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A Survey on Recent Theories and Empirical Analyses Regarding Currency Crises

--The Role of Liquidity Provision as a Policy Measure in Currency Crisis Management--

September 2001
Masazumi HATTORI

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  1. CCL, established by IMF in 1999, and intra-regional swap agreements among the ASEAN+3 countries are considered to be frameworks for foreign liquidity provision when a country experiences a liquidity crisis. It is probable that such movements would see further progress in the future, involving more member economies (the members of already existing international organizations, regional members, members at different stages of economic development) and applying different schemes (fund lending, currency swaps, currency swaps by currency). The role of central banks in such an environment is likely to be an issue as well. Thus, having considered the situation, I believe it indispensable to thoroughly evaluate the importance of liquidity provision as well as the role that should be played by central banks.
    In this paper, as background material for such discussion, I have surveyed the theories and empirical analyses put forward to explain the outbreak of past currency crises, the aggravation of crises, and the mechanism that leads to a drop in total output of a crisis-hit country. As for the scope of the survey, I have mainly focused on the Asian currency crisis (1997), which shares the closest relation with our economy.
  2. As for the theories that explain the formative background of the Asian currency crisis, there are two opposing views. One is "fundamentals-driven crisis theory", and the other is "financial panic-driven crisis theory". Lately, a theory regarding the relation between the formation of investors' expectations and economic fundamentals has also been advocated. The idea that "economic fundamentals and the formation of investor expectations are not independent of each other" is receiving theoretical support. As for the mechanism of currency crisis (depreciation of the currency) leading to a drop in total output, theories such as the twin-crisis hypothesis, the agency theory, and debt-overhang theory are referred.
  3. Empirical analyses regarding currency crises have attempted to examine the validity of the aforementioned theories by measuring the influence of the followings: (1) fundamentals-related variables, (2) contagion channels, and (3) changes in investors' expectations. The major results are as follows:
    • (i) Fundamentals-related variables can explain to some extent the probability of a currency crisis occurrence and the depth of the crisis. Among the fundamentals-related variables, the influence of external short-term debt is substantial. However, fundamentals-related variables alone can not explain the development of currency crises.
    • (ii) Inclusion of financial panic elements and contagion channels in quantitative analysis significantly improves explanatory power of quantitative estimations.
    • (iii) Among plausible contagion channels, neighborhood effect is the most significant in improving the explanatory power of quantitative estimations.
    Such results seem to support the theory that some kind of relation exists between investors' expectations and economic fundamentals.
  4. Looking at past currency crises, we can arrive at the conclusion that there have been cases where a country, which should not have had a problem servicing external debt in the long run, has fallen into a situation of temporary illiquidity (i.e. solvent but illiquid). There has also been a case where the magnitude of a crisis went beyond the degree that could be explained by a deterioration of fundamentals. The existence of such cases is supported not only by theory but also by the results of empirical analyses. It can thus be said that the results of academic studies would support the "necessity of liquidity provision as an emergency measure in a crisis."
  5. In considering desirable ways of providing liquidity at the outbreak of a crisis, further discussion on the following points is necessary; (I) the need for surveillance to prevent moral hazard and to verify the cause of a crisis; (ii) the allocation of roles between international organizations and regional cooperation in the provision of liquidity; and (iii) the role of central banks in the provision of liquidity in international financial crisis management.