Financial crises in emerging markets: a canonical model

We present a simple model that can account for the main features of recent financial crises in emerging markets. The international illiquidity of the domestic financial system is at the center of the problem. Illiquid banks are a necessary and a sufficient condition for financial crises to occur. Domestic financial liberalization and capital flows from abroad (especially if short-term) can aggravate the illiquidity of banks and increase their vulnerability to exogenous shocks and shifts in expectations. A bank collapse multiplies the harmful effects of an initial shock, as a credit squeeze and costly liquidation of investment projects cause real output drops and collapses in asset prices. Under fixed exchange rates, a run on banks becomes a run on the currency if the central bank attempts to act as a lender of last resort.Banks and banking, Central ; International finance ; Liquidity (Economics) ; Monetary policy ; Money supply

Monetary Policy and the Currency Denomination of Debt: A Tale of Two Equilibria

Exchange rate policies depend on portfolio choices, and portfolio choices depend on anticipated exchange rate policies. This opens the door to multiple equilibria in policy regimes. We construct a model in which agents optimally choose to denominate their assets and liabilities either in domestic or in foreign currency. The monetary authority optimally chooses to float or to fix the currency, after portfolios have been chosen. We identify conditions under which both fixing and floating are equilibrium policies: if agents expect fixing and arrange their portfolios accordingly, the monetary authority validates that expectation; the same happens if agents initially expect floating. We also show that a flexible exchange rate Pareto-dominates a fixed one. It follows that social welfare would rise if the monetary authority could precommit to floating.

Liquidity Crises in Emerging Markets: Theory and Policy

We build a model of financial sector illiquidity in an open economy. Illiquidity defined as a situation in which a country's consolidated financial system has potential short-term obligations in foreign currency that exceed the amount of foreign currency it can have access to on short notice can be associated with self fulfilling bank and/or currency crises. We focus on the policy implications of the model, and study the role of capital inflows and the maturity of external debt, the way in which real exchange rate depreciation can transmit and magnify the effects of bank illiquidity, options for financial regulation, the role of debt and deficits, and the implications of adopting different exchange rate regimes.

Liquidity crises in emerging markets: Theory and policy

We build a model of financial sector illiquidity in an open economy. Illiquidity is defined as a situation in which a country's consolidated financial system has potential short-term obligations that exceed the amount of foreign currency available on short notice. We show that illiquidity is key in the generation of self-fulfilling bank and/or currency crises. We discuss the policy implications of the model and study issues associated with capital inflows and the maturity of external debt, the role of real exchange depreciation, options for financial regulation, fiscal policy, and exchange rate regimes.Financial crises ; Foreign exchange ; Capital movements ; Liquidity (Economics)

The Asian liquidity crisis

A country's financial system is internationally illiquid if its potential short-term obligations in foreign currency exceed the amount of foreign currency it can have access to in short notice. This condition may be necessary and sufficient for financial crises and/or exchange rate collapses (Chang and Velasco 1998a, b). In this paper we argue that the 1997-98 crises in Asia were in fact a consequence of international illiquidity. This follows from an analysis of empirical indicators of illiquidity as well as other macroeconomic statistics. We trace the emergence of illiquidity to financial liberalization, the shortening of the foreign debt structure, and the currency denomination of assets versus liabilities. We explain how financial crises became exchange rate collapses due to a government policy of both fixing exchange rates and acting as lender of last resort. Finally, we outline the policy implications of our view for preventing crises and for dealing with them.Banks and banking, Central ; International finance ; Liquidity (Economics) ; Monetary policy ; Money supply

Dollarization: Analytical Issues

This paper discusses major analytical aspects of dollarization and their practical implications. We develop a simple model to stress that dollarization implies the loss of independent monetary policy and of seigniorage, yet the significance of such losses can only be evaluated in conjunction with assumptions about the policymaking process. If the government is benevolent and has no credibility problems, dollarization causes a fall in welfare, which can be measured by the implied seigniorage loss or using Mundellian optimal currency area criteria. However, outcomes are rather different if credibility is absent and dollarization can serve as a commitment device: the welfare impact of dollarization is ambiguous, and seigniorage measures and Mundellian criteria may be misleading indicators of the true cost of dollarization. We also evaluate other implications of dollarization, such as those related to last resort lending and financial stability.

Financial fragility and the exchange rate regime

We study financial fragility, exchange rate crises, and monetary policy in an open economy version of a Diamond-Dybvig model. The banking system, the exchange rate regime, and central bank credit policy are seen as parts of a mechanism intended to maximize social welfare; if the mechanism fails, banking crises and speculative attacks become possible. We compare currency boards, fixed rates, and flexible rates with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, bank runs are possible under a currency board. A fixed exchange rate system may implement the social optimum but is more prone to bank runs and exchange rate crises than a currency board. A flexible rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies are appropriately designed.Banks and banking, Central ; Financial crises ; Financial institutions ; Foreign exchange rates

Must Original Sin Cause Macroeconomic Damnation?

Original sin, coupled with other financial imperfections, causes macroeconomic penance of two kinds: adverse shocks have larger and more persistent effects and monetary policy becomes less effective as a shock absorber. But macroeconomic damnation is not inevitable: in some cases, suitable changes in money and exchange rates can still partially stabilize output, investment and consumption.

Balance Sheets and Exchange Rate Policy

We study the relation among exchange rates, balance sheets, and macroeconomic outcomes in a small open economy. Because liabilities are dollarized,' a real devaluation has detrimental effects on entreprenurial net worth, which in turn constrains investment due to financial frictions. But there is an offsetting effect, int hat devaluation expands home output and the return to domestic investment, which are also components of net worth. We show that the impact of an adverse foreign shock can be strongly magnified by the balance sheet effect of the associated real devaluation. But the fall in output employment, and investment is stronger under fixed exchange rates than under flexible rates. Hence the conventional wisdom, that flexible exchange rates are better absorbers of real foreign shocks than are fixed rates, holds in spite of potentially large balance sheet effects.