Essays on financial crises in emerging markets

Tuomas Komulainen

Essays on financial crises

in emerging markets

Bank of Finland Studies

E:29 · 2004

Tuomas Komulainen

Essays on ﬁ nancial crises

in emerging markets

Bank of Finland Studies

E:29 · 2004

The views expressed in this study are those of the author and

do not necessarily reﬂ ect the views of the Bank of Finland.

ISBN 952-462-140-1

ISSN 1238-1683

(print)

ISBN 952-462-141-X

ISSN 1456-5943

(online)

Vammalan Kirjapaino Oy

Vammala 2004

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Abstract

The financial crises in emerging markets in 1997–1999 were preceded

by financial liberalisation, rapid surges in capital inflows, increased

levels of indebtedness, and then sudden capital outflows. The study

contains four essays that extend the different generations of crisis

literature and analyse the role of capital movements and borrowing in

the recent crises.

Essay 1 extends the first generation models of currency crises. It

analyses bond financing of fiscal deficits in domestic and foreign

currency, and compares the timing and magnitude of attack with the

basic case where deficits are monetised. The essay finds that bond

financing may not delay the crisis. But if the country’s indebtedness is

low, the crisis is delayed by bond financing, especially if the

borrowing is carried out with bonds denominated in foreign currency.

Essay 2 extends the second generation model of currency crises by

adding capital flows. If these depend negatively on crisis probability,

there will be multiple equilibria. The range of country fundamentals

for which self-fulfilling crises are possible is wider when capital flows

are included, and thus more countries may end up in crisis. An

application of the model shows that in 1996 in many emerging

economies the fundamentals were inside the range of multiple

equilibria and hence self-fulfilling crises were possible.

Essay 3 studies financial contagion and develops a model of the

international financial system. It uses a basic model of financial

intermediation, but adds several local banks and an international bank.

These banks are able to use outside borrowing, the amount of which is

determined by the value of their collateral. The essay finds that the use

of leverage by local and global banks and the fall in collateral prices

comprise an important channel and reason for contagion.

Essay 4 analyses the causes of financial crises in 31 emerging

market countries in 1980–2001. A probit model is estimated using 23

macroeconomic and financial sector indicators. The essay finds that

traditional variables (eg unemployment and inflation) and several

indicators of indebtedness (eg private sector liabilities and banks’

foreign liabilities) explain currency crises. When the sample was

divided into pre- and post-liberalisation periods, the indicators of

indebtedness became more important in predicting crisis in the post-

liberalisation period.

Key words: currency crises, banking crises, emerging markets,

borrowing, collateral, contagion, liberalisation

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Tiivistelmä

Vuosien 1997–1999 valuutta- ja pankkikriisejä kehittyvillä markki-

noilla edelsi pääomavirtojen nopea kasvu, velkaantumisen lisääntymi-

nen ja yhtäkkinen pääomapako. Tämä tutkimus koostuu neljästä artik-

kelista, jotka laajentavat nykyistä kirjallisuutta tutkimalla pääomavir-

tojen ja velkaantumisen merkitystä.

Ensimmäisessä artikkelissa laajennetaan ensimmäisen sukupolven

valuuttakriisimalleja tutkimalla koti- ja ulkomaanvaluutan määräistä

velkaantumista ja vertaamalla sitä perustilanteeseen, jossa budjetti-

alijäämät katetaan keskuspankkirahoituksella. Lainaaminen ei välttä-

mättä lykkää kriisiä. Jos maan velkaantuminen on vähäistä, lainaami-

nen kuitenkin lykkää kriisiä, varsinkin jos obligaatiot ovat ulkomaan-

valuutan määräisiä.

Toisessa artikkelissa laajennetaan toisen sukupolven valuuttakriisi-

malleja tutkimalla pääomavirtoja. Jos pääomavirrat ovat riippuvaisia

kriisin syntymisestä, syntyy monen tasapainon tila. Kun pääomavirrat

lisätään malliin, itseään toteuttavat kriisit ovat entistä todennäköisem-

piä. Mallin sovellus osoittaa, että monien kehittyvien maiden funda-

mentit olivat vuonna 1996 alueella, jolla itseään toteuttavat kriisit oli-

vat mahdollisia.

Kolmannessa artikkelissa tutkitaan kriisien leviämistä ja kehitetään

yksinkertainen malli kuvaamaan kansainvälistä rahoitusjärjestelmää.

Tutkimuksessa laajennetaan perusmallia rahoituksen välittymisestä

lisäämällä siihen monta paikallista ja yksi globaali pankki. Pankit

voivat käyttää ulkopuolista rahoitusta, jonka suuruuden määräävät

pankkien vakuusarvot. Artikkelissa osoitetaan, että velkaantuminen ja

vakuusarvojen romahtaminen luovat merkittävän väylän ja syyn

rahoituskriisien leviämiselle.

Neljännessä artikkelissa tutkitaan valuutta- ja pankkikriisien syitä

31 kehittyvässä maassa vuosina 1980–2001. Selittävinä muuttujina on

23 makrotaloutta ja rahoitussektoria kuvaavaa indikaattoria, joiden

vaikutusta kriiseihin tarkastellaan probit-menetelmän avulla. Tulosten

perusteella eräät perinteiset muuttujat, kuten työttömyys ja inflaatio, ja

useat maan velkaantuneisuutta kuvaavat indikaattorit, kuten yksityisen

sektorin velkaantuminen ja pankkien ulkomainen velkaantuminen,

selittävät valuuttakriisejä hyvin. Rahoitusmarkkinoiden vapauttamisen

jälkeen velkaindikaattorien selitysaste kasvoi entisestään.

Asiasanat: valuuttakriisi, kehittyvät maat, liberalisointi, velkaantumi-

nen, probit-menetelmä, kriisien tarttuminen, pääomavirrat

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Acknowledgements

This thesis was inspired by the financial crises in Asia, Russia and

Latin America in 1997–1999. These crises have been interesting and

fun for economists and have inspired numerous academic studies, but

they surely were not fun for the citizens of these poor countries.

Hopefully, the essays of the thesis and my future work can provide

some practical help for the authorities in these emerging economies.

The thesis will be presented at the Turku School of Economics and

Business Administration and was written mainly at the Bank of

Finland Institute for Economies in Transition (BOFIT). Without

BOFIT’s pleasant environment and resources, this project would have

never been completed. I am greatly indebted to Pekka Sutela, the head

of the Institute, who in the summer of 1998 gave me the opportunity

to pursue these inquires. The project took longer than it should have,

and now Pekka might well regret his recruitment decision.

I have had the privilege of having not just one supervisor but

several talented commentators. I owe my special gratitude to Professor

Pertti Haaparanta and Research Supervisor Jukka Pirttilä, who have

carefully read and commented on the various versions of the essays.

Also many other colleagues have commented on my papers and

encouraged me. For example, Fernando Broner, Abdur Chowdhury,

Douglas Gale, Lauri Kajanoja, Iikka Korhonen, Mika Kuismanen,

Paul Masson, and Pedro Rodriguez have provided valuable comments.

I would also like to thank Johanna Lukkarila, the co-author of the

fourth essay, for fluent and productive cooperation. I am also grateful

to Professor Guillermo Calvo, who gave me the opportunity to spend

the year 2001 at the University of Maryland, where, among other

things, the ideas for the first and third essay were born. In the final

stages, the suggestions by the preliminary examiners, Professors Tapio

Palokangas and Kari Heimonen, clearly improved the thesis. Naturally

all the remaining errors are mine.

I would also like to thank the whole BOFIT staff, the Bank of

Finland’s great library, Glenn Harma who revised the language, and

Päivi Nietosvaara for the make-up work. Finally, I would like to thank

my family and friends. My parents, Maija and Eero, have given

valuable support during the early years of my life, and today Riina and

Camilla are my sources of daily encouragement and support. This

work is dedicated to Riina and our children.

Helsinki, July 2004

Tuomas Komulainen

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Contents

Abstract…………………………………………………………………………………..3

Tiivistelmä……………………………………………………………………………….4

Acknowledgements…………………………………………………………………..5

Introduction

Capital mobility, borrowing, and financial crises……………………….9

Essay 1

Borrowing and balance of payment crises………………………………..33

Essay 2

Sudden stop of capital inflows and currency crises …………………..53

Essay 3

Contagion via financial linkages ……………………………………………..93

Essay 4

What drives financial crises in emerging markets?…………………141

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9

Introduction

Capital mobility, borrowing,

and financial crises

Tuomas Komulainen

1 Motivation …………………………………………………………………………10

2 Literature overview……………………………………………………………..12

2.1 First generation models ………………………………………………..12

2.2 Second generation models…………………………………………….15

2.3 Banking crises in an open economy ……………………………….18

2.4 Empirical literature………………………………………………………20

3 Summary of the essays and contributions……………………………….22

3.1 Borrowing and balance of payments crises ……………………..22

3.2 Sudden stop of capital inflows and currency crises…………..23

3.3 Contagion via financial linkages ……………………………………24

3.4 What drives financial crises in emerging markets? …………..24

3.5 Main contributions and discussion …………………………………25

References………………………………………………………………………………27

1 Motivation

The literature on financial crises has generally progressed most

rapidly in the wake of actual crises, and the resulting analyses have

changed in line with the economic circumstances and problems of the

period in question.1 The most recent round of crises started in Asia in

July 1997, when the Thai authorities allowed the baht to float and

depreciate. Shortly thereafter, four other Asian countries (Philippines,

Malaysia, Indonesia and Korea) were forced to float their currencies.

During 1997–1999 altogether more than ten emerging market

countries experienced currency crisis, which inspired a new wave of

academic research. The new studies should be closely attuned to the

current economic environment and thus better able to explain the

recent crises in emerging markets.

The answer surely is that capital movements today are the central

issues. Crises are now different in that they involve very large

amounts of very short-term money. That is one aspect. Second, that

the economy is highly leveraged around that money, so that when

something happens, the whole house of cards collapses. And

thirdly, the world economy is deeply global, through the financial

structures and that means that when something happens anywhere,

it happens everywhere. So that of course makes international

financial crises today something really interesting. (R. Dornbusch

1998)

The financial liberalisation, and capital flows that followed, clearly

changed the environment in which emerging market countries