- Catherine Pattillo, Andrew Berg, Gian Milesi-Ferretti, and Eduardo Borensztein
- Published Date:
- January 2000
This appendix provides a selective review of the economic literature on currency crises, focusing on the explanations that have been advanced of the determinants and the processes leading to crises.37
In his seminal paper on balance of payments crises, Krugman (1979) considers a small open economy with a pegged exchange rate where domestic credit expands continuously, typically to finance a budget deficit. The peg is sustained by a positive stock of foreign exchange reserves, but reserves are gradually depleted as agents continuously buy foreign currency as a result of the imbalance between the expanding domestic credit and the stable money demand. Krugman shows that reserves will eventually be wiped out by a speculative attack once they have reached a sufficiently low level, even though there is no change in policies to trigger the attack. With well-informed, rational speculators assessing the situation, the currency attack will take place only when the transition from the pegged exchange rate to its successor system (presumed to be a float) yields the required return to speculators. Although the policy inconsistency that condemns the exchange rate system is well recognized in advance, and the eventual demise of the peg is known to be unavoidable, it is not profitable to launch an attack too early (or to wait too long). In fact, the determination of the timing of the attack is the main analytical question that first-generation models attempt to answer.
Although Krugman's model is very stylized, and may seem artificial, other models have extended his framework to capture the features usually present in balance of payments crises. With some degree of price sluggishness or the introduction of nontraded goods, the buildup to a crisis features an appreciating real exchange rate and widening current account deficits (Calvo, 1987). Introducing some degree of uncertainty, the timing of the devaluation cannot be exactly predicted and a “peso problem” emerges, that is, a persistent divergence between nominal domestic and foreign interest rates owing to the expectation of an impending devaluation (Krasker, 1980; Penati and Pennacchi, 1989).
Several empirical studies of devaluations have found common features that are consistent with the framework of first-generation models. Indeed, large devaluations in developing countries have often been preceded by expansionary fiscal and monetary policies, interest rate premia, real exchange rate appreciations, and widening current account imbalances (Edwards, 1989). Analyses of individual country experiences have also found a link between excessive credit growth and subsequent crises in a number of case studies of devaluations including in Mexico, Argentina, Italy, and France.38
The breakdown of the exchange rate mechanism (ERM) of the European Monetary System (EMS) in 1993 and the Mexican crisis of 1994 spurred a reconsideration of the explanations of exchange rate crises offered by the economic literature. Some aspects of those crises were hard to reconcile with traditional models of speculative attacks for two reasons. First, as underscored by Obstfeld and Rogoff (1995) among others, the decision to abandon an exchange rate peg in the context of the ERM crises was not due to the exhaustion of foreign exchange reserves, but to the reluctance of governments to fight prolonged speculative attacks with high interest rates. In this regard, the second-generation models explain speculative attacks in a context in which the government decisions take into account the costs and benefits involved in abandoning the peg. In contrast, first-generation models provide no explicit rationale for government policy actions.
The second reason for reassessing theories of currency crises was the unexpected and apparently inexplicable nature of some of these crises, which led several observers to suggest the possibility that self-fulfilling expectations may have played a prominent role (see Eichengreen and Wyplosz (1993) for an interpretation of the EMS crisis along those lines, and Sachs, Tornell, and Velasco (1996b) and Cole and Kehoe (1996) for such an interpretation of the Mexican crisis). For example, France was subject to repeated speculative attacks that led to a widening of the fluctuation band vis-à-vis the deutsche mark, even though traditional “fundamentals” were not visibly out of line—France had modest fiscal imbalances, its real exchange rate had not appreciated, and it was running a current account surplus.
But how can self-fulfilling crises occur? The key feature is the link between the government's assessment of the costs of maintaining the peg and the private sector's expectations. If private investors expect that the peg might be abandoned, the cost to the government of maintaining a fixed exchange rate becomes higher, and this may indeed lead it to devalue the currency, thus validating market expectations. Obstfeld (1994) provides several examples. One is based on the impact of high government debt. When expectations of an impending devaluation are built into nominal interest rates, maintaining the peg will raise the real debt burden significantly. Under the circumstances, the government might find it too costly to keep the exchange rate unchanged. Conversely, if no devaluation is expected, the cost for the government of maintaining the peg is reduced and the peg will be maintained (see also Bensaid and Jeanne, 1997).39
It is important to underscore that the possibility that crises can be self-fulfilling does not imply that the likelihood of an attack is unrelated to fundamentals. Indeed, in second-generation models, there is typically a range of “strong” fundamentals in which a speculative attack would not occur, that is, the government would never find it advantageous to validate market expectations and devalue the currency. Under these circumstances, it would indeed not be rational for market participants to expect a depreciation. Similarly, there is a range of “weak” fundamentals where the cost of defending the peg (the temptation to devalue) is so high that a speculative attack forcing the abandonment of a peg is inevitable. Finally, there is an intermediate “vulnerable” range of fundamentals, in which a peg could survive if expectations were favorable but would be abandoned if an attack were to materialize (Obstfeld, 1996). A shortcoming of these models is that they do not explain what reasons determine whether the attack takes place or the peg is maintained (see the discussion in Masson, 1998).
Second-generation models suggest that crises may be inherently difficult to predict because the currency attacks may or may not materialize rather than being the inevitable and predictable outcome of a progressive deterioration in fundamentals. Yet, although these models and the various country experiences suggest a number of additional indicators of vulnerability to a currency crisis, they do not differ sharply from those suggested by first-generation models. Both kinds of models of speculative attacks have a similar implication: attacks always occur in countries with weak (or “vulnerable”) fundamentals in the macroeconomic sense. In fact, it is usually hard to distinguish whether fundamental policy inconsistencies or self-fulfilling attacks provide the best explanation for a certain episode.40
Role of Asset Markets
The models reviewed so far focus squarely on macroeconomic policy. A peg can be abandoned either because of a policy inconsistency or because of a government policy decision that weighs costs and benefits of maintaining the peg. However, some aspects of the Mexican crisis and, especially, the more recent crises in several Asian countries seem to be related to market failures in asset markets or distortions in the financial system, rather than resulting from clear macroeconomic imbalances or an exchange rate misalignment. In all of these episodes, investors refused to roll over short-term debt (Tesobonos in the case of Mexico) and redeemed the proceeds in foreign currency. Authors such as Calvo (1997) have stressed taking a broader view of asset markets rather than focusing exclusively on the evolution of international reserves. For example, if the government is running an unsustainable deficit but resorts to bond financing rather than monetization of the deficit, international reserves may be stable, rather than declining, in the period leading to an attack. The speculative attack essentially occurs in bond markets, as agents refuse to roll over short-term government paper and convert the proceeds into foreign currency.
Although the linkage between financial sector problems and balance of payments crises received prominent attention only after the Mexican crisis in 1994 and, especially, after the Asian crisis, it had played an important role in previous episodes (see Diaz-Alejandro (1985) for an insightful discussion). For example, the 1982 crisis in Chile was preceded by a period during which the conduct of fiscal policy was conservative, but the private sector borrowed extensively on international markets. The presence of explicit and implicit government guarantees created a severe moral hazard problem, and external shocks precipitated a crisis that resulted in a costly bailout of the banking system and a “socialization” of private external liabilities. With this experience in mind, Velasco (1987) presents a model of currency and banking crises where a negative external shock reduces the value of banks' assets, but because of the deposit guarantee banks do not liquidate bad loans, relying instead on external borrowing to cover their losses. Once access to external borrowing is curtailed, the government has to intervene and bail out the banks. The costs of the bailout and the “socialization” of banks' external liabilities leads to a depletion of foreign exchange reserves and a collapse of the peg. More generally, in situations in which the banking system is fragile because of maturity or currency mismatches, crises can occur because the role of the central bank as lender of last resort comes into conflict with the need to defend the exchange rate peg.
In the Chilean crisis of 1982, self-fulfilling expectations played no role as the crisis was essentially inevitable given the deposit guarantee scheme and the banks' behavior. In contrast, Goldfajn and Valdes (1997) and Chang and Velasco (1998) highlight the role of banking fragility in making a country more vulnerable to speculative attacks. Bank runs based on self-fulfilling expectations can cause the collapse of a solvent but illiquid domestic banking system, as foreign investors refuse to extend credit or roll over existing loans, in a framework similar to that of the well-known banking model of Diamond and Dybvig (1983). Even such purely speculative financial crises can generate large output costs, because banks may be forced to liquidate potentially profitable but illiquid long-term assets to face a liquidity squeeze. A number of factors can make an economy more vulnerable to this type of “run,” among them, a large share of short-term external debt and a lowering of reserve requirements. Empirical evidence presented by Kaminsky and Reinhart (1999) indeed shows that banking crises tend to precede balance of payments crises.41
In addition to underlining the importance of asset market problems, the recent Asian crisis has drawn attention to the moral hazard generated by implicit government guarantees of private sector external liabilities. In Krugman (1998), government provision of (implicit) bailout guarantees leads to private sector overinvestment and asset price inflation.42 If the bailout guarantee is not unlimited, asset prices will eventually collapse as the bubble bursts.43 Corsetti, Pesenti, and Roubini (1998) tell a similar story. In their model, the existence of (implicit or explicit) government guarantees leads firms to “overborrow” from abroad. The guarantees, however, are not unlimited. Under these circumstances, it can be shown that a period of overborrowing can be followed by a sudden withdrawal of external funds once doubts surface over the ability or willingness of the government to cover existing losses. These interpretations of crises do not necessarily emphasize self-fulfilling expectations—rather, they rely on the existence of a fundamental distortion that leads to a gradual buildup of imbalances. One interesting aspect is that the contingent nature of these government liabilities implies that fiscal imbalances will emerge expost, but may not be detectable ex ante.44
Recent experience has also focused attention on distortions generating large capital inflows and their later reversal. A model by Dooley (1997) postulates that governments provide insurance against external shocks to the private sector, which is thus enticed to borrow at above-market rates.45 This attracts capital to the country. However, the available resources of foreign exchange reserves for paying “insurance claims” are limited. This implies that the degree of insurance is declining over time, and therefore the rates of interest that the private sector can afford to pay must also be declining, making the reversal of capital flows eventually unavoidable. When foreigners withdraw their funds, the government steps in to bail out the private sector, but in so doing it depletes its foreign exchange reserves and a crisis occurs. Dooley underlines that if one includes in the government's “war chest” funds made available by international organizations then the moral hazard problem that leads to the capital inflow-crisis sequence is worsened. He also notes that the model provides a simple explanation for contagion: namely, a large bailout by, say, the IMF or the international community may reduce the resources available for similar bailouts in other developing countries.
Role of Contagion
A feature shared by all the major financial crises of the 1990s—the EMS, the Mexican peso and its tequila effects, Asian currencies, and the Russian ruble—is the spreading of difficulties from one country to another, generally referred to as “contagion.” In practice, many factors can account for this phenomenon. First, a crisis in one country may be triggered by a large shock common to several countries—for example, an increase in interest rates on world markets—in which case the crisis can be expected to affect other countries particularly vulnerable to this type of shock.46 Second, devaluation by one country can affect other countries through “spillover effects.” These can occur through several channels. For example, countries that either trade intensively with the country in question or compete with it in third markets will experience a loss in competitiveness and a fall in external demand.47 The recent crises in East Asia and Russia also highlighted the importance of spillover effects that work through the capital account. For example, the Russian crisis affected the profitability and risk appetite of hedge funds, banks, and other investors, leading to portfolio adjustments that spread difficulties to other markets.48 Russia's crisis may have led to a revision in expectations concerning the possibility that the IMF would act as a lender of last resort.
Contagion effects proper, in Masson's (1998) taxonomy, occur when crises spread even in the absence of changes in macroeconomic fundamentals. This may occur because of incomplete information and herd behavior on the part of private investors so that a small shock may trigger a massive outflow of capital from several emerging market countries. For example, Calvo and Mendoza (1997) present a model in which investment fund managers choose to “follow the herd” if they are evaluated based on their relative performance vis-à-vis other managers.49 This type of “collective action” problem increases the likelihood of large swings in capital flows even in the absence of correspondingly large changes in fundamentals. A crisis can also act as a “wake-up call.” For example, Goldstein (1998) argues that after the Thai crisis investors reassessed the economic and financial situation of other countries in the region and found them to be less creditworthy than previously believed.
Empirical work on contagion is still at a preliminary stage. The most basic contagion studies assess whether the existence of speculative attacks elsewhere in the world increase the probability of a currency crisis, controlling for a country's macroeconomic, financial, and external sector factors. Studies use either a simple zero/one variable indicating whether there was a crisis elsewhere in the world, or a measure of the number of recent crises in other countries that gives more weight to the most recent crises (see Eichengreen and others, 1996b) and J.P. Morgan, 1998). There is also some evidence that contagion may have a regional dimension (Krueger and others, 1998). However, this finding may be due to the fact that countries within a region often have strong trade ties. In fact, some studies suggest that trade linkages are an important factor of contagion: countries that have strong trade links or compete in an export market with a country experiencing a crisis are themselves more likely to have a crisis (see Eichengreen and others, 1996b and Glick and Rose, 1998). For some episodes, however, it seems difficult to argue that trade links were the only, or even an important, channel of transmission (for example, the pressure on Brazil following the collapse of the Russian ruble in August 1998). Partly for this reason, some analysts have focused on similarities across countries in macroeconomic policies and conditions. However, the hypothesis that contagion spreads more easily to countries with similar macroeconomic fundamentals has not found much empirical support. Testing more directly the importance of financial market spillovers is inherently more difficult, because it would, inter alia, require information on the positions of financial institutions on a global scale.
A currency crisis usually refers to a situation in which speculative attacks force a sharp devaluation. A balance of payments crisis is a broader concept that involves a shortage of reserves to cover balance of payments needs. This paper focuses on balance of payments crises as well as currency crises. Empirically, this means that the paper considers situations in which speculative attacks force a sharp drop in international reserves or a sharp devaluation or both. Furthermore, although most of the theoretical literature concentrates on attacks against a pegged exchange rate regime, this paper takes a broader view, considering also the possibility of speculative attacks against more flexible regimes, such as managed floats.
Most notably, Kaminsky, Lizondo, and Reinhart (1998). More detailed references are provided in Sections III and IV.
The staff at a number of institutions, including the Federal Reserve Board, the Federal Reserve Bank of New York, and the Bank for International Settlements are also undertaking research in the area of early warning systems to complement their analysis of financial markets.
While all models try to anticipate exchange rate movements, some of them take a broader focus and try to anticipate both currency crashes and failed attacks. The latter are evidenced by losses in international reserves and/or sharp increases in domestic interest rates.
The figure is from Goldfajn and Valdes (1999), where a more systematic analysis of exchange rate expectations is conducted. See also Agenor and Masson (1999).
While it is possible that an increase in the expected devaluation was offset by other factors, in particular the change in the composition of Mexican debt toward dollar-indexed securities (Werner, 1996), there was not an unequivocal signal of higher expected depreciation that could be picked up from interest differentials.
Actions by rating agencies such as Moody's and Standard and Poor's have also not provided reliable leading indicators, as in the case of the recent Asian currency crises (Adams, Mathieson, Schinasi, and Chadha, 1998, Box 2.13).
Other prescriptions had to do with the nature of the relationships between countries and their creditor banks: to favor market-based options for debt renegotiations and to avoid a socialization of private debts at time of distress.
An exception may be Diaz-Alejandro (1985) with reference to Chile.
But the fiscal situation would have been considered less favorably if allowance was made for the contingent liability of the government arising from the support to financial institutions that might become necessary. But even making such allowance, the fiscal position would not have suggested an unsustainable burden.
It is noteworthy that the reserves to imports ratio, the traditional measure of reserves adequacy has become obsolete for many emerging economies with large capital inflows and outflows.
Eichengreen, Rose, and Wyplosz (1995); Frankel and Rose (1996); Kaminsky and Reinhart (1999); and Milesi-Ferretti and Razin (1998) use event studies in addition to other approaches. See also Moreno (1995).
Studies analyzing advanced economies, such as Eichengreen, Rose, and Wyplosz (1995), typically combine information on interest rate changes, reserve changes, and exchange rate changes into an index of speculative attack. This is generally not possible for developing countries because historical data on market interest rates are often not available.
For example, using the original Frankel-Rose definition it is found that countries with an exchange rate peg are less likely to suffer a currency crisis. This result, however, does not hold when the definition of crisis is changed. The reason is that countries with high inflation (which are “overrepresented” in the sample of currency crises using the basic Frankel-Rose definition) typically do not (cannot) peg their exchange rates.
They find that an appreciated real exchange rate, high current account deficits, and a low ratio of reserves to broad money, among other indicators, increase the probability of a crisis.
Glick and Rose (1998) look at crises in several cross sections of countries in years of widespread currency crises. They find that the incidence of crisis across countries is partly explained by trade linkages with the country that initiated the round of contagion (for example, Mexico in 1994–95). This would not help predict and does not even help with relative vulnerabilities, unless one knows which country initiates the contagion.
A recent development is models produced by several investment banks to forecast the probabilities of large currency depreciations. The banks' studies seek to provide information that could be profitable to participants in foreign exchange markets, often using models similar to those in the third category above. (See Event Risk Indicator Handbook of J.P. Morgan, Emerging Markets Risk Indicator of Credit Suisse First Boston, Emerging Markets Strategy of Lehman Brothers, Early Warning System of Citicorp, and GS-Watch of Goldman Sachs.)
This approach has the disadvantage that it cannot do better than the market itself, whereas one of the goals of a warning system is to provide early warning. As we saw in Section II, market expectations of crisis typically do not rise until very shortly before the crisis.
Another potentially important category of variables, not included in the studies considered here, are political variables, such as the timing of elections.
The findings in this chapter are based on Berg and Pattillo (1999a).
Their approach has also been applied to the Asian crisis. Tornell (1998), Radelet and Sachs (1998b), and Corsetti and others (1998) estimate variants of STV for 1997. IMF (1998) constructs a composite indicator of crisis based on the STV approach and argues that it accords well with the pattern of country experience in the Asian crisis.
The countries in the different samples are listed in footnotes to Table 3.
An alternative, less exacting benchmark would be to consider a crisis as correctly called whenever an indicator signaled “at least once” within the 24 months prior to each crisis. On this measure, the average good indicator signaled before 66 percent of the crises.
More precisely, the model issued a signal in 46 percent of the months in the two years prior to each crisis.
Weak banking systems are proxied in a somewhat crude way by the presence of a “lending boom” under the view that rapid expansion of bank assets is associated with a deterioration of the quality of those assets.
The original STV results, with a slightly different sample, are more successful in fitting the 1994–95 crises.
The objective of the original STV exercise was largely to explain, not predict, the incidence of crises. Tornell (1998) and others have used the same framework with a more explicit predictive intent.
The KLR approach, in contrast, assumes that the probability of crisis in the subsequent 24 months is a step function of the value of the indicator, equal to 0 when the indicator variable is below the threshold and equal to 1 at or above the threshold. Berg and Pattillo (1999b) found that a probit model with variables entered linearly had somewhat higher predictive power than the pure threshold framework.
See Berg and Pattillo (1999b) for a full discussion of the specification and estimation of the DCSD model.
Actually, a few countries came very close to meeting the F R conditions for identification of a crisis, most notably Indonesia and Turkey.
It is remarkable that, applying a probability cutoff of 50 percent, the predictions generated on the basis of the KLR model do not forecast any crisis in the whole May 1995-December 1997 period.
In the KLR, STV, and DCSD models, a crisis is defined to occur when a weighted average of the exchange rate depreciation and loss of reserves exceeds its average by a certain magnitude. FR define a crisis as an exchange rate depreciation of at least 25 percent that also exceeds the previous year's depreciation by at least 10 percent.
For comprehensive reviews of the theoretical and empirical literature, see Garber and Svensson (1995) and Flood and Marion (1998a). Agenor, Bhandari, and Flood (1992) provide a useful survey of the literature on first-generation speculative attacks.
See Calvo (1988) for an earlier application of this idea to the problem of the persistence of high inflation rates.
See Jeanne (1997) for an attempt to detect the effect of self-fulfilling expectations.
See also Demirguc-Kunt and Detragiache (1998).
Domestic financial intermediaries will base their decisions on “Panglossian values” for rates of return (i.e., rates of returns that are based only on favorable circumstances, given the government guarantee that would come into effect should circumstances prove unfavorable).
Note that even in this setting in which a crisis is inevitable, self-fulfilling expectations can accelerate the collapse. The reason is that the size of the bailout depends on the magnitude of the fall in asset prices. While government resources may be sufficient to undertake a full bailout for given expectations about asset prices (which would imply no crisis yet) they may be insufficient if asset prices collapse. If agents expect this to occur, they will precipitate a crisis.
It should also be noted that the bursting of an asset price bubble can simply imply that asset prices revert to their fundamental values. In contrast, in models emphasizing lack of liquidity, such as Chang and Velasco (1998), potentially viable projects are liquidated and asset prices can fall below their fundamental value, emphasizing the importance of providing liquidity.
In other words, the existence of insurance is equivalent to an implicit transfer from the government. Some of the proceeds from this transfer are appropriated by domestic financial intermediaries and the rest by foreign lenders, who earn above-market rates on implicitly guaranteed assets.
Masson (1998) refers to the effects of type of shock as “monsoonal effects.”
Gerlach and Smets (1995) provide a theoretical illustration of this channel and an application to Sweden and Finland.
Valdes (1996) highlights how lack of liquidity in one market hit by a crisis may cause contagion by leading financial intermediaries to liquidate positions in other emerging markets.
Their idea is similar to the one in Scharfstein and Stein (1990), who show that “bad” portfolio managers would mimic the behavior of others so as to “hide in the herd.” Calvo and Mendoza also highlight how investors may react to rumors about future returns in a country by shifting their resources out of a country instead of trying to ascertain (at a cost) whether the rumors are founded. If emerging market securities represent a small share of their portfolios, investors would choose not to spend resources trying to ascertain whether the rumor is accurate.
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Note: For information on the title and availability of Occasional Papers not listed, please consult the IMF Publications Catalog or contact IMF Publication Services.