Understanding Financial Crises
Franklin Allen and Douglas Gale
Clarendon Lectures in Finance
June 9-11, 2003
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Lecture 2
Currency Crises
Franklin Allen
University of Pennsylvania
June 10, 2003
http://finance.wharton.upenn.edu/~allenf/
2
Introduction
Major theme of the banking crises literature

Central bank/government intervention is
necessary to prevent crises
From 1945-1971 banking crises were
eliminated but currency crises were not
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Many of the currency crises were due to
inconsistent government macroeconomic
policies


Explanations of currency crises are based
on government mismanagement
Contrasts with banking literature where
central banks/government are the solution
not the problem
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First generation models


Krugman (1979) and Flood and Garber
(1984) show how a fixed exchange rate
plus a government budget deficit leads to
a currency crisis
Designed to explain currency crises like
that in Mexico 1973-82
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

Salant and Henderson (1978): Model to
understand government attempts to peg
the price of gold
Market Solution: Earn r on gold holdings
P(t) = P(0) ert
Ln P(t) = Ln P(0) + rt
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Ln P(t)
Ln Pc
Ln P(0)
T
t
7
If the government pegs price at P*, what
does the price path look like?
Ln P(t)
Ln Pc
Ln P*
T
t
Can’t be an equilibrium because of
arbitrage opportunity
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Ln P(t)
Ln Pc
Ln P*
T’
T
t
Equilibrium: Peg until T’ then there is a
run on reserves and the peg is abandoned
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Krugman (1979) realized that the model
could be used to explain currency crises


Government is running a fiscal deficit
It can fix the exchange rate and
temporarily fund the deficit from its
foreign exchange reserves
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There is an exchange rate over time such
that the “inflation tax” covers the deficit
Ln S(t)
Ln S*
T’
t
Equilibrium has predictable run on
reserves and abandonment of peg
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Problems with first generation
models

Timing of currency crises is very unpredictable

There are often jumps in exchange rates

Government actions to eliminate deficits?

E.g. ERM crisis of 1992 when the pound and the
lira dropped out of the mechanism
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Second generation models

Obstfeld (1996): Extent government is prepared to fight
the speculators is endogenous. This can lead to multiple
equilibria.

There are three agents

A government that sells reserves to fix it currency’s
exchange rate

Two private holders of domestic currency who can
continue to hold it or who can sell it to the government
for foreign currency
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
Each trader has reserves of 6

Transactions costs of trading are 1

If the government runs out of reserves it
is forced to devalue by 50 percent
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High Reserve Game: Gov. Reserves = 20
Trader 1


Hold
Sell
Trader 2
Hold
0,0
-1,0
Sell
0,-1
-1,-1
There is no devaluation because gov. doesn’t
run out of reserves. If either trader sells they
bear the transaction costs.
The unique equilibrium is (0, 0)
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Low Reserve Game: Gov. Reserves = 6
Trader 1


Hold
Sell
Trader 2
Hold
0,0
2,0
Sell
0,2
0.5,0.5
Either trader can force the government to
run out of reserves
The unique equilibrium is (0.5, 0.5)
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Medium Reserve Game: Gov. Reserves = 10
Trader 1


Hold
Sell
Trader 2
Hold
0,0
-1,0
Sell
0,-1
1.5,1.5
Both traders need to sell for a devaluation to
occur
Multiple equilibria (0.5, 0.5) and (1.5,1.5)
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Equilibrium selection

Sunspots – doesn’t really deal with issue

Morris and Shin (1998) approach

Arbitrarily small lack of common knowledge
about fundamentals can lead to unique
equilibrium
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With common knowledge about
fundamentals e.g. currency reserves C
Unique
Peg fails
CL
Multiple
CU Unique
Peg holds
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With lack of common knowledge
Unique
C*
Peg fails
Unique
Peg holds

Major advance over sunspots

Empirical evidence?
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Twin Crises

Kaminsky and Reinhart (1999) have investigated
joint occurrence of currency and banking crises


In the 1970’s when financial systems were highly
regulated currency crises were not accompanied by
banking crises
After the financial liberalizations that occurred in the
1980’s currency crises and banking crises have
become intertwined
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


The usual sequence is that banking sector
problems are followed by a currency crisis and
this further exacerbates the banking crisis
Kaminsky and Reinhart find that the twin
crises are related to weak economic
fundamentals - crises when fundamentals are
sound are rare
Important to develop theoretical models of
twin crises
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Panic-based twin crises


Chang and Velasco (2000a, b) have a
multiple equilibrium model like Diamond
and Dybvig (1983)
Chang and Velasco introduce money as an
argument in the utility function and a
central bank controls the ratio of currency
to consumption
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


Banking and currency crises are “sunspot
phenomena”
Different exchange rate regimes
correspond to different rules for regulating
the currency-consumption ratio
Policy aim is to reduce parameter space
where “bad equilibrium” exists
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Fundamental-based twin crises
Allen and Gale (2000) extends Allen and
Gale (1998) to allow for international
lending and borrowing


Risk neutral international debt markets
Consider small country with risky
domestic assets
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Banks



Use deposit contracts with investors
subject to early/late liquidity shocks
Can borrow and lend using the
international debt markets
Domestic versus dollar loans
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Domestic currency debt
Risk sharing achieved through:

Bank liabilities



Deposit contracts
Large amount of domestic currency bonds
Bank assets


Domestic risky assets
Large amount of foreign currency bonds
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


Government adjusts exchange rate so the value
of banks’ foreign assets allows them to avoid
banking crisis and costly liquidation
Risk neutral international (domestic currency)
bond holders bear most of the risk while
domestic depositors bear little risk
If portfolios large enough all risk transferred to
international market
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

Viable system of international risk sharing
for developed countries whose banks can
borrow in domestic currency
Many emerging countries’ banks cannot
borrow in domestic currency because of
the fear of inflation – they must borrow
using dollar-denominated debt
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Dollar-denominated debt

The benefits that a central bank and
international bond market can bring are reduced

Dollarization: The central bank may no longer be

Dollar debts and domestic currency deposits: It may
able to prevent financial crises and inefficient
liquidation of assets
not be possible to share risk with the international
bond market
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Policy Implications
Is the IMF important as lender of last
resort like a domestic central bank
(Krugman (1998) and Fischer (1999)
OR
 It misallocates resources because it
interferes with markets (Friedman (1998)
and Schwartz (1998)?

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
Framework above allows these issues to
be addressed


Case 1: Flexible Exchange rates and Foreign
Debt in Domestic Currency – No IMF needed
Case 2: Foreign Borrowing Denominated in
Foreign Currency – IMF needed to prevent
banking crises with costly liquidation and
contagion
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Conclusions



When is government the problem and
when is it the solution?
The importance of twin crises
Interaction of exchange rate policies and
bank portfolios in avoiding crises and
ensuring risk sharing
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