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I would like to thank Ben Bernanke, Donald Mathieson, and Kenneth Rogoff for their comments. All remaining errors are mine.
In the ERM crisis, the countries which were driven off their pegs generally did better in the following period than those that stuck with their currencies. In the Latin American and Asian crises, however, the decision to devalue have led to severe short-run consequences for the real economy.
Indonesia was the only country that experienced a significant bank run.
Since the focus is on the real effects of devaluations, only the experiences of those countries which left the ERM are examined. These include the UK, Italy, Spain, Finland, Portugal, and Sweden
Most of these external liabilities were not hedged because exchange rates were, in many cases, rigidly pegged to the US dollar with either limited variation or very predictable change. Thus investors perceived little risk in such obligations. Ironically, the Asian pegs seem to have enjoyed too much credibility prior to the crisis.
The barrier against equity financing in developing countries are due primarily to informational asymmetries and the associated problems of adverse selection and moral hazard. See Mishkin (1996) for a discussion.
It is often argued that Britain’s departure from the ERM in 1992 was motivated by such a trade-off.
For simplicity it is assumed that banks’ assets are all denominated in the local currency. Relaxing this assumption makes no difference as long as foreign liabilities outweigh foreign assets so that a depreciation still reduces net worth.
Here, the shock is taken to affect the overall net worth of banks. Alternatively, it could have been assumed that the shock affected only specific components of net worth, but at the cost of a less clean exposition. In any case, the underlying results and intuition are exactly the same.
Note that the expected cost of funds takes into consideration the case where foreign investors are repaid out of domestic bank’s net worth. The expected cost of this outcome is (1 – θ) (1 – q) (1 + R) L.
Implicit in (8) is the assumption that the expected rate of depreciation is zero, otherwise there would an additional term to reflect compensation for this risk. This simplifying assumption is made since the focus is on what happens after a devaluation rather than what causes one.
It is also worth noting that currency crises are often associated with stock market declines which may hurt the assets of banks also. This is likely to compound the effects of increased debt burdens by reducing net worth even more with the consequence that any negative effects of the depreciation on the real economy will be magnified.
There is actually one other effect, the expected payment in the case of a default per unit of loan,
In this case, domestic banks’ cost of funds is equal to (1 + r*) L regardless of whether firms default or not. It is as if domestic banks were lending out of their own funds at the opportunity cost of (1 + r*) L.