Twin crises

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In economics, twin crises, also called a balance of payments crisis, are simultaneous crises in banking and currency. The term was introduced in the late 1990s by economists Graciela Kaminsky and Carmen Reinhart [1] after several such crises worldwide.

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Relationship between banking and currency crises

Twin crises diagram Twin Crises Diagram.png
Twin crises diagram

The wave of twin crises in the 1990s, which started with the 1994 Mexican crisis, also known as the "Tequila crisis", and followed with the 1997 Asian financial crisis and the 1998 Russian financial crisis, gave rise to a huge discussion on the relations between banking and currency crises. And although the literature on financial crises provided several theoretical economic models that tried to understand the linkages between these two types of crises, the causality direction was not unambiguous. While one research stream argued that currency crises could cause banking crises, [2] [3] another stream argued that banking-sector problems could cause currency crises, [4] [5] Moreover, there was yet a third stream of researchers that defended the idea that there would not be a causality relation between banking and currency crises, arguing that both types of crises would be caused by common factors. [6] [7] [8]

To address this ambiguity in the theory, Kaminsky and Reinhart (1999) [1] conducted an extensive empirical work for 20 countries over a 25-year sample and found that banking-sector problems not only are generally followed by a currency crisis, but also help to predict them. A currency crisis, on the other hand, does not help to predict the beginning of a banking crisis, but does help to predict the peak of a banking crisis. That is, although it doesn't cause the beginning of a banking crisis, a Balance-of-Payment crisis may help to deepen an existing banking crisis, creating thus a "vicious cycle". This result is supported by Goldstein (2005), [9] who found that with the existence of strategic complementarities between speculators and creditors in the model, an increase in the probability of one type of crisis generates an increase in the probability of the other type. This "vicious cycle" would be responsible for the severity of twin crises if compared to single crises, resulting in much higher fiscal costs [10] for the affected economy.

Financial liberalization

If on the one hand the frequency of currency crises has been relatively constant over time, on the other hand the relative frequency of individual banking and twin crises has significantly increased, specially during the 1980s and the 1990s. [8] In fact, during the 1970s, when financial markets were highly regulated, banking crises were rare, but as the world experienced several episodes of financial liberalization, the occurrence of banking crises more than quadruplicated, giving rise to the "twin crises" phenomenon. [1]

Goldfajn and Valdes (1997) [7] gives theoretical support to this idea by showing that financial intermediaries (that would arise as a consequence of financial liberalization) can generate large capital inflows, as well as increase the risk of massive capital outflows, which could lead to higher probabilities of twin crises. Moreover, in a sample that goes from 1970 to 1995, Kaminsky and Reinhart (1999) [1] documented that the majority of the twin crises happened in the aftermath of financial liberalization events. More specifically, the pattern shows that financial liberalization generally preceded banking crises (this happened in 18 out of 26 banking crises in the sample!), which would be followed by currency crises in most of the times, completing the link between financial liberalization and twin crises, and thus pointing to possible common causes to banking and Balance-of-Payment crises.

Economic fundamentals

Since one stream of the literature on currency crises argues that some of those events are actually self-fulfilling crisis, [11] this idea could be naturally expanded to the twin crises at first. However, the linkage between financial liberalization and twin crises gives a clue on which economic fundamentals could possibly be common causes to both types of crises. In this spirit, Kaminsky and Reinhart (1999) [1] analyzed the behavior of 16 macroeconomic and financial variables around the time that the crises took place, aiming to capture any pattern that would indicate a given variable to be a good signal to the occurrence of such crises. That is, the goal was to create signals that, by surpassing some threshold, would alarm policymakers about upcoming crises, in order to prevent them from happening (or at least to diminish their effects) by making use of adequate economic policy.

The results show that there are actually several "good" signals for both types of crises, with variables related to capital account (foreign-exchange reserves and real interest-rate differential), financial liberalization (M2 multiplier and real interest rate) and current account (exports and terms of trade) being the best signals, and the fiscal-sector variable (budget deficit/GDP) being the worst signal. All the variables previous cited as good indicators sent a pre-crisis signal in at least 75% of the crises, getting up to 90% for some variables, while the fiscal-sector variable only sent a signal in 28% of the crises. In fact, the real interest rate sent a signal for 100% of the banking crises, which supports the idea that financial liberalization may cause banking crises, since financial deregulation is associated with high interest rates.

The real-sector variables (output and stock prices) are an interest case, as they are not very good signals to currency crises but are excellent signals to banking crises, suggesting that the bursting of asset-price bubbles and bankruptcies associated with economic downturns seem to be linked to problems in the domestic financial system.

In a nutshell, they find that the majority of crises present several weak economic fundamentals prior to its burst, leading to the conclusion that they are mainly caused by macroeconomic/financial factors, and that self-fulfilling crises seem to be very rare. Moreover, most of the signals (13 out of 16) performed better with respect to twin crises than to single currency crises, which can partially explain the greater severity of the twin crises in comparison to single crises, since there is more instability in the macro/financial variables in those cases.

Emerging markets vs. advanced economies

Policy measures to reduce the risk of twin crises

During the last three decades of the 20th century, developing and emerging market countries suffered both banking and currency crises more often than advanced economies. The openness of emerging markets to international capital flows, along with a liberalized financial structure, made them more vulnerable to twin crises. On the other hand, due to the previous cited vicious cycle mechanism, at least in financially liberalized emerging markets, policy measures that are taken to help avoid a banking crisis have the additional benefit of lowering the probability of a currency crisis, and policy measures that are taken to help avoid a Balance-of-Payment crisis might also lower the probability of a banking crisis, or at least reduce its severity if such a crisis actually happens. [8] That is, measures that reduce the exposure and enhance the confidence in the banking sector may reduce the incentives for Capital flight (and consequent currency devaluations), while credible policies designed to promote exchange rate stability may enhance the stability in domestic banking institutions, which lowers the probability of a banking crisis. Thus, since the emerging market economies suffered from severe crises during the 1980s and 1990s, they developed (in general) more regulated banking systems in the 2000s as a precautionary measure, becoming then less susceptible to banking (and consequently to twin) crises than before.

The global financial crisis from 2007 in advanced economies

On the other hand, before the 2007 global financial crisis there was a belief that for advanced economies, destabilizing, systematic, multi-country financial crises were a relic of the past that would not recur. Those economies were in fact experiencing a period of "Great Moderation", a term coined by Stock and Watson (2002) [12] in reference to the reduction of the volatility of business cycle fluctuations, which could be seen in the data since the 1980s. However, the conclusion of some economists that those countries were now immune from such crises was unjustified. Robert Lucas Jr., 1995 Nobel Memorial Prize in Economic Sciences winner, for example said that the "central problem of depression-prevention (has) been solved, for all practical purposes". [13] Relying on this misconception advanced economies engaged in excessive financial risk-taking by allowing great deregulation of their banking systems, which made them more susceptible to banking crises.

As Reinhart and Rogoff (2008) [14] showed later, this idea was myopic because those countries only took into consideration a very short and recent sample of crises; all the research was being made with data starting on the 1970s. By using data on banking crises that goes back to either 1800 or the year of independence of each country, whatever comes first, they showed that banking crises have long been an "equal opportunity menace", in the sense that the incidence of banking crises proves to be remarkably similar in high-income and middle-to-low-income countries. And, more surprising, there are qualitative and quantitative parallels across disparate income groups. Also, a more careful analysis would have shown that even in the 1990s there were banking crises in advanced economies, such as the crises in the Nordic countries (a systemic crisis that affected Finland, Norway and Sweden), in Japan and in Greece, which shows that the "immunity to crises" idea was very weakly based.

As a consequence there were global financial crises in 2007–2008, and the world banking system collapsed, causing much more severe consequences to advanced economies than to emerging markets due to their less-regulated banking systems. Emerging markets showed a much faster recovery from the crisis, while several advanced economies faced deep and long recessions. However, most of these severe banking crises in the advanced countries were not followed by currency crises (Iceland was an exception, having a huge currency devaluation; for details, see 2008–2011 Icelandic financial crisis). This was probably due to the impossibility of several of the most affected countries (members of the Eurozone such as Greece, Portugal, Ireland and Spain) to use the currency exchange rate as a policy instrument, due to the European Union's currency union, with members using a common currency, the euro. This did not allow them to devalue their currency to dampen the impact of negative shocks and restore balance to the current account, which ultimately contributed to the European sovereign-debt crisis. Another reason for currency crises usually not following the banking collapses was probably the "liability dollarization" practiced by some countries, since in this case a currency devaluation would cause a considerable increase in the Sovereign debt/GDP ratio, as the debt of such a country would be denominated in US dollars (or another foreign currency) while its assets were denominated in local currency. [15]

Related Research Articles

<span class="mw-page-title-main">Global financial system</span> Global framework for capital flows

The global financial system is the worldwide framework of legal agreements, institutions, and both formal and informal economic action that together facilitate international flows of financial capital for purposes of investment and trade financing. Since emerging in the late 19th century during the first modern wave of economic globalization, its evolution is marked by the establishment of central banks, multilateral treaties, and intergovernmental organizations aimed at improving the transparency, regulation, and effectiveness of international markets. In the late 1800s, world migration and communication technology facilitated unprecedented growth in international trade and investment. At the onset of World War I, trade contracted as foreign exchange markets became paralyzed by money market illiquidity. Countries sought to defend against external shocks with protectionist policies and trade virtually halted by 1933, worsening the effects of the global Great Depression until a series of reciprocal trade agreements slowly reduced tariffs worldwide. Efforts to revamp the international monetary system after World War II improved exchange rate stability, fostering record growth in global finance.

<span class="mw-page-title-main">Balance of payments</span> Difference between the inflow and outflow of money to a country at a given time

In international economics, the balance of payments of a country is the difference between all money flowing into the country in a particular period of time and the outflow of money to the rest of the world. In other words, it is economic transactions between countries during a period of time. These financial transactions are made by individuals, firms and government bodies to compare receipts and payments arising out of trade of goods and services.

In economics, hot money is the flow of funds from one country to another in order to earn a short-term profit on interest rate differences and/or anticipated exchange rate shifts. These speculative capital flows are called "hot money" because they can move very quickly in and out of markets, potentially leading to market instability.

The Mexican peso crisis was a currency crisis sparked by the Mexican government's sudden devaluation of the peso against the U.S. dollar in December 1994, which became one of the first international financial crises ignited by capital flight.

Structural adjustment programs (SAPs) consist of loans provided by the International Monetary Fund (IMF) and the World Bank (WB) to countries that experience economic crises. Their stated purpose is to adjust the country's economic structure, improve international competitiveness, and restore its balance of payments.

<span class="mw-page-title-main">Floating exchange rate</span> Currency value as determined by foreign market events

In macroeconomics and economic policy, a floating exchange rate is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange market events. A currency that uses a floating exchange rate is known as a floating currency, in contrast to a fixed currency, the value of which is instead specified in terms of material goods, another currency, or a set of currencies.

In macroeconomics and international finance, the capital account, also known as the capital and financial account, records the net flow of investment into an economy. It is one of the two primary components of the balance of payments, the other being the current account. Whereas the current account reflects a nation's net income, the capital account reflects net change in ownership of national assets.

A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. A currency crisis raises the probability of a banking crisis or a default crisis. During a currency crisis the value of foreign denominated debt will rise drastically relative to the declining value of the home currency. Generally doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate, if it has any.

International economics is concerned with the effects upon economic activity from international differences in productive resources and consumer preferences and the international institutions that affect them. It seeks to explain the patterns and consequences of transactions and interactions between the inhabitants of different countries, including trade, investment and transaction.

<span class="mw-page-title-main">Financial contagion</span> Scenario in which financial shocks spread to other financial sectors

Financial contagion refers to "the spread of market disturbances – mostly on the downside – from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads, and capital flows". Financial contagion can be a potential risk for countries who are trying to integrate their financial system with international financial markets and institutions. It helps explain an economic crisis extending across neighboring countries, or even regions.

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. These measures may be economy-wide, sector-specific, or industry specific. They may apply to all flows, or may differentiate by type or duration of the flow.

At the micro-economic level, deleveraging refers to the reduction of the leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm. It is the opposite of leveraging, which is the practice of borrowing money to acquire assets and multiply gains and losses.

A sudden stop in capital flows is defined as a sudden slowdown in private capital inflows into emerging market economies, and a corresponding sharp reversal from large current account deficits into smaller deficits or small surpluses. Sudden stops are usually followed by a sharp decrease in output, private spending and credit to the private sector, and real exchange rate depreciation. The term “sudden stop” was inspired by a banker’s comment on a paper by Rüdiger Dornbusch and Alejandro Werner about Mexico, that “it is not speed that kills, it is the sudden stop”.

The 1991 Indian economic crisis was an economic crisis in India resulting from a balance of payments deficit due to excess reliance on imports and other external factors. India's economic problems started worsening in 1985 as imports swelled, leaving the country in a twin deficit : the Indian trade balance was in deficit at a time when the government was running on a huge fiscal deficit.

<span class="mw-page-title-main">Carmen Reinhart</span> American economist

Carmen M. Reinhart is a Cuban-American economist and the Minos A. Zombanakis Professor of the International Financial System at Harvard Kennedy School. Previously, she was the Dennis Weatherstone Senior Fellow at the Peterson Institute for International Economics and Professor of Economics and Director of the Center for International Economics at the University of Maryland. She is a research associate at the National Bureau of Economic Research, a Research Fellow at the Centre for Economic Policy Research, Founding Contributor of VoxEU, and a member of Council on Foreign Relations. She is also a member of American Economic Association, Latin American and Caribbean Economic Association, and the Association for the Study of the Cuban Economy. She became the subject of general news coverage when mathematical errors were found in a research paper she co-authored.

Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole. In the aftermath of the late-2000s financial crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective.

Fear of floating refers to situations where a country prefers a fixed exchange rate to a floating exchange rate regime. This is more relevant in emerging economies, especially when they suffered from financial crisis in the last two decades. In foreign exchange markets of the emerging market economies, there is evidence showing that countries who claim they are floating their currency, are actually reluctant to let the nominal exchange rate fluctuate in response to macroeconomic shocks. In the literature, this is first convincingly documented by Calvo and Reinhart with "fear of floating" as the title of one of their papers in 2000. Since then, this widespread phenomenon of reluctance to adjust exchange rates in emerging markets is usually called "fear of floating". Most of the studies on "fear of floating" are closely related to literature on costs and benefits of different exchange rate regimes.

Prudential capital controls are typical ways of prudential regulation that takes the form of capital controls and regulates a country’s capital account inflows. Prudential capital controls aim to mitigate systemic risk, reduce business cycle volatility, increase macroeconomic stability, and enhance social welfare.

Graciela Kaminsky is a professor of economics and international affairs at George Washington University and a faculty research associate at the National Bureau of Economic Research. Kaminsky studied economics at the Massachusetts Institute of Technology where she received her Ph.D. In 1984 she did a brief research stay at the Argentine Central Bank, later in 1985 she moved to San Diego as an assistant professor at the University of California. In 1992 she worked on the board of governors of the US Federal Reserve System, later in 1998 she was appointed a full professor at George Washington University, where she works at the Elliot School of International Affairs. Kaminsky has been a visiting scholar at the Bank of Japan, the Bank of Spain, the Federal Reserve Bank of New York, the Hong Kong Monetary Authority, and the Central Bank of France.

References

  1. 1 2 3 4 5 Kaminsky, Graciela L. and Carmen M. Reinhart (1999). "The Twin Crises: The Causes of Banking and Balance of Payments Problems." American Economic Review, Vol. 89 No. 3, 473–500.
  2. ↑ Stoker, James (1994). "Intermediation and the Business Cycle Under a Specie Standard: The Role of the Gold Standard in English Financial Crises, 1790–1850." Mimeo, University of Chicago.
  3. ↑ Mishkin, Frederic S. (1996) "Understanding Financial Crises: A Developing Country Perspective," in Michael Bruno and Boris Pleskovic, eds., Annual World Bank conference on development economics. Washington DC: World Bank.
  4. ↑ Velasco, Andres (1987). "Financial Crises and Balance of Payments Crises: A Simple Model of the Southern Cone Experience." Journal of Development Economics, 27 (1–2), pp. 263–83.
  5. ↑ Diaz-Alejandro, Carlos F. (1985) "Good-Bye Financial Repression, Hello Financial Crash." Journal of Development Economics, 19 (1–2), pp. 1–24.
  6. ↑ McKinnon, Ronald I. and Pill, Huw (1996). "Credible Liberalizations and International Capital Flows: The ‘Overborrowing Syndrome’, " in Takatoshi Ito and Anne O. Krueger, eds., Financial deregulation and integration in East Asia. Chicago: University of Chicago Press, pp. 7–42.
  7. 1 2 Goldfajn, I. and R. Valdes. (1997). Capital Flows and the Twin Crises: The Role of Liquidity. IMF working paper no. 97/87.
  8. 1 2 3 Glick, Reuven, and Michael Hutchison (1999). "Banking and currency crises: how common are twins?," Pacific Basin Working Paper Series 99-07, Federal Reserve Bank of San Francisco.
  9. ↑ Goldstein, Itay. 2005, "Strategic Complementarities and the Twin Crises", Economic Journal, 115, pp. 368–90.
  10. ↑ Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo (2001). "On the Fiscal Implications of Twin Crises." NBER Working Paper No. 8277.
  11. ↑ Obstfeld, Maurice (1986), "Rational and Self-Fulfilling Balance-of-Payments Crises", American Economic Review 76, 72-81.
  12. ↑ Stock, James; Mark Watson (2002). "Has the business cycle changed and why?". NBER Macroeconomics Annual.
  13. ↑ Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, 93(1), 1-14.
  14. ↑ Reinhart, Carmen M., and Kenneth S. Rogoff (2008). "Banking Crises: An Equal Opportunity Menace." National Bureau of Economic Research Working Paper 14587.
  15. ↑ Korinek, A. (2011). "The New Economics of Prudential Capital Controls", IMF Economic Review 59(3), 523-561
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