Lectures 3-4

3- Currency Crises
a. Impossible trinity
FREE CAPITAL
MOVEMENTS
FIXED MONETARY
EXCHANGE INDEPENDENCE
RATE Capital controls
(China)
129
Impossible trinity
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
FIXED MONETARY
RATE
130
Impossible trinity
FREE CAPITAL
MOVEMENTS
Monetary Flexible
Union exchange
(within EU) rate (US, UK, Japan)
FIXED MONETARY
RATE Capital controls
(China)
131
b. Currency crises
1 . What is a currency/financial crisis?

North European countries 92-3, Tequila crisis (Mexico)
94-5, Brazil 98-9, Argentina 01-9,…
Currency crisis:
High volatility in the exchange rates
Fixed exchange rates  devaluation (forced
change in parity or abandonment of a pegged ER)
Floating exchange rate  high depreciation
The extreme case = insolvency
Central Bank Balance Sheet
Assets Liabilities
Foreign reserves Deposits held by private banks
Domestic assets Currency in circulation
Total Assets Total Liabilities

Banking crisis: Financial distress resulting from
the erosion of most or all aggregate banking system
capital.
Ex: near-bankruptcy of the hedge fund LTCM (Long
term Capital Management).
Twin crisis: Banking+currency crisis
Financial crisis: Problem of illiquidity and
insolvency among financial-market participant.
Global financial crisis
2. Is Financial crises a growing problem?
1880- 1919- 1945- 1973-

1913 1939 1971
Currency Crisis
frequency
1.5% 4% 6.5% 7%
Banking Crisis
2% 4.2% 0% 2%
frequency
Higher probability of the occurrence of a crisis in the

recent past.
Explanations:
. Democratization has made it more difficult for

governments to credibily commit to exchange rate
stabilization. It is no more credible that all other
goals of policy would be subordinate to the
maintenance of a peg. (Eichengreen, 1996 and
Jeanne, 1997)
+ High capital mobility

c. Source of the currency crises:
. Macroeconomic policy: Inadequate policies lead to a fall in
the reserves, and at some stage the defense of the currency (to
respect the external balance) is impossible:
example: Expansionary monetary policy  pressure
for a future devaluation of the currency (as E should ).
These are the 1st generation crisis models

But also it exists non fondamental based currency crises (2nd
generation crises model)
. Contagion: Propagation of shocks in excess to that which can

be explained by fundamentals.
ex: Asian Flue: The shart depreciation of the Thainland Bath
has led investors to withdraw their investment from the Whole
Asia. Idea the same causes can lead to the same consequences.
. Self-fulling propethies: A speculative attacks can occur even

with good macro-fundamentals
ex: Sorros' attack of the British pound 1992.
d. How to cure a financial crisis?
It depends of course on the factor at its origins.
. Improve macro-fundamental: Cut budget spending (to avoid
the overevaluation), devaluate (in order to gain competitiveness,
while stabilising inflation), moderate wage increase and
monetary expansion === Austerity package
Sometimes difficult to apply because of domestic trouble (see

Argentine, 2001).
. If contagion, or self-fulfilling speculative attacks, a credible

announcement should be done by international authorities.
 Need for international help (IFS)
.Loans to smooth the Austerity package (IMF and World
Bank).
. Regulation and supervision role (BIS).
. Lender as last ressort.
Probleme Doing so, moral hazard is favored: As the international

financial system would prevent a global crisis, government,
banks have no incentive to run "correct" policies. It could
lead to an increase in risky investment, or populist economic
policies.
Brazil 98 Currency Crisis
1- Brazil from 1994-1998.

2- The Crisis and its possible origins.
3- Policy proposed to rule out the financial turmoil.
4- Brazil now.
1- Brazil from 1994-1998.
 1994. High level of inflation 3.000% a year on average

early 90 (despite previous stabilization plans Bresser
Plan, 06/1987, Summer Plan, 01/1989)
.Tequila Crisis in Mexico  speculation attack in
Brazil  no more confidence in the cruzeiro
Political corruption: 1992, President Fernando Color
has been destituted.
In 1994, Real Plan

What is the Real plan?
Stabilisation program to restaure confidence in

the currency and controle inflation.
. Cuts in current government spending.

. Limit monetary growth: Wage and prices are
fixed for a certain period of time.
. The cruzeiro real ceased to exist and is replaced
by the Real, which is pegged to the US$
(dollarization).
Consequences of the Real Plan?
1994 1995 1996 1997
Current Account
1.22 -9.27 -11.31 -15.52
(Millions of R)
Real exchange
rate (vs US$)
80 110 100 105
GDP growth
4.8 4.2 2.7 3.3
Prices (imp
GDP) %
2.240 77.6 17.4 8.3
Minimum wages
80.4 91.3 108.0 117.3
Primary balance
(deficit -)
3.4% 0.4% -0.2% -1.1%
M2
125.4 128.5 169.3 178.1
(Millions of R)
Until 1995-96, inflation decreases, with contained deficit
in CA (BP is equilibrated via FDI).
+ Strong economic growth (4.2%).
After 95/96, increases in wages (thus public deficit via

public employment).
decrease in prices  automatic overevaluation of the
currency (thus deficit in the trade balance).
 automatic increase in public
deficit (Patinkin's effect) + increase in the debt
labelled in foreign currency.
Crises in the financial sector which was fueled by
government spending (from national to local
government) + can not extract any more
inflationary taxes.
ex: bankruptcy of BANESPA.
2- The Crisis and its possible origins
At the end of 1998, the Foreign currency reserves
falled by $30 billion,
and despite the first financial assistance of the IMF,
the finance minister Malaan decided to abandon on
Tuesday, January 12th the peg of the Brazilian Real,
which lost 35% of its value in few days.
The sources:
- Real plan: mainly overevaluation of the

Real
- Exogeneous shocks:
Contagion of the 2nd pesos crisis from
Mexico + the Rusian crisis (graph 35).
- Other explanations: El Niño hurricane,

which has destroyed croops of coffee and sugar.
Which is the explanation to be favored?
. FDI compensate before 1997 the deficit in CA.

. Overevaluation of the rer is small
Favored 2nd generation of crisis
. Similarities between interest rate evolution and

other crises.
3- Policy proposed to rule out the financial turmoil.
. Free floating of the Real

. Policy mix: reduced primary deficit (pensions)
+ expansionary monetary policy.
. Help of the IMF to avoid the inflationary

consequences of such a policy (increase in nominal
interest rates). Loan to maintain the standard of living
and avoiding the explosion of the debt.
4- Brazil now
The stabilisation plan was successfull.
May 1999, appreciation of the Real +

decrease in the short-run interest rates + growth
in output growth.
Member of the BIRCS

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3- Currency Crises

1 . What is a currency/financial crisis?

Domestic assets Currency in circulation

Total Assets Total Liabilities

1880- 1919- 1945- 1973-

Higher probability of the occurrence of a crisis in the

. Democratization has made it more difficult for

+ High capital mobility

These are the 1st generation crisis models

. Contagion: Propagation of shocks in excess to that which can

. Self-fulling propethies: A speculative attacks can occur even

Sometimes difficult to apply because of domestic trouble (see

. If contagion, or self-fulfilling speculative attacks, a credible

Probleme Doing so, moral hazard is favored: As the international

1- Brazil from 1994-1998.

 1994. High level of inflation 3.000% a year on average

In 1994, Real Plan

Stabilisation program to restaure confidence in

. Cuts in current government spending.

After 95/96, increases in wages (thus public deficit via

- Real plan: mainly overevaluation of the

- Other explanations: El Niño hurricane,

. FDI compensate before 1997 the deficit in CA.

Favored 2nd generation of crisis

. Similarities between interest rate evolution and

. Free floating of the Real

. Help of the IMF to avoid the inflationary

May 1999, appreciation of the Real +

Member of the BIRCS

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