Financial Crises in Emerging Markets
* Velasco is a Research Associate in the NBER's Program on International Finance
and Macroeconomics. He is also Director of the Center for Latin American and Caribbean
Studies at New York University. His "Profile" appears later in this issue.
Recent events in Mexico, East Asia, Russia, and Brazil have confirmed that a satisfactory
explanation of emerging market financial and currency crises remains elusive. Not long ago,
the prevailing view was that such crises were the inevitable outcome of ongoing fiscal
imbalances coupled with fixed exchange rates. But this "first generation" of models of
crisis, pioneered by Paul R. Krugman,(1) has fallen out of fashion, because many actual
crises seem to lack the crucial fiscal disequilibriums.
Maurice Obstfeld(2) proposed a "second-generation" view, in which central banks may decide
to abandon the defense of an exchange rate peg when the social costs of doing so, in terms
of unemployment and domestic recession, become too large. This change of perspective implied
that crises may be driven by self-fulfilling expectations, since the costs of defending an
exchange peg may depend on anticipation that the peg will be maintained. But Obstfeld's
emphasis on mounting unemployment and recession, while appropriate for the Exchange Rate
Mechanism 1992 crisis, was at odds with the crises of Mexico in 1994 and of East Asia in
1997. Asian countries, in particular, were growing quickly until shortly before the
Instead of fiscal imbalances or weakness in real activity, recent crises in emerging
markets have revealed financial sources of vulnerability. In the Southern Cone of the
Americas in the early 1980s, Scandinavia in the early 1990s, Mexico in 1995, and Asia
more recently, the currency crashed along with the financial system. Formal econometric
work by Graciela Kaminsky and Carmen M. Reinhart(3) suggests that banking troubles are good
predictors of currency crises.
Almost all of the countries affected by the recent turmoil also had large ratios of
short-term debt, public or private, to international reserves. In Mexico in 1995, Russia
in 1998, and Brazil in 1999, the debt was the government's; in Indonesia, Korea, and
Thailand in 1997, the debt was primarily owed by private banks and firms. However, in
each case, the combination of large short-term liabilities and relatively scarce
internationally liquid assets resulted in extreme vulnerability to a confidence crisis.
Furman and Stiglitz consider the ability of this variable alone to predict the crises of
1997 to be "remarkable."(4)
Weak banks and large stocks of short-term debt are manifestations of a more general
phenomenon: international illiquidity, defined as a situation in which a country's
consolidated financial system has potential short-term obligations in foreign currency
that exceed the amount of foreign currency to which it has access on short notice.
Illiquidity is a key problem for emerging market countries because of their limited
access to world capital markets. If banks in mature economies face a liquidity problem,
as long as they are solvent they are likely to get emergency funds from the world capital
markets. This seldom occurs in emerging economies: a private bank in Bangkok or Mexico City
will get many international loan offers when things go well, and none when the bank is being
run on by depositors.
Illiquidity is certainly not necessary for currency crashes to occur. The European Monetary
System troubles of the early 1990s, for instance, had more to do with governments' desire
to fight unemployment than with any difficulties in servicing short-term obligations.
Nevertheless, illiquidity comes close to being sufficient to trigger a crisis. The options
left after creditors lose confidence, stop rolling over, and demand immediate payment on
existing loans - whether to the private sector as in Asia or to the government as in Mexico
and Brazil - are painfully few. The collapse of the currency or the financial system, or
even of both, is the likely outcome.(5)
Take the case of Asia after it was hit by what Guillermo A. Calvo(6) terms the "sudden stop
syndrome": a massive reversal of capital inflows in the second half of 1997 that amounted to
3.6 percent of gross domestic product.(7) Proliferating bankruptcies and payment moratoriums
weakened bank balance sheets just as panicky domestic depositors were withdrawing their funds.
Governments attempted to help by providing liquidity and moderating the rise in interest
rates, but the additional domestic currency quickly found its way back to the central bank,
causing a fall in reserves and an eventual collapse of the peg.
Several recent papers I co-authored with Roberto Chang of the Federal Reserve Bank of Atlanta
and one written with Dani Rodrik of Harvard University(8) try to build a new class of crisis
models that places financial fragility and illiquidity at the center of the story. We are not
alone in trying to develop such a "third generation" of currency crisis models.(9)
The Basic Analytical Story
Any model in which financial institutions issue demandable debt as a liability, therefore
placing themselves in a potentially illiquid position, is useful for studying crisis. Chang
and I(10) start from a version of the celebrated banking model by Bryant and by Diamond and
Dybvig.(11) Banks are essentially transformers of maturity that take liquid deposits and invest
part of the proceeds in illiquid assets. In doing so, they pool risk and enhance welfare, but
they also create the possibility of self-fulfilling bank runs.
While the Diamond-Dybvig model focuses on the microeconomics of banking, our version embeds
banks into a small, open economy. This extension brings three macroeconomic/international
issues to the fore. First, in an open economy, the ability of governments to come to the
rescue of banks under attack is severely limited by the availability of international
reserves. With capital mobility, printing unbacked money can only cause the exchange rate
to crash, as both standard theory and the experience of Asia suggest.
Second, domestic bank runs, understood as a panic by depositors in the banking system, may
interact with panics by foreign creditors of the system. The nature of this interaction
depends, in particular, on the structure of international debt and on how strongly banks
can commit to repay their international obligations. For instance, Chang and I(12) identify
situations in which a run by domestic depositors can occur in equilibrium if and only if
foreign creditors run at the same time. Such results seem relevant to recent events.
Third, real exchange depreciation may both cause bank runs and multiply their deleterious
real effects. The logic is circular: if bank runs cause the real exchange rate to depreciate,
then producers of nontradable goods may go bankrupt if these firms had borrowed from local
banks, the bank's liquidation value would have declined, and a run would have been even more
Choosing Debt Maturity
Domestic banks and firms have a choice about the maturity of the loans they contract abroad.
How do we understand the preponderance of short-term borrowing in most of the emerging
economies that recently crashed? A common answer is that short-term debt "is cheaper" than
long-term debt. But the term structure of interest rates is determined by the riskiness of
different debt maturities, and these should in turn reflect the possibility of a crisis
associated with illiquid portfolios. Consequently, the role of short-term debt in generating
a crisis can only be analyzed in a model of the simultaneous determination of debt maturity
and the term structure of interest rates.
In my papers with Chang and with Rodrik, we build such a model.(13) We find that the share of
short-term debt that is optimal ex ante depends on various factors, such as the extent to
which early investment liquidation is costly; the probability that a run on short-term debt
will take place if one is possible (something that depends, among other things, on the
borrowing country's previous credit record); and the likelihood and costliness of attempted
This work focuses on the undistorted optimal choice of maturity. However, many plausible
distortions could lead local borrowers to prefer short-term loans beyond the level that is
socially desirable, including biases in the local tax and regulatory structure, informational
limitations that prevent foreign lenders from distinguishing across borrowers from the same
country, and the moral hazard caused by the expectations of government bailouts. In that last
case, we argue, Chilean-style taxes on short-term capital movements may be desirable.
The Role of the Exchange Rate Regime
Chang and I show that the macroeconomic effects of creditor runs depend crucially on the
monetary and exchange rate policy in place.(14) The combination of fixed rates and a central
bank that stands ready to act as a lender of last resort is predictably troublesome: bank
runs are avoided only at the cost of causing currency runs.
Currency boards that fix the exchange rate and prevent central banks from issuing domestic
credit indeed can prevent bank crises from expressing themselves in the currency market. Yet,
precisely because a currency board prevents the central bank from acting as a lender of last
resort, it may render fractional reserve banks endemically unstable. Creating a "fiscal war
chest" to be used at times of bank trouble is an alternative, but one that has efficiency
Greater exchange rate flexibility may be a better alternative. For example, a regime in which
bank deposits are denominated in domestic currency, the central bank stands ready to act as a
lender of last resort, and exchange rates are flexible, may help to forestall some types of
self-fulfilling bank crises. The intuition for this is simple. An equilibrium bank run occurs
if each bank depositor expects that others will run and exhaust the available resources.
Under fixed rates, those who run to the bank withdraw domestic currency, which they in turn
use to buy hard currency at the central bank. If depositors expect this sequence of actions
to cause the central bank to run out of dollars or yen, then it is a best response for them
to run as well, and the pessimistic expectations become self-fulfilling. On the other hand,
under a flexible-rates regime with a lender of last resort, there is always enough domestic
currency at the commercial bank to satisfy those who run. Since the central bank is no longer
compelled to sell all the available reserves, those who run will face a depreciation,
who do not run know that there will still be dollars available when they want to withdraw
them at a later date. Hence, running to the bank is no longer a best response; pessimistic
expectations are not self-fulfilling; and a depreciation need not happen in equilibrium.
This makes a strong case for flexible exchange rates, but there are caveats. One is that
such a mechanism can protect banks against self-fulfilling pessimism on the part of domestic
depositors (whose claims are in local currency), but not against panic by external creditors
who hold short-term IOUs denominated in dollars. To the extent that this was the case in Asia,
a flexible exchange rate system would have provided only limited protection.(15) In addition,
proper implementation is subtle. If flexible exchange rates are to be stabilizing, they must
be part of a regime in which agents take into account the regime's operation when forming
expectations. Suddenly adopting a float because reserves are dwindling, as Mexico did in 1994
or as several Asian countries have done recently, may have the opposite effect by further
frightening concerned investors.
Krugman, "A Model of Balance of Payments Crises," Journal of Money, Credit,
and Banking (1979).
Obstfeld, "The Logic of Currency Crises," Cahiers Economiques et Monetaires,
no. 43 (Paris: Banque de France, 1994), pp. 189-213.
Kaminsky and C. M. Reinhart, "The Twin Crises: The Causes of Banking and
Balance of Payments Problems," International Finance Discussion Paper
No. 544, Board of Governors of the Federal Reserve System, March 1996.
and J. E. Stiglitz, "Economic Crises: Evidence and Insights from East Asia," Brookings
Papers on Economic Activity, 1998.
"close to sufficient" because, as Obstfeld and Rogoff (Journal of Economic
Perspectives, 9, no. 4, Fall 1995, pp. 73-96) have stressed, any central
bank that has enough resources to buy back the monetary base is capable, in a
technical sense, of maintaining an exchange rate peg. But, as the authors
recognize, in situations of financial distress, the de facto claims on central
bank reserves may be as large as or larger than M2. In those cases, as we later
study in detail, maintaining the peg becomes a more treacherous task.
"Balance of Payments Crises in Emerging Markets: Large Capital Inflows and
Sovereign Governments," University of Maryland, Discussion Paper, March 1998.
figure is from S. Radelet and J. Sachs, "The Onset of the Asian Financial
NBER Working Paper No. 6689,
and A. Velasco, "Financial Fragility and the Exchange Rate Regime,"
NBER Working Paper No. 6469,
March 1998; Chang and Velasco, "Financial Crises in
Emerging Markets: A Canonical Model,"
NBER Working Paper No. 6606,
June 1998; Chang and Velasco, "Banks, Debt Maturity, and Financial Crises," forthcoming,
Journal of International Economics; Chang and Velasco, "Liquidity Crises in
Emerging Markets: Theory and Policy,"
NBER Working Paper No. 7272,
July 1999; and D. Rodrik and Velasco, "Short-Term Capital Flows," paper presented at
Annual Bank Conference on Development Economics, World Bank, 1999.
papers in the same line of research include: E. Detragiache, "Rational
Liquidity Crises in the Sovereign Debt Market: In Search of a Theory," IMF
Staff Papers, 43, no. 3 (1996); I. Goldfajn. and R. Valdes, "Capital Flows
and the Twin Crises: The Role of Liquidity," Working Paper 97-87, International
Monetary Fund, July 1997; Calvo, "Balance of Payments Crises in Emerging
Markets" and "Varieties of Capital Market Crises," Working Paper No. 15, Center
for International Economics, University of Maryland, 1995; O. Jeanne,
"International Liquidity and the New Architecture," International Monetary
Fund, mimeo, 1998; P. Aghion, P. Bacchetta, and A. Banerjee, "Capital Markets
and the Instability of Open Economies," Working Paper No. 9901, Studienzentrum
Gerzensee, 1999;and Krugman, "Balance Sheets, the Transfer Problem, and
Financial Crises," paper presented at MIT, 1999. The policy implications of the
liquidity approach are stressed by M. S. Feldstein, "A Self-Help Guide for
Emerging Markets," Foreign Affairs (March-April 1999); and Chang and
Velasco, "Liquidity Crises in Emerging Markets."
Velasco, "Financial Crises in Emerging Markets."
Bryant, "A Model of Reserves, Bank Runs, and Deposit Insurance," Journal of
Banking and Finance, no. 4 (December 1980); D. Diamond and P. Dybvig, "Bank
Runs, Deposit Insurance, and Liquidity," Journal of Political Economy,
91 (1983), pp. 401-19.
Velasco, "Financial Crises in Emerging Markets."
Velasco (forthcoming, Journal of International Economics) analyze a
domestic banks choice of foreign debt maturity; Rodrik and Velasco,
"Short-Term Capital Flows," focus on the choice faced by domestic nonfinancial
Velasco, "Financial Fragility and the Exchange Rate Regime."
is not totally useless in this case, for panic by foreign creditors could
perfectly well be triggered by a run by domestic depositors, with the outcome
self-fulfilling. For details on this line of argument, see Chang and Velasco,
"Financial Crises in Emerging Markets."