An exchange rate peg may collapse because, if and when a bank crisis comes, stabilizing the banks and keeping the exchange rate peg become mutually incompatible objectives. A Central Bank may attempt to fight a bank crisis by keeping interest rates from rising (which would further wreck the banks) or by providing lender-of-last-resort funds. But then agents will use the additional domestic currency to buy reserves, eventually forcing the abandonment of the fixed exchange rate. It is in this sense that we observe “twin crises”: a financial crisis and a balance of payments crisis.
While potentially illiquid banks exist in emerging and mature economies alike, we believe that our story is most relevant for emerging markets because of two reasons. First, banks play a much larger role in emerging than in mature economies; this observation justifies a focus on banks to the detriment of other credit mechanisms such as debt or equity markets.
Second, focusing on illiquidity is natural for emerging markets because their access to world capital markets is more limited. If fractional reserve banks in mature economies face a liquidity problem (as opposed to a solvency one) 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 lots of international loan offers when things go well, and none when it is being run on by depositors. The combination of fractional reserve (and hence potentially illiquid) banks and external credit ceilings is potentially devastating – and is the focus of our model.
This paper draws on and extends in many directions our previous theoretical work (Chang and Velasco 1998a), which focused on the relations between banking crises, balance of payments crises, and central bank policy. While we depart substantially from the mainstream currency crisis literature, we also draw on a number of papers which have identified the main empirical features of this financial crisis syndrome and made some preliminary headway in formalizing its logic.
The basic framework
In this section we present a framework that will serve as a benchmark for the discussion in later sections. The framework is a simple open economy version of the well known model of Diamond and Dybvig (1983). The Diamond-Dybvig paper focused on the microeconomics of banking; our version embeds banks into a small open coimtry and allows for the analysis of macroeconomic questions. payday loan debt consolidation