FRBSF Economic Letter
99-11; April 2, 1999
 Economic
Letter Index
Dealing with Currency Crises
The currency crises of the 1990sthe European Union's in 1992, Mexico's
in 1994, East Asia's in 1997, and Russia's and Brazil's more recentlyraise
concerns for a number of reasons. They are not only hard on the countries
experiencing them, but if they spread widely they also may disrupt the
international flow of credit, hindering trade, investment, and GDP growth
in the world economy.
Currency crises reflect actions by investors that are very similar to
bank runs or classic financial panics. They differ, however, in that currency
crises are common, while bank runs have been relatively rare during the
postwar period, particularly in industrialized economies. This Economic
Letter discusses the similarities and differences between bank runs
and currency crises as well as their implications for efforts to prevent
future currency crises.
Why bank runs are rare
Banks do not fully back their deposits with reserves, which makes them
vulnerable to financial panics or bank runs. During a bank run, each depositor
fears that other depositors will withdraw their funds; since the bank
does not have enough reserves to give all depositors their money, depositors
race to be first to withdraw their money before the reserves are depleted.
This process can drive an otherwise solvent bank to bankruptcy.
Bank runs have been limited by two institutional arrangements. First,
the central bank serves as a lender of last resort; that is, it can increase
the money supply and also lend funds to individual (typically solvent)
banks that may be experiencing runs. A sufficiently large increase in
liquidity can end the incentive to flee the banking system. The second
arrangement is deposit insurance, which ensures that depositors' funds
are safe even if their bank fails. In the United States, deposit insurance
explicitly covers $100,000 for each depositor in a given bank. In addition,
implicit insurance operates in many countries where some banks may be
considered "too big to fail;" thus, depositors (but not necessarily equity
holders) are implicitly fully insured against any losses.
While lender of last resort and deposit insurance facilities explain
why bank runs in industrial countries have been rare in the postwar era,
they also create an incentive for banks to take on more risk than they
otherwise wouldthis is known as moral hazardwhich can contribute to
future panics. To curb moral hazard, banks face extensive regulation and
supervision. Regulators directly assess the riskiness of loan portfolios
and require that financial institutions insure themselves against failure
by holding adequate amounts of capital.
Why currency crises are frequent
With the growing integration of financial markets, investors from developed
market economies have acquired large claims in developing countries (for
convenience I will use this last term also to refer to emerging markets).
A central bank that pegs its exchange rate to a "hard" currency (one that
is widely traded internationally) implicitly guarantees that any investors
who want to exchange their local currency assets for that hard currency
can do so at the prevailing exchange rate, that is, without experiencing
a capital loss from a devaluation of the local currency. If investors
fear a devaluation and think that the central bank's foreign reserves
are not adequate to make good on this guarantee, they may flee the currency,
depleting hard currency reserves and forcing the devaluation they fear.
Investors may fear devaluation for many reasons; for example, a rise in
bad loans may create doubts about the government's ability to raise interest
rates in order to maintain a peg. Such weaknesses in the financial system
often play an important role (Moreno 1998).
Thus, just as commercial banks are vulnerable to panics because they
can run out of cash reserves, central banks that peg the exchange rate
are vulnerable to panics because they can run out of foreign exchange
reserves. However, in contrast to commercial banks from industrial countries,
central banks in developing countries have no automatic access to lender
of last resort facilities in "hard" currencies. This is one reason currency
crises have been frequent, while bank runs in industrial countries have
not.
International lender of last resort?
In principle, industrial countries that issue hard currencies could prevent
currency crises in developing countries by acting as lenders of last resort.
They could adopt expansionary monetary policies or provide sufficiently
generous access to hard currencies (directly or through international
organizations like the International Monetary Fund (IMF)) to countries
experiencing speculation against their currencies (Calvo 1994, Fischer
1999). However, industrial countries have had difficulty in fully assuming
such a role for at least three reasons.
First, the monetary policies of industrial countries ultimately must
be geared to their own national policy objectives. At times (for example,
1998, when industrial countries' monetary policies eased), industrial
countries' policy objectives may help emerging markets experiencing liquidity
pressures. However, conditions change, and the policy objectives of industrial
countries and developing countries may not always coincide.
Second, developing countries cannot be required to adopt policies that
may prevent currency crises. In contrast to commercial banks, which must
submit to domestic regulation and supervisionin extreme cases they may
be taken over by their regulatorsdeveloping countries are sovereign entities
that cannot legally be required by foreign countries or international
organizations to hold adequate reserves or to adopt macroeconomic and
prudential measures that would make them less vulnerable to runs on their
currencies. As a result, the access of developing countries to hard currency
financing around times of currency crises has not been automatic, but
has followed negotiations in which they agree to implement adjustment
programs intended to facilitate recovery or prevent future currency crises.
Developing countries typically accept adjustment programs after currency
crises have broken out, but they have had little or no incentive to do
so during good times.
Third, distributing the burden of adjustment in the wake of a crisis
is very difficult. In deciding whether or not to provide hard currency
support in the wake of a crisis, industrial countries and the international
organizations they fund face a dilemma. On the one hand, such support
can create moral hazardthat is, incentives for risky behavior on the
part of developing countries and international investors. On the other
hand, withholding support may mean delayed recovery in developing countries
or, in extreme cases, the spread of crises to other countries.
The resulting difficulties in achieving smooth responses to crises are
illustrated by the experience with the debt crisis of the 1980s. After
this crisis broke out in 1982, the debt burdens of developing countriesalready
unsustainableinitially increased instead of declining. According
to Dooley (1995), this reflected the unwillingness of bank lenders to
forgive any portion of the debt and the unwillingness of the governments
of industrial countries to assume any part of it. Ultimately, market forces
and U.S. government initiatives that facilitated the securitization of
developing country debt and its sale at a discount in the open market
brought about reductions in debt burdens, the resumption of capital flows
to indebted countries, and the resumption of growth in these countries
in the 1990s. However, the process took years. Latin America experienced
a "lost decade" in which living standards declined and the trade and investment
opportunities offered by the region were very limited.
New approaches
The experience with currency crises in the 1990s has prompted a search
for new approaches for dealing with such crises. So far, the emphasis
has been on the timely mobilization of large amounts of money and on crisis
prevention.
More money. The financial rescue packages put together in response
to crises in the 1990s are very large by historical standards, and they
have helped end instability in currency markets relatively quickly. For
example, the rescue package for Korea in the last quarter of 1997 totaled
$58.4 billion (the IMF share was $21.1 billion), and an additional $22
billion in short- term debt (about 36% of the total short-term debt) was
almost immediately rescheduled. While the package did not prevent a painful
economic contraction, it stabilized Korea's exchange rate a few months
after the crisis broke out and set the stage for an expected recovery
in the Korean economy in 1999.
Financial packages are now being geared to encourage the adoption of
policies that could prevent crises in selected developing countries. Backed
by a recent IMF quota increase of about $90 billion (including $17.9 billion
from the U.S.), an enhanced IMF Facility is being considered to provide
a contingent short-term line of credit that would be available before
a crisis breaks out, but only if a country adopts certain policies that
would limit its vulnerability. The line of credit is expected to be of
short maturity and to charge interest rates above market rates to discourage
misuse.
Another important feature of the new financial packages is that they
do not rely exclusively on IMF funds. Governments and other international
organizations are to make financing available along with the IMF, and
private investors are encouraged to participate in providing financial
relief. While the precise details are still being worked out, this may
include arrangements which ensure that private investors or lenders do
not flee financial markets during periods of uncertainty and instead voluntarily
reschedule their loans to prevent or attenuate crises. As such arrangements
would impose costs on private creditors in the aftermath of a crisis,
they are also seen as a way of curbing moral hazard and preventing future
crises. Recent financial rescue packagesincluding those for Korea in
1998 and Brazil in 1999, already contain some of these elements.
Crisis prevention. While large money packages can prevent or
end panics in the short run, they also can create moral hazard, increasing
the vulnerability to future crises. To avoid such an outcome, recent rescue
programs have called for the adoption of structural reforms in the financial
and corporate sectors, as well as improved prudential supervision. The
idea is to improve risk management as well as the overall operation of
the financial sector, thus reducing the chances of the type of panic that
can trigger currency crises. In line with this, legal reforms in some
countries that have experienced crises now allow more efficient and well-capitalized
banks or firms to take over bankrupt institutions. Furthermore, sectors
previously closed to foreign investment have been opened. Reforms also
aim to enhance transparency in government, the financial sector, and the
corporate sector in order to increase accountability and facilitate the
assessment of risk.
Some actions are also contemplated at the international level. German
Bundesbank President Hans Tietmeyer recently proposed enhancing the surveillance
of the global financial system to reduce the chances of future crises.
The enhancements include improving the information provided by financial
institutions as well as national authorities, strengthening the coordination
of national and international regulatory bodies, and assessing whether
currently unregulated financial institutions should be regulated. Tietmeyer
also proposed the creation of a G-7 (Canada, France, Germany, Italy, Japan,
U.K., and U.S.) Financial Stability Forum that would identify and oversee
actions to prevent crises.
Conclusions
While it is too early to assess their effectiveness fully, recent measures
to strengthen the international response to currency crises appear to
be facilitating the early recovery of countries affected by such crises
and may also contribute to their prevention. Nevertheless, some of the
obstacles to the smooth provision of international lender of last resort
support that were cited earlier will remain. Under these conditions, developing
countries may be well advised to give the highest priority to making their
economic systems less vulnerable to crises. Experience with recent currency
crises (Moreno 1998) suggests that countries may reduce their vulnerability
by developing robust and well-supervised financial systems, with well-capitalized
financial institutions that are more able to absorb shocks. Eliminating
the government guarantee implied by a fixed exchange rate, by allowing
greater exchange rate flexibility, may also reduce the likelihood of future
currency crises.
Ramon Moreno
Senior Economist
References
Calvo, Guillermo. 1994. "Mexico: Stabilization, Reform and No Growth.
Comments." Brookings Papers on Economic Activity, 0(1), pp. 298-303.
Fischer, Stanley. 1999. "On
the Need for an International Lender of Last Resort." Manuscript.
Dooley, Michael P. 1995. "A Retrospective on the Debt Crisis." In Understanding
Interdependence: The Macroeconomics of the Open Economy, ed., Peter
Kenen. Princeton: Princeton University Press.
Moreno, Ramon. 1998. "What Caused East Asia's Financial Crisis?" FRBSF
Economic Letter, 98-24
(August 7).
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
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