We now have a basic framework with several desirable features. A banking system emerges naturally to attempt to implement a socially optimal allocation. A demand deposit system may implement the social optimum. However, it also creates a problem of illiquidity and the possibility of crises.
As in other models with multiple equilibria, what equilibrium prevails is essentially indeterminate and may depend on extraneous uncertainty or features of the environment that would otherwise be irrelevant. This implies, in particular, that in our model bank and currency crashes may come as relatively unexpected events. This may seem surprising but is perfectly in keeping with the stylized facts. Source Sachs, Tornell and Velasco (1996a) provide evidence that the Mexican 1994 was not anticipated by investors, and Radelet and Sachs (1998) argue the same was largely the case in the 1997 Asian collapse.
Yet runs may occur only if the financial system is illiquid. This means, in particular, that adverse expectations are not, by themselves, sufficient for a run to occur: the fundamentals of the economy must also be “fragile.”
Our next task is to employ this framework to study several issues related to crises in emerging markets. We pursue this agenda below, starting with a discussion of the role of international credit.
The popular press often blames “excessive” foreign borrowing for bank and currency collapses. This view is also echoed in more formal discussions. It has been emphasized, for example in Corsetti, Pesenti, and Roubini (1998), that the recent crisis in East Asia was preceded by a notable increase in foreign borrowing, suggesting the existence of a causal link. However, the details of such a link remain controversial.
Accordingly, in this section we investigate the role, if any, of the size and kind of foreign borrowing in affecting the vulnerability of domestic financial intermediaries. We argue that two factors play a crucial role. The first is the attitude of foreign lenders in response to a bank run, and in particular whether they will refuse to extend new loans. The second is the maturity of the external debt. We will see that, in accordance with conventional wisdom (but not to traditional academic literature), both factors affect financial fragility
It ha5 been argued by Radelet and Sachs (1998) and others that recent Asian crises were triggered by a foreign creditors’ refusal to extend new credit to the affected countries. The developing country debt crisis of the 1980s, according to some observers such as Sachs (1982), was also prompted by such a flight by foreign creditors.
This section shows that in our model it isn’t just domestic depositors, but also foreign creditors, who can panic. In fact, certain kinds of behavior by foreign lenders can increase the fragility of domestic banks even further.