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KINGSTON UNIVERSITY, LONDON

SCHOOL OF ECONOMICS

Monetary Economics in Developing Countries

(FE3178), 2009-2010

Financial crises in the 1990s

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Financial crises in the 1990s

There is a large literature explaining crises including,

inter alia, classical works such as Kindleberger’s (2001)

(See also Calvo and Végh’s, 1999, survey, and Agénor

and Montiel, 1999).

Some models were developed with the aim of better

understanding the incidence of these phenomena during

the 1980s –which at the time mainly developed due to

debt and balance of payments related problems.

But the 1990s brought a new wave of crises in Mexico

during the 1994-1995 ‘Tequila crisis’, Asia during 1997-

1998 (beginning with the Thai baht’s devaluation in

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1997), Russia in 1998, Brazil in 1999, Turkey in 2000,

and notably Argentina in 2002.

An important phenomenon known in the literature as

‘contagion’, basically describing the transmission of

adverse events from a crisis-hit country to other countries

or whole regions, seems to have been operational

following Mexico’s, Asia’s, and Russia’s crises.

Yet that does not seem to have been the case following

the crises occurring in Brazil, Turkey, and Argentina.

However, Argentina’s troubles to an extent did spill-over

to neighbouring Uruguay.

In that respect, Kaminsky, Reinhart, and Végh (2003)

argue that there are three elements distinguishing crises

leading to contagion.
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Namely that (1) capital stops flowing into the economy,

(2) there are surprising announcements, and (3) there is a

common creditor to the parties affected.

Also, the world economy is to some extent better

equipped for detecting the potential of financial turmoil

following the consequential Mexican crisis.

For instance, institutions such as the International

Monetary Fund and the World Bank have launched

several initiatives in that direction, and they are

discussed further in Chapter 12.

In any case, subsequent to this wave of crises economists

have been busy developing suitable models and

providing assorted interpretations.

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Kaminsky and Reinhart (1999) advance an insightful

empirical analysis which examines banking and currency

crises as closely related phenomena -what they term

‘twin crises’.

They argue that such was not the case during the 1970s,

when financial regulation was tighter. Yet financial

liberalisation policies seem to have strengthened the link

between banking and currency crises.

In fact, Kaminsky and Reinhart show that banking crises

are significant in predicting currency/balance of

payments crises, though the causality can also run in the

opposite direction –i.e. currency crises pre-dating

banking crises.
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An important point worth noting is that a factor

explaining twin crises during the 1990s was a

depreciating exchange rate’s impact on firms’

balance sheets.

And particularly on firms with substantial foreign

liabilities (i.e. liability dollarization), for which a

depreciation leads to an erosion of their net worth.

Further, Kaminsky and Reinhart show that twin crises

seem to affect more acutely countries with weak

economic fundamentals.

In the most recent wave of crises financial flows

played a significant role.

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SEE: The next great globalisation: How disadvantaged

nations can harness their financial systems to get rich by

Frederic S. Mishkin, Princeton University Press, 2006.

Kaminsky, Reinhart, and Végh (2004) provide important

stylised facts on the matter.

They do so by investigating 104 developed and

developing countries during the period 1960-2003.

They show that capital flows are procyclical. That is,

capital flows are higher when an economy is doing well,

but decrease when the economy’s performance weakens.

Further, in developing countries fiscal and monetary

policies also tend to be procyclical.

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So, differing from what could be expected, in bad times

these policies move towards contracting rather than

expanding economic activity.

Additionally, Kaminsky, Reinhart, and Végh estimate

that when capital is flowing in macroeconomic policy is

expanding, and vice versa.

These findings are important, because they highlight the

fact that developing countries have a limited scope for

implementing an efficient stabilisation policy in times of

crises.

And that obviously complicates managing and

overcoming financial crises.

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It is worth noting that in Asia capital flows mainly led to

investment, whereas, for instance, in Mexico they

translated into consumption.

Further factors singled-out as triggering the crises in Asia

are weak banking systems and the sequence in which

liberalising the capital account took place.

During the early 1990s several Asian economies had

moved towards opening their financial markets to foreign

investors, and many argue that the resulting capital

convertibility was a major flaw in the reforming process,

particularly in terms of its timing.

Alongside these developments, exchange rates were

virtually fixed and mildly overvalued.

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That played a destabilising role by encouraging

excessive risk-taking in foreign currency and increasing

the potential problems associated with negative shocks to

borrowers’ net worth -like short-term capital flows

reversals.

So even though Asian economies experienced healthy

rates of economic growth during the early 1990s, short-

term capital was flowing into relatively weak banking

systems.

Sudden stops

Liberalising, and particularly opening-up for

international capital, can lead to several developments.

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The resulting capital inflows usually lead to currency

appreciation and current account imbalances.

Typically, that deteriorating situation reaches a critical

point where only a shock, sometimes apparently

negligible, is needed for triggering a crisis.

In this regard, sudden stop is a term for identifying large

and sharp reductions in the amount of capital inflowing

to an economy, usually alongside output contraction and

collapsing goods and assets prices (e.g. Mendoza, 2006).

Consequently these crises can be extremely costly.

For instance, Hutchison and Noy (2006) investigate 24

emerging market economies, and find that sudden stops

can reduce output by up to 8% in the crisis year.

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That is in addition to the related costs such as those from

contemporaneous currency crises.

Some models on the topic aim at explaining the acute

asymmetries involved in foreign investors’ decision to

pull-out from an economy following apparently small

changes in macroeconomic fundamentals (Gopinath,

2004).

Still, this research agenda highlights the role played by

weaknesses in the domestic economy.

It is worth noting that sudden stops do not seem to be an

exclusive feature of the 1990s economies.

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Bordo (2006) finds that the 1990s’ financial crises

largely resemble those happening during the so-called

first era of globalisation, i.e. during the period 1870-

1913.

Interestingly, he finds that then, as now, a country’s

institutional characteristics played a key role in

determining its fate.

For instance, ‘original sin’, a concept used to denote

problems associated with a country’s inability to borrow

abroad in its own currency in the recent literature (e.g.

Hausmann and Panizza, 2003) and with external or

internal debt denominated in gold or sterling during the

first-era of globalisation, seems to be a significant factor

in explaining economic turmoil during 1870-1913.

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However, as Table 11.2 taken from Bordo (2006) shows,

sudden stops are a worse problem in recent times, at least

I terms of the associated output loss.

Table 11.2
Financial crises and sudden stops

1880-1913 1980-1997
Sudden Sudden
stops Average stops Average
during output during output
period loss period loss
(%) (%)
Sudden Sudden
stops stops
with 45% -4.04% with 93% -6.25%
financia financial
l crisis crisis
Sudden Sudden
stops stops
without 55% -0.34% without 7% -0.44%
financia financial
l crisis crisis

Source: adapted from Bordo (2006, p. 15)

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Theoretical models

Calvo (2003), inter alia, advances a model for

understanding this problem.

He models sudden stops as arising from a discontinuity

in macroeconomic fundamentals.

His model emphasises crises’ unanticipated component

-but the framework does not rule out the fact that such

effects can be anticipated.

Regarding the latter, the model highlights the problems

arising from weak domestic institutions and financial

vulnerability, and insists on the importance of reforming

the corresponding institutional and regulatory

frameworks in overcoming those weaknesses.

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Calvo derives policy implications.

He argues that, in the light of diminishing credit

availability, the optimal response to a sudden stop is for

the central bank to supply foreign reserves in cushioning

these developments’ potential impact on the private

sector.

But there are pitfalls in implementing this policy, not

unusual in developing countries facing sudden stops.

Notably, the central bank reserves injection may not

benefit those originally intended.

A potential solution that Calvo puts forward is for the

central bank/government to offer ‘exchange rate hedge

contracts’ that will automatically supply needed reserves

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according to the evolution of certain key economic

indicators.

Finally, an important result arising from Calvo’s

modelling is the appeal of pursuing relative price

stickiness, which may be achieved by pegging the

exchange rate alongside price stickiness, following a

sudden stop.

Interestingly, Caballero and Panageas suggest hedging

strategies that may be useful in protecting countries

prone to suffering from sudden stops.

They illustrate their ideas using Chile’s case.

They emphasise that even though Chile is a rather

successful developing economy underlying potential

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weaknesses, like its dependence on copper, make it more

vulnerable to sudden stops.

Balance sheets, liability dollarization,

and monetary policy

The exposition so far clearly points to the fact that

financial crises’ adverse impact is usually aggravated by

the idiosyncrasies, such as the stage of financial

development, characterizing developing economies (e.g.

Aghion, Bacchetta, and Banerjee, 2004).

In this context engineering related policy responses is

also challenging. Aghion, Bacchetta, and Banerjee

(2000) advance some basic ideas on this problem.

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Essentially, they model an economy in which firms are

financially constrained and hold debt in domestic and

foreign currency -a scenario typical of economies facing

financial crises during the 1990s.

They show that, for a certain level of financial

development, the optimal interest rate policy in response

to a crisis is to decrease the interest rate.

The reason is that raising interest rates will actually

increasing domestic firms’ debt burden and likely reduce

future investment, assuming the financial constraint is

binding, and that may also lead to adverse exchange rate

developments.

Céspedes, Chang, and Velasco (2003) modify the

standard perfect capital mobility assumption in IS-LM-

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type models in accounting for capital market

imperfections (See also the related work Céspedes,

Chang, and Velasco, 2004).

They also consider balance sheet effects.

These effects matter because they tend to exacerbate the

impact of foreign shocks on the domestic economy.

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Preventing crises and early warning systems (EWS)

The International Monetary Fund and other institutions

have been working on a practical framework that should

help in preventing currency crises.

The outcome from this effort is known as ‘Early

warning systems’ (EWS) and formally started in 1999.

The basic objective behind this initiative is devising

quantitative models that are able to generate forecasts of

economic conditions for a given economy.

If these statistical models are indeed successful in

forecasting future developments in the economy EWS

could become a useful tool for policymakers. In technical

terms, EWS’s accuracy is measured by their out-of-

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sample predictions, and is also evaluated in reference to

benchmark models and individual indicators.

Comparing EWS to more traditional indicators (e.g.

spreads on foreign currency denominated sovereign

bonds and country credit ratings) in predicting the 1997-

1998 Asian crisis shows that EWS have superior power

for that task in relation to the market’s views.

For instance, Berg, Borensztein, and Patillo (2004) show

that Kaminsky, Lizondo, and Reinhart’s (KLR) (1998)

early contribution to the EWS literature –a model

designed before the Asian crisis which monitors a large

set of monthly indicators like exchange rates and foreign

reserves and signals a crisis when those variables cross a

certain threshold- performs fairly well when used in

forecasting that event.

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However, they also argue that EWS models like KLR are

more likely to be useful in combination with the more

traditional indicators highlighted above and other

surveillance techniques.

To illustrate this point, the authors use Korea as an

example.

Specifically, traditional indicators such as credit ratings

did not signal the country’s vulnerability to an external

shock during 1997-1998, probably due to the country’s

till then stellar performance.

In contrast, the more mechanical EWS show that the

Korean economy had an increased crisis probability

around that time.