Central European University
Department economics
The roles of fiscal, monetary and exchange rate
policies in preventing currency crises and
overcoming the consequences
Term paper for the course ‘Comparative macroeconomic policy’
Professor:
Jacek Rostowski
Authors: Gregor Langus and Willen Lipatov
Budapest, 2000
CONTENT
Introduction ........................................................................................................................... 3
Definitions and the role of government ................................................................................. 3
Propagation of crisis .............................................................................................................. 6
Buildup of the crisis in East Asia .......................................................................................... 7
Causes................................................................................................................................. 7
Crisis outbreak.................................................................................................................... 8
Policy responses .................................................................................................................... 9
The roles of macroeconomic policies in overcoming the consequences ............................. 10
Fiscal policy ..................................................................................................................... 10
Monetary policy ............................................................................................................... 11
Exchange rate policy ........................................................................................................ 12
Other crisis management policies ........................................................................................ 13
The role of IMF ................................................................................................................ 13
Prevention issues ................................................................................................................. 14
Conclusion ........................................................................................................................... 17
2
Introduction
The problem of currency crises has been an issue since the introduction of money in national
economies. With globalization of financial markets the frequency of crises and their impact
on the real economy dramatically increased. This raised interest in crisis prevention and
overcoming its consequences. The latest advances of economic theory give a better
understanding of crisis mechanism and provide better tools for prevention and post-crisis
stabilization.
The availability of modern techniques in dealing with crises puts a greater responsibility on
the government's shoulders. However, the literature on currency crises is huge, and this
review summarizes the main recommendations for pursuing various government policies.
This paper aims to show basic relations between macroeconomic variables that cause crises
and those variables that governments can control by adopting proper policies.
Firstly, we define the crisis as an extreme point of instability. We further underline the
relevance of official intervention in order to preserve stability. Following that, we discuss
what forms official policy responses took in recent Asian crises, and summarize what
advantages and disadvantages official measures may have. Next, we turn to the problem of
preventing crises, and conclude by stressing importance of maintaining healthy financial
system and macroeconomic conditions.
Definitions and the role of government
First of all, there is no commonly accepted definition of financial instability. Obviously, it’s a
lack of financial stability, which usually implies, according to A. Crockett (1997), two
principal features:
 key institutions are stable, that is meet their contractual obligations
 key markets are stable, that is prices reflect fundamental forces driving them
There is a couple of problems with this definition. First, it’s not clear what institutions are
key ones, and what are not. Second, price stability is not equivalent to market stability, so
there is no good measure for the latter. Moreover, it is difficult to distinguish between
inability of institutions to meet obligations leading to problems for the whole market system
and healthy failures of institutions, which are necessary for functioning of this system.
Similarly, it is not simple to determine a degree of price instability that could be considered
to be a threshold value between healthy price flexibility (again necessary for the functioning
of the markets) and market instability.
3
Because of these problems another, rather ‘functional’ definition of a crisis is accepted.
According to it, absence of financial stability (crisis) causes wide economic damage. Already
from this property it is obvious that one should worry about crises, as it is necessary to
minimize economic damage caused by them. This is where there can be scope for
government activities in overcoming consequences of crises. Moreover, it certainly makes
sense to try to prevent crises, as long as prevention measures do not hinder growth potential.
There are some reasons why official intervention is not only possible, but also necessary for
crisis management. First of all, financial and asset markets have broad linkages to saving and
investment decisions, so instability on these markets has greater potential impact on the
economy in general, than instability on markets for goods and services. Second, there are
some immanent characteristics of financial institutions that make them vulnerable to crises:
 losses are exacerbated due to bank runs, so government can protect potentially solvent
institutions and provide pooled monitoring (because of the economies of scale)
 there is high probability of contagion and spillover, so financial stability can be
considered to be a public good which only government can provide efficiently
Third, there are following major types of costs of financial instability:
 budgetary costs to protect depositors and bail out institutions, in other words costs of
resolving a crisis
 widespread macroeconomic consequences, eventually leading to GDP growth reduction
 loss of confidence raises problems of asymmetric information (moral hazard and adverse
selection)
Therefore relevance of government intervention for preserving stability of financial
institutions is widely accepted.
The situation around preserving stability of financial markets is not so clear. Markets also
have instability bias in a sense that any disturbance causes moves in the same direction. The
costs of instability of markets include
 difficulties to formulate macroeconomic policy, as it is not clear whether a change in a
market situation will not bring about obsolescence of current policy
 undermining the stability of financial institutions
 real economic costs if measures to fight crisis are taken
4
So, there is no strong reason for direct regulation of markets, as long as government can
concentrate on institutions in order to correct market failures. In general, however, official
intervention in dealing with crises is desirable. Let’s consider how a crisis can occur even in
presence of such an intervention.
5
Propagation of crisis
In the framework of asymmetric information (analyzed by F. Mishkin (1997)) all crises have
four basic reasons:
1.
2.
3.
4.
Increases in interest rates.
Deterioration of bank balance sheets.
Negative shocks to non-bank balance sheets as stock market declines.
Increase in uncertainty.
All these factors are interrelated and can cause each other. For example, an increase in
interest rates leads to deterioration of balance sheets for both banks (because of maturity
mismatch the value of assets is lowered more than the value of liabilities) and non-banks
(credit servicing becomes more expensive). Deterioration of non-bank balance sheets also
leads to deterioration of bank balance sheets, as non-bank firms are less likely to repay their
loans.
The most important thing, however, is that all the four factors worsen the problems of moral
hazard and adverse selection. In an emerging-market country that leads to a currency crisis,
as speculators realize that defense of domestic country is too costly for the central bank (it
can raise the interest rate, but danger of being involved in a vicious circle is very high). A
crisis is associated with substantial depreciation or devaluation of the domestic currency.
This, taking into account short duration of debt, large foreign currency denominated debt,
and lack of inflation-fighting credibility leads to a large-scale financial crisis (Mexico 1994,
East Asia 1997, Russia 1998). Interest rate can be raised once more to fight inflation, that
deteriorates balance sheets more, and vicious circle appears once again.
Apart from devaluation, decline in economic activity caused by moral hazard and adverse
selection problems makes paying-off debts less likely, thus worsening banking crisis in both
industrialized and emerging-market countries. This leads to further worsening of problems
connected with asymmetric information, and suppresses economic activity more.
The aftermath of a crisis consists in sorting out healthy firms from insolvent ones. This
reduces uncertainty, stock market recovers, interest rate goes down, so adverse selection and
moral hazard become weaker, and the economy gets conditions to grow. On this stage it is
very important to provide efficient mechanism of sorting out solvent institutions, as without
it there is no reason to overcome the crisis.
6
However, in developed economies, as there are no problems with currency devaluation and
high inflation, economic downturn can lead to a decline in prices. Then a phenomenon called
‘debt deflation’ can occur: unanticipated deflation leads to deterioration of firms’ net worth
and through it to increasing of moral hazard and adverse selection problems. This, in turn,
brings about downturn in economic activity, as it happened in the USA in 1873, 1907, during
the Great depression, and in Japan in 90s.
So, that’s the way how a crisis evolves in the theoretical framework of asymmetric
information. Now let’s see how it happened in reality using the example of East Asian
countries.
Buildup of the crisis in East Asia
Causes
Opinions on the causes for the East Asian crisis in 1997 differ, we can, however, identify
some agreement between authors (for example: Dornbusch, 1998; BIS 1998; Fischer, 1998)
on the following main categories of causes:
1.
2.
3.
4.
Financial sector weaknesses and inadequately supervised banking systems
Excessive credit growth and over-expansion of the capital stock.
The bubble economy.
Rigid exchange rate regimes.
All the stated causes are complementary. Financial sectors in the East Asian countries were
unable to efficiently transform massive inflows of foreign funds in 1995 and 1996. This was
combined with weak supervision and improper prudential regulation of financial institutions.
In an increased competition banks made risky, uncollateralised loans, kept offshore dollar
borrowings unhedged and exposed themselves to maturity mismatches.
Following the credit expansion, with foreign funds being channeled into equity investment,
stock market values increased and this created asset bubbles. Dowling and Lloyd (2000), also
allege increasing inflation as a consequence of capital inflows, partly because of the upward
pressures on asset and property prices, but mainly through increased money supply. To this
list of causes for the crisis we could also add external influences of changes in international
markets (increased competition on export markets, saturation with consumer electronics,
drop in price of chips) and some systemic changes, especially in the pattern of financial
intermediation with formation of non-bank institutional investors.
7
However clear the case for the currency crisis in East Asia seems now, it was not so prior to
the outbreak. Since 1980 these economies have been growing at an average annual growth
rates around 8%, while keeping inflation at moderate levels. There was no sign of worsening
fundamentals and macroeconomic policies were kept on a prudent course. Budget deficit was
broadly balanced and the monetary policies seemed to have been cautious, judging from
substantial stability of prices. Except for the widening current account deficit there was no
obvious sign of the upcoming events.
How come then, did the crisis occur? Crockett (BIS 1998, page 35) argues, that the system of
governance in all sectors of Asian economies failed to keep pace with the rapid expansion. In
a fast growing business environment with high saving rates, investment strategies
encompassed risky projects with low returns, consequently leading to overinvestment.
Overinvestment in turn led to conditions of oversupply and the exports started to shrink;
additionally the rates of return on investments in new capital were eroding. Moreover, dollar
appreciation had negative effects on competitiveness, since real appreciation was transmitted
through a pegged exchange rate to Asia. Because of commitments to maintaining exchange
rate, monetary policy makers have had less scope to focus on the domestic liquidity
requirements and failed to dampen overheating by raising interest rates. Fixed exchange rate
policies also gave economic agents a false perception of low exchange rate risk, and as a
result they had incentives to take large unhedged exposures in foreign currency.
Crisis outbreak
The first stage of the crises unfolded in Thailand. Investors confidence eroded mainly
because of the large and growing current account deficit (8% in 1996). Even though there
were no apparent fundamental problems (negligible inflation and conservative fiscal policy
with budget surpluses), except for a moderate appreciation over previous few years, the fact
that Thailand was vulnerable was enough to face currency attacks and capital flow reversals.
As Dornbusch (1998) argues, this vulnerability emerges from the combination of a weak
banking system, dollar debts held by its clients, short term structure of debt and lack of
transparency with a pervasive overlay of corruption.
On the 2nd July 1997 the Thai baht was let to float. Even though the monetary policy was
tightened and interest rates were raised significantly the baht continued its downward path
and lost 45% of its value against the dollar, by the end of 1997. Current account deficit
narrowed to 2% of GDP in 1997, mainly due to collapse of domestic demand and drop in
imports.
8
Investors sentiments quickly spread over the region, focusing on similar vulnerabilities as in
the case of Thailand. The Philippines, Indonesia and Malaysia as well as Taiwan, faced
strong pressures and the governments first widened exchange rate bands, but had to let the
currencies float by October 1997.
Policy responses
First and direct response to currency attacks in the Asian countries was the adoption of the
floating exchange rate regime, followed by tightening of monetary policy. Moreover, fiscal
restraints were imposed to tackle with the budget imbalances, but fiscal stances were eased
after the depth of the crisis became clearer. Crockett (BIS 1998, page 135) also argues that
the degree to which interest rate were raised was not enough to counter attacks. In addition
the rates were allowed to fall back after the immediate pressures had subsided. This kind of
wavering monetary policy leads to high dependence on heavy intervention.
Financial response to crisis included official liquidity assistance in the form of IMF standby
credits and substantial additional multilateral and bilateral assistance. These packages aimed
at restoring investors confidence, but this can only be achieved if financial packages are
combined with credible policy measures, which was not the case at the outset of stabilization
in Asia.
At the core of the South-East Asian crisis was a fragile financial sector and other structural
weaknesses and this was the reason that adjustment programs also included institutional and
structural reforms, mainly of the banking sector, but also of enterprises.
Meanwhile in the case of Latin America the conventional policy mix – tight monetary and
fiscal policy worked well, it was not so in East Asia. The difference is mainly due to the
reason, that Latin-American countries have been running lax fiscal policy prior to the crisis,
whereas Asia had maintained conservative fiscal policies, hence it did not have so much
scope for fiscal maneuvering.
9
The roles of
consequences
macroeconomic
policies
in
overcoming
the
Because of the high costs of currency crises per se, and costly stabilization policies, the
prevention is important and should not be substituted by "fire fighting". On the brim of the
currency collapse, however, different macroeconomic policies should be carefully considered
in the context of the nature of crisis and the nature of economy. Every adopted measure will
namely have both positive and negative effects in the stabilization, depending on the specific
relations between macroeconomic and microeconomic variables in the economy. In what
follows we will discus the theoretical framework of macroeconomic policies and relate it to
the case of East-Asian crisis.
Fiscal policy
Conventional economic theory prescribes tightening of fiscal policy after the crisis hits the
country. Lower government spending accounts for a fiscal adjustment that would cover the
carrying costs of financial sector restructuring and helps restore a sustainable balance of
payments. One strong argument in favor of tight fiscal policy is, as Fischer (1998) argues,
limited access to borrowing in turbulent times. Another argument for fiscal prudence is
prevention of subsequent crises. Namely, with a budget surplus or low deficit the probability
of speculative attacks is lower. It is however not excluded, as a recent experience in Asia
shows.
On the other hand, one could argue that tighter fiscal policy will further depress aggregate
domestic demand and expectations, and increase the cost in terms of drop in output growth.
Even more worrying is deterioration of infrastructure that could result from tight fiscal
policy. This would in turn constrain the export sector, which will be the main motor of
growth in the period after stabilization. This consideration was particularly important for the
Asian economies. Since they were already running balanced fiscal policies, they did not have
much room for tightening. In addition, the role of government in provision of infrastructure
and promotion of exports was big in these countries. Big budget cuts in these circumstances
were not considered a solution.
10
Monetary policy
Higher interest rate should act as an incentive for increased holdings of home currency
denominated assets, thereby countering speculative pressures. That is the most obvious
reason why tight monetary policy should be adopted. In times of plummeting value of
currencies and previously low foreign reserves it is important to restore confidence in the
currency. As Fisher (1998) argues, the lessons of the "tequila crisis" as well as of those in
Brazil, Hong Kong and the Czech Republic show that a timely and forceful tightening of
monetary policy combined with other supporting measures can successfully fend off
speculative attacks.
Crockett (BIS 1998, page 137) underlines the importance of expectations in limiting currency
depreciation by tightening interest rates. He claims that only substantial increases in interest
rates can support the currency under attack. Investors faced with moderate increases in
interest rate expect further upward movement, and delay moving into assets denominated in
domestic currency until the interest rate has reached a subjective peak value. In this line, if
the initial rise in interest rate is not high enough, this creates unfavorable expectations and
the government loses credibility.
Other side of the coin, tightening of interest rates will worsen the situation of the already
weak banks and corporations through credit contraction and increase in the debt servicing
burden. That way tightening monetary policy could depress aggregate demand and
expectation.
Apart from direct effect of interest rate on credit availability, there are also other mechanisms
at work. An example of one is what happened in East Asian currency crisis. After tightening
monetary policy, higher interest rate (through discount factor) resulted in property and other
assets price decreases, and this decrease was even furthered when speculators were selling
their assets to repay the costly debt. As a result the value of collateral dropped, hence
accentuated credit contraction.
Despite these ambiguous effects of monetary policy on the economy, the prevailing opinion
is that the confidence in the currency and stabilization are crucial factors in overcoming the
currency crisis and therefore the monetary policy should be tightened.
11
Exchange rate policy
Once again there are different views on how to lead exchange rate policy. The most extreme
is not to fight currency attacks at all, but let the rate flow from the beginning. Dornbusch
(1998) argues that the central bank has no chance of succeeding in fighting off speculators.
Because of limited reserves, and adverse effects of high interest rates on the economy,
combined with political considerations, finally the government fill have to devalue the
currency or let it float. And this drop will have to be larger the more depleted reserves are
and the higher the external debt is. In other words, the longer the government postpones
adoption of floating exchange rate regime.
Conventional economic theory predicts that devaluation or depreciation in countries highly
reliant on trade will generally result in an expansion of output through stimulation of export
and import competing industries, particularly if inflation is relatively low. In addition, purely
flexible exchange rate will lead to continuous adjustment to relative price movements and
will thereby release speculative attacks and price bubbles. Besides these, additional argument
for flexible exchange rate in times of crisis is that it provides a clear signal of the effects of
government policies; an issue which is important for restoration of investor confidence.
Adoption of flexible exchange rate in times of volatile movements and inflationary pressures
can also have adverse effects on the economy. The level of uncertainty that economic agents
face is higher and enterprises are reluctant to make long run commitments. In addition, deep
currency depreciation is particularly undesirable in the economies where corporations or the
governments hold substantial foreign currency denominated debts (as for example East Asian
corporations) as this would significantly increase their debt servicing burden. Not least,
exchange rate depreciation can translate into inflation and further into inflationary
expectations.
In the case of Asian crisis a lack of responsiveness of output growth to currency depreciation
was observed. Crockett (BIS 1998, page 44-48) gives results of empirical studies on output
growth projections and movements of real effective exchange rate. It turns out, that in reality
exchange rate depreciation and the level of activity often reveal a contractionary effect.
Despite high openness to trade this was the case for East-Asian countries. As possible
explanations for this fact Crockett identifies several reasons:
1. Importance of intraregional trade: because the depression in the whole region there was a
sharp drop in demand for intermediate and final products.
12
2. Exchange rate uncertainty: enterprises do not want to make a long run commitments;
resulting in coordination failures, increase in production uncertainty and drop in
investment demand.
3. Financial fragility: due to high levels of debt denominated in foreign currency,
enterprises were facing increased costs of debt servicing. This was further aggravated by
banks curtailing credits.
Other crisis management policies
Obviously implementing tight monetary and fiscal policy with a more flexible exchange rate
regime is not enough, especially in cases like East Asian. Besides ambiguous effects on
economy, these policies do not do away the causes of crises. They must therefore be
combined with reforms in trade policies, in the area of foreign direct investment incentives,
in changed of the role of the government in economy and the reform of financial markets.
As the experience in Asian crisis shows, financial intermediation and capital markets played
the key role in crisis propagation. This is also true in theory in the framework of asymmetric
information (analyzed by F. Mishkin (1997)), which was already mentioned. Of the four
basic reasons that Mishkin identifies, deterioration of bank balance sheets and negative
shocks to non-bank balance sheets as stock market declines, are directly related to financial
intermediation as well as capital markets. Increase in uncertainty and increases in interest
rates are again related to this issue – markets are highly sensitive to uncertainty, and interest
rate enters discount factor. Therefore regulation of financial markets should be put high on
authorities agendas. In this context tight controls and transparency with higher standards of
disclosure are required. This will decrease the level of uncertainty and vulnerability of the
financial systems. In the stabilization period financial markets regulation will speed up
investors confidence restoration.
The role of IMF
A subject to many debates in the context of currency crises, it seems that the IMF does play
an important role in the post crisis stabilization. . Its role is primarily in the provision of loans
and restoration of investors confidence. As proponents of the IMF claim, its role is also in the
expertise that it can offer (Fischer, 1998). Without being cynical, we claim, that it is more
about the international resources that it helps to mobilize and the credibility that it brings
about. As Dornbusch says: "It's not over till the fat lady sings." (Dornbusch, 1998, page 8),
meaning by that, that the stabilization is not to be expected before IMF is "called in" and its
13
traditional program is implemented. It consists of budget balancing, flexibilization of the
currency, banking sector reform and monetary program. Experience in many crises, but
especially in the case of "tequila" and Asian currency collapse , show, that this is true, as it is
a strong support to government credibility and investors confidence build-up.
Prevention issues
We presented the main ways of fighting crises, but it’s obviously better to prevent them.
Government can use a number of policies to achieve this goal, and we shall discuss them one
by one.
First, it is not even arguable that fiscal policy should be tight, as it lowers probability of a
speculative attack. Moreover, though it depresses economic activity in the short run, it does
not undermine growth potential in the long run. So running a balanced budget is a preferable
strategy for crisis prevention, as far as fiscal policy is concerned. The empirical evidence
from Asia-pacific countries over the period 1980-1994 (Moreno 1995) supports the view that
larger budget deficit is associated with speculative attacks, and also with depreciation.
However, the Asia in 1997 shows that tight fiscal policy does not insure countries against
currency crises, but rather reduces their probability, other things being equal.
As far as monetary policy is concerned, the classical recommendation is once again tight
policy, and namely (Herrero 2001) monetary targeting. But it is very hard to pursue in
emerging economies as monetary-inflation relation in these countries is not stable. Instead
inflation targeting may be used that includes announcement of medium-term numerical
targets for inflation with commitment. The big advantage of such policy is its transparency to
public, and in this sense it can substitute pegged exchange rate. On the other hand, the
credibility problem arises if the inflation target is not hit. This is more likely to happen with
higher inflation, as it is more difficult just to predict inflation rate correctly in such
circumstances.
The empirical evidence from the mentioned sample suggests that speculative attacks are
positively correlated with growth in Central bank domestic credit, and depreciation may
result from faster money growth. A stochastic model of currency crisis with misaligned
central parity (Corrado, Holly 2000) also predicts a speculative attack for big enough
increase in domestic credit. However, tight monetary policy and associated with it high
interest rates may lead to worsening of moral hazard and adverse selection problems, and
ultimately to provoke a crisis. So, the difficult task is to keep interest rate high enough to
14
prevent ‘running’ from the domestic currency and low enough to prevent big troubles arising
from asymmetric information problems.
The choice of exchange rate policy is not so straightforward. One should be aware of many
dangers the fixed exchange rate poses. Apart from loss of monetary policy independence, it
provides automatic transmission of shocks from the anchor country. Moreover, pegged
exchange rate encourages capital inflows, as it creates a false sense of security (no risk of
depreciation of the domestic currency). In case of negative market situation the defense of
the peg leads to high interest rates and – with very high probability – to a currency crisis.
Developed countries, however, can even gain from such kind of a crisis, as they usually do
not have large foreign currency denominated debt, and devaluation increases their
competitiveness. Indeed, the United Kingdom after crisis in 1992 experienced economic
revival, caused by devaluation. This is obviously not the case with emerging market
countries, as large foreign currency denominated debt brings about sharp deterioration of net
worth of financial and non-financial institutions. That leads to riskier behavior and moral
hazard. Firms have less collateral, therefore they can get less credit. All these factors
accompanied by renewed inflation expectations and raised burden of foreign debt lead to
slowdown of economic growth.
Fixed exchange rate or crawling peg is particularly dangerous if the banking system is
fragile, debt contracts are of short duration, and foreign debt is large. In such circumstances
(common for emerging markets) devaluation leads to a full-fledged financial crisis. Loss of
confidence in Central Bank in this case leads to further rise of interest rates and slowdown of
economic activity (vicious circle). So, in order to prevent crises fixed exchange rate policy
should be avoided, especially if the situation is similar to described above. It can be probably
substituted by inflation targeting. At the same time, if inflation is very high, pegged rate is
probably unavoidable, and gains from overcoming inflation exceed expected costs of
currency crisis. But even in such situation fixed rate should be used only as a temporary
measure to fight inflation.
The free floating is preferable for crisis prevention, since flexible rate makes it clear to firms
that there is a risk involved in issuing liabilities in foreign currency. Moreover, it provides
early warning signals to policymakers. But it does not eliminate the possibility of a crisis to
occur, and it does not help to fight with inflation, so that usually only developed countries
can allow it.
It is well known that capital inflows may provoke currency crisis if the flow is suddenly
reversed or even just stopped. One possible way to fight with it is by means of monetary
policy, namely by sterilization. But it leads to an increase of interest rates that stimulates
15
capital inflows even more and results in the vicious circle with moral hazard and adverse
selection problems already discussed. So, there is an alternative way to regulate capital
inflows, and that is capital controls.
Capital controls are measures taken by the government to prevent capital from flowing into
the country by constructing some barriers for its mobility. It can be very useful in attaining a
desired structure of capital inflows, namely long term inflows are usually welcomed. Capital
controls helped Malaysia in 1997 to reduce its short-term borrowing. Still, they also may
worsen the allocation of resources and dampen economic growth, failing to help to prevent
devaluation, as it happened to Venezuela in 1994. So, capital controls should in general be
only temporary (when the threat of a crisis is significant) and not influence direct investment,
since the latter are considered to be irreversible. Problems with direct investment, in turn,
usually stem from worsening investment climate rather than from inappropriate monetary
policy.
Since capital controls are costly in terms of efficiency losses, they can be substituted by
tightening of monetary policy. It is possible to do without big negative consequences if there
is a well-functioning money market and floating exchange rate regime, allowing
appreciation. The other substitution is the tightening of fiscal policy that leads to decrease in
domestic demand and increase in savings.
One of the most important tasks of currency crisis prevention is the maintaining of a healthy
banking system. It is accepted in literature (Crockett 1997, Mishkin 1997, Herrero 2001), that
liberalization of financial system should be carried out only together with strengthening the
regulation and supervision. Strong bank regulatory/supervisory system should include:





adequate resources available
accounting and disclosure requirements
prompt corrective action (stop and punish)
independence of political process
supervisors accountable
Moreover, liberalization should be pursued gradually in order to keep a lending boom (and
arising from it moral hazard problem that raises probability of crisis) at hand.
There are also some remedies for vulnerability of financial system in general. One is reliance
on market forces that leads to more prudent behavior, as there is no moral hazard of official
intervention. But such policy lacks credibility as there is always some political pressure that
makes government to act as a lender-of-last resort. Moreover, full reliance on market forces
16
depresses economic activity, as banks have to keep too much reserves taking into account
risk of unexpected political, economic event or a natural disaster.
The other remedy is two kinds of safety nets, namely deposit insurance and lender-of–last
resort role of Central Bank. Both increase confidence in financial institutions, thus lowering
the probability of bank runs. But deposit insurance eliminates market discipline, as depositors
don’t look for less risky banks. To avoid this moral hazard problem, deposit insurance
schemes should be explicitly defined in law, adequately funded, and premiums should be
charged independently according to the risk of any given bank.
Lender-of-last resort function of Central Bank consists in lending freely during the panics at
a penalty rate. It should be provided not only for banks, but for all other institutions as well.
But it also endangered by moral hazard, as banks are in a sense insured against liquidity
problems during crises, especially big ones, raising the problem of ‘too big to fail’. So, there
is a trade-off between cost of moral hazard and benefit of preventing crises, that is why
lender-of-last resort function should be used very infrequently, but very quickly.
Finally, empirical evidence supports the view that if output is sluggish, inflation is relatively
high, or the current account is unbalanced, it is costly to defend the exchange rate, and that
triggers speculative pressures. It’s natural to conclude that the policy mix chosen to prevent
currency crises depends greatly on the circumstances in which these policies are
implemented. There is no uniform approach, moreover, macroeconomic conditions rather
than macroeconomic policy usually contributes to evolving of crises. So, prevention policy
should be first of all aimed at establishing healthy macroeconomic environment in general,
and healthy financial system in particular.
Conclusion
In this paper we showed that it is important to prevent currency crises because of the high
costs they impose in terms of potential growth reduction. The nature and propagation
mechanisms of currency crises point out the relevance of government intervention in crisis
management. The experience of the East Asian crisis shows that the adoption of the classical
mix of macroeconomic policies is not sufficient to restore investors’ confidence, as it doesn’t
eliminate its real causes. We argue that financial sector weaknesses typically play the key
role in crisis propagation, therefore, reforms of financial sector should be put high on
authorities’ agendas. The failure to prevent crisis usually also stems from the weakness of
financial system, that is why we reach the conclusion that proper measures for prevention
and management of crises are basically the same.
17
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