11

Understanding Financial Understanding Financial CrisesCrises

Franklin Allen and Douglas Franklin Allen and Douglas GaleGale

Clarendon Lectures in FinanceClarendon Lectures in Finance

June 9-11, 2003June 9-11, 2003

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Lecture 2Lecture 2

Currency CrisesCurrency Crises

Franklin AllenFranklin Allen

University of PennsylvaniaUniversity of Pennsylvania

June 10, 2003June 10, 2003

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

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IntroductionIntroduction

Major theme of the banking crises Major theme of the banking crises literatureliterature

Central bank/government intervention Central bank/government intervention is necessary to prevent crisesis necessary to prevent crises

From 1945-1971 banking crises were From 1945-1971 banking crises were eliminated but currency crises were noteliminated but currency crises were not

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Many of the currency crises were due Many of the currency crises were due to inconsistent government to inconsistent government macroeconomic policiesmacroeconomic policies

Explanations of currency crises are Explanations of currency crises are based on government based on government mismanagementmismanagement

Contrasts with banking literature Contrasts with banking literature where central banks/government are where central banks/government are the solution not the problem the solution not the problem

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First generation modelsFirst generation models

Krugman (1979) and Flood and Krugman (1979) and Flood and Garber (1984) show how a fixed Garber (1984) show how a fixed exchange rate plus a government exchange rate plus a government budget deficit leads to a currency budget deficit leads to a currency crisiscrisis

Designed to explain currency crises Designed to explain currency crises like that in Mexico 1973-82like that in Mexico 1973-82

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Salant and Henderson (1978): Model Salant and Henderson (1978): Model to understand government attempts to understand government attempts to peg the price of goldto peg the price of gold

Market Solution: Earn r on gold Market Solution: Earn r on gold holdingsholdings

P(t) = P(0) eP(t) = P(0) ertrt

Ln P(t) = Ln P(0) + rtLn P(t) = Ln P(0) + rt

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Ln P(t)

t

Ln Pc

T

Ln P(0)

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

Can’t be an equilibrium because of Can’t be an equilibrium because of arbitrage opportunityarbitrage opportunity

Ln P(t)

Ln P*

Ln Pc

tT

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Equilibrium: Peg until T’ then there is Equilibrium: Peg until T’ then there is a run on reserves and the peg is a run on reserves and the peg is abandonedabandoned

Ln P(t)

Ln P*

Ln Pc

tTT’

1010

Krugman (1979) realized that the Krugman (1979) realized that the model could be used to explain model could be used to explain currency crisescurrency crises

Government is running a fiscal deficitGovernment is running a fiscal deficit

It can fix the exchange rate and It can fix the exchange rate and temporarily fund the deficit from its temporarily fund the deficit from its foreign exchange reservesforeign exchange reserves

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There is an exchange rate over time There is an exchange rate over time such that the “inflation tax” covers such that the “inflation tax” covers the deficitthe deficit

Equilibrium has predictable run on Equilibrium has predictable run on reserves and abandonment of pegreserves and abandonment of peg

Ln S(t)

Ln S*

tT’

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Problems with first generation Problems with first generation modelsmodels

Timing of currency crises is very Timing of currency crises is very unpredictableunpredictable

There are often jumps in exchange ratesThere are often jumps in exchange rates

Government actions to eliminate deficits? Government actions to eliminate deficits?

E.g. ERM crisis of 1992 when the pound and E.g. ERM crisis of 1992 when the pound and the lira dropped out of the mechanismthe lira dropped out of the mechanism

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Second generation modelsSecond generation models

Obstfeld (1996): Extent government is prepared Obstfeld (1996): Extent government is prepared to fight the speculators is endogenous. This can to fight the speculators is endogenous. This can lead to multiple equilibria.lead to multiple equilibria.

There are three agentsThere are three agents

A government that sells reserves to fix it A government that sells reserves to fix it currency’s exchange ratecurrency’s exchange rate

Two private holders of domestic currency who Two private holders of domestic currency who can continue to hold it or who can sell it to the can continue to hold it or who can sell it to the government for foreign currencygovernment for foreign currency

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Each trader has reserves of 6Each trader has reserves of 6

Transactions costs of trading are 1Transactions costs of trading are 1

If the government runs out of If the government runs out of reserves it is forced to devalue by 50 reserves it is forced to devalue by 50 percentpercent

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High Reserve Game: Gov. Reserves = 20High Reserve Game: Gov. Reserves = 20

There is no devaluation because gov. There is no devaluation because gov. doesn’t run out of reserves. If either doesn’t run out of reserves. If either trader sells they bear the transaction trader sells they bear the transaction costs.costs.

The unique equilibrium is (0, 0)The unique equilibrium is (0, 0)

Trader Trader 22

HoldHold SellSell

Trader Trader 11

HoldHold 0,00,0 0,-10,-1

SellSell -1,0-1,0 -1,-1-1,-1

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Low Reserve Game: Gov. Reserves = Low Reserve Game: Gov. Reserves = 66

Either trader can force the Either trader can force the government to run out of reservesgovernment to run out of reserves

The unique equilibrium is (0.5, 0.5)The unique equilibrium is (0.5, 0.5)

Trader Trader 22

HoldHold SellSell

Trader Trader 11

HoldHold 0,00,0 0,20,2

SellSell 2,02,0 0.5,0.50.5,0.5

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Medium Reserve Game: Gov. Reserves = Medium Reserve Game: Gov. Reserves = 1010

Both traders need to sell for a devaluation Both traders need to sell for a devaluation to occurto occur

Multiple equilibria (0.5, 0.5) and (1.5,1.5)Multiple equilibria (0.5, 0.5) and (1.5,1.5)

Trader Trader 22

HoldHold SellSell

Trader Trader 11

HoldHold 0,00,0 0,-10,-1

SellSell -1,0-1,0 1.5,1.51.5,1.5

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Equilibrium selectionEquilibrium selection

Sunspots – doesn’t really deal with Sunspots – doesn’t really deal with issueissue

Morris and Shin (1998) approachMorris and Shin (1998) approach

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

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

CL CUUnique

Peg fails

Multiple Unique

Peg holds

2020

With lack of common knowledgeWith lack of common knowledge

Major advance over sunspotsMajor advance over sunspots

Empirical evidence?Empirical evidence?

C*Unique

Peg fails

Unique

Peg holds

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Twin CrisesTwin Crises

Kaminsky and Reinhart (1999) have Kaminsky and Reinhart (1999) have investigated joint occurrence of currency investigated joint occurrence of currency and banking crisesand banking crises

In the 1970’s when financial systems were In the 1970’s when financial systems were highly regulated currency crises were not highly regulated currency crises were not accompanied by banking crisesaccompanied by banking crises

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

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The usual sequence is that banking The usual sequence is that banking sector problems are followed by a sector problems are followed by a currency crisis and this further currency crisis and this further exacerbates the banking crisisexacerbates the banking crisis

Kaminsky and Reinhart find that the Kaminsky and Reinhart find that the twin crises are related to weak twin crises are related to weak economic fundamentals - crises when economic fundamentals - crises when fundamentals are sound are rarefundamentals are sound are rare

Important to develop theoretical Important to develop theoretical models of twin crisesmodels of twin crises

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Panic-based twin crisesPanic-based twin crises

Chang and Velasco (2000a, b) have a Chang and Velasco (2000a, b) have a multiple equilibrium model like multiple equilibrium model like Diamond and Dybvig (1983)Diamond and Dybvig (1983)

Chang and Velasco introduce money Chang and Velasco introduce money

as an argument in the utility function as an argument in the utility function and a central bank controls the ratio and a central bank controls the ratio of currency to consumptionof currency to consumption

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Banking and currency crises are Banking and currency crises are “sunspot phenomena”“sunspot phenomena”

Different exchange rate regimes Different exchange rate regimes correspond to different rules for correspond to different rules for regulating the currency-consumption regulating the currency-consumption ratioratio

Policy aim is to reduce parameter Policy aim is to reduce parameter space where “bad equilibrium” existsspace where “bad equilibrium” exists

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Fundamental-based twin Fundamental-based twin crisescrises

Allen and Gale (2000) extends Allen Allen and Gale (2000) extends Allen and Gale (1998) to allow for and Gale (1998) to allow for international lending and borrowinginternational lending and borrowing

Risk neutral international debt marketsRisk neutral international debt markets

Consider small country with risky Consider small country with risky domestic assets domestic assets

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BanksBanks

Use deposit contracts with investors Use deposit contracts with investors subject to early/late liquidity shockssubject to early/late liquidity shocks

Can borrow and lend using the Can borrow and lend using the international debt marketsinternational debt markets

Domestic versus dollar loans Domestic versus dollar loans

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Domestic currency debtDomestic currency debt

Risk sharing achieved through:Risk sharing achieved through:

Bank liabilitiesBank liabilities Deposit contractsDeposit contracts Large amount of domestic currency bondsLarge amount of domestic currency bonds

Bank assetsBank assets Domestic risky assetsDomestic risky assets Large amount of foreign currency bondsLarge amount of foreign currency bonds

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Government adjusts exchange rate so the Government adjusts exchange rate so the value of banks’ foreign assets allows them value of banks’ foreign assets allows them to avoid banking crisis and costly to avoid banking crisis and costly liquidationliquidation

Risk neutral international (domestic Risk neutral international (domestic currency) bond holders bear most of the currency) bond holders bear most of the risk while domestic depositors bear little risk while domestic depositors bear little riskrisk

If portfolios large enough all risk If portfolios large enough all risk transferred to international markettransferred to international market

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Viable system of international risk Viable system of international risk sharing for developed countries sharing for developed countries whose banks can borrow in domestic whose banks can borrow in domestic currencycurrency

Many emerging countries’ banks Many emerging countries’ banks cannot borrow in domestic currency cannot borrow in domestic currency because of the fear of inflation – they because of the fear of inflation – they must borrow using dollar-must borrow using dollar-denominated debtdenominated debt

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Dollar-denominated debtDollar-denominated debt

The benefits that a central bank and The benefits that a central bank and international bond market can bring are international bond market can bring are reducedreduced

DollarizationDollarization: The central bank may no longer : The central bank may no longer be able to prevent financial crises and be able to prevent financial crises and inefficient liquidation of assetsinefficient liquidation of assets

Dollar debts and domestic currency depositsDollar debts and domestic currency deposits: : It may not be possible to share risk with the It may not be possible to share risk with the international bond marketinternational bond market

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Policy ImplicationsPolicy Implications

Is the IMF important as lender of last Is the IMF important as lender of last resort like a domestic central bank resort like a domestic central bank (Krugman (1998) and Fischer (1999)(Krugman (1998) and Fischer (1999)

OROR It misallocates resources because it It misallocates resources because it

interferes with markets (Friedman interferes with markets (Friedman (1998) and Schwartz (1998)?(1998) and Schwartz (1998)?

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Framework above allows these issues Framework above allows these issues to be addressedto be addressed

Case 1: Flexible Exchange rates and Case 1: Flexible Exchange rates and Foreign Debt in Domestic Currency – No Foreign Debt in Domestic Currency – No IMF neededIMF needed

Case 2: Foreign Borrowing Case 2: Foreign Borrowing Denominated in Foreign Currency – IMF Denominated in Foreign Currency – IMF needed to prevent banking crises with needed to prevent banking crises with costly liquidation and contagioncostly liquidation and contagion

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ConclusionsConclusions

When is government the problem When is government the problem and when is it the solution?and when is it the solution?

The importance of twin crisesThe importance of twin crises

Interaction of exchange rate policies Interaction of exchange rate policies and bank portfolios in avoiding crises and bank portfolios in avoiding crises and ensuring risk sharingand ensuring risk sharing