Currency Crisis

Introduction

The process of integration of global financial markets and liberalisation of world economy which started in 1980's has accelerated during 1990's. This increasing globalisation of finance and capital flows has been one of the mitigating factors for the severe financial turbulence which affected both the emerging markets and the developed countries. The 1990's has witnessed several episodes of currency crises; notable among the crises was the near breakdown of the European exchange rate mechanism (ERM) in 1992-93, the Mexican crisis in 1994-1995 saw a devaluation of peso by putting Mexico on the verge of default, and which spread into Brazil and Argentina through the so called "Tequila effect". The Asian crisis in 1997-98 has led to a devastating effect not only in Asia, but also on other countries such as Thailand, Philippines, Malaysia, Indonesia and South Korea.

In 1996, the capital inflows to developing countries were very high until the first half of 1997; it was almost 190 billion, more than ten times the annual inflows between 1984 and 1989. This pattern was drastically reversed and funds started flowing out at staggering pace, which amounted to a sizeable shock to the developing countries. (Ramkishen 2001)

The emerging markets also faced intense market selling of their currencies and required to take the assistance of International Monetary Fund (IMF) during the period 1998 and 1999. The Russian rubble was devalued in 1998 and the Brazil's peg was also broken in 1999 and some other small emerging countries like Turkey, Ecuador also experienced currency crisis in 1990s. (Ramkishen 2001)

These far reaching consequences of currency crisis have generated wide spread interest in the currency crisis models and its implications on the world economy. Since 1990s currency crisis has been most debatable topic among the economists and policy analysts. The last decade has motivated many academic researchers to do an empirical study on the cause effects of currency crisis in different regions. This literature review can be broadly classified to three categories. First were the empirical papers which concentrated on the development of early signals or indicators which would be helpful in predicting the currency crisis beforehand (Kaminsky 1999). Second are the theoretical papers that attempted to study the important aspects such as government intervention and the financial sectors role in the economy. Third are the descriptive studies on each individual crisis hit regions or countries.

Taking all these studies into consideration this paper aims to study the variety of currency crisis and also discuss the currency crisis in emerging and mature markets individually and what factors differentiate the currency crisis between both the markets. The study is organised as follows: Section 2 highlights the currency crisis models and their relevance in the recent financial crisis. Section 3 will study about the currency crisis in emerging markets and the reasons behind it. Section 4 discusses the crisis in mature markets and the causes for their existence. Section 5 examines the factors which differentiates the crisis in both the markets. Section 6 summarizes the conclusion of the study.

2. CURRENCY CRISIS MODELS:

The currency that led to devastating effects on many countries with increasing frequency since 1980s had inspired many academicians and economists to do a huge amount of research. In order to discuss the currency crisis within the perspective of two different market regions, it is important to first analyse the various models of currency crisis. Three broad categories or generations of currency models can be delineated.

First Generation Models:

The first generation models was laid out by Krugman (1979) and Flood and Garber (1984). They viewed the crisis as the unavoidable result of the unsustainable economic policies and structural imbalances. This model often referred to as exogenous model views a currency crisis within a monetary framework, the presence of rational speculators would hasten the breakdown of fixed exchange rate regime that was unsustainable in the face of the policy maker's attempt to monetize the fiscal deficit. Investors are generally ready to hold the currency as long as it is fixed and once they anticipate that the peg is about to end they will try and flee the currency. This model is a monetary based model and has unique equilibrium. (Paolo P, Cedric T)

Second Generation Models:

In contrast to the first generation models the second generation models are highly varied. This model optimises the policymakers' loss and has multiple equillibria. In this model the market participants base their expectations on the assumption that their actions will not affect the fiscal policies. This leads to self fulfilling prophecies were investors attack the currencies with the expectation that other investors will attack the currency. This model is an endogenous model, where policymakers' uses discretion in the exceptional situation, but otherwise follows a policy rule as sighted before (Paolo P, Cedric T). This model can also be reduced to first generation model once one allows for a secular relapse of fundamentals (Krugman 1996).

Third Generation Models:

The Third generation models lay emphasis on the balance sheet effects associated with the devaluations. The model highlighted the problems of banking and financial sector relate with currency crisis and their impact on the whole economy. The banks in emerging market countries have explicit currency mismatches on their balance sheet because they borrow in foreign currency and lend in domestic currency. Many authors such as Mc Kinnon and Pill (1996) and Burnside, Eichenbaum and Rebelo (2001) argue that, it is optimal for banks and firms to expose themselves to currency risk in the presence of the government guarantees.

The Third generation of model focus on the capital account, whereas the other two models highlight the current account. Caballero and Krishnamurthy (1998) state that "the Asian crisis is just the most recent chapter of an increasing trend toward shifting the blame from current account to capital account issues. Many think that this trend is almost an unavoidable side effect of increasing globalisation of capital market".

3. CURRENCY CRISIS IN EMERGING MARKETS:

Several studies have shown that the most important factors responsible for the emergence of the currency