995 therouble was pegged to the US dollar using anexchange-rate band. The support of western govern-ments and new investment opportunities led to astrong influx of portfolio capital since investorsbought large amounts of government bills (GKO's).The fragility of the Russian economy led to a massiveoutflow of capital at the beginning of August 1998. Torestructure Russian debt a 90-day moratorium wasannounced, which put strong pressure on the rouble.On August 28 flexible exchange rates were introducedand the rouble devalued more than 50% within a fewdays.

• The Brazil crisis (1999): The Brazilian economyshowed a high and persistent inflation over manyyears, which reached a four-digit level in 1994. Withthe help of a stabilisation plan (Piano Real) whichincluded a monetary reform and fiscal measures,inflation was quickly reduced and the governmentbudget became balanced. The new Braziliancurrency, the real, was linked to the US dollar by acrawling peg. Since the stepwise devaluation of theBrazilian currency was insufficient it revalued in realterms. As a consequence a high current accountdeficit was generated and a large budget deficitevolved because of the lack of fiscal discipline. Brazilwas thus characterised by "twin deficits". In spite ofpursuing a restrictive monetary policy which led tohigh interest rate increases, heavy losses of foreignexchange reserves resulted. In January 1999 atransition to flexible exchange rates took place andthe Brazilian currency devalued by more than 40%within two weeks.

• The Ecuador crisis (2000): Ecuador experiencedhigh inflation and low economic growth for manyyears. From 1996 on, there was a substantial deterio-ration of the fundamentals, so the current accountand budget deficits climbed to high levels. Because ofthe growing pressure on the Ecuadorian currency thedevaluation rate of the crawling peg of the sucre

5 A characterisation of the East Asia crisis is given e.g. in: G.A s c h i n g e r : An Economic Analysis of the East Asia Crisis, in:INTERECONOMICS, Vol. 33, 1998, No. 2, pp. 55-63.

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CURRENCY CRISES

against the US dollar was continuously raised. From1997 to 1999 foreign exchange reserves were halvedand in February 1999 the central bank decided tointroduce flexible exchange rates. The sucre devaluedmore than 40% against the US dollar within twoweeks. Because of considerable withdrawals ofdeposits, commercial banks were closed for oneweek in order to prevent a bank crisis. Ecuadorbecame insolvent in September 1999 because theinterest on Brady bonds could not be paid. Becauseof the impossibility of stabilising the sucre, thegovernment decided to substitute its nationalcurrency for the US dollar. Dollarisation was thusintroduced in September 2000.

Whereas the currency crises in Russia, Ecuadorand Brazil were mainly driven by fundamental imbal-ances, the Mexico crisis was a self-fulfilling crisis andthe East Asia crisis could be characterised as aspeculative crisis which was influenced by moralhazard, triggering first a real estate and a bank crisis,which then led to a currency crisis.

Table 1 summarises some important aspects ofcurrency crises in emerging countries. Currencycrises involve similar phases, which were describedabove and are illustrated by Figure 1 for the EastAsian crisis.

Measures That Could Prevent Currency Crises

With growing globalisation in financial markets,international capital became fully mobile and short-run capital very volatile. The potential for speculationincreased enormously. While market imbalanceswould be cured by. (stabilising) speculation if newrelevant information appeared, destabilising specu-lation could lead economies into serious problems bymeans of self-fulfilling mechanisms. Open economiesunder globalised conditions are submitted to quickmarket changes that lack frictions. Such an economicsystem may become unstable analogously todynamic mechanical systems, as illustrated by thefollowing example. In the 19th century wheel bearingswere improved substantially by reducing friction. In

Table 1Comparison of Recent Currency Crises

Mexico (1995) East Asia (1997/98) Russia (1998) Brazil (1999) Ecuador (2000)

Starting position low inflation

equilibrated

budget

member of NAFTA

and OECD

high current

account deficit

- low inflation

- high .economic

growth

- budget surplus

- high current

account deficit

- low inflation

- transition to

market economy

- high budget deficit

- reduction of real

GDP

- low inflation

- high current

. account and

budget deficits

- equilibrated budget

- high inflation

- high current

account deficit

- low economic

growth

Currency peg crawling peg vis-a-vis fixed peg vis-a-vis

the US dollar the US dollar

currency band vis-a- crawling peg vis-a-

vis the US dollar vis the US dollar

(devaluation 7.5%

per year)

crawling peg vis-a-vis

the US dollar with

increasing devaluation

rate

-> transition to

"dollarisation"

Deregulation/globalisation

liberalisation of local markets, reduction of capital controls, privatisation

Capital inflows high inflow of short run capital (portfolio investment), increase of money supply

Domestic credit high liquidity of banks, moral hazard, adverse selection, accumulation of non-performing credits; increase in speculationexpansion -> boom in real estate and equity markets

Increase of credits increase of debts in foreign currency of domestic firms and banks (without hedging in East Asian countries),in foreign money increasing foreign.debts of government, expectation of obtaining IMF credits

Factors that trigger domestic political bank and real estate threatening insolvency moratorium of local reduction of oil price,the currency crisis problems crises, moral hazard of government sector, states, problems with bank crisis, domestic

moratorium of private curing governmental political problemsforeign debts debts

Models to explaincrisis

second generationmodels:self-fulfillingcurrency crisis

models of bank andreal estate crises,model of speculativecrisis (Kindleberger)

first generationmodels:fundamental crisis

first generationmodels:fundamental crisis

first generationmodels:fundamental crisis

158 INTERECONOMICS, May/June 2001

CURRENCY CRISES

the course of this technical progress steam enginesshowed unstable behaviour by the centrifugal forcegovernor, which hampered smooth power trans-mission to the wheels. The only way to correct thiswas to reintroduce friction to the wheel bearings. Thisfinding generally applies to dynamical systems andshows that a minimum of friction is necessary toguarantee stability.

In order to reinsert friction into a globalisedeconomic system, one could think of levying a capitalimport tax, such as was applied in Chile for manyyears, of making use of capital controls or introducinga transaction tax on foreign exchange (Tobin tax),thereby throwing sand into the wheels of the super-efficient financial markets, as Tobin expressed it.6 Acapital import tax has the advantage that the inflow ofcapital could be impeded in good times, whereas witha capital export tax or capital controls it would bedifficult to prevent capital outflow during bad times.The Tobin tax collects a low but fixed percentage onthe amounts of all foreign exchange transactionswhich should apply with the same rate to all kinds oftransactions and in all countries. It does not seempossible to levy such a tax in the foreseeable future,given the fact that reaching an internationalagreement on this matter would be difficult. Capitalcontrols, which were reintroduced in Malaysia andRussia," could be helpful to protect a country fromhuge capital outflows in the case of a currency crisisbut they should be removed as soon as possible inorder not to produce adverse effects on the country'scompetitiveness.

Local markets should not be liberalised too quicklywithout flanking measures such as a good supervisingsystem for banks, requirements for capital ratios, riskmanagement and bookkeeping devices. New financialinstitutions would have to be introduced or existingones would have to be reformed.

Domestic firms and banks should not be allowed toborrow foreign money without authorisation from thegovernment. High foreign indebtedness of domesticenterprises has been a main factor for the depletion ofcentral banks' exchange reserves in the course ofcurrency crises.

Implicit guarantees that give rise to moral hazardshould be reduced but not eliminated. Private(domestic and foreign) creditors should not rely onbeing bailed out either by the government or indirectly

6 J. Tob in : A Proposal for International Monetary Reform, in:Eastern Economic Journal, 19781 p. 153-159.

by international rescue programmes, but have to carrythe risks themselves (bail in) in the case of a crisis.Foreign banks should then be required to extend theircredits (roll over) to domestic debtors.

The peg of the domestic currency should not bedefended under all circumstances. Some flexibility ofthe exchange rate would be desirable at an earlierstage in order to avoid a currency crisis. This alsodepends on the expectations of investors who mightbecome suspicious and exchange domestic forforeign currency. If no peg were to exist, currencycrises would be moderate, but the positive effects ofa peg such as stabilising the economy in the case ofhigh inflation or promoting economic growth couldnot be attained.

There are, however, different forms of pegs:crawling pegs, fixed pegs, currency boards or dollar-isation. The crawling pegs used in Latin America (e.g.Brazil and Mexico) allowed mini-devaluations forcountries under inflationary pressures, therebyreducing the likelihood of currency attacks. For acurrency board the monetary basis must always becovered one hundred per cent by the foreignexchange reserves of the central bank. A currencyboard (e.g. Hong Kong and Argentina) seem to bemore crisis-prone than a regular fixed peg because ofthe higher degree of monetary discipline demanded.Currency attacks, however, cannot be excluded forcurrency boards since the money supply (e.g. M1 orM2) is not covered one-to-one by foreign exchangereserves. With dollarisation a country has given upmonetary policy, which is determined by the reservecountry alone. For a country adopting dollarisation,however, there could be a problem in getting enoughof the reserve currency in order to be prosperous anddevelop accordingly.

Corruption and nepotism should be fought and themonopolisation of industries with respect to chaebolsin South Korea or big conglomerate firms in Indonesiashould be put to an end. Credits should not begranted because of personal relations but rather bebased on efficiency grounds.

Crisis contagion could be reduced if better infor-mation about the differences and similarities betweencountries were made available. Better transparencyabout the links and decision-making of industries andgovernment could enhance investors' confidence in aparticular country.

Given the condition of human nature, however, andin spite of the preventive measures taken, crisescannot be completely avoided at all times.

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