The previous chapter described a world where a financial accelerator first generates a lending driven boom and then its inev­itable collapse.

But that collapse contains within itself the seeds of a new boom; and so the economy continues, bouncing from boom to crisis and back.

The evidence, described in the previous chapter, from GVL (2001), is primarily about what happens when a lending boom collapses.

Fig. 5.1 Indonesia: potential and actual GDP.

Note: Projected output for the years 1997-2002 based on output trend over the 1991-6 period. Values are in US$ 1989 billion.

Source: Griffith-Jones (2004), figure 1.

In this chapter we present a highly stylized model, based, as in previous chapters, on limited access to credit,^{* [17]} that can explain why an economy that is carrying a large amount of for­eign currency debt might be vulnerable to currency crises, which leave it with a depreciated currency and GDP that remains lower than the pre-crisis trend for some time into the future. We are about to argue that, in a monetary economy with standard price rigidities, credit constraints together with pecuniary externalit­ies working through the nominal exchange rate are sufficient to generate currency crises.

There is, of course, a long tradition of models aimed at helping us understand currency crises. Thus, a first generation of models^[18] took the view that currency crises resulted from large budget defi­cits. While this explanation could fit the case of Latin American countries in the 1980s, it can hardly account for why currency crises occurred in East and South-east Asia in the late 1990s, since governments in this region were all running budget surpluses. A second generation^[19] attributes the occurrence of currency crises to credibility problems faced by governments with the conflicting objectives of maintaining a fixed exchange rate parity and redu­cing unemployment. While this could explain the collapse of the European Monetary System in the early 1990s, the unemployment rates in the Asian economies of the 1990s were among the lowest in the world, and it is hard to believe that reducing unemploy­ment was a priority for these governments. Our view of the crisis falls into the class of “third generation"theories: These are theories which locate the proximate source of the crisis in the private sector rather than in the government.^[20]

The basic mechanism that generates crises is simply summar­ized as follows: if nominal prices are rigid in the short run, a currency depreciation leads to an increase in the foreign currency debt repayment obligations of firms.

This story of currency crises has the significant advantage that it is based on two well-known facts: first, the countries most likely to go into a crisis were those in which firms held a lot of foreign currency denominated debt. For example, Figure 5.2 shows the ratio of claims to liabilities with respect to BIS banks; since these transactions are mostly in foreign currency, this ratio is a meas­ure of aggregate foreign currency exposure. It is striking that all the countries that had a ratio higher than 1.5 have experienced a serious crisis in the 1990s. In the next section, we discuss possible rationales for firms to hold foreign currency debt.

The second fact is that there are substantial and persistent devi­ations from purchasing power parity following an exchange rate shock: Engel (1993) decribes this evidence in some detail. In a recent important paper Burstein et al. (2004) have shown that in the case of large devaluations, this is mainly driven by the

Fig.

94 The Third Generation Approach to Currency Crises nonadjustment of the prices of nontradables; this filters into the price of tradables in part because of distribution costs and in part because people move to cheaper, less traded, goods.^[22]

This means that for our story to go through, the firms produ­cing nontraded goods must be carrying foreign currency debt. The same evidence shows that a very large part of GDP is effectively nontraded which makes this more likely. For example, there is no reason why foreign currency debt is more likely to be held by a firm that produces a tradable, than by the firm that builds or owns warehouses that store the tradable good. While there are many very small firms in the nontraded sector, there are also many very large firms, especially in construction and distribution.

Our credit-based approach to currency crises also has the advantage of being consistent with the observation that countries with less developed financial systems are more likely to experience an output decline during a crisis.^[23] Second, it makes it clear why a currency crisis can also happen under a flexible exchange rate or without any significant decline in foreign exchange reserves. Third, crises may occur even in countries that are conventionally well-behaved, in the sense of having low unemployment rates and conservative fiscal and monetray policies.

It still remains that public policy variables such as fiscal defi­cits, influence whether a currency crisis occurs, as stressed by the existing literature on the subject. However, in contrast to first- and second generation models, in the world described in this chapter a deterioration of fiscal balances will lead to a crisis mainly through its impact on private firms' balance sheets rather than through simple money demand adjustments as in the pre­vious models.^[24] Moreover, the presence of public sector debt may exacerbate the problems of private sector debt, especially if a large fraction of public sector debt is in foreign currency.

sharp contrast with the previous literature that argues that foreign currency (public) debt should have a stabilizing effect.

Another advantage of our model is that it lends itself very natur­ally to the analysis of monetary policy. There has been an important debate on the stance of monetary policy in the context of currency crises; one side in this debate emphasizes the importance of past government failures and advocates monetary tightening, in part to signal the government's commitment to restraint.^{[25] [26] The other side blames shifts in expectations and bad luck (the multiple equilib­rium view) and sees no reason why we should punish the already battered firm sector even more by tightening monetary policy.11 Strikingly, though our model is of the multiple equilibrium kind, as long as the credit multiplier only depends on real interest rates and prices adjust relatively quickly, a restrictive monetary policy is the optimal response to the risk of a currency crisis. This is because the shift in exchange rates generated by tightening remains the best way to help the beleagured firm sector. However, we also show that this conclusion may cease to hold when credit supply is affected by the nominal interest rate and/or when price adjust­ment takes longer than it takes to discharge the inherited debt obligations of the firm sector.}

The rest of the chapter is organized as follows. Section 5.1 lays out the basic model. Section 5.2 shows that this model naturally gives itself to graphical analysis. Using this graphical apparatus we examine the occurrence of currency crises and demonstrate the possibility of multiple equilibria. Section 5.3 analyzes the policy implications of the model, and Section 5.4 concludes.

5.1