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Why Do Currency Crises Arise and How Could They Be Avoided?

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Why Do Currency Crises Arise and How Could They Be Avoided? A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Aschinger, Gerhard Article — Digitized Version Why do currency crises arise and how could they be avoided? Intereconomics Suggested Citation: Aschinger, Gerhard (2001) : Why do currency crises arise and how could they be avoided?, Intereconomics, ISSN 0020-5346, Springer, Heidelberg, Vol. 36, Iss. 3, pp. 152-159 This Version is available at: http://hdl.handle.net/10419/41119 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu INTERNATIONAL TRADE American countries except the largest. In 1995, the. not only remain, it will become larger. Nor will this Equivalent Producer Subsidy represented 41 % of the asymmetry abate if Latin America keeps exporting production value of these products. This high level coffee, oil seeds, tropical and subtropical fruit as well persisted in spite of the fact that it had decreased as fruit juice, meat and animal food or if it continues from 20% "to 15% in the United States from 1994 to focusing on maquila production based on cheap 1995 as a result of lower direct payments and higher labour and inputs that are specifically imported for world market prices, whereas it had increased in the exportable production. European Community mainly due to the incorporation Evidence leads to the inevitable conclusion that in 34 of new members. It should be noted that this 20% trade liberalisation there is a gap between what indus- increase in total support occurred during the decade trial countries say must be done and what they do to in which the Uruguay Round was,negotiated and in make it happen. If the EU continues granting which the official discourse focused on state subsidies to agriculture and to other sectors and reduction. maintains its protectionist stance, it will be extremely Contrarily, support of this kind has been systemat- difficult for negotiations to level out the playing field. ically eliminated in Latin American countries because Under these conditions, the gap between what Latin of the discourse on globalisation and the pressure of America sells to the EU and what it buys from the EU international organisations. Although comprehensive will continue to expand. information regarding support to agriculture in these countries is lacking, the FAO, based on different 34 FAO: Commodity Market Review, 1996-97, p. 7. studies, accepts that this particular tendency is 35 A. Valdes: Surveillance of agricultural price and trade policy in confirmed in Latin America35 as well as in grain selected Latin American countries at the time of major reform, The 36 World Bank, 1996. producing countries. As long as industrial countries c 36 maintain subsidies and developing countries reduce FAO: Review of Cereal Prices Developments in Selected Developing Countries in 1995-96 and Policy Response, Commodities them the asymmetry between these economies will and Trade Division, September 1996. CURRENCY CRISES Gerhard Aschinger* Why Do Currency Crises Arise and How Could They Be Avoided? In the 1990s currency crises arose in different regions, e.g. in Mexico, East Asia, Russia, Brazil and Ecuador, to mention only the most important ones. What are the main factors which may trigger such events? How does globalisation and deregulation of financial markets influence the emergence of a currency crisis? What forms of crises exist? Are they driven by fundamental imbalances in a country or are they caused by self-fulfilling mechanisms involving herd behaviour and destabilising speculation? To what extent do such crises reflect implicit governmental and international guarantees which may cause moral hazard and adverse selection, thereby increasing the risk behaviour of enterprises and banks? currency crisis is characterised by a sudden dollar) creates a higher potential for such crises since Aattack on a country's currency, which will devalue under flexible exchange rates investors directly bear accordingly. Although currency crises may also occur the exchange-rate risk. The commitment of a under flexible exchange rates, the pegging of the government to defending the peg of its currency domestic currency to a reserve currency (e.g. the US (falsely) signalises investors that exchange-rate risks are virtually non-existent. It is often believed that * Professor of Economics, University of Fribourg, Switzerland. domestic money could always be exchanged for 152 INTERECONOMICS, May/June 2001 CURRENCY CRISES foreign currency at par such that the central bank's Emerging economies (especially in East Asia) foreign reserves would not be exhausted. A loss of experienced high economic growth over a long period confidence, however, may exert heavy pressure on of time, encouraged by low salaries, skilled labour and the domestic currency, leading to a currency attack attractive investment opportunities especially during and thereby depleting the foreign currency reserves of the recession in industrial countries in the 1990s. In the central bank even if the amount of these reserves order to attract capital, emerging economies liber- seemed to be sufficiently high. Whatever the reason alised their financial sectors to facilitate access by for the increased demand for foreign currency, a fixed foreign investors. Since equity and obligation markets peg would amplify the danger of a currency crisis. in such countries are not sufficiently developed, capital inflows usually take the form of bank credits. Factors which may Trigger a Currency Crisis The lack of efficient institutions and supervision of the banking system as well as the absence of binding Although different currency crises in emerging rules for risk management and bookkeeping economies depend on specific constellations and standards enhanced the danger of financial distress. evolutions^ they are driven by important common factors as well. Some influential determinants which While foreign direct investment constituted an may trigger currency attacks are discussed below. important part of capital imports, the share of short- run capital inflows (portfolio investment) increased Introducing a Peg: Many developing countries substantially over time. With globalised financial suffering from economic imbalances such as high markets, short-run capital became extremely volatile, inflation or budget deficits decided to peg their reacting quickly to changes in investors' expecta- currency to a reserve currency as a nominal anchor in tions. Using short-term capital to finance long-run order to stabilise the domestic economy. Under fixed investment augmented the default risk of firms and exchange rates a country has ah incentive to disci- banks. pline its economic policy in order not to lose too much of its foreign currency reserves. While maintaining the Excessive Credit Creation: Given the peg, strong peg, the home country may "inherit" stability from the capital inflows led to a substantial accumulation of reserve currency country and gain the confidence of central banks' foreign currency reserves and to an investors. Especially in emerging economies which increase in money supply and domestic credit need a high amount of foreign credit to finance although emerging countries pursued stabilising economiagrowth, a stable exchange rate is a prereq- monetary and fiscal policies in order not to run into uisite for attracting substantial capital inflow. Although inflation. Domestic firms and banks increasingly exchange-rate risks seem to be eliminated by intro- demanded credits in foreign currency, due to the fact ducing a peg, the danger of a currency attack is that foreign interest rates were lower than domestic reinforced in the longer run, given the fact that capital ones and the government was expected to guarantee is highly volatile and susceptible to pessimistic expec- the peg. Ignoring exchange-rate risks the interest tations. In such situations investors have an incentive differential seemed to be too high. The accumulation to exchange domestic currency for foreign currency at of short-term foreign debt could therefore trigger a a given price. currency crisis. The need to pay back maturating foreign debt and to make interest payments would Globalisation and Capital Flows: With the globali- induce domestic firms to buy foreign currency from sation of financial markets international capital the central bank at the given peg. If doubts should mobility has increased enormously. Financial deregu- arise concerning the maintenance of the peg,
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