Transcript Chapter 7

Chapter 7
Currency Crises and Financial
Volatility
© Pierre-Richard Agénor
The World Bank
1
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Sources of Exchange Rate Crises
Currency Crises: Recent Experiences
Currency and Banking Crises
Predicting Financial Crises
Sources and Effects of Financial Volatility
Coping with Financial Volatility
2
Sources of Exchange Rate
Crises


Inconsistent Fundamentals
Rational Policymakers and Self-Fulfilling Factors
3
Inconsistent Fundamentals
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Conventional or first-generation model of currency
crises was formulated by Krugman (1979) and
Flood and Garber (1984).
Single (tradable) good, full-employment, small
open-economy model with exogenous output.
Assumptions:
Foreign-currency price of the good is fixed and
domestic price level is equal to the nominal
exchange rate due to purchasing power parity.
Perfect foresight agents hold three categories of
perfect substitutes assets: domestic money, and
domestic and foreign bonds.
4
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Demand for money depends positively on output
and negatively on the domestic interest rate.
Uncovered interest parity equates the domestic
interest rate to the foreign rate plus the expected
rate of depreciation of the nominal exchange rate.
There are no private banks, so that the monetary
base is equal to the sum of domestic credit issued
by the central bank and the domestic-currency
value of foreign reserves held by the central bank.
The central bank pegs the exchange rate through
unsterilized intervention.
Domestic credit expands at a constant growth rate
to finance the government budget deficit.
5
md = p + y - i,  > 0,
hs = d + (1 - )R, 0 <  < 1,
.
d =  > 0,
p= e,
.
i = i* + e.
md: nominal money demand; p: price level;
y: real output; hs: nominal supply of base money;
d: domestic credit; e: spot exchange rate;
i*: constant foreign interest rate; i: domestic interest
rate;
R: domestic-currency value of the foreign reserves
6
held by the central bank.

Assume  = 0 and ms = 2hs:
ms = d + R.

Money market equilibrium:
ms = md = m.

Assume i* = 0:
.
m - e = y - e.
7

.
When exchange rate is credibly fixed at e = e, e =
0:
m = e- + y.

Under a fixed-exchange-rate regime, the rate of
depreciation is zero and real money balances are
also constant because output is constant.

In this case official reserves and growth rate of it:
R = y + e - d,
.
R = - .
8
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For the nominal money supply to remain constant
and ensure equilibrium of the money market, official
reserves must fall at the same rate as the rate of
credit expansion.
When  > 0, any finite stock of official reserves will
be exhausted in a finite period of time.
Once foreign reserves reach a lower bound (Rmin)
the central bank will be unable to defend the
prevailing parity and will be forced to abandon the
pegged-rate regime: natural collapse.
9
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With  > 0, rational agents will anticipate that,
without speculation, reserves will eventually fall to
the lower bound, and will therefore foresee the
ultimate collapse of the system.
At that point, the rate of depreciation will jump from
zero to a positive value; i will jump upward, and md
will fall.
To maintain money market equilibrium, the real
money supply must also fall; and because the
nominal money stock cannot change in a discrete
manner, the nominal exchange rate must undergo
a step depreciation.
Rise in prices imposes therefore a capital loss on
agents holding domestic-currency assets.
10
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
Speculators endowed with perfect foresight will not
wait passively to absorb the capital loss; they will
attempt to reduce their holdings of domestic assets
and in the process will force a crisis before the
lower bound on reserves is reached.
Issue: determine the exact moment at which the
fixed-exchange-rate regime is abandoned or,
equivalently, the transition time to a floating-rate
regime.
Flood and Garber (1984): this transition time
can be calculated through a backward-induction
process:
11
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In equilibrium, under perfect foresight, agents can
never expect a discrete jump in the level of the
exchange rate, because a jump would provide
them with profitable arbitrage opportunities.
So arbitrage in the foreign exchange market
requires the exchange rate prevailing immediately
after the attack to be equal to the fixed rate
prevailing at the time of the attack.
Time of collapse is found at the point where the
shadow floating rate, the exchange rate that
would prevail if reserves had fallen to the minimum
level and the exchange rate were allowed to float
freely, is equal to the prevailing fixed rate.
12

Time of collapse:
tc = (R0 - Rmin)/  - ,


R0: initial stock of reserves.
Implications:
The higher R0, the lower Rmin, or the lower , the
longer it will take for the collapse to occur.
With no speculative demand for money ( = 0) the
collapse occurs when reserves are run down to
Rmin.
13
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The interest rate (semi-) elasticity of money
demand determines the size of the downward shift
in money balances and reserves that takes place
when the fixed exchange-rate regime collapses;
 nominal interest rate jumps to reflect an
expected depreciation of the domestic currency;
 the larger  is, the earlier the crisis.
The speculative attack always occurs before the
CB would have reached the minimum level of
reserves in the absence of speculation.
14

Stock of reserves just before the attack:
Rtc- = Rmin+ .
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Figure 7.1: The path continuing through point A
corresponds to the natural collapse ( = 0).
At that point the rate of depreciation of the
exchange rate jumps from zero to  and the
domestic interest jumps from i* to i* + .
Expected capital loss leads to a speculative attack.
e remains constant at e- until the collapse occurs
and begins depreciating smoothly at point B.
15
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16
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The domestic interest rate, as a result of the
interest parity condition jumps by  at the moment
the attack takes place (from F to F`).
Prior to the collapse, the money stock is constant.
In the postcollapse regime, the money stock is
equal to Rmin plus domestic credit, and grows also
at the rate  .
After speculative attack both reserves and the
supply of money fall by  .
The size of the attack,  , corresponds exactly to
the reduction in money demand induced by the
upward jump in the domestic interest rate.
17
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Extension (Agénor and Flood, 1994):
nature of the fiscal constraint that underlies the
assumption of an exogenous rate of credit growth
and the factors that may prevent policymakers from
adjusting their fiscal and credit policies to prevent a
crisis;
nature of the postcollapse exchange-rate regime;
output, real exchange rate, and current account
implications of an anticipated exchange-rate crisis;
role of external borrowing and capital controls;
uncertainty over the critical threshold of reserves
and the credit policy rule.
18
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Ozkan and Sutherland (1995): fixed exchange rate
system can survive longer with capital controls. But
anticipation of controls may have exactly the
opposite effects.
Dellas and Stockman (1993): possibility of
introducing capital controls may generate selffulfilling crises.
Introduce uncertainty on domestic credit
growth:
sharp increases in domestic nominal interest rates
that often precede an exchange-rate crisis can be
explained.
19
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Other implications:
The transition to a floating-rate regime becomes
stochastic and collapse time becomes a random
variable that cannot be determined explicitly.
There will be a nonzero probability of a
speculative attack in the next period, a possibility
that in turn produces a forward discount on the
domestic currency (peso problem).
Reserve losses tend to exceed increases in
domestic credit because of a rising probability of
regime collapse.
Reserve depletion tends therefore to accelerate
prior to the regime change (as observed in actual
crises).
20
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Key assumption of the conventional model: money
supply falls, in line with money demand, at the
moment the currency attack takes place.
But if reserve losses are completely sterilized,
there will be no discrete jump in the money supply.
Flood, Garber, and Kramer (1996):
In such conditions a fixed exchange rate regime
cannot be viable; as long as agents understand
that the central bank plans to sterilize an eventual
speculative attack, they will attack immediately.
By adding a risk premium, fixed exchange rate
can remain viable under sterilized intervention.
21
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Risk premium adjusts to keep the md constant when
the attack occurs, just as sterilization maintains ms
constant.
Problem: since ms does not change and e cannot
jump, the domestic interest rate cannot jump
either (in contrast to empirical evidence).
Evidence: currency crises tend to be preceded by a
real exchange rate appreciation and growing current
account deficits.
22
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Extension of the model to explain these facts
(Willman, 1988):
Assume: two goods, one tradable the other
nontradable; nontradable sector prices are set as a
markup over wage costs; and nominal wages are
forward looking.
Anticipated future depreciation of the nominal
exchange rate will translate into higher nominal
wages and higher prices of nontradables today.
Because prices of tradables remain fixed until the
actual regime change, the real exchange rate
appreciates.
23

This reduces the relative price of importables and
thus leads to increased imports and a growing
current account deficit prior to the collapse.
24
Rational Policymakers and SelfFulfilling Factors


Problem with the conventional model: exact timing
of an exchange rate crisis may be difficult to pin
down if the inconsistency between fiscal and
exchange rate policies is conditional or
contingent on the occurrence of a speculative
attack.
Key feature of the second-generation literature on
currency crises: explicit modeling of policymakers'
preferences and policy rules.
25
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Policymakers: deriving benefits from pegging the
currency and also facing other policy targets
(accumulation of foreign reserves, a high level of
output, low unemployment, and low domestic
interest rates).
Depending on the circumstances, they may find it
optimal to abandon the official parity.
Abandonment of the peg is the result of the
implementation of a contingent rule for setting the
exchange rate.
Each period, the policymaker considers the costs
and benefits associated with maintaining the peg
for another period, and must decide whether or not
to abandon it.
26

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This decision depends on the realization of a
particular set of domestic or external shock.
Obstfeld (1995): illustrates self-fulfilling crises
and multiple equilibria.
Log of output:
y = - (w - e) - u,
 > 0.
(w - e): real wage;
e: log of nominal exchange rate. It is equal to log of
domestic price level due to PPP assumption.
u: serially independent shocks.
27

Nominal wages are set before the demand shock
is observed. Constant expected real wage:
w = E-1e,
E-1: expectations operator conditional on
information available at period t-1.

Policymaker’s loss function:
L = (1/2)(y -
~ 2
y) +
2/2,  > 0,
~ desired level of output;
y:
: inflation.
28

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
First term: cost of deviations from the desired level
of output;
Second term: cost of deviating from zero inflation.
Implications:
Under a discretionary policy regime, a fixed
exchange rate prevails in equilibrium only if inflation
is infinitely costly.
Economy is characterized by a systematic
devaluation bias.
29

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But although a precommitment to a fixed exchange
rate would eliminate the devaluation bias, it would
also prevent the policymaker from responding to
unpredictable shocks to output. There is therefore a
trade-off between credibility and flexibility.
In choosing whether or not to maintain a fixed
exchange rate or to devalue, the policymaker will
select the alternative that minimizes its loss.
Decision to devalue takes place whenever the
policy loss associated with maintaining the
exchange rate fixed exceeds the total loss
associated with a realignment.
Potential for self-fulfilling speculative attacks arises
from a circularity problem.
30

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
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Threshold point U that determines whether the
policymaker devalues, depend on prior
expectations of depreciation; in turn, these
expectations depend on market perceptions of
where U lies.
Shift in market expectations, or in the cost of
devaluing, c, can lead to a change in the position of
U and to a currency crisis.
Figure 7.2:
Possibility of multiple devaluation trigger points.
If the private sector adopts the high value u* as the
value that will trigger the abandonment of the fixedexchange rate rule, then high u* will also solve the
policymaker's optimization problem.
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32

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Similarly, if the private sector adopts the low value
u* as the value that it believes will induce an
exchange rate regime switch, then it will also be
optimal for the policymaker to adopt it as well.
Thus, the economy can jump from one equilibrium
to another; the shift in perceptions that triggers the
jump can be completely unrelated to the behavior
of macroeconomic fundamentals.
Increase in the cost of abandoning the peg may
increase the likelihood of a crisis.
Other sources of policy trade-offs on selffulfilling crises:
Agénor and Masson (1999): adverse effects of
high interest rates.
33

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
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Example: banks may come under pressure if
market interest rates rise unexpectedly.
To avoid a costly bailout, policymakers may want to
implement a quick devaluation.
Calvo (1998) and Sachs, Tornell, and Velasco
(1996a): it is a large volume of short-term debt (in
domestic or foreign currency) that puts a country's
exchange rate peg in a vulnerable position.
Large stock of domestic-currency short-term debt:
 generate doubts about public-sector solvency;
 raise fears that the authorities may inflate to
reduce the real value of public debt;
34
impose constraints on the ability of policymakers
to use high interest rates to fend off speculative
attacks.
 These factors may lead creditors to refuse to
rollover the existing stock of debt and may
increase the currency's vulnerability.
Large stock of foreign-currency short-term debt:
 raise concerns about external solvency.
 When short-term foreign debt to official reserves
ratio is high, the risk of short-term liquidity
problems may increase the vulnerability of the
exchange rate to a sudden shift in expectations
or perceptions.


35
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Implications:
Flow measures of the adequacy of reserves and
vulnerability and long-term solvency indicators
have limited usefulness as indicators of exchange
rate vulnerability relative to stock measures.
Alternative indicator of short-term vulnerability
(Calvo, 1998) is the ratio of broad money to official
reserves.
But, this indicator may also understate potential
exchange market pressures if, for instance, holders
of short-term domestic public debt become
concerned about the sustainability of the exchange
rate or about the government's ability to service its
debt.
36

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Generally: possibility of self-fulfilling crises makes
any pegged rate regime precarious.
Fundamentals affect the multiplicity of equilibria.
But the policymaker is incapable of enforcing its
preferred equilibrium should market expectations
focus on an inferior one.
Sunspots could shift the exchange rate from a
position where it is vulnerable to only very bad
realizations of domestic and external shocks to one
where output is so low absent a devaluation and a
fall in real wages that even relatively small shocks
will induce policymakers to devalue.
37


Two important issues remain:
Obstfeld (1995): if currency crises are viewed as a
manifestation of possible multiple equilibria, there
are no convincing explanations of the mechanisms
through which market expectations coordinate on a
particular self-fulfilling set of expectations.
Second, the evidence on the role of self-fulfilling
factors in exchange rate crises remains limited.
38
Currency Crises: Recent
Experiences


The 1994 Crisis of the Mexican Peso
The Thai Baht Crisis
39
The 1994 Crisis of the Mexican Peso



Between 1988 and 1993, macroeconomic
stabilization and economic reform in Mexico led to
a sharp reduction in inflation and an improvement
in the operational balance of the public sector
(Figure 7.3).
Key factor in bringing down inflation: exchange rate
policy, which involved the fixing of the Mexican
peso-U.S. dollar exchange rate in December 1987,
followed by a preannounced narrow margin
crawling peg and the adoption in November 1991
of a crawling peg with adjustable bands.
Figure 7.4.
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l9
9
J
u
n
0
0
J
a
l9
9
J
u
n
1
1
J
a
l9
9
J
u
n
2
2
J
a
l9
9u
n
3
3
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
.
43
F
i
g
u
r
e
7
.
4
M
e
x
i
c
o
:
N
o
m
i
n
a
l
E
x
c
h
a
n
g
e
R
a
t
e
a
n
d
I
n
t
e
r
v
e
n
t
i
o
n
B
a
n
d
s
,
1
9
9
4
(
P
e
s
o
s
p
e
r
U
.
S
.
d
o
l
l
a
r
)
6
D
e
v
a
l
u
a
t
i
o
n
(
D
e
c
e
m
b
e
r
2
0
)
5
.
5
S
e
c
o
n
d
C
h
i
a
p
a
s
u
p
r
i
s
i
n
g
(
D
e
c
1
9
)
F
i
r
s
t
C
h
i
a
p
a
s
u
p
r
i
s
i
n
g
(
J
a
n
u
a
r
y
1
)
5
C
o
l
o
s
s
i
o
a
s
s
a
s
s
i
n
a
t
i
o
n
(
M
a
r
c
h
2
3
)
P
r
e
s
i
d
e
n
t
i
a
l
e
l
e
c
t
i
o
n
(
A
u
g
u
s
t
2
1
)
4
.
5
Z
e
d
i
l
l
o
t
a
k
e
s
o
f
f
i
c
e
(
D
e
c
e
m
b
e
r
1
)
4
U
p
p
e
r
i
n
t
e
r
v
e
n
t
i
o
n
b
a
n
d
3
.
5
3
L
o
w
e
r
i
n
t
e
r
v
e
n
t
i
o
n
b
a
n
d
2
.
5
J
a
n F
e
b M
a
r
A
p
r
M
a
y J
u
n J
u
l
S
o
u
r
c
e
:
B
a
n
k
o
f
M
e
x
i
c
o
a
n
d
B
l
o
o
m
b
e
r
g
,
I
n
c
.
A
u
g S
e
p O
c
t
N
o
v D
e
c
44




Nominal depreciation over the period was not
sufficiently large to prevent a growing appreciation
of the real exchange rate.
Figure 7.5.
Surge in capital inflows led to a significant increase
in gross international reserves.
In order to sterilize capital inflows, the authorities
issued large amounts of short-term treasury bills
Certificados de Tesoreria or Cetes bonds)
denominated in pesos.
45
F
i
g
u
r
e
7
.
5
a
M
e
x
i
c
o
:
C
u
r
r
e
n
t
A
c
c
o
u
n
t
,
1
9
8
0
9
4
4
C ur r e
( b
illio
n
s
o
f
2
0
- 2
- 4
- 6
- 8
- 1
1
0
9
1
8
9
1
0
8
9
q
1
2
8
1
9
q
1
4
8
1
9
q
1
6
8
1
9
q
1
8
9
1
9
q
1
0
9
1
9
q
2
9
1
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
a
n
d
O
E
C
D
.
1
/
A
n
i
n
c
r
e
a
s
e
i
s
a
d
e
p
r
e
c
i
a
t
i
o
n
.
46
F
i
g
u
r
e
7
.
5
b
M
e
x
i
c
o
:
R
e
a
l
E
x
c
h
a
n
g
e
R
a
t
e
I
n
d
i
c
e
s
,
1
9
8
0
9
4
3
0
0
R
e
a
l
E
x
c
h
a
n
g
e
R
a
t
e
I
n
d
i
c
e
s
1
/
(
1
9
8
0
=
1
0
0
)
2
5
0
2
0
0
U
n
i
t
l
a
b
o
r
c
o
s
t
b
a
s
e
d
i
n
d
e
x
(
O
E
C
D
)
C
P
I
b
a
s
e
d
i
n
d
e
x
(
I
M
F
)
1
5
0
1
0
0
E
x
p
o
r
t
u
n
i
t
v
a
l
u
e
b
a
s
e
d
i
n
d
e
x
(
O
E
C
D
)
5
0
1
9
8
0
q
1
1
9
8
2
q
1
1
9
8
4
q
1
1
9
8
6
q
1
1
9
8
8
q
1
1
9
9
0
q
1
1
9
9
2
q
1
1
9
9
4
q
1
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
a
n
d
O
E
C
D
.
1
/
A
n
i
n
c
r
e
a
s
e
i
s
a
d
e
p
r
e
c
i
a
t
i
o
n
.
47


Large capital inflows continued, after the approval
of NAFTA. As a result, the interest rate differential
between Cetes bonds and interest rates in the
United States declined significantly (Figure 7.6):
 Currency risk indicator: interest rate differential
between Cetes and Tesobonos (short-term
dollar liabilities repayable in pesos);
 Default risk indicator: Tesobono-U.S. certificate
of deposit rate differential.
Expansion in domestic credit and relaxation of the
fiscal stance and a series of adverse political
events brought the Mexican peso under severe
pressure in the second quarter of 1994.
48
F
i
g
u
r
e
7
.
6
a
M
e
x
i
c
o
:
C
u
r
r
e
n
c
y
R
i
s
k
I
n
d
i
c
a
t
o
r
s
,
1
9
9
1
9
4
(
I
n
p
e
r
c
e
n
t
)
3
0
2
5
C
u
r
r
e
n
c
y
R
i
s
k
I
n
d
i
c
a
t
o
r
1
/
2
8
d
a
y
c
e
t
e
s
2
8
d
a
y
t
e
s
o
b
o
n
o
r
a
t
e
2
0
1
5
1
0
9
1
d
a
y
c
e
t
e
s
9
1
d
a
y
t
e
s
o
b
o
n
o
r
a
t
e
5
1
03
42 /N
92 /F o
21 /Ae v
0 4 /J pb /9
63 /Our//9 1
12 /J cl/ 9 2
/13 Ma t 9 2
/0 4 J n /92
/08 Suar/9 2
22 /D en /93
51 /Me p/9 3
0 7/M ac /93
9 / A a r/ 9 3
/ N u y/ 9 3
g/ 4
0
S
o
u
r
c
e
s
:
B
a
n
k
o
f
M
e
x
i
c
o
a
n
d
B
l
o
o
m
b
e
r
g
,
I
n
c
.
1
/
B
a
s
e
d
o
n
m
o
n
t
h
l
y
a
v
e
r
a
g
e
s
o
f
w
e
e
k
l
y
a
u
c
t
i
o
n
r
a
t
e
s
.
49
F
i
g
u
r
e
7
.
6
b
M
e
x
i
c
o
:
C
o
u
n
t
r
y
R
i
s
k
I
n
d
i
c
a
t
o
r
s
,
1
9
9
1
9
4
(
I
n
p
e
r
c
e
n
t
)
6
C
o
u
n
t
r
y
R
i
s
k
I
n
d
i
c
a
t
o
r
2
/
5
9
1
d
a
y
t
e
s
o
b
o
n
o
m
i
n
u
s
U
.
S
.
3
m
o
n
t
h
C
D
r
a
t
e
4
3
2
1
0
-
2
1
03
24 /N
29/F o
1 2/Ae v
0 4 / J pb / 9
3 6/O ur//9 1
21 /J c l/ 9 2
31 /Ma t 9 2
/0 4 J n/92
/08 Sua /92
r2/ n /
2 D e 93
51 /Mep/9 3
0 7/M ac /93
9 / A r/ 9 3
/N ua / 3
y9
og / 4
-
1
2
8
d
a
y
t
e
s
o
b
o
n
o
m
i
n
u
s
U
.
S
.
1
m
o
n
t
h
C
D
r
a
t
e
S
o
u
r
c
e
s
:
B
a
n
k
o
f
M
e
x
i
c
o
a
n
d
B
l
o
o
m
b
e
r
g
,
I
n
c
.
2
/
B
a
s
e
d
o
n
m
o
n
t
h
l
y
a
v
e
r
a
g
e
s
o
f
w
e
e
k
l
y
a
u
c
t
i
o
n
r
a
t
e
s
o
f
t
e
s
o
b
o
n
o
s
.
50






The Cetes-Tesobono interest rate differential rose
above 10 percentage points in April (Figure 7.6).
Stock of international reserves fell.
To stem capital outflows, the authorities raised
domestic interest rates and allowed the peso to
move to the upper limit of the exchange rate band.
Authorities also substituted short-term debt
denominated in foreign currency for pesodenominated debt.
Due to these swap operations, the outstanding
stock of Tesobonos more than doubled (Figure 7.7).
Current account deficit continued to deteriorate.
51
F
i
g
u
r
e
7
.
7
M
e
x
i
c
o
:
S
h
a
r
e
o
f
T
e
s
o
b
o
n
o
s
H
e
l
d
b
y
C
o
m
m
e
r
c
i
a
l
B
a
n
k
s
a
n
d
t
h
e
N
o
n
f
i
n
a
n
c
i
a
l
P
r
i
v
a
t
e
S
e
c
t
o
r
,
1
9
9
1
9
4
1
/
(
I
n
p
r
o
p
o
r
t
i
o
n
o
f
t
o
t
a
l
s
t
o
c
k
o
f
C
e
t
e
s
a
n
d
T
e
s
o
b
o
n
o
s
)
9
0
8
0
7
0
6
0
5
0
4
0
3
0
2
0
1
0
0
J
a
n
9
1J
u
l
9
1J
a
n
9
2J
u
l
9
2J
a
n
9
3J
u
l
9
3J
a
n
9
4J
u
l
9
4
S
o
u
r
c
e
:
B
a
n
k
o
f
M
e
x
i
c
o
.
1
/
I
n
c
l
u
d
e
s
r
e
s
i
d
e
n
t
s
a
n
d
n
o
n
r
e
s
i
d
e
n
t
s
.
52





Political unrest in Chiapas intensified.
These developments were accompanied by
increased exchange rate pressures and large
capital outflows.
Official reserves fell further.
Stock of Tesobonos continued to increase.
Continued accumulation of short-term U.S. dollar
liabilities offset the movements in reserves but
exposed the authorities' debt servicing operations
to greater exchange rate risk.
53




Although currency risk and default risk indicators
did not deteriorate, Cetes-Tesobono interest rate
differential remained significantly above its first
quarter level since investors' devaluation
expectations were higher.
Exchange rate band was widened (December 20);
but Bank of Mexico was unable to hold the
exchange rate there.
Widespread investor fears put further pressure on
foreign exchange and financial markets and forced
the adoption of a floating exchange rate regime.
Between December 20 and January 3, 1995, the
peso depreciated by about 30% from its predevaluation rate.
54


Domestic interest rates rose sharply.
At end-December 1994, the value of the
outstanding stock of Tesobonos was about 29
billion U.S. dollars at the prevailing exchange rate.
55
The Thai Baht Crisis







Thailand experienced a surge in capital inflows
beginning in 1988 as a response improved
economic prospects.
Economic reforms:
drop in fiscal deficit;
reduction or elimination of government controls
over economic activity;
privatization of state-owned firms;
reduction in tariffs and quantitative import barriers;
removal of capital controls.
Capital inflows were associated with a sharp
increase in investment.
56






Public consumption spending fell sharply.
Beginning in 1984 and until the 1997 crisis, the
Thai baht was pegged to a weighted basket of
currencies of Thailand's major trading partners.
Because inflation in Thailand in the early 1990s
exceeded the levels recorded by its trading
partners, the pegged exchange rate regime led to a
significant real appreciation (17-18%).
Appreciation of the real exchange rate led to a
worsening of external accounts.
Figure 7.8.
Public sector fiscal balance, in fact, remained in
surplus throughout the 1990s.
57
F
i
g
u
r
e
7
.
8
a
T
h
a
i
l
a
n
d
:
M
a
c
r
o
e
c
o
n
o
m
i
c
I
n
d
i
c
a
t
o
r
s
,
1
9
9
0
9
7
(
I
n
p
e
r
c
e
n
t
p
e
r
a
n
n
u
m
,
u
n
l
e
s
s
o
t
h
e
r
w
i
s
e
i
n
d
i
c
a
t
e
d
)
1
8
0
1
7
0
8
n
la
t
Ma n u I
f
af
c
t
u
(
in
p
e
(
se
a
so
n
a
lly
a
7
1
6
0
1
5
0
6
1
4
0
1
3
0
5
1
2
0
4
1
1
0
1
0
0
3
9
0
2
8
0
1
1
9
1
9
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
9
9
1
1
9
1
9
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
9
9
5
9
6
7
S
o
u
r
c
e
:
I
n
t
e
r
n
a
t
i
o
n
a
l
M
o
n
e
t
a
r
y
F
u
n
d
a
n
d
B
a
n
k
o
f
T
h
a
i
l
a
n
d
.
N
o
t
e
:
T
h
e
v
e
r
t
i
c
a
l
l
i
n
e
c
o
r
r
e
s
p
o
n
d
s
t
o
t
h
e
d
a
t
e
o
f
f
l
o
t
a
t
i
o
n
o
f
t
h
e
B
a
h
t
(
J
u
l
y
2
,
1
9
9
7
)
.
58
F
i
g
u
r
e
7
.
8
b
T
h
a
i
l
a
n
d
:
M
a
c
r
o
e
c
o
n
o
m
i
c
I
n
d
i
c
a
t
o
r
s
,
1
9
9
0
9
7
(
I
n
p
e
r
c
e
n
t
p
e
r
a
n
n
u
m
,
u
n
l
e
s
s
o
t
h
e
r
w
i
s
e
i
n
d
i
c
a
t
e
d
)
1
0
F
i
s
c
a
l
b
a
l
a
n
c
e
a
n
d
t
h
e
c
u
r
r
e
n
t
a
c
c
o
u
n
t
(
i
n
p
e
r
c
e
n
t
o
f
G
D
P
)
1
E
x
t
e
r
n
a
l
a
c
c
o
u
n
t
s
(
i
n
b
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l
l
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o
f
U
.
S
.
d
o
l
l
a
r
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)
0
5
F
i
s
c
a
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b
a
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n
c
e
,
e
x
c
.
o
f
f
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s
1
2
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3
T
r
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b
a
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4
5
C
u
r
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t
a
c
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o
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d
e
f
i
c
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t
5
C
u
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1
0
6
1
9
9
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


In 1996 and early 1997, markets grew increasingly
concerned about Thailand's macroeconomic
problems and financial sector vulnerability.
Factors led to questions about the vulnerability
to sudden reversals in capital inflows and the
sustainability of Thailand's external deficits:
Merchandise exports slowed down sharply in 1996
and early 1997, reflecting in part the real
appreciation of the baht and the loss in
competitiveness.
Real output growth dropped to 6.4% in 1996,
compared with 8.6% in 1995.
64



There was a perceived shift in regional comparative
advantage in some industries to lower-wage
countries such as China, India, and Vietnam.
Net private capital inflows into Thailand averaged
more than 10% of GDP during the 1990s and
reached 13% of GDP in 1995 alone. However, 46%
of the flows recorded during 1990-96 were in the
form of short-term borrowing.
The early favorable perception of the high levels of
investment as a sign of economic strength gave
place to questions and concerns about the
allocation of capital outlays and their sources of
financing.
65





In this case, much of the investment was risky and
of low quality, going to low-productivity and
speculative activities.
Weaknesses in the banking system began to
emerge (large proportion of nonperforming loans).
Financial institutions had exposed themselves to
significant risk by relying heavily on short-term
borrowing in foreign currency, combined with
long-term loans in bahts.
This created a mismatch in terms of both maturity
and currency on commercial banks' balance
sheets.
Speculative pressures on the Thai baht started
around December 1996.
66




During that month, the Central Bank lost about
2.3% of its foreign exchange reserves in defense of
the currency.
On February 14, 1997, a massive attack led to a
drop in the value of the baht by almost 1% against
the U.S $.
The authorities responded to these pressures
through sterilized intervention, increases in
interest rates, and restrictions on foreign exchange
movements.
On May 14-15, 1997, renewed speculative
pressures on the baht led to heavy intervention by
the Central Bank.
67






But, speculative pressures continued in June,
forcing the central bank to intervene to defend the
exchange rate.
In June, the Bank lost about $4 billion.
On July 2, it was announced a managed float
regime and to seek assistance from the IMF.
The baht was effectively devalued by about 15%.
The ratio of the country's gross short-term liabilities
to reserves was in the range of 6 to 8 (potential
source of vulnerability).
After flotation of the baht, it was discovered that the
financial difficulties faced by financial and
nonfinancial firms were far worse than originally
68
thought.





This generated uncertainty about the possibility of a
full-blown financial crisis developing.
This uncertainty led to a further weakening of the
baht.
Between the end of 1996 and September 1997, the
baht depreciated relative to the U.S. dollar by 42%.
This worsened the real burden of external debt
faced by firms that had borrowed heavily in foreign
currency.
The Bank tightened its monetary policy stance and
increased interest rates only after the currency had
collapsed and after a continuing period of
depreciation.
69



Timing of the policy change did nothing but
aggravate the financial situation of domestic firms;
because the depreciation had already increased
sharply the domestic-currency value of their
foreign-currency liabilities.
Sharp fall in domestic credit was accompanied with
a fall in output, an increase in the bankruptcy rate
and the proportion of nonperforming loans.
Conclusion:
Thailand's growing external deficits and a weak and
poorly supervised financial system were the two
main factors triggering the baht crisis.
70


Stability of the fixed exchange rate had a perverse
effect: most borrowers did not hedge their foreigncurrency liabilities; so they felt the brunt of the
devaluation.
Delayed policy response to the mounting problems
and the authorities' resistance to an early
adjustment of the exchange rate also exacerbated
the crisis.
71
Currency and Banking
Crises
72




Recent evidence on financial crises: existence of
close links between currency crises and banking
crises.
Definitions of banking crisis:
Caprio and Klingebiel (1996):
the capital of the banking system is practically
exhausted;
nonperforming loans amount to or exceed 15 to
20% of total bank loans;
the cost of resolving these problems amounts to at
least 3 to 5% of GDP.
73



Kaminsky and Reinhart (1999):
bank run, associated with the closure, merging, or
takeover by the public sector of at least one large
financial institution;
in the absence of a bank run, the closure, merging,
or takeover of, or large-scale government
assistance to, at least one important financial
institution.
Causes of banking crises:
Diamond and Dybvig (1983):
Purely self-fulfilling, because depositors think that
there will be a significant amount of withdrawals in
the very near future.
74





With fractional reserves and a first-come firstserved rule, depositors at the end of the sequential
service line may suffer losses.
To avoid these losses, all depositors try to place
themselves at the head of the line, causing a panic
in the process.
Diamond-Dybvig model:
Assumptions:
Two categories of agents in the economy:
households and a financial intermediary.
Number of households is large and there is no
aggregate uncertainty.
Three periods, h = 0,1, 2, and a single consumption
75
good available to agents in each period.





Each household has an initial endowment of one
unit of the consumption good at period 0 and none
in subsequent periods.
They all deposit their endowment, C0, with the bank
at period 0 in return for consumption in periods 1 or
2.
They observe in period 1 an idiosyncratic
preference shock that is not observed by the bank
Depending on the value of the shock, they decide
to either withdraw their deposit and consume now
(period 1) or keep their deposit and consume later
(period 2).
Households are also able to store consumption
between periods 1 and 2, if they so choose.
76





u: utility function;
Ch:consumption at period h.
u(C1): type-E agents’ utility function;
u(C2): type-L agents’ utility function;
: probability that a household to withdraw its
endowment and consume now and it is also the
proportion of type-E households realized at period
1.
u(C1) with probability 
u(C0, C1, C2) =
u(C2) with probability 1-.
{
77



The bank accepts a deposit of one unit from each
depositor and knows that a fraction  of them will
be type-E agents.
In exchange for the deposit, the bank offers each
household a contract that allows it to withdraw
either C1 units of consumption at period 1 or C2
units at period 2.
The bank has access to two investment
technologies:
 short-term asset, yields one unit of consumption
at period 1 for every unit of investment made at
the beginning of that period;
78
long-term asset, yields R > 1 units of consumption
at period 2 for every unit of investment made in
period 1.
In case of withdrawals in period 1, the bank must
finance them by liquidating L units (per capita)
invested in the long-term asset in period 1, receiving
only R(1-L) in period 2.


79

The bank chooses (C1, C2, L) to maximize the ex
ante expected utility of individual agents:
max [u(C1) + (1-)u(C2)]
C1, C2 , L
subject to
C1 = L;
(1-)C2 = R(1-L).
80

Any interior optimum must satisfy:
~
~
u’(C1) = Ru’(C2),
~
(35)
~
C1 = L/, C2 = R(1-L)/(1-).

These equations, together with R > 1, imply that:
~
~
C2 > C1.

~ ~
A sufficient condition for C2/C1 to be less than R is
to have Cu’(C) decreasing in C.
81





If u has a coefficient of relative risk aversion
greater than unity, type-E households will share in
the higher returns of illiquid assets.
Is the first-best allocation achievable?
Key insight of the Diamond-Dybvig analysis is that
in attempting to implement (35) the bank faces a
coordination problem.
In defining the first-best allocation problem above, it
was assumed that only type-E households
consumed C1 and only type-L households
consumed C2.
However, because preference shocks are privately
observed, the bank is not able to guarantee this.
82



In fact, the type-L household's decision whether to
withdraw C1 at period 1 and store it for later
consumption or to withdraw C2 at period 2 is a
strategic one, which depends on what other
households do.
Two equilibrium outcomes in this model:
First: only those households with a true preference
for early consumption choose to make an early
withdrawal.
Second: agents who actually prefer late
consumption, fearing withdrawals by others of the
same type:
 also choose to withdraw early (bank run):
83
costly and inefficient because the bank is forced
to liquidate prematurely some of its higheryielding investments.
Primary causes of banking crises in
developing countries:
Goldstein and Turner (1996):
external and domestic macroeconomic
volatility;
lending booms;
rapidly increasing bank liabilities, with large
mismatches with respect to liquidity, maturity, and
currency denomination;




84





insufficient strengthening of bank supervision and
regulation prior to financial liberalization;
heavy government involvement in the banking
system and loose controls on connected lending;
weaknesses in the accounting, disclosure, and
legal infrastructure;
distorted incentives, such as pressures for
regulatory forbearance;
rigid exchange rate regime, such as a currency
board;
85


Two ways for currency crisis to lead to a
banking crisis:
In the absence of sterilization, the large loss in
international reserves may cause a sharp decline in
the base money stock and the supply of credit. This
may have an adverse effect on output and lead to a
rise in nonperforming loans, and, in turn, to a
banking crisis.
Exchange rate depreciation that accompanies a
currency crisis can create solvency problems
among banks.
86


How does banking crisis lead to a currency
crisis?
Related to a situation in which the central bank
must inject liquidity to bail out ailing banks or
depositors, because of deposit insurance
scheme.
Two options for the central bank to finance the
bailout:
allow an excessive expansion of domestic credit to
provide liquidity; this lead to an speculative attack
that forces the central bank to abandon the
exchange rate peg;
87


issue large amounts of domestic debt as the
counterpart to assuming a large portfolio of
nonperforming loans;
 market participants may perceive that the
authorities have an incentive to reduce the
burden of the debt through inflation or currency
devaluation;
 this may lead to a self-fulfilling crisis.
Both currency and banking crises may result from
common macroeconomic shocks, such as,
unexpected sharp increase in world interest rates.
88
Predicting Financial Crises
89





Early warning indicators: to predict currency and
banking crises.
Kaminsky and Reinhart (1999):
Incidence of both types of crises increased sharply
between the early 1980s and 1995.
Figure 7.9: incidence of currency crises during the
1990s was not higher than in the early 1980s.
Currency crises: identified by an index of currency
market turbulence (weighted average of exchange
rate changes and reserve changes).
The values of the index were at least three
standard deviations above the mean were
identified as crises.
90
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7
.
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.
91




Banking crisis: either a bank run or the closure,
merging, takeover, or large-scale government
assistance to at least one important financial
institution.
Indicators, such as output and stock prices,
financial sector variables, and external sector
variables, used to assess the extent to which they
help predict banking and balance-of-payments
crises.
Main conclusions:
banking crises are often preceded by financial
liberalization;
banking and currency crises appear to share
common causes;
92



best predictors of currency crises are degree of
overvaluation of the real exchange rate, adverse
movements in exports, an increasing ratio of broad
money over official reserves, falling stock prices,
and output;
best predictors of banking crises are real
exchange rate, the broad money multiplier, the
stock market, output, and real interest rates;
earliest signals provided by the best predictors are
between 17 months and a year before a currency
crisis occurs, and between 18 months and as late
as 6 months prior to banking crisis;
93




both currency and banking crises appear to be
more severe in Latin America than in other
regions;
pre- and postcrisis behavior of most of the
indicators show very similar patterns across
regions, for both currency and banking crises.
Demirgüç-Kunt and Detragiache (1998a):
Banking crises during the period 1980-94 tended to
erupt when growth is low, and inflation and real
interest rates are high.
Vulnerability to currency crises (as measured by a
high ratio of the broad money stock to official
reserves) and the existence of an explicit deposit
insurance scheme also played a role.
94



Demirgüç-Kunt and Detragiache (1998b): banking
crises are more likely to occur in liberalized
financial systems.
Berg and Pattillo (1998):
Assessed the ability of several empirical models of
currency crises to predict the Asian exchange rate
crises.
Conclusion: although none of the models reliably
predicted the timing of the crises, they had some
value in the sense that variables (high credit growth
rate, an overvalued exchange rate, and a high ratio
of broad money to reserves) did affect positively the
probability of a crisis.
95
Sources and Effects of
Financial Volatility



Volatility of Capital Flows
Herding Behavior and Contagion
The Tequila Effect and the Asia Crisis
96
Volatility of Capital Flows






Volatility of capital flows related to:
actual or perceived movements in economic
fundamentals;
external factors;
investor herding and contagious factors.
actual or expected policy responses.
Evidence: volatility may lead to exchange rate
instability, large fluctuations in official reserves and
money supply.
Financial volatility may also have adverse effects
on the real side: nominal exchange rate volatility, in
particular, may hamper the expansion of exports.
97
Herding Behavior and Contagion





Portfolio flows tend to be sensitive to herding
behavior and contagion effects.
Herding: large movements into certain types of
assets, followed by equally large movements out,
without no apparent reason.
Reasons for herding (Devenow and Welch,
1996):
payoff externalities;
principal-agent considerations;
information cascades.
98
Calvo and Mendoza (1997): with informational
frictions, rational herding behavior may become
more prevalent as the world capital market
grows.
 Small rumors can induce herding behavior and
lead to large capital outflows and a self-fulfilling
speculative attack on the domestic currency.
Financial contagion: massive capital outflows
triggered by a perceived increase by international
investors in the vulnerability of a country's
currency, or, more generally, a loss of confidence
in the country's economic prospects, as a result of
developments elsewhere.
Examples: Tequila effect and the Asia crisis. 99





Other two ways for contagion to occur:
terms-of-trade shocks;
competitiveness effect.
100
The Tequila Effect and the Asia Crisis




Tequila effect:
Collapse of the Mexican peso on December 20,
1994 triggered exchange market pressures and
increased financial market volatility in a number of
developing countries.
In Latin America, two economies were hit
particularly severely: Argentina and Brazil.
External interest rate spreads rose sharply in
Argentina (Figure 7.10).
In both economies, gyrations in market sentiment
led in early 1995 to
 sharp reduction in net capital inflows,
101
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102
fall in official reserves,
 pressure on asset prices.
Argentina had a fixed exchange rate regime.
Figure 7.11: output contracted significantly in 1995,
whereas bank deposits and domestic credit fell
dramatically. The unemployment rate increased
sharply.
Liquidity crunch led to a sharp rise in bank lending
rates and spread between the lending rates
widened.
Shift from peso deposits, capital flight and the
reduction in new borrowing led to a collapse of
foreign reserves, and a dramatic fall in the
103
monetary base.





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104
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105
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.
106




Would a crisis have occurred anyway?
Boom-recession cycle characterizes exchangerate-based stabilization programs would have
indeed predicted an eventual recession.
Current account deficit increased reflecting a sharp
increase in consumption and gross domestic
investment.
But timing and severity of the economic downturn in
Argentina suggests a contagious effect.
Following the Thai baht crisis, currencies of several
other Asian countries (Hong Kong, Korea,
Malaysia, the Philippines, Singapore, and Taiwan)
came under severe speculative pressures.
107




Some of them were forced to abandoned their
exchange rate regime.
Despite some positive developments on the
macroeconomic side, all of these countries were
suddenly viewed by investors as suffering from
similar weaknesses in economic fundamentals.
These were overvalued exchange rates pegged to
the U.S. dollar, growing current account deficits,
declining equity prices, and weak banking systems.
Figure 7.12: nominal exchange rates depreciated
significantly and equity prices fell dramatically after
the collapse of the Thai baht in all of these
countries.
108
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111



Two factors interacted to transform the initial
market turbulences into a vicious circle of currency
depreciation and deteriorating confidence in the
region's economic prospects:
Overborrowing on world capital markets at short
maturities and excessive exposure to foreign
exchange risk in the financial and corporate
sectors;
 Figure 7.13 shows the sharp increase in foreign
borrowing by bank and nonbank private sector.
 Figure 7.14: short-term external debt exceeded
by a large amount the level of official reserves.
Weak asset portfolios of domestic banks (high
ratios of nonperforming loans).
112
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118




These financial fragilities may have led speculators
to believe that pegged exchange rate regimes
could not be defended very long with high interest
rates and led to persistent pressures on foreign
exchange markets.
Currency depreciations led to a deterioration of the
financial positions of banks and nonfinancial
corporations.
This heightened concerns about the viability of
domestic banking systems
These factors further undermined confidence--leading to renewed pressure on foreign exchange
markets.
119
Coping with Financial
Volatility



Macroeconomic Discipline
Information Disclosure
The Tobin Tax
120
Macroeconomic Discipline





Preventive measures to reduce the risk of
sudden changes in market sentiment:
monitoring exchange rate levels to ensure
consistency with underlying fundamentals;
implementing appropriate policy adjustments to
correct fiscal imbalances;
prevent an excessive buildup of domestic debt;
maintaining a monetary policy consistent with low
inflation;
ensuring that the ratio of unhedged foreign debt
over official reserves remains sufficiently low.
121




Adequate management of the public foreigncurrency debt is an important component of a
strategy to reduce the volatility of capital flows.
Large stock of foreign-currency debt may magnify
the impact of adverse external shocks on the
economy and may constrain the policy options
available to policymakers during a financial crisis.
Large, unhedged foreign-currency debt carries
risks resulting not only from its maturity profile but
also from its currency composition.
Short-term foreign-currency debt at floating rates
exposes countries to interest rate risk resulting
from abrupt changes in world interest rates.
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Macroeconomic discipline and improved
management of foreign debt are not sufficient:
Unwarranted changes in expectations can and do
occur, even when underlying economic
fundamentals appear strong: example is Chile.
The strengthening of the financial system takes
time.
Because of these reasons, short-term controls on
capital flows can be used during a transitory period
to resort to prevent excessive volatility.
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Information Disclosure
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Providing appropriate and timely information to
markets may be beneficial in reducing volatility.
Two problems:
countries have limited incentives to provide bad
news quickly to markets;
markets have limited ability to verify the
information that is provided.
Knowing this, countries may be tempted to exploit
this advantage by falsifying the information.
Current efforts by multilateral institutions such as
the IMF and the WB to encourage countries to
provide more timely data and at the same time
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impose quality standards are important.
The Tobin Tax
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Tobin: Uniformly tax spot transactions in foreign
exchange as a way to reduce volatility on world
financial markets.
Key feature of the tax: it would reduce noise from
market trading while allowing traders to react to
changes in economic fundamentals.
By making currency trading more costly, it would
discourage speculation.
Spahn (1995): extension of the Tobin tax to a twotier tax for countries operating flexible exchange
rate or band regimes.
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Impose minimal-rate transaction tax that would
not impair market efficiency under normal market
conditions, and an exchange surcharge that
would be activated only in periods of heavy
speculative trading.
During this trading price for a currency crosses an
admissible band, consisting of a +/- x percent
margin around a target.
When the surcharge is triggered, transactions costs
would rise sufficiently to cause some traders to
delay transactions, thus smoothing out fluctuations
in exchange rates.
Surcharge is thus a variable tax on transactions in
foreign exchange.
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Difficulties (Garber, 1996):
These are establishing the tax base, identifying
taxable transactions, setting the tax rate, and
implementing the tax across borders.
Establishing tax base:
Distinguish between normal trading that assures
the efficiency and stability of financial markets and
destabilizing noise trading, which should be the
only target of the tax.
By reducing trading, it may paradoxically lead to
less liquid markets and entail greater volatility.
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Identifying taxable transactions:
Applying the Tobin tax only to spot transactions
involving foreign currencies is likely to be
ineffective, because market operators would
eventually avoid the tax by trading in more
sophisticated financial instruments.
High degree of substitutability between financial
instruments may thus hamper the application of the
tax.
Setting the tax rate:
Tobin's initial proposal called for a low, uniform tax
rate.
In normal times, low rate may represent a
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significant tax on trading activities.
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Since some financial transactions are undertaken
by several intermediaries, taxes on these
transactions may have a cascading effect.
In this case effective tax rate may be significantly
higher than the nominal rate applied to a single
transaction.
In heavy speculation times, even a higher tax rate
is unlikely to deter speculators who expect a
significant short-term change in the exchange
rate.
The possible benefits in reducing short-term
speculative trading would be outweighed by the
possible costs associated with impairing the
efficiency of financial intermediation.
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Implementing the tax across borders:
Mobility of financial transactions would make the
tax easy to avoid.
But universal tax can only be viewed as a remote
possibility, in part because of the difficult political
and economic issues that the distribution of
proceeds raises.
Eichengreen, Tobin, and Wyplosz (1995): tax
foreign exchange transactions, which is a tax on
lending to nonresidents.
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