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    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.
                                 Go for the Jugular
                 ERM Crisis
• In 1980’s, European economies constructed a
  system of linked currencies called the
  Exchange Rate Mechanism.
• Inflationary German fiscal policy following re-
  unification 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 credit-
   worthiness 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.       Link
   – 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)

           Banking                              Currency
            Crisis                               Crisis

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.                 Link
  – 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

        Current         Net
        Account   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   Link
       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 9-


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