Currency Crises in Emerging - Market Economis: Causes, Consequences and Policy Lessons

Abstract

Currency crises have been recorded for a few hundreds years but their frequency increased in the second half of the 20th century along with a rapid expansion of a number of fiat currencies. Increased integration and sophistication of financial markets brought new forms and more global character of the crises episodes. Eichengreen, Rose and Wyplosz (1994) propose the operational definition, which helps to select the episodes most closely fitting the intuitive understanding of a currency crisis (a sudden decline in confidence towards a specific currency). Among fundamental causes of currency crises one can point to the excessive expansion and over-borrowing of the public and private sectors, and inconsistent and nontransparent economic policies. Over-expansion and overborrowing manifest themselves in an excessive current account deficit, currency overvaluation, increasing debt burden, insufficient international reserves, and deterioration of other frequently analyzed indicators. Inconsistent policies (including the so-called intermediate exchange rate regimes) increase market uncertainty and can trigger speculative attack against the domestic currency. After a crisis has already happened, the ability to manage economic policies in a consistent and credible way becomes crucial for limiting the crisis' scope, duration and negative consequences. Among the dilemmas that the authorities face in such circumstances is the decision on readjustment of an exchange rate regime, as the previous regime is usually the first institutional victim of any successful speculative attack. The consequences of currency crises are usually severe and typically involve output and employment losses, fall in real incomes of a population, deep contraction in investment and capital flight. Also the credibility of domestic economic policies is ruined. In some cases a crisis can serve as the economic and political catharsis: devaluation helps to temporarily restore competitiveness and improve a current account position, the crisis shock brings the new, reform-oriented government, and politicians may draw some lessons for future. The responsible macroeconomic policy can help to diminish a risk of an occurrence of a currency crisis. It involves balanced and transparent fiscal accounts, proper monetary-fiscal policy mix, and low inflation, avoiding indexation of nominal variables and intermediate monetary/ exchange rate regimes. On the microeconomic level key elements include privatization, demonopolization and introduction of efficient competition policy, prudential regulation of the financial sector, trade openness, and simple, fair and transparent tax system. All the above should help elimination of soft budget constraints, overborrowing on the side of both private and public sector and moral hazard problems. All these measures need to be strengthened by legal reforms, efficient and fair judiciary system, implementation of international accounting, reporting and disclosure standards, transparent corporate and public governance rules, and many other elements. Reforms can be supported by the IMF and other international organizations, which on their part should depoliticize their actions and decision-making processes, sticking to the professional criteria of country assessment and their consequent execution.currency crisis, financial crisis, contagion, emerging markets, transition economies, exchange rates, monetary policy, fiscal policy, balance of payments, debt, devaluation