Capital Account Liberalization, Currency Float, and Twin Crises
After the collapse of the Bretton Woods system in early 1970s, a new breed of financial crisis emerged. Three quarters of the IMF’s member countries suffered some form of banking crisis between 1980 and 1996, and their study did not include the subsequent Asian financial crisis in 1997. In many of these crises, banking panics in the traditional sense were avoided either by central bank intervention or by explicit or implicit government guarantees. But the advent of financial liberalization in many economies in the 1980s, in which free capital in- and out-flows and the entrance and competition from foreign investors and financial institutions follow in the home country, has often led to “twin” banking and currency crises. A common precursor to these crises was financial liberalization and significant credit expansion and subsequent stock market crashes and banking crises. In emerging markets this is often then accompanied by an exchange rate crisis as governments choose between lowering interest rates to ease the banking crises or raising them to defend the home currency. Finally, a significant fall in output occurs and the economies enter recessions.
The entrance of China to the WTO (World Trade Organization) potentially introduces cheap foreign capital and technology, but large scale and sudden capital flows and foreign speculation significantly increase the likelihood of a twin crisis. The first key question is, when and to what extent should a country open its capital account and financial sector to foreign capital and foreign financial institutions? The prevailing view is that success or failure of this policy hinges on the efficiency of domestic financial institutions, while others have promoted reforming the financial sector as a precondition to liberalizing. This latter view assumes that financial liberalization does not alter the efficiency of domestic financial institutions. But this policy change affects both the supply and price of capital, two important determinants of lending contracts. A model of endogenous financial intermediation demonstrates that an efficient financial sector prior to liberalization is neither necessary nor sufficient for a successful financial liberalization. Read more
Relationship between Hard Ped and Banking Crises
Since 1998 crisis Asian countries have accumulated huge amounts of foreign exchange reserves. Such kind of a “large life jacket” helps to minimize the probability of speculative attacks on currency even under floating exchange rate regimes, makes countries less vulnerable to sudden stops of foreign capital flows and helps to sustain exports by keeping nominal exchange rate of the domestic currency artificially low. This is why many emerging market economies cannot be viewed any more as net exporters of foreign capital, but increasingly the situation changes to the opposite.
Since currencies of many emerging market economies tend to appreciate over time, it would be only natural for domestic borrowers to prefer to borrow in foreign currency and for lenders to lend in domestic currency given credibility of sustainable appreciation path. Therefore, the concept of the “Original Sin” might not be appropriate any longer for many emerging market economies, and this, in turn acts to alleviate the problem of currency and maturity mismatches, thus making bank bankruptcies less likely. Read more
Retrospect: The Currency Controversy
Although the bullionist camp won the debate and convertibility of the paper currency into bullion upon demand was restored in 1821 as a remedy against the inflationary practices of the BoE, it was soon clear to some of the participants in the currency debates from the subsequent developments (widespread financial crises followed by intervals of depression and unemployment) that convertibility alone was not enough, and that the chronic mismanagement of the currency together with the new structure of the industry were the cause of these fluctuations. Thus, the debate’s main focus was whether the note component of the convertible, gold standard currency needed regulation to prevent overissue, the Currency School advocating for rules while the Banking School allowing for discretion.
The position of the Currency School in relation to that of their predecessors, the Bullionists, only goes up to advocating rules to prevent overissue. While it will be remembered that the Bullionists argued that convertibility per se was enough to prevent overissue, the Currency School went further and argued that even convertible currency can be issued in excess, requiring strict regulation. Particularly, it was argued that the contraction of the note issue required to curb a loss of reserves would arrive too late, given the Bank’s profit motives and lack of a required reserve ratio, and with such violence that it would destabilize the economy. The solution was to be embodied under the Currency Principle: a mixed currency (paper and coin) should behave as if it were wholly metallic, that is, there should be one to one contractions in notes outstanding due to loss of gold reserves and vice versa. Thus money was considered to be exogenous, and determined by the amount of gold which was regarded to be the most stable of the monetary standards. Read more
Types of Exchange Rate Regimes
Before posing the question whether banking crises are more likely under hard-pegged exchange rate regimes let us make an overview of the different exchange rate regimes.
Sometimes there is a considerable difference between what the monetary authorities declare as de jure exchange rate regime and what they actually practice, de facto exchange rate regime. From this difference arises the difficulty in classifying the exchange rate arrangements. Furthermore, in some countries parallel exchange rate markets may exist, complicating even more the de facto classification.
From the IMF evaluations of the de facto regimes it can be concluded that 38 percent of the countries had either a hard peg or a floating exchange rate in 1991, while 62 percent had various types of soft peg arrangements. By 1999 the situation had essentially reversed so that 66 percent of the countries had a hard peg or a floating exchange rate whereas only 34 percent had a soft peg arrangement. Table 1 presents the situation by number and percentage in the trend of exchange rate regimes from 1991 to 2002. Read more
