🪅Global Monetary Economics Unit 12 – Currency Crises and Financial Contagion

Key Concepts and Definitions

• Currency crisis occurs when a country's currency experiences a sharp depreciation or comes under speculative attack
• Financial contagion refers to the spread of financial distress from one country or market to others
• Speculative attack happens when investors sell a currency in anticipation of its depreciation, putting pressure on its value
• Balance of payments crisis arises when a country struggles to pay for its imports or service its external debt
• Exchange rate regime (fixed, floating, or pegged) determines how a country manages its currency's value relative to other currencies
• Capital flight is the rapid outflow of money from a country due to economic or political instability
• Moral hazard occurs when individuals or institutions take excessive risks, believing they will be protected from the consequences
• Herd behavior describes investors following the actions of others, leading to amplified market movements

Historical Context and Notable Examples

• Latin American debt crisis (1980s) involved multiple countries defaulting on their sovereign debt
• European Exchange Rate Mechanism (ERM) crisis (1992-1993) saw speculative attacks on several European currencies
• Mexican peso crisis (1994) was triggered by a sudden devaluation of the peso and led to a severe economic downturn
• Asian financial crisis (1997-1998) began in Thailand and spread to other East Asian countries, causing significant economic and social distress
  • Affected countries included Indonesia, South Korea, and Malaysia
  • Crisis was characterized by currency devaluations, stock market declines, and high levels of debt
• Russian financial crisis (1998) resulted from a combination of falling oil prices, high government debt, and political instability
• Argentine economic crisis (1999-2002) involved a currency peg collapse, sovereign debt default, and a severe recession
• Global financial crisis (2007-2008) originated in the United States but quickly spread to other countries, highlighting the interconnectedness of global financial markets

Causes and Triggers of Currency Crises

• Unsustainable macroeconomic policies, such as large fiscal deficits or excessive money supply growth
• Overvalued exchange rates that make a country's exports less competitive and imports more attractive
• High levels of foreign currency-denominated debt, which become more difficult to service when the domestic currency depreciates
• Weak financial systems with inadequate regulation and supervision, leading to excessive risk-taking and vulnerabilities
• Political instability or policy uncertainty that erodes investor confidence and triggers capital outflows
• External shocks, such as changes in global commodity prices (oil) or interest rates in major economies (US Federal Reserve)
• Contagion effects from crises in other countries, particularly those with similar economic characteristics or strong financial linkages
• Self-fulfilling expectations, where investors' beliefs about an impending crisis can actually contribute to its occurrence

Mechanics of Financial Contagion

• Trade linkages transmit shocks as a crisis in one country reduces demand for exports from its trading partners
• Financial linkages, such as cross-border bank lending or portfolio investment, can spread financial distress across countries
  • Banks with exposure to a crisis-hit country may reduce lending to other countries to shore up their balance sheets
  • Investors may sell assets in other countries to cover losses or meet margin calls, putting pressure on asset prices and exchange rates
• Information asymmetries can lead to investor herding and panic, as lack of clear information about a country's fundamentals may cause investors to rely on the actions of others
• Common shocks, such as changes in global risk aversion or commodity prices, can simultaneously affect multiple countries
• Wake-up call effect occurs when a crisis in one country alerts investors to reassess risks in other countries with similar vulnerabilities
• Liquidity channels can spread contagion as a crisis in one market leads to a general tightening of credit conditions and higher borrowing costs
• Sovereign credit rating downgrades can trigger capital outflows and increase borrowing costs for affected countries, potentially spreading financial distress

Economic Models and Theories

• First-generation models (Krugman, 1979) attribute currency crises to unsustainable macroeconomic policies, such as persistent fiscal deficits financed by money creation
  • These models assume a fixed exchange rate regime and perfect capital mobility
  • A crisis occurs when the central bank's foreign reserves are depleted due to the need to defend the fixed exchange rate
• Second-generation models (Obstfeld, 1986) emphasize the role of self-fulfilling expectations and multiple equilibria
  • These models allow for the possibility of a crisis even when macroeconomic policies are not necessarily unsustainable
  • Investors' beliefs about the likelihood of a devaluation can lead to speculative attacks that ultimately force the government to abandon the fixed exchange rate
• Third-generation models (Chang and Velasco, 1998) focus on the role of financial fragility and balance sheet vulnerabilities
  • These models highlight the importance of foreign currency-denominated debt and maturity mismatches in the banking system
  • A crisis can be triggered by a sudden stop in capital inflows, which exposes the banking system's vulnerabilities and leads to a currency depreciation
• Contagion models (Masson, 1999) explore the mechanisms through which crises can spread across countries
  • These models consider trade and financial linkages, as well as the role of information asymmetries and investor behavior
  • Contagion can occur through fundamentals-based channels (trade and financial linkages) or through investor behavior (herding and information cascades)

Policy Responses and Prevention Strategies

• Implementing sound macroeconomic policies, such as sustainable fiscal and monetary policies, to reduce vulnerabilities
• Maintaining adequate foreign exchange reserves to defend the currency against speculative attacks
• Adopting flexible exchange rate regimes to absorb external shocks and reduce the likelihood of currency misalignments
• Strengthening financial sector regulation and supervision to prevent excessive risk-taking and build resilience
  • Implementing capital and liquidity requirements for banks
  • Monitoring and managing foreign currency-denominated debt
  • Promoting transparency and disclosure to reduce information asymmetries
• Developing local currency bond markets to reduce reliance on foreign currency borrowing and exposure to exchange rate risk
• Implementing capital flow management measures, such as taxes or restrictions on short-term capital inflows, to reduce vulnerability to sudden stops
• Establishing regional and global financial safety nets, such as swap lines between central banks or multilateral lending facilities (IMF), to provide liquidity support during crises
• Promoting international policy coordination and information sharing to monitor and address potential risks and spillovers

Global Impact and Interconnectedness

• Currency crises and financial contagion can have significant negative impacts on global trade and investment flows
• Crises in systemically important countries or regions can have spillover effects on the global economy
  • The Asian financial crisis (1997-1998) led to a slowdown in global growth and a decline in commodity prices
  • The global financial crisis (2007-2008) originated in the United States but quickly spread to other countries, leading to a global recession
• Contagion can occur through various channels, such as trade linkages, financial linkages, and investor behavior
• The interconnectedness of global financial markets has increased the potential for contagion and the speed at which crises can spread
• Currency crises and financial contagion can have social and political consequences, such as increased poverty, unemployment, and political instability
• The global impact of currency crises and financial contagion highlights the need for international policy coordination and cooperation to prevent and manage crises

Current Trends and Future Outlook

• The increasing size and complexity of global financial markets may increase the potential for contagion and the severity of future crises
• The growing importance of emerging markets in the global economy may make them more vulnerable to currency crises and contagion
  • Emerging markets often have less developed financial systems and may be more exposed to external shocks
  • The COVID-19 pandemic has put pressure on emerging market currencies and increased the risk of debt distress
• The rise of digital currencies and fintech may create new challenges and opportunities for managing currency risks and preventing crises
• Climate change and the transition to a low-carbon economy may create new sources of financial risk and potential for contagion
  • The physical and transition risks associated with climate change could lead to asset price volatility and financial instability
• The ongoing shift towards greater protectionism and trade tensions may increase the likelihood of currency crises and contagion
• The effectiveness of traditional policy tools, such as monetary policy and capital controls, may be challenged by the evolving nature of financial markets and the global economy
• The future outlook for currency crises and financial contagion will depend on the ability of policymakers to adapt to new challenges and maintain global financial stability