“Original Sin”,Balance Sheet Crises, and the Roles of International Lending Olivier Jeanne Jeromin Zettelmeyer IMF Research Department* November 2002 * The views expressed in this presentation are the authors’ only and do not necessarily reflect the views or policies of the International Monetary Fund

Motivation Consensus: (unhedged) foreign currency debt is a source of fragility can lead to “balance sheet crises” (possibly self-fulfilling) complicates domestic economic policies BUT: dizzying array of models little consensus on how to deal with “balance sheet crises” (e.g. Asian Crisis)

Objectives Develop a framework that is sufficiently general (and simple) to encompass several “balance sheet approaches” how do approaches map into policy prescriptions? which policy implications seem common? which are not? roles (if any) for international crisis lending? Limitations Very stylized, partial equilibrium Balance sheet mismatches are exogenous

Basic Structure Policy Problems 1.Even without feedback from to, the link magnifies shocks and complicates policy response (CCV, 2001, 2002) 2.With feedback from can get multiple equilibria. Can policy rule out inferior one? = Our focus Exchange rate expectations Some systemic problem Net worth

Basic Structure Encompasses Several “Balance Sheet Approaches” Credit crunch, Low Investment Banking Crisis K, ABB, ST JW BER JW ABB ABB, JW K, ST BER Ass. about M 2 Home goods market clearing Gov. guarantees, debt monetization all

The Basic Link

The Link : Bank Runs Agent is a bank: Dollar deposits Withdrawals subject to sequential service constraint For simplicity, assume Then, get bank run iff: Next, assume banks are continuously distributed in terms of the cut-off at which, with c.d.f. Then, bank runs are increasing in

The Link : Credit Crunch Agent is a firm: No short-term dollar debt (only long term), so no runs For simplicity, again assume Assume first-best level of investment if, else Implies that “investment gap” is a function of

Closing the Model: The Link Three stories: Low investment depresses price of home goods in terms of foreign goods [Krugman (1999), Schneider and Tornell (2001)]. Low investment or banking crisis depress future output. Given monetary policy, this feeds through to higher prices [Jeanne and Wyplosz (2001), Aghion, Bacchetta, Banerjee (2000, 2001)]. Banking crisis leads to debt-financed bailout, which is ultimately monetized (Burnside, Eichenbaum, Rebelo) Here: just assume reduced form:

Multiple Equilibria nAnA Ĩ 0 1 Bank run function Banking Crises u (invest- ment gap) A B Exchange rate function Investment gap function C Credit Crunch 0 A B C Exchange rate function n (bank runs) IAIA At A, exchange rates are appreciated and X (= n or u) is low At C exchange rates are depreciated and X is high

Exchange Rate Regimes Feedback from to can exist for both floats and pegs (for pegs, can expect devaluation) So, multiple equilibria can arise in any exchange rate regime except irreversible dollarization Caveat: We are conditioning on the balance sheet structure. To the extent that “original sin” is endogenous to the exchange rate regime, this could be an argument for a particular regime.

Monetary Policy 1.With, monetary policy is entirely ineffective (Joe effect and Stan effect cancel): 2.With and heterogeneous agents, optimal interest rate policy exists. However, given optimal policy, still have negative link In general, multiple equilibria survive even with optimal choice of i

Fiscal Policy Government introduced as a large agent (like firm) Assume that it can undertake policies that directly offset X in the first period (e.g. make transfers to firms that enable them to invest), subject to its own net worth constraint (= intertemporal budget constraint). Then, investment gap is redefined as: (thresholds now refer to aggregate net worth) Upward shift in investment gap schedule. Depending on solvency of the government, multiple equilibria may or may not disappear.

International Lending: Bank Run Case Last resort lending: lend through discount window to banks that are solvent in the “good” equilibrium (or equivalently guarantee their deposits) Caps bank collapses at, “bad equilibrium” is always eliminated, discount loans are repaid. Only requires covering aggregate dollar liquidity gap of conditionally solvent banks. n nAnA 1 Bank collapses 0 A Exchange rate function nAnA

International Lending: Credit Crunch Case Lending to loosen fiscal constraints: lend to government based on its net worth in the “good” equilibrium Caps investment gap function at Bad equilibrium may be eliminated (but not necessarily so: depends on ) Ĩ 0 A B Exchange rate function Investment gap function C IAIA Ĩ 0 A Exchange rate function Investment gap function IAIA

Conclusions Main theme: Balance sheet mismatches... (1)constrain domestic policies (2)create a role for international crisis lending Monetary policy is in a bind: high interest rates are bad; depreciated exchange rates are also bad. Fiscal policy is constrained by net worth, which is low just when it is needed most (i.e. when ) Without international crisis lending, need either high reserves (cover aggregate dollar liquidity gap) or supersolvent government (high net worth even in crisis) With international crisis lending, don’t need reserves, and solvency threshold is lower (high net worth only in normal times)