Connection between Banking and Currency Crises Literature: Kaminsky & Reinhart (1999) Empirical research, considers 20 countries with fixed exchange rate, crawling peg or floating within a band. Monthly data from 1970 1996: 312 months of observation number of data points: 20 * 312 = 6240. Identify a crisis by various indices - Currency crises: index, constructed with weighted average of changes in the exchange rate and changes of central bank reserves. - Banking crises: closure, liquidation, takeover or public refinancing of one or more important financial intermediaries. - Begin of a banking crisis: first bank run or first takeover / public refinancing. - Peak of a banking crisis: month with the most bank failures or the largest public injections. Definition Twin Crisis: a currency crisis follows a beginning banking crisis within 48 months. 1 2
Since 1980s twin crises occur more frequently 1970-1979 1980 1995 Type of crisis total per year total per year Pure currency crisis 25 2,5 32 2,0 Pure banking crisis 2 5 Twin crisis 1 0,3 18 1,4 cf. Bordo et al. (2001), presented in the introduction to this course. 3 Probability of a currency crisis within 24 months: - unconditional: 29% - after a banking crises has begun: 46% - after the peak of a banking crisis: 26% Probability for a beginning banking crisis within 24 months: - unconditional: 10% - after a currency crisis: 8% - after liberalization of financial markets: 14% Probability for the peak of a banking crisis within 24 months: - unconditional: 10% - after a currency crisis: 16% Liberalization of financial markets raises the probability of a subsequent banking crisis. Begin of a banking crisis raises the probability of a currency crisis. The peak of a banking crisis occurs mostly after a currency crisis. 4
Measuring the impact of a crisis: for banking crises: Costs of a bailouts - pure banking crises 5,1% of one year s GDP - twin crises 13,3% of one year s GDP for currency crises: Loss of central bank reserves - pure currency crises 8,3% - twin crises 25,4% Real depreciation (change in the real exchange rate - pure currency crises 26,7% - twin crises 25,7% Twin crises are associated with higher losses as pure banking crises. CB tries harder to keep the exchange rate regime if there is a banking crisis. 5 Macroeconomic data before, during and after a crisis 1. Indicators, connected with financial liberalization M2 multiplier: M2 divided by monetary base (M2 includes deposits with maturity up to 2 years or at 3 months notice; monetary base = banknotes, coins and deposits of commercial banks at the central bank). M2 multiplier measures money creation by banking sector. Liberalizing financial markets (e.g. reduction of reserves) raises the M2 multiplier. Before and after a pure currency crisis (dotted curve), the M2 multiplier is about the same as in tranquil times (= normalization at 0). Before twin crises (solid curve), the M2 multiplier is about 10-20% higher than in tranquil times. Indicates a connection between financial liberalization and twin crises. 6
Domestic Credit / GDP LHS: Ahead of a pure currency crisis, credit volume is just slightly higher than in tranquil times (dotted curve). Ahead of a twin crisis, credit volume rises to more than 20% above its value in tranquil times. It goes back to normal within a year after the currency crisis (solid curve). RHS: Solid curve: Deviation from long-run mean before, during, and after banking crises. Dotted curves: confidence interval of 1 standard deviation (relates to 70% for a normal distribution). Definition of the crisis interval in the figures: begin + 18 months. Increase in credit volume is significant shortly before and during the early phase of a banking crisis. Possible explanation: CB pumps money into the banks in distress. => risky credits are not written off or replaced by new credit contracts. ( good money follows bad money.) 7 Real interest rate Banking crises Twin crises (solid) and pure currency crises (dotted) Banking crises: real interest rate is significantly higher than normal. Possible explanations: Liberalization, higher risk, contractive monetary policy. Pure currency crises: real interest rate is much lower than normal. Possible explanation: expansive monetary policy, interest-rate regulation of the 1970s. 8
2. Other Financial Market Indicators Money demand Effective money demand minus estimated money demand Banking crises Twin crises (solid) and pure currency crises (dotted) In twin crises, money demand is rising during the banking crisis and before the currency crisis. This reflects the closure of the inter-bank market. The central bank provides more liquidity to commercial banks. Expansion of domestic currency may trigger a currency crisis. 9 Relation between M2 and foreign reserves of the central bank Before a currency crisis this relation is rising strongly (80%). Reasons are 1. Credit expansion and money creation 2. Outflow of reserves for keeping the exchange rate regime. The relation between M2 and reserves increases during the same time during which the M2 multiplier goes back to normal (see above). => Central bank money replaces privately created money. 10
3. Balance of Payments Indicators Real exchange rate Overvaluation of domestic currency before a currency crisis. Weaker in twin crises (solid) than in pure currency crises (dotted). Possible explanation: in situations leading to a twin crisis, the currency crises is not just caused by overvaluation, but also by expected bail-outs. => In pure currency crises, the overvaluation needs to be stronger for triggering an attack. currency crisis = devaluation After currency crises: under-evaluation. 11 Growth rates in foreign trade Volume of foreign trade decreases before a currency crisis and returns to normal after devaluation with exports lagging about 1 year (J-curve effect). Imports stay low for a longer time. 12
Foreign reserves Before a currency crisis the growth rate of foreign reserves declines. It returns to at least normal values with some delay after devaluation. Banking crises: Before banking crisis begins, the growth rate of foreign reserves declines. 13 4. Indicators of real economic activity Growth rate of output Before a banking crisis, output growth rates decline. They stay low during the crisis and return to normal by the end of a crisis. Growth rate of stock prices Before a banking crisis: unusually high growth rates in stock prices. Their decline precedes the banking crisis. It takes several years until stock prices return to their pre-crisis levels. 14
For twin crises (solid curve) growth rates of stock prices return tio normal about 1 year after devaluation. In a pure currency crisis (dotted) the is no significant decline in the growth rate of stock prices. Possible explanation: banks liquidate assets to serve foreign debt and demands by depositors. High supply brings down prices. 15 Connection between Banking and Currency Crises Financial market liberalization lays grounds for events that eventually lead to a twin crisis. Banking crises are almost always connected with a subsequent currency crisis. Currency crises may result from banking crises. Immediate causes might be a deterioration of the trade balance, over-evaluation of domestic currency, low-out of reserves, expansionary monetary policy, and expected bail-outs. Chain of events for twin crises: Financial market liberalization leads to credit expansion. Once real activity stays behind expectations, some banks get problems in refinancing debt. => Begin of a banking crisis Central bank supports commercial banks by injecting liquidity (lender of last resort, expansionary monetary policy). => Overvaluation of domestic currency, Flow-out of reserves. Bail-out or expectation of a bail out raises expectations of a devaluation. Speculative attacks Currency crisis Devaluation of credits denominated in domestic currency Additional losses for banks (who were engaged in currency transformation) Peak of the banking crisis 16
Bank balance sheet Claims and assets denominated in domestic currency Liabilities in foreign currency Equity Devaluation of domestic currency leads to losses on equity. Banks sell domestic assets Decline in asset prices Further losses in the banking sector First, the central bank tries to mitigate the banking crisis. Thereby, it creates the prerequisits for a currency crisis. Then, CB tries to avoid or delay the currency crisis. => Flow-out of reserves. Once currency is devalued, it aggravates the banking crisis. => currency crisis after begin of banking crisis. => peak of banking crisis after currency crisis. 17