1. Third Generation of Currency Crises Models Tomáš Holub (Tomas.Holub@cnb.cz) International Macroeconomics FSV UK, 12 April 2016

2. Main features Historical context: Asian crisis (1997-98); Type of crises: Self-fulfilling character (contagion); interaction of macroeconomic developments with balance sheet vulnerabilities; sharply negative impact on investment and real activity; Policy implications: Reduce financial vulnerabilities in the first instance (FSAP, etc.); if crises takes place, policies must aim at restoring balance sheets of banks and companies.

3. Some papers Over-borrowing syndrome: McKinnon, Pill (1996), Krugman (1998), Corsetti, Pesenti, Roubini (1998) ER mismatches (main topic of the lecture)  Krugman (1999) model of ER mismatches by firms  DeLong (2001) modified IS curve Liquidity mismatches: Chang, Velasco (1998) model of bank runs (seminar topic)

4. Balance sheet of firms (i) The model assumes that the companies finance themselves partly by FX loans, without having corresponding FX assets. The model also assumes that the ability to invest is proportionate to the firms‘ own wealth (i.e. firms face borrowing constraints). ER depreciation reduces own wealth and thus financeable investment.

5. Balance sheets of firms (ii)

6. Balance sheets of firms (iii)

7. Multiple equilibria (self-fulfilling crisis); Vicious circle:  Expected investment  ↑ER (depreciation)   Wealth   Financeable investment   Actual investment …; Defending the ER also leads to a recession and a drop in wealth.

8. Modified IS curve (i)

9. Modified IS curve (ii) Direct effect of ER depreciation is expansionary; Contractionary impact of ER depreciation due to currency mismatches (e.g. Hungary in the recent crisis).

10. FX lending share (% of total loans) Loan Euroization in CEEC

11. Model of bank runs (D-D) Investing in financial markets (ST technology) People‘s expected utility Long term technology (r  1  R) …probability of consumption in period 1

12. Situation with banks and foreign borrowing Red line: situation without banks - individual people can not diversify the risk of early consumption. Blue line: banks rely on the law of large numbers and can thus avoid liquidation of projects and provide better returns to depositors. Green line: if banks have access to cheap foreign borrowing, they can increase returns further. But: This works only if there is no bank run!

13. Bank runs Multiple equilibria (self-fulfilling runs); Vulnerability increases further, if foreigners refuse to continue lending (sudden stop), or if they even withdraw their previous lending (capital flight). A run leads to liquidation of LT project, which is costly.

14. Balance sheet illustration If foreigners refuse to lend or even withdraw money in this phase, there is a problem.

15. 3rd generation models respond to Asian crises; Self-fulfilling nature of crises; Interaction with balance sheet vulnerabilities („twin crisis“); Alternative models focusing on different sectors of the economy and different kinds of B-S mismatches; Crisis causes a sharp drop in investment and output; Policy implication: avoid financial vulnerabilities in the first instance; when crisis hits, restore the balance sheets. Summary