Causes of Currency Crises and Banking Crises

Causes of Currency Crises and Banking Crises existenceBased on my readings, I turn out found that up-to-dateness crises often accompanied by banking crises or banking crises preceded by currency crises or hitherto has no significant relationship surrounded by the two. So, why argon currency crises often accompanied by banking crises? In this paper, I will discuss on how such problem whitethorn excrete ground on historical perspective, in which the countries that have experienced Twin Crises. The next issue isthe effectiveness and dynamism of detonator controls as a content by which developing countries can manage sudden jacket crown in fly the coops and/or outflows. This is where the credibility of heavy(p) controls argon being ch all in allenged whether such restriction should be taken into a serious consideration for the policymakers to implement. It is important to analyse these economicalal situations due to past economic disasters in which the issues state were sig nificant in the 1994 Mexican peso crisis, 1997 Asian Financial crisis and the 1998 Russian monetary crisis.Twin CrisisThe coincidental occurrence of currency crises and banking crises is k immediatelyn in economic term as Twin Crises, introduced by economists Carmen Reinhart and Graciela Kaminsky in the late nineties. This phenomenon became a common problem in financially liberalized emerging market economies in the 1990s which started with the1994 Mexican crisis, followed with the 1997 Asian financial crisisand the1998 Russian financial crisis. Kaminsky and Reinhart (1999) did an extensive research on the relationship amid financial and banking crises for 20 countries and over a 25-year sample and found that banking crises often precede currency crises. The machine basically relies on two features. Firstly, organizations hold a fixed flip range system and secondly, a mismatch between national assets and strange liabilities by interior(prenominal) banks, thus, exposing t o change over rate risks( Goldstein, Itay 2005 ).A currency crises, also known as the Balance of Payment crises,is a situation in which a earth is suffering from a chronic balance of payment deficit. This problem exists when a nation is unable to finance the imports and debt repayments. The coun approximates key bank would be in a doubtful position whether, given(p) the fixed exchange rate, it has sufficient foreign exchange militia to maintain the pass judgment of domestic currency. authorities often step ins by using the countrys own currency reserves or itsforeign reserves to play the excess demand for a given currency ( Wikipedia, 2014 ). It came to a conclusion when these emerging market economies were experiencing speedy economic growth, creating massive great(p) influxs, which will then lead to the crises.A banking crises, however, is a financial crisis that affects banking bodily function which includes bank runs, banking panics and systemic banking crises, in wh ich a country experiences a big number of defaults and financial institutions guinea pig difficulties repaying contracts. A bank run occurs when depositors believe that the bank may fail which led them to withdraw all of their deposits from that bank. This causes the banking system to be insolvent if it can non pay its debts as they fall due. Insolvency can be defined as the inability to pay ones debts. Cash flow insolvency, or a lack of liquidity may occur as well when the bank might end upowingmore than itowns or is owed ( postivemoney.org, n.d ).Twin Crises started off when investors begin to put down their confidence as the massive slap-up inflow in the country creates uncertainty among investors in which the debt their capital is generating. The countrys currency will be at stake as the resulting outflow of capitals created by investors as they withdraw all of their bills will de treasure the moved(p) nations currency. Firms of the affected nation who have received the in bound investments and loans will suffer, as the earning of those firms is typically derived domestically but their debts are often denominated in a reserve currency ( Kallianiotis, 2013 ). Once the nation has exhausted its foreign reserves trying to support the observe of the domestic currency, government can raise its interest evaluate to try to prevent from only decline in the value of its currency. While this helps those with debts denominated in foreign currencies, it generally further depresses the local economy as high interest rate uncouthly encourages saving and discourages investment.Real-World Financial CrisesThe 1997 Asian financial crisis was a period of financial crisis which affected mevery economies in the East Asia. It began in Thailand when they had accumulate a massive foreign debt. In the effort to support the value of baht, the government had no pick but to float the Thai baht due to insufficient of foreign currency reserves, reducing finalize against the US sawhorse. Until 1999, economies in South East Asia enjoyed a prosperous period as they had received large inflow of money. High interest rates in emerging economies attracted many investors due to the fact that it may give a high return for the investors. As a result, price of assets in these countries began to rise at an alarming rate which created insecurity among investors. Lenders started to withdraw all of their funds at a large scale, creating recognise crunch and bankruptcies. Furthermore, there was a depreciativepressure on their exchange rates as the put out of currencies of the crisis countries was high in the exchange market. Governments from these countries had to intervene in the exchange market. To prevent any loss in value of domestic currency, they had to raise domestic interest rates by buying up any surplus of the domestic currency.The Mexican governments move to devalue the peso against the US dollar created an outburst which led to the Mexican peso crisis in 1994. In order to maintain in the value of peso, the Mexicos central bank allowed the peso to free float within a narrow pot against the US dollar through an exchange rate peg ( Wikipedia, 2014 ). Furthermore, the central bank would constantly intervene in the open market by purchasing or selling the pesos. The central banks intervention involved issuing new little-term public debt instruments denominated in U.S. dollars, using the borrowed dollar capital to purchase pesos in the foreign exchange market, will cause an appreciation in its value. Since the peso is reckoned to be increasing in value, the high purchasing power by domestic businesses, firms and consumers created an incentive to purchase more imported goods, resulting in a large trade deficit. Speculations regarding the over-valuation of peso began to circulate which encouraged investors to purchase more of U.S assets. It will be more profitable for investors as they will be able to capitalize the high exchange rat e when they exchange dollars for pesos later. The resulting capital outflow from Mexico to United States ca apply a capital trajectory which put a downward(prenominal) market pressure on the value of peso. To curb this issue, newly inaugurated President Ernesto Zedillo in 1994announced the Mexican central banks devaluation of the peso between 13 and 15 part. callable to the unpredictability of Mexican policymakers, investors felt insecure and timid of further devaluations in the currency, putting an upward market pressure in the interest rates and a further downward pressure on the value of peso. Foreign investors began to rapidly withdraw their capital from Mexican investments due to possible devaluation of peso. As a result, the Mexican central bank had to raise the interest rates to prevent from capital flight.Capital FlowsCapital flows is simply defined as the transaction of authoritative and financial assets and it is recorded in the capital distinguish. When a country has a deficit in the capital account, it means the country is experiencing a capital outflow, like Japan. The country is supposedly purchasing more assets or qualification more loans or both at the same time, thus accumulating net claims on other countries. It is a situation in which it is undesirable to the economy. Contrarily, if the country is having a surplus in the capital account, depicting capital inflows, it is said that other countries are accumulating claims on that particular country.Capital flows admits many great economic advantages. Countries are now able to catch-up with the advancement of other countries by capitalizing on their disparitys. Capital flows enables residences of contrastive nations to invest in other countries by engaging in inter-temporal trade, allowing them to reap benefits or profits for future consumption. Be it an economic boom or recession, optimum level of national consumption or expenditure is vital in every economy. Thus, capital flows hel ps to prevent from a fall in national consumption in subject area of an unexpected economic downturn, by selling domestic assets or borrowing from the rest of the world. Thus, overall cash advance in economic performance can be achieved as it will aid substantially in terms of productivity and efficiency.Free capital mobility may seem desirable, though, in reality it comes at a cost. Given the exchange rate, developing countries or emerging market economies tend to acquire more assets by purchasing a massive amount of goods and services than the rest of the world. This is due to several reasons. These countries may not be on par in terms of economic performance, efficiency as well as resources compared to the rest of the world. Besides, it may be due to fluctuation in the world price of commodities. The implementation of expansionary economic policy by government will increase the demand for imports. As a result, appreciation of foreign currency will occur due to high demand of fo reign goods and at the same time, a disparagement in own currency due to a low demand for domestic commodities. Since government would want to hold a fixed exchange rate regime, they can implement a contractionary monetary policy, a method of selling domestic bonds which increases the domestic interest rate, in order to maintain the value of domestic currency. The demand of domestic currency will be improved which will increase the value of domestic currency. Again, it proves to be costly as high interest rate will discourage investment, since it is now more expensive to borrow from the bank, reducing a potentially larger economic growth. This shows that free flow of capital may cause an upward pressure in the value of currency which may exist local firms, making them little competitive in the global market. Emerging market economies are the usual target for hot money with sudden injection or withdrawal of funds, thus, creating distortion or mental unsoundness in the market. Larg e record books of capital inflows on search for higher yields causes dislocations in the financial system. Foreign funds might fuel asset price bubbles, encourage excess risk taking by cash-rich domestic intermediaries ( Magud, Reinhart Rogoff, 2005 ).Having a strong and independent monetary policy is more viable than sustaining free flow of capital. Due to potential harmful effects of free flow of capital to the economy, capital controls is introduced to prevent such consequences from happening. A capital control is any policy designed to limit or redirect capital account transactions and may take the form of taxes, price or quantity controls, or outright prohibitions on international trade in assets ( Neely, Christopher J. , 1999 ).Capital ControlsThere are two types of controls which are the controls on inflow and outflow of capital. Like Malaysia during the Asian financial crisis in the late 1990s, control on capital outflows was introduced to supposedly generate revenue, corr ect balance of payment deficit as well as preserve nest egg for domestic use. Control on capital inflows, use by chilli pepper during the Latin American debt crisis, was used to prevent potential volatility inflows, financial destabilisation and real appreciation as well as correcting balance of payment surplus and limit foreign ownership of domestic assets. This shows various type of capital controls are targeted at specific type of movement. The chief is, how effective capital control is and to what extent should it be implemented ?During the Asian Financial Crises, Malaysian government imposed controls on outflows in 1998 by pegging the exchange rate at RM 3.80 for every US dollar. Their objective was to delay from exhaustion of foreign reserves and provide as much time possible for policymakers to implement reflationary policies as well as eliminating speculation against the ringgit. Malaysias stock market capitalization ratio at 310 percent of GDP, compared to 116 percent i n the U.S., and 29 percent in Korea and domestic debt-GDP ratio at 170 percent were, at the time, highest in the world (Perkins and Woo, 2000). In response to the crisis, Malaysian government raised the interest rates to stem the decline of the ringgit and restructured their expenditure by reducing it by 18 percent ( Ethan Kaplan and Dani Rodrik, 1999 ). However, the economy showed no sign of improvement. Their effort to reduce domestic interest rates seemed to be pointless as speculation against the ringgit in offshore markets was circulating widely. The speculation lead to the borrowing of ringgit at premium rates to purchase dollars, which created a devaluation pressure on ringgit. hard-pressed of capital flight and further depreciation of the currency, the Malaysian government also banned for a period of one year all repatriation of investment held by foreigners. Malaysia also lowered the 3-month Bank Negara Intervention score from 9.5% to 8% and the liquid asset ratio was red uced from 17% to 15% of total liabilities ( Ethan Kaplan and Dani Rodrik, 1999 ). On February 15th, 1999, the exchange Bank of Malaysia changed the regulations on capital restrictions, shifting from an outright ban to a graduated levy and renew the levy on capital with a profits levy on future inflows ( Ethan Kaplan and Dani Rodrik, 1999 ). After the pain of capital controls in 1998, Malaysia showed a strong and quick revival from the Asian financial crisis. The fact that Korea and Thailand, which had opted for IMFs programme, recovered remarkably suggesting that capital controls imposed in Malaysia did not make any significant difference than the IMFs financial aid. jalapeno seemed to favour controls on capital inflows and been relying on it in two different occasions (1978-82 and 1991-98). The effectiveness is questionable, however, as in 1981-82 Chile went through a currency crisis despite with controls and restrictions. The peso was devalued by almost 90 percent and a large nu mber of banks had to be, bailed out by the government ( Edwards, Sebastian 1999 ). The controls were being reintroduced in 1991 with the objectives of slowing down the volume of capital inflows into own country, reducing the real exchange rate appreciation resulted from these inflows, allowing the Central Bank to maintain a high differential between domestic and international interest rates. In 1984, Chile has adopted a slightly flexible exchange rate system, where the peso-dollar rate was allowed to fluctuate within an upward-moving band. The authorities argued that by maintaining domestic (peso) denominated interest rates above international rates, inflation would decline gradually (Massad, 1998). This policy mix worked relatively well until the late 1980s, when Chile regained access to international financial markets, and capital began to flow into the country putting pressure both on the real exchange rate and domestic interest rates ( Edwards, Sebastian 1999 ). By early 1990, domestic firms were advantageously affected, as the rapid strengthening of peso has reduced their level of competitiveness and profitability. To sum it up, the effectiveness of Chiles controls on capital inflows has been overestimated. After the controls were imposed, the maturity of foreign debt contracted by Chile increase significantly. The evidence suggests more than 40 percent of Chiles debt to G-10 banks had a residual maturity of less than one year ( Edwards, Sebastian 1999 ). Although the policy affected the composition of capital inflows, it did not reduce the total volume of aggregate flows moving into Chile during the 1990s. The controls on inflows had no significant effect on Chiles real exchange rate in which it appreciated by approximately 30% during the 1990s. The controls had a short term effect on domestic interest rates. The magnitude of the effect was very small, however, raising the question of whether the central banks ability to undertake independent monetary policy really raise by the controls on capital inflows ( Edwards, Sebastian 1999 ) .ConclusionControl on inflows seems to be more favourable among authors and economists than those on outflows. Controls on outflows usually create corruption as it easier to evade than the inflows (Reinhart and Smith, 1998 Eichengreen, et al. 1999). If there is an anticipation in the depreciation of domestic currency, this creates an incentive for investors to evade controls on outflows to prevent from losses.When faced with the prospect of a major crisis, the orphic sector finds ways of evading the controls, moving massive volumes of funds out of the country. Controls on capital outflows have resulted in corruption, as investors try to move their monies to a safe haven. In almost 70% of the cases were controls on outflows were used as a preventive measure, there was a significant increase in capital flight after the controls had been put in place. Cuddington (1986) reached a similar conclusion in h is study on the determinants of capital flight in developing countries. Evading controls on inflows, however, proved to be less beneficial among investors as investing in other countries would be less viable compared to domestic return.REFERENCES L. Kaminsky, Graciela and M. Reinhart, Carmen (1999) The Twin Crises The Causes of Banking and Balance-of-Payments Problems Vol. 89 No. 3 Online at http//home.gwu.edu/graciela/HOME-PAGE/RESEARCH-WORK/WORKING-PAPERS/twin-crises.pdf Accessed 20 celestial latitude 2014Goldstein, Itay (April 2005) Strategic Complementarities and the Twin CrisesEconomic Journal. Online at http//www.res.org.uk/details/mediabrief/4392181/Explaining-Twin-Financial-Crises.htmlAccessed 20 declination 2014Tornell, Aaron (2002) Twin Crises The National Bureau of Economic Research Online at http//www.nber.org/reporter/winter02/tornell.html Accessed 20 December 2014J. Neely, Christopher (1999) An Introduction To Capital Controls Online at http//research.stlouisfed.org /publications/review/99/11/9911cn.pdf Accessed 27 December 2014Baba, Chikako and Kokenyne, Annamaria (2011) Effectiveness of Capital Controls in Selected Emerging Markets in the 2000s IMF Working Paper Online at https//www.imf.org/external/pubs/ft/wp/2011/wp11281.pdf Accessed 27 December 2014Edwards, Sebastian (1999) HOW powerful ARE CAPITAL CONTROLS? The National Bureau of Economic Research Online at http//www.nber.org/papers/w7413.pdf Acccessed 27 December 2014