Financial Crisis

International Financial Crises
• Currency Crises – Loss of credibility of fixed
exchange rate system.
• Banking Crisis – Sudden collapse of the
domestic banking system.
• Systemic Financial Crisis/Sudden Stops –
Breakdown of system of international capital
• Sovereign Debt Crisis – Gov’t unable to pay-off
IMF World Economic Outlook, 1998
• Devaluation of the currency occurs when
central bank operating an exchange rate peg
increases the number of domestic dollars
needed to purchase one foreign dollar.
• Revaluation is a decrease in domestic currency
price of foreign dollars.
Currency Crises
• Market believes that exchange rate will be
devalued in the near future.
• Lenders demand higher interest rates to lend in
domestic dollars to compensate for loss of
value after devaluation.
• Central bank must use its foreign reserves to
buy domestic currency and prop up exchange
• If pain of interest rates is too painful or loss of
reserves too severe, central bank may be forced
to devalue.
ERM Crisis
Go for the Jugular
• In 1980’s, European economies constructed a
system of linked currencies called the
Exchange Rate Mechanism.
• Inflationary German fiscal policy following reunification led to high DM interest rates.
• To maintain link, other Euro currencies needed
to have interest rates too high for their own
• In Sept. 1992, markets expected a
delinking/devaluation of currencies.
Currency Crisis
• Speculation against the
pound forced Bank of
England to raise interest
rates and buy pounds in
forex markets.
• Pain of interest rates
was viewed as too
severe and B of E was
forced to abandon the
Principal Global Indicators Database
Roles of Banking System
Why Not Finance Corporate Sector w/ Stocks and Bonds?
Banks accept deposits from retail customers and
make larger, longer-term loans.
• Information: Banking institutions study creditworthiness of borrowers.
• Monitoring: Banks can enforce covenants and
conditions on lending.
• Liquidity : Deposits easily used for necessary
Banking Crises
• Bank Runs – Sudden withdrawal of deposit base
forcing bank closures or gov’t assistance.
– Solvency Crisis: Banks have substantial amounts of
loans gone bad and thus have insufficient funds to
repay depositors.
• Swedish Banking Crisis, 1991 Link
– Liquidity Crisis: Sudden deposit withdrawal requires
liquidation of otherwise sound assets.
• Bank of East Asia,
2008 Link
Systemic Crisis
Bank failure can be contagious
1. Interbank Lending
2. Panic conditions
Lender of Last Resort
• Banking system sufficiently important that gov’ts will
usually protect depositors and prevent mass
– Liquidity Crisis: Lend at penalty rates against good
collateral. Walter Bagehot, 1840’s.
– Solvency Crisis: 1) Containment: Administrative
intervention, temporary closure, nationalization. 2)
Resolution. Recapitalize banks through gov’t purchase of
equity, diluting or destroying shareholder value.
• Moral Hazard: Banks creditors and (sometimes
owners) are protected from consequences of risky
Fragile banking system makes high interest rates untenable and
can lead to fears of devaluation (especially if central bank funds
used to bailout banking system)
Exchange rate devaluation can damage balance sheets if balance
sheets (deposits or borrowings) are dollarized.
Sudden Stops
• International hot money (short-term lending) is
subject to herding behavior from international
financial market.
– Rapid inflows and rapid outflows.
• When capital inflows stop, either those can be
replaced with forex reserves, or domestic
borrowers will face bankruptcy.
– Domestic firms can no longer finance investment
– Demand, GDP, and employment fall.
– Devaluation of currency.
Sudden stop?
Capital Outflows
Capital Outflows
Financial Crises
• Sudden Stops: Foreign investors herding behavior and
short-termism lead them to move in and out of countries
– “The greatest concern I have is that capital account
convertibility would leave economic policy in a
typical ‘emerging market’ hostage to the whims and
fancies of two dozens or so thirty-something country
analysts in London, Frankfurt, and New York. ” Dani
Rodrik, 1998
East Asian Crisis
IMF World Economic Outlook Database
East Asian Crisis
Dealing with Hot Money
• Short-term Money Flows
– Zero-Interest Reserve Requirements
– Tobin Tax
– Administrative Controls
Buildup Foreign Reserve Assets
IMF Financial Statistics
Foreign Reserves
Measures of Adequate Reserves
• Import Coverage: Reserves > Imports for 2-3
• Greenspan-Guidotti Rule: Reserves exceed
100% of debt due within one year.
Dealing with Sudden Stops
• Modern Approach
Swap lines Link
Chiang Mai Initiative Multilateralization
• ASEAN+3 has a pool of US$120billion
(financed mostly by +3) in reserve swaps
available for liquidity in a crisis to allow for
region-wide insurance
• In size, amount seems reasonable. IMF-led
programs in Thailand and Indonesia were
about $20billion and $40 billion through 91998

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