Credits, Crises, and Capital Controls: A Microeconomic Analysis

Abstract

We analyze the behavior of foreign banks who sequentially provide credit to finance projects in an emerging market. The foreign banks are exposed to both micro-economic risks and the macro-economic risk of a currency crisis, and there are no bailout guarantees. Nevertheless, we show that it is often the case that banks provide too much credit too easily and that this behavior may precipitate the onset of a currency crisis. We demonstrate how the imposition of capital controls in the form of taxes and subsidies on foreign investment may improve the situation. Whereas most of the literature explains currency crises as the consequence of causes that lie within the debtor countries, the general message of our paper may be interpreted as placing part of the blame on the international financial community as well.