Thesis

Currency Crises and Optimal
International Liquidity

Mateusz Szczurek

Doctor of Philosophy Thesis
University of Sussex

March 2005
I hereby declare that this thesis has not been and will not be, submitted in whole or in
part to another University for the award of any other degree.

Mateusz Szczurek
University of Sussex
Mateusz Szczurek
Doctor of Philosophy thesis
Currency Crises and Optimal International Liquidity
Summary
The thesis investigates the importance of international liquidity for currency crisis gen-
eration, prevention and costs. It includes a case study of the main 1990s currency crises,
a model of policymaker optimising foreign exchange reserve stock with respect to its
alternative costs, its impact on currency crisis probability and expected damage related
to the currency collapse. An attempt is also made at matching revealed policymakers
crisis aversion with real-life output losses related to currency crises. International liquid-
ity played significant, albeit very rarely dominant role in the crises of the 1990s. The
exceptions included Korea, Thailand and, possibly, Mexico. Calibration and application
of the reserve stock optimisation model showed that most of the emerging markets poli-
cymakers are prepared to suffer considerable annual costs of maintaining their official
reserves. On average, the central banks in the sample spent 0.3% of GDP annually on
their reserve holdings. The implied aversion to crises (expected crisis cost) was about
9% of GDP. In case of some of the countries, prospective currency crisis would have to
cost (in terms of both forgone output and reputation) over 20% of GDP in order for their
0.9% of GDP annual investment in reserves stock to pay back. This is far more than the
estimated average output loss of 2.3% of GDP in the past currency crises. The article
underscores that the quasi-fiscal costs of keeping war-chests of international liquidity
are considerable enough to justify cooperation between governments and central banks
on a more active foreign debt and liquidity management policy.

- 4 -
Table of Contents
TABLE OF CONTENTS 4
LIST OF FIGURES AND TABLES 8
CHAPTER 1 INTRODUCTION 10
CHAPTER 2 RESERVES IN CRISIS MODELS: A SURVEY OF
LITERATURE 17
Section 2.1 First generation models 17
Section 2.2 Second generation models 27
Section 2.3 Asymmetric information as a cause of crises 34
Section 2.4 Liquidity and balance sheet models 38
Section 2.5 Inventory model of foreign exchange reserves 47
Section 2.6 Summary: liquidity in crisis models 51
CHAPTER 3 LEADING INDICATORS LITERATURE 53
Section 3.1 When and where 54
Section 3.2 Methods used 56
Section 3.2.1 Quantal response techniques 56
Section 3.2.2 Standard regression 57
Section 3.2.3 Signals approach 58
Section 3.2.4 Other methods 61
Section 3.3 What is a currency crisis? 62
Section 3.3.1 Exchange rate definitions 62
Section 3.3.2 Capital flows definitions 63
Section 3.3.3 Exchange Market Pressure (EMP) 64
Section 3.3.4 Discretionary definitions 67
Section 3.3.5 Other definitions 68
Section 3.4 What works? 69
Section 3.4.1 International liquidity 69
Section 3.4.2 Money supply 76
Section 3.4.3 Budget deficit, public debt 76
Section 3.4.4 Other balance of payments variables, real exchange rate 79
Section 3.4.5 The real sector 80
Section 3.4.6 Contagion variables 81
- 5 -
Section 3.4.7 Institutional and structural factors 83
Section 3.4.8 Political variables 85
CHAPTER 4 RECENT CURRENCY CRISES: LIQUIDITY PERSPECTIVE 92
Section 4.1 Introduction 92
Section 4.2 1992 EMS crisis 98
Section 4.2.1 Crisis identification 98
Section 4.2.2 The role of reserves 100
Section 4.3 The Tequila crisis 1994 105
Section 4.3.2 The role of liquidity 108
Section 4.3.3 The cost of liquidity 111
Section 4.4 Bulgarian crisis of 1996-1997 112
Section 4.4.2 Role of liquidity and the cost of reserves 117
Section 4.5 East Asian crisis of 1997 118
Section 4.5.3 The cost of liquidity 127
Section 4.6 1998 Russian crisis 131
Section 4.6.2 Role of liquidity 136
Section 4.6.3 Cost of reserves 137
Section 4.7 1998 crises in other FSU counties: Ukraine and Moldova 138
Section 4.7.1 Crises identification 138
Section 4.7.2 Role of liquidity 142
Section 4.8 2000-2001 Turkey default and lira collapse 143
Section 4.8.2 The role and cost of liquidity 146
Section 4.9 The end of Argentine currency board 147
Section 4.10 Case study conclusions 155
CHAPTER 5 INTERNATIONAL LIQUIDITY TARGETING: A MODEL 158
Section 5.1 Crisis and its costs 158
Section 5.2 International liquidity and its cost 164
Section 5.3 Optimisation problem 170
- 6 -
Section 5.4 Empirical application: Introduction 172
Section 5.5 Model calibration 173
Section 5.5.1 Data 174
Section 5.5.2 The results 176
Section 5.6 Model application: best value for money liquidity 185
Section 5.7 Model application: How much policymakers fear the crisis? 189
Section 5.8 Conclusions 194
CHAPTER 6 THE OUTPUT COST OF CURRENCY CRISES 196
Section 6.1 Introduction 196
Section 6.2 Crises and output: the theory 197
Section 6.3 Empirical treatments 199
Section 6.4 Research concept and data used 204
Section 6.5 The results 206
Section 6.6 Crisis costs conclusions 211
CHAPTER 7 FINAL CONCLUSIONS 213
REFERENCES 215
APPENDIX 1. CHRONOLOGY OF RECENT CURRENCY CRISES 227
Chronology of the Mexican crisis 227
Chronology of the Bulgarian Crisis 227
Chronology of Thai crisis 229
Chronology of the Malay crisis 231
Chronology of the Indonesian crisis 232
Chronology of the Korean crisis 234
Chronology of the Russian Crisis 235
Chronology of the Ukrainian crisis 236
Chronology of the Moldovan Crisis 237
The chronology of the Turkish crisis 237
- 7 -
Chronology of the Argentine crisis of 2001 238
APPENDIX 2: ALTERNATIVE SET OF MODEL EQUATIONS 248
APPENDIX 3: MODEL OPTIMISATION MATHEMATICA
5 CODE 250
APPENDIX 4: THE LIST OF COUNTRIES USED FOR ESTIMATIONS IN
CHAPTER 5 255

- 8 -

List of figures and tables
Figure 1 Target exchange rate with limited reserves 24
Figure 2 Target exchange rate with large reserves 25
Figure 3 Reserves determine the range of possible equilibria 28
Figure 4 Devaluation and fixing loss functions under devaluation and fixing
expectations 32
Figure 5 Expected profit of domestic economy/investor as a function of short-term debt
44
Figure 6 Modified Mundell-Fleming model 46
Figure 7 Binary recursive tree estimation result 61
Figure 8 Leading indicator literature summary: methods, datasets, results (sorted by
publication date) 86
Figure 9 GBP/ECU rate and UKs reserves 103
Figure 10 ECU/SEK rate and Swedens reserves 103
Figure 11 ECU/ESP rate and Spanish reserves 103
Figure 12 ECU/LIT rate and Italian reserves 103
Figure 13 IRP/ECU rate and Irish reserves 104
Figure 14 ECU/FIM rate and Finnish reserves 104
Figure 15 UKs reserves/M4 104
Figure 16 Swedish reserves/M3 104
Figure 17 Spanish reserves/M3 104
Figure 18 Italian reserves/M2 104
Figure 19 General budget deficit (% of GDP) 105
Figure 20 Real GDP growth (YoY%) in ERM 105
Figure 21 Real GDP growth in Mexico (YoY) 107
Fig 22 Mexican CA and budget balance (% GDP) 107
Fig 23 Nominal exchange rate and reserves 108
Fig 24 Mexican international liquidity measures 108
Figure 25 Mexico Par Brady bond zerocoupon spread (bps) 112
Figure 26 Bulgarian money demand function 114
Figure 27 Purchasing power parity test 115
Figure 28 Bulgarian exchange rate and reserves 116
Fig 29 Bulgarian international liquidity measures 116
Fig 30 Bulgarian monetary indicators (in logs) 116
Fig 31 Deficit monetisation and exchange rate 116
Fig 32 GDP, CA and unemployment in Bulgaria 116
Figure 33 Bulgarian Discount Brady bond zerocoupon spread (bps) 118
Fig 34 Budget balances in ASEAN-5 (% of GDP) 121
Figure 35 ASEAN-5 Current account (%) of GDP 121
Fig 36 Indonesian exchange rate and reserves 121
Figure 37 Korean exchange rate and reserves 121
Figure 38 Malaysian exchange rate and reserves 122
Figure 39 Philippine exchange rate and reserves 122
Figure 40 Thai exchange rate and reserves 122
Figure 41 Reserves/Money+quasi-money 124
Figure 42 Reserves/Money+quasi-money 124
Figure 43 Philippines Brady spread (bps) 130
- 9 -
Figure 44 Indonesia Yankee 06 spread (bps) 130
Figure 45 Korea Dev Bank 06 130
Figure 46 Thailand 02 zerocoupon spread (bps) 130
Figure 47 Malaysia 00 zerocoupon spread (bps) 131
Figure 48 Russian exchange rate and reserves 132
Figure 49 Rus Reserves to short term debt (BIS) 132
Figure 50 Russian budget and reserves/M2 133
Figure 51 Russian GKO yield 133
Figure 52 Hryvna rate and reserves (US$m) 140
Figure 53 Ukraines reserves/M2 140
Figure 54 Moldovan exchange rate and reserves 141
Figure 55 Reserves/M2 and deficit monetisation 141
Figure 56 Ukrainian growth and CA 142
Figure 57 Moldovan growth and CA 142
Figure 58 US$/TKL and Turkish reserves 145
Figure 59 Reserve/M2 and TCMB gov. financing 145
Figure 60 YoY GDP growth and CA balance 145
Fig 61 Turkey Republic 30, zerocoupon spread 145
Fig 62 Argentina Discount Brady bond zerocoupon spread (bps) 155
Figure 63 Summary of the case studies 157
Figure 64 Probability of a crisis vs. international liquidity and a budget deficit 159
Figure 65 Marginal return to international liquidity vs. liquidity and REER 163
Figure 66 Optimal international liquidity marginal cost and benefit 171
Figure 67 Probability of a crisis as a function of key variables only 177
Figure 68 Crisis probability as a function of all main variables 177
Figure 69 Final benchmark model of crisis probability 178
Figure 70 OLS results of the impact of liquidity, lagged fundamental variables and crisis
dummy on the current account (full sample) 181
Figure 71 OLS results of the impact of liquidity, lagged fundamental variables on the
current account (crisis sample) 182
Figure 72 OLS results of the impact of liquidity, lagged fundamental variables on the
real exchange rate (crisis sample) 183
Figure 73 OLS results of the impact of liquidity, lagged fundamental variables on
budget deficit (crisis sample) 183
Figure 74 OLS results of the impact of liquidity, lagged fundamental variables on GDP
growth (crisis sample) 183
Figure 75 International bond spreads as a function of liquidity, currency crises and
foreign debt 184
Figure 76 Annual costs of keeping foreign exchange reserves 186
Figure 77 Optimal liquidity holding versus cost of the crisis, sample average. 188
Figure 78 Expected crisis cost to the policy maker, as of 2001 189
Figure 79 Marginal liquidity cost and benefit curves in emerging markets 190
Figure 80 Marginal benefit from international liquidity for sample countries 192
Figure 81 Implied crisis costs and sovereign spreads 192
Figure 82 Output loss in first and two first years of a crisis 207
Figure 83 Output crisis cost in 2 years of the crisis; all variables 207
Figure 84 Output crisis cost in 2 years of the crisis; parsimonious version 208
Figure 85 Output crisis cost in the year of a crisis; all variables 209
Figure 86 Crisis year output loss; final model 209
Figure 87 Expected output loss, and total implied crisis cost (% of GDP) 212
- 10 -
Chapter 1 Introduction
1

Because the IMF and other international organisations do not have the resources to
act as lenders of last resort, the emerging market countries that want to prevent sharp
currency declines must provide for their own protection through increased liquidity.
Martin Feldstein, 1999
The point seems to make perfect sense: even with less-than perfect macro policy, the
government could survive any speculative attack, provided it has enough foreign ex-
change ammunition. What is more, if the reserves are high enough, the attack (bound
to fail) will never happen. The simple argument for higher reserves is not obvious, how-
ever.
First, in monetary terms sterilised intervention (and foreign exchange interventions are
very often sterilised) should not influence the exchange rate significantly. The main
problem here is that sterilisation increases the potential for hot money outflow multi-
plies the enemy with the same amount of ammunition to stick with the military par-
able. If the foreign exchange intervention is not sterilised, the economy (and the bank-
ing sector in particular) must be able to survive a serious liquidity squeeze (which could
have worse effects than devaluation itself).
Second, in fixed exchange regime sufficient liquidity may mean foreign exchange re-
serves close to money supply. Any level of reserves smaller than this may not fully
eliminate the attack equilibrium, as not only foreign investors, but also residents could
choose to exchange domestic for foreign currency. It may well be that relationship be-
tween foreign exchange reserves and probability of a crisis is not linear at all it would

1
I would like to thank Robert Eastwood for skilful supervision, Jerzy Pruski and other
participants of CASE seminars for useful comments, David Spegel from ING Financial
Markets for his extensive bond price database, ING Bank for financial support and,
above all, my family for endless support and patience.
- 11 -
be plausible that a country with very high reserves would enjoy almost zero probability
of a speculative attack. Would a marginal decline in liquidity have the same effect on
the crisis risk regardless of the state of other fundamentals?
Finally, liquidity is costly. Even if the government issues international debt solely for
the purpose of building up the war chest of international reserves (with the annual cost
of the spread over the US Treasuries) the gain in terms of liquidity will be limited be-
cause of the additional build-up of obligations. If the proper measure of liquidity in-
cludes the level of short-term debt, borrowing short to build up reserves will make little
sense. Still, provided the international reserves are built up with the long-term bonds, an
increase of international liquidity is feasible.
This work aims at answering several questions related to the role of foreign exchange
reserves, international liquidity in crisis prediction, crisis prevention and crisis costs.
First, where does international liquidity fit in the existing theoretical and empirical work
on currency crises? Second, what was the role of international liquidity in the currency
crises of the 1990s? Third, if the liquidity can reduce crisis probability, what is the de-
sired stock of foreign exchange reserves to be held by countries facing risk of a cur-
rency crash? Fourth, how does the behaviour of the emerging market borrowers fit with
the model, the existing literature and estimates of currency crisis-related output loss?
The first question concerns the theoretical reasons why international liquidity should
influence the timing or probability of the crisis. If theory speaks for the importance of
international liquidity for crisis timing or probability, can the knowledge of the mecha-
nisms bring any benefit to the policymakers? The answer to these issues require a thor-
ough review of the theoretical crisis literature, from early, first-generation models in
which crisis erupts as a result of a macroeconomic policy incompatible with fixed ex-
- 12 -
change rates, through the latest balance sheet crises in which capital outflow expecta-
tions becomes self-fulfilling though its negative effect on real output, or ability to bor-
row and invest.
The answer to the first part is usually yes, as foreign exchange reserves do appear in
most of the models describing the currency crises. The answer to the second part is
much less encouraging. In some models (e.g. in Krugmans classic, or in Dooleys in-
surance model) the amount of reserves influence timing of the crisis, but governments
cannot postpone the crisis by managing reserve level, as it either boosts fiscal costs, the
ultimate cause of the crisis, or increases the moral hazard for local corporations. Other
models leave some more room for deliberate liquidity targeting as a tool for crisis pre-
vention. In particular, many balance sheet models allow for a trade off between costly
liquidity and higher crisis risk.
Vast empirical literature confirms that foreign exchange reserves and other measures of
international liquidity are one of the most reliable leading indicators of currency crises.
Just as predicted in the theoretical models, however, the significance of such variables
in crisis probability equations does not mean that targeting high liquidity can avert the
currency crises or even that low liquidity is among their main causes of crises (as op-
posed to warning signals).
This is confirmed in the answer to the second of the main questions of the work. The
currency crises of the nineties and early 21
st
century, including EMS, Mexican, Bulgar-
ian, Asian, Russian, Turkish and Argentine collapses are rarely caused solely by poor
liquidity. But some countries, in particular Thailand, Korea and Mexico could have
avoided at least some of the costs of crises (if not crises altogether) without the reliance
on the short term foreign financing.
- 13 -
The answer to the third of the main questions required construction of an optimising
policymaker model. In the model, international liquidity is the only variable under the
direct control. The policymaker tries to minimise the loss function including the cost of
the currency crisis (the probability of which depends partially on the liquidity held) and
the annual cost of international liquidity. Using the structure presented it is possible to
estimate the implicit reputation cost of a prospective currency crash to the policy-maker.
This line of modelling joins the strain of the buffer stock modelling of desired foreign
exchange reserves stock (Frenkel and Jovanovic, 1981) and the more recent research on
currency crises.
Empirical testing of the model required calibration of the main parameters. Pooled logit
regression study was performed to check if and how different measures of international
liquidity and other control variables help in averting emerging market crises. Reserves
to short-term foreign debt, money supply growth, budget and current account deficits
were found to influence crisis risk significantly. Other estimations included checks of
responsiveness of the main model variables to the crisis occurrence (to allow for esti-
mating the costs of postponing the crisis), and the influence of liquidity targeting policy
on sovereign spreads and costs of liquidity itself. It turned out that the negative effect of
higher overall debt outweighs the benefits of lower perceived crisis risk on spreads.
Thus, the countries borrowing in long maturities cannot count on cheaper financing
thanks to lower liquidity, on the contrary, trying to offset the burden of short-term li-
abilities by borrowing liquid assets increases debt and costs of external financing.
The theoretical model was employed to estimate the curve of optimal international li-
quidity holdings with respect to changing expected crisis costs for a group of countries.
The Guidotti rule dictating 100% coverage of short term debt by (usable) foreign ex-
- 14 -
change reserves implies about 8% of GDP average crisis cost for a median country. This
is a reasonable result, as some of the crisis cost studies (e.g. Bordo et al., 2001, Hutchin-
son and Neuberger, 2001) point to the output losses of a similar magnitude. However,
the variations in both costs of borrowing and in fundamentals faced by different coun-
tries makes the quick 100% rule very unreliable. Countries like Croatia could profitably
increase their official reserve stock (by means of long-term borrowing) the benefits of
thus bought protection against excessive foreign exchange volatility outweigh the cost
of keeping reserves. On the other extreme is Singapore, which is prepared to pay con-
siderable annual amounts to keep the duration of debt its reserves high, without signifi-
cant crisis protection gains.
The intersection of the optimum liquidity curve with actual liquidity held by various
countries sheds light on the fourth and final of the main questions of the thesis. Re-
vealed expected crisis cost to the policymakers is at about 9% of GDP, but with the in-
dividual results varying from 1.5% in Croatia to over 15% for the pegged exchange rate
countries, and as much as 78% for Singapore.
The latter result confirms the limitations of the model: for many countries reserves are
more than just a tool for crisis protection. Own calculations suggest that the average
output cost of a currency crisis in the group of emerging market economies sums up to
slightly above 2% of GDP. The cost grows with debt, but falls with the importance of
the export sector for the economy. This result is close to the lower-end of the findings of
the existing literature on output costs of the crises, but no paper estimates the output loss
anywhere close to the 15% of GDP, the figure significantly exceeded by estimated ex-
pected crisis cost to policy makers of Argentina, Bulgaria, or Singapore. In fact, no cri-
sis in the past 20 years proved that expensive (yet the impact of the Argentine currency
- 15 -
board collapse was not included in the calculations). The model suggests the policy-
makers fear for crisis output costs is dwarfed by dislike to the potential reputation or
political power loss.
The second chapter provides a survey of all major strains of currency crisis theory with
the emphasis given to the links between international liquidity and timing, probability or
costs of the currency crises.
The third chapter reviews the vast empirical literature on leading indicators of the cur-
rency crises, including the analysis of techniques and variables as well as a comprehen-
sive summary table with the results and estimation methods of 75 papers on leading cri-
sis indicators.
Chapter four consists of case studies of the currency crises in the EU in 1992, Mexico in
1994, Bulgaria in 1996, East Asia in 1997, Russia, Ukraine and Modova in 1998, Tur-
key in 2000, and Argentina in 2001. The main issues confronted are the role of various
measures of international liquidity as a crisis prediction and the feasibility of the re-
serves as crisis prevention tool.
The fifth chapter presents the international liquidity policy optimisation model, its em-
pirical calibration and the estimates of optimal liquidity curves for various levels of cur-
rency crisis costs and resulting implied crisis aversion by policymakers in a group of
emerging market economies.
Finally, chapter six reviews the theoretical and empirical literature on actual output
costs of currency crises, and estimates the determinants and size of output loss related to
currency crises in the 1990s in emerging markets. This allows for comparison of prefer-
- 16 -
ences revealed by policymakers in their international liquidity holdings, and expected
output loss in the prospective currency crisis. The final section concludes.
- 17 -
Chapter 2 Reserves in crisis models: a survey of literature
Section 2.1 First generation models
Beginning of the currency crisis literature is attributed to Krugman (1979) classic, later
simplified and extended by Flood and Garber (1984) and surveyed in Agenor et al.
(1992)
2
. So called first generation crisis models base on exhaustible resource literature
originating in Hotelling (1931). The first generation crisis occurs as a result of an unre-
formable macroeconomic policy incompatible with fixed exchange rate. In Krugmans
example the policy is the one of excessive fiscal deficits, monetised away.
The international reserves are quite central to the analysis: they take the role of ex-
haustible resource in the equivalent model of Salant and Henderson (1978). Incompati-
ble macroeconomic policy causes gradual depletion of reserves. Fixed exchange regime
can last only until foreign exchange reserves reach certain critical level. The model pre-
dicts, however, that the end comes earlier than that. Rationally thinking speculators at-
tack and buy all remaining stock of reserves as soon as the shadow price the price
which would prevail without central bank fixing the exchange rate reaches the official
rate. The regime turns smoothly to a float (exchange rate does not jump, only the level
of reserves).
The model presented below (following Flood and Marion, 1998) is the simple linear
version of the original, but it captures well enough all the main features of the class.

2
Balance of payments models are older than that: Mundell (1960) shows an example of
a general equilibrium model in which abandonment of a peg depends on the level of in-
ternational reserves.
- 18 -
The model can be described with four equations, showing, respectively, money demand,
money supply, price level (following the PPP), and exchange determination model (fol-
lowing uncovered interest parity):
m - p=- i, >0,
m = ln(D + R),
p = p*+ s,
i = i* + s`
m is the (nominal) money supply, p and p* domestic and foreign price level, i and i*
domestic and foreign interest rate, D is the domestic credit level, R is the stock of for-
eign reserves, s is the exchange rate, and s is the expected (and actual, perfect foresight
is assumed) rate of change of the exchange rate. All variables except D, R, i and i* are
in logs.
Log of domestic credit d is assumed to grow at a constant rate , envisaging a
monetised budget deficit financing. When the exchange rate is fixed at , expected de-
preciation s is equal to 0, and domestic interest rate equal to foreign interest rate i*.
With foreign interest rates and price level constant, the money market equilibrium re-
quires that the log of reserves r must be falling at the rate -, because money supply m
is constant. Thus, the country must run out of reserves at some stage, which will trigger
growth in m (along with growing domestic credit) and the collapse of the fixed ex-
change rate.
When this will actually happen depends on the expectations of future exchange rate pol-
icy, and on the threshold level of reserves, at which the central bank lets the currency
go. In what follows, I assume that the threshold (log) level of reserves is zero, and that
the post-crisis regime is a float.
- 19 -
To determine the timing of the collapse, lets define shadow exchange rate as the ex-
change rate consistent with the money market equilibrium, provided the reserves are at
the threshold level (completely exhausted in our case). For simplicity, lets also normal-
ise foreign price and interest rate level at zero. Combining four initial equations, we get:
d =- ,
where d is log of domestic credit D.
Because with the reserves depleted, money supply, price level and the exchange rate all
grow together with d at the rate , so the shadow exchange rate is equal to:
= d + .
The peg collapses with the speculative attack when the shadow exchange rate exceeds
the fixed rate . As long as the shadow rate is smaller, the attack would leave the attack-
ers with capital losses. But competition between the speculators makes the profitable
run on the currency impossible, thus shadow rate cannot be bigger than the fixed rate.
Thus the speculative attack is not associated with a discrete jump in exchange rate.
What will jump is the domestic interest rate i, which from the moment of the attack
must reflect the devaluation rate equal to the credit growth . This allows the drop in
money supply (caused by discrete fall in reserves at the moment of the attack) to be
matched with a drop in money demand (due to a hike in interest rate). During the attack,
reserves will fall so that m is equal to -.
What is the timing of the speculative run? We know that the domestic money follows
d
t
= d
0
+ T.
- 20 -
At the moment of the attack, shadow exchange rate is equal to the fixed rate (which, in
turn is equal to the log of the initial money supply, assuming zero foreign interest rates
and inflation):
m
0
= d
0
+ T + .
Thus
|
|
\
|
+
=
|
|
\
|
=

=
0
0
0
0
0
1 ln ln
D
R
D
M
d m
T
o
, where T is the timing of the at-
tack, and R
0
is the initial stock of reserves.
The result shows that the attack comes later when the initial stock of reserves (relative
to domestic money) is higher or domestic credit expands more slowly. Foreign ex-
change reserves are crucial as a leading indicator of the currency crisis. The importance
of the reserves in crisis prevention, however is limited, as, in the basic form of the
model, the government influences (decreases) the level reserves only by expanding do-
mestic credit (at a constant rate).
In reality, policymakers often fail to behave as assumed in the Krugmans model. Tan-
ner (1997) shows that the outflow of reserves in Latin America and Asian countries in
the 1990s was usually associated with offsetting growth of domestic money
3
. Countries
undergoing crises in late 1990s resisted the temptation to offset money supply fall by
domestic money growth only until a point (early, in case of Ukraine, or Russia, late in

3
There are examples though of central bankers taking the exchange rate policy seriously
Moldova in 1998 experience severe tightening of the money supply and temporary
falls in inflation because of the speculative attack. Also, Tanners results could indicate
central banks reacting to banking panics and rising money demand and currency ratio.
Injecting liquidity in such a case would still leave models findings relevant.
- 21 -
case of Moldova or Turkey), when other factors, like banking system stability started to
weigh more than the durability of the peg. Governments refusal to defend the peg in
such a way would make reserves irrelevant, because in case of a speculative attack, the
rate of change of domestic credit would increase above the normal rate , as the policy-
maker would start printing money to offset falling money supply. Rational investors
would attack the currency immediately, regardless of the reserves (see Flood and
Jeanne, 2000).
Another problem, which concerns also later extensions of the basic versions, is the use
of the standard monetary model of exchange rate determination. This model simply
does not work well in explaining exchange rates in developed economies, as was
pointed out in the classic paper by Meese and Rogoff (1983). The problem is not even
with the fact that the budget deficits may be financed by other means than monetisation
in open developed economies. The core of the model is the unsustainable monetary pol-
icy leading to the collapse. But due to the money demand function instability, econo-
metric attempts to link monetary policy with G7 exchange rates tend to fail. This ren-
ders Krugmans model rather ineffective in predicting the developed countries currency
crises. Also, in many developed countries, the government has little control over mone-
tary policy for example, EMU member governments cannot simply order the ECB to
finance their deficits. Somewhat relieving is the stylised fact of better performance of
monetary models in developing countries currencies forecasting, possibly due to faster
changing money stocks in such countries (or less problems with near money defini-
tions, and money demand estimations).
The basic model can be extended to incorporate a possibility of an interest rate defence,
leading to a (short-term) build-up of reserves. Such a model can be found in Flood and
- 22 -
Jeanne (2000). By adding the uncertainty in the portfolio balance framework, they relax
the simple uncovered interest parity condition, allowing for an interest rate defence.
While it leads to a replenishment of the reserves, it also increases the fiscal costs, the
ultimate reason behind the vulnerability of the peg. As a result, the collapse is usually
hastened because domestic credit starts to expand faster due to the increased fiscal costs.
This important result serves a reminder that the reserves do not come for free.
An interesting model from the point of view of the importance of international liquidity
is one by Krugman and Rotemberg (1992). It joins two strands of the exchange rate lit-
erature target zones models and currency crisis models
4
. The model goes as follows
(the variables designations are as before, unless otherwise indicated):
|
\
|
+ + =
t
s
E v m s , where a change in v is a shock to the money demand following
random walk with a drift:
z t v + =
Log money supply m = ln(D + R)
Under the free floating regime, expected depreciation is equal to the drift in the money
demand. The exchange rate equation is then: s m v = + +
Holding money supply constant, the general solution of the model, is
5
:

4
Other models of this kind are shown in Flood and Garber (1989), models in Krugman
and Miller (1992) and Bertola and Svensson (1993).
5
See e.g. Garber and Svensson (1994) for the derivation of the solution, which uses
Itos lemma
- 23 -
v v
Be Ae v m s
2 1
+ + + + =

, where A and B are free parameters, and
0
2
0
2
2
<
+
=
>
+ +
=
2
2 2 2
2
2 2 2
1

With the exchange rate fully floating, money supply is truly constant and cannot be ex-
pected to change, thus the expectations component is simply equal to the expected
change in v the drift. In such case both A and B are equal to zero. If, however, the cen-
tral bank is expected to spend the reserves, defending some target exchange rate, then
rational speculators expect money supply to fall as soon as exchange rate reaches the
edge of the band. The size of A and B depends on the amount that the government is
willing to spend defending the edges, the size of the reserves in the case of A, and the
amount of reserves the central bank will buy in case of an attack on the stronger side
of the band (which determines B). We assume that the band is single-sided, which
means that v may fall as much as it wants, without triggering the response of the central
bank. This means that B is equal to zero (investors do not expect an increase in money
supply as a result of the strengthening pressure on the local currency). A can be deter-
mined, knowing the level of the foreign exchange reserves, and that no predictable dis-
crete jumps in exchange rate can happen.
After the speculative attack, when reserves r are exhausted, log money supply m falls to
log domestic money d, and the regime is floating, thus the shadow exchange rate is:
= d + v +
- 24 -
For small level of reserves (reserve/domestic credit ratio 1
1
<
1
e
D
R
), The attack oc-
curs, as before, when shadow exchange rate is equal to the regime exchange rate. This is
the only rate that eliminates the possibility of capital gains for the speculators. The at-
tack happens when v reaches the critical level v (for which is equal to the targeted
level of the exchange rate s
max
):
v
Ae v m v d
1
+ + + = + +

' '
A, which ensures the no-exchange rate jump attack is equal to:
( )
r e
d s
2

max
.
Figure 1 Target exchange rate with limited reserves

2 4 6 8 10
v
2
4
6
8
10
s
s
max
v

X

Y

Z

Source: Author, based on Krugman and Rotemberg (1992) model
Figure 1 shows exchange-rate-money demand shock loci for the free-float (dashed line)
and zero-reserves (post attack) float (solid straight line, parallel to the free float). The
latter can be considered a shadow exchange rate. It becomes the actual exchange rate at
a point where it crosses the curved line (target regime).
While it is obvious that the zero-reserves curve shows stronger exchange rate than the
(no-attack) free-float (total money supply is lower by the amount of reserves spent, so
the exchange rate must be stronger for a given shock to money demand after the attack),
the fact that the target regime curve is below the free float is more exciting. It shows
- 25 -
that despite inability of the government to defend the target rate (as soon as v reaches v
the regime collapses and the exchange rate starts to follow the zero-reserves curve), the
exchange rate is supported by the sheer willingness of the authorities to spend reserves
defending the target (Krugmans honeymoon effect). The kinked thick curve (X-Y-Z) is
the actual exchange rate-money demand schedule.
The situation looks different when reserves to domestic credit ratio is bigger. For large
reserves, the regime curve reaches its maximum to the left of the post-attack locus. The
speculative attack does not then take place at all, and the target can be kept with very
small interventions. Situation like that is shown in Figure 2. A is set to make the regime
locus tangent to the exchange rate target (s cannot be expected to grow above the s
max

without the attack). Each intervention, however shifts the regime locus to the right, as
the reserves get smaller and smaller. When the reserves reach small limit
( 1
1
=
1
e
D
R
), i.e. when the maximum of the regime locus is at the (s
max
,v) point,
speculative attack occurs consuming all remaining reserves, and the regime turns into
free float.
Figure 2 Target exchange rate with large reserves
2 4 6 8 10
v
2
4
6
8
10
s

Source: Author, based on Krugman and Rotemberg (1992) model
- 26 -
The important point from this analysis is that the attack cannot occur for sufficiently
large reserves. If the initial reserves are much larger then domestic credit, reserve loss is
zero when fundamentals are good enough (v is low). As v gets worse, the reserves start
to dribble out (along the horizontal part of the bold curve in Figure 2). As they keep
worsening, the attack occurs at some stage (the drift in the money demand shock term
ensures that), which eliminates all the remaining reserves.
When the reserves are initially small, they do not contribute radically to the defence of
the exchange rate target. All the reserves are suddenly wiped out when the fundamentals
v worsen beyond some threshold. The only benefit from the reserves is the some support
to the currency for moderate levels of fundamentals, before the attack.
Other extensions of the 1
st
generation crisis model include adding price stickiness,
which leads to real appreciation ahead of the crisis as agents increase prices expecting
the exchange rate depreciation (Goldberg, 1991), including forward-looking wage con-
tracts, which boost wages ahead of currency depreciation (Willman, 1988); uncertainty
about the rate of deficit monetisation, which increases interest rate spread and makes it
possible temporarily for the shadow exchange rate to be weaker than the peg rate (Flood
and Garber, 1984), introducing the capital controls, which could lengthen the peg and
make the step-devaluation possible.
- 27 -
Section 2.2 Second generation models
Second generation models (a good example is shown in Obstfeld 1994) addressed seri-
ous drawbacks of the first generation models
6
. First, the governments and central banks
of the models building on Krugman (1979) were like lemmings: once engaged in a pol-
icy incompatible with fixed exchange rates, they were heading for the disaster of reserve
depletion. In reality, the governments have more options. For example, they can change
their policy when balance of payments gets worse, or devalue without depleting the re-
serves first. The second-generation models allow the governments to optimise. The loss
function usually includes the exchange rate and some variable dependent on both actual
depreciation and the prior public expectations of depreciation. In two models presented
in Obstfeld (1996), the variable is a level of taxation (dependent on nominal interest
rates, and thus on public expectations of nominal depreciation), or unemployment (de-
pendent on agents wage setting decisions, and thus nominal depreciation).
The circular causality indicated above gives rise to fascinating properties of second-
generation models. Exchange rate regimes that at first glance may seem to be perfectly
viable may suddenly collapse simply because they are expected to. The possibility of
multiple equilibria and self-fulfilling attacks fits well with crises like 1992 EMS col-
lapse. Important feature of most of the second-generation models is that self-fulfilling
attacks cannot occur for any value of fundamentals. Usually, there is a range of funda-
mentals for which an attack is impossible, a range for which the attack is certain, and a
range in which both attack and calm equilibria are possible.

6
For other models of this kind see e.g. Obstfeld (1996), Velasco (1996), Ozkan and
Sutherland (1998), Drazen (1999). A survey is provided in Eichengreen, Rose and Wy-
plosz (1996)
- 28 -
What is the role of international reserves, so central to first generation models, in the
second-generation alternatives? Many models of the second kind, and the ERM crisis
itself seem to suggest that reserves influence neither probability nor the timing, nor the
scale of the currency collapse. In principle, the British problem of 1992 was not about
being able to defend the currency, but about Britain not wanting to do it. Britain had
plenty of reserves, could borrow more from other European central banks
7
, or could de-
crease the money supply and defend the pound for a long time (as it had been doing be-
fore the 1
st
World War). ERM crisis erupted because the speculators believed Britain
would have found defending the pound unprofitable if attacked.
A simple explanation of the possible role of the international reserves is shown in
Obstfeld (1996), and reproduced in Figure 3.
Figure 3 Reserves determine the range of possible equilibria
Trader 2 Trader 2 Trader 2
Hold Sell Hold Sell Hold Sell
Hold 0,0 0,-1 Hold 0,0 0,2 Hold 0,0 0,-1
T
r
a
d
e
r

1

Sell -1,0 -1,-1
T
r
a
d
e
r

1

Sell 2,0 ,
T
r
a
d
e
r

1

Sell -1,0 3/2,3/2
(a) High Reserve game (b) Low Reserve game (c) Intermediate Res. game
Source: Obstfeld (1996)
In a simplified model, Obstfeld envisages three agents: the government (selling foreign
reserves to fix the currencys exchange rate), and two investors who either hold to their

7
According to some market commentators the Bank of England was actually unable to
arrange enough foreign currency in time to defend the pound on Black Wednesday. A
very stylised model trying to explain why a currency can collapse despite arrangements
such as VSTFF (Very Short Term Financing Facility) of the EMS which provide virtu-
ally unlimited intervention financing is provided by Lall (1997). The model assumes
that the amount of foreign currency that a central bank can access in any given day is
limited, and that an unexpected shock to the money demand could trigger a collapse of
the currency peg.
- 29 -
local currency assets, or sell them, draining reserves. When the reserves (which serve as
a measure of the governments commitment to the peg) are high enough to absorb both
investors selling-out of the domestic assets, the only Nash equilibrium in the one-shot
non-cooperative game is the no crisis equilibrium. When the reserves are insufficient
to satisfy even one of the traders, than it is optimal for each one of the investors to force
devalue the currency and get some profits. The most exciting situation is when the cur-
rency is devalued only when both traders sell. Then two equilibria exist it is optimal
for trader 2 to attack the currency only when trader 1 does so. Without the attack, the
peg may last forever, when attack occurs, the peg fails
8
.
The simple model above served only as an example of multiple equilibria in foreign ex-
change markets. But other, full-fledged, second-generation models exist, which stress
the importance of international liquidity. Sachs et al. (1996a) provide one example, in
which the fundamental, which governs the possibility of a successful attack, is the net
level of debt the government owes. Sufficiently high level of reserves (net of govern-
ment debt) makes an attack impossible to succeed. Such a model could explain the styl-
ised fact of relative crisis immunity of highly liquid developing countries.
In the simplified version of Sachs et al. model, the government faces the following
budget constraint and loss function:
( ) 0 , > = +
t t
e
t t
x Rb

8
But this outcome relies on the assumption of the discretionality of the speculative deci-
sions one can argue that the speculator knows that his fellow speculator would attack
as soon as he starts the attack. In such case the attack equilibrium would be the only one
viable in this case the payoff is the highest for the attack in the intermediate reserve
level case. This looks like a trivial error in Obstfelds example.
- 30 -
0 ,
2
2 2
>
+
=
t t
x
L
The budget constraint forces the policymaker to equalise tax revenues x with debt ser-
vice costs (international real interest rate R, taken as given by the small open economy
times the inherited stock of debt net of reserves b). Debt service costs can be lowered by
surprise devaluation/inflation tax gains being a function of the difference between ex-
pected (
e
) and actual () depreciation.
The loss function L says that the government dislikes taxes and depreciation. Additional
reputation cost c is borne by the policymaker in case of devaluation (provided he did not
devalue in the first period).
The basic framework provides the scene for a typical feature in this kind of model: inde-
terminacy of the outcome multiple equilibria. The policymaker must choose the level
of taxation x and devaluation subject to the state of the economy (in this case the level
of inherited debt over reserves) and expectations of devaluation. The expectations, how-
ever, are set rationally by investors/economic agents, who understand the governments
optimisation problem and its incentives to devalue. Thus for some levels of fundamen-
tals, the government devalues if and only if when the public expects it to (there are vari-
ous channels by which this could be happening: higher depreciation expectations boost
interest rate burden, drives up wages increasing unemployment, and hampers growth
and taxes).
First order conditions require the policymaker to set taxes and devaluation minimising
the loss function at:
( ) ( )
e
t t
e
t t
R b R b x

+
+
= +
+
=
2 2
;
- 31 -
Assuming perfect foresight equates expected and actual devaluation
e
=. The tax lev-
els and devaluation now become:

R b
R b x
t e
t t t
= = = ;
Corresponding devaluation governments loss is equal to:
( )
( )
c
R b
L
e
t t d
+
+
+
=
2
2
2

, where c is the one-off reputation cost to the government.
If the policymaker commits to the fixed exchange rate, then
t
= 0. The fixing loss
function is then:
( )
2
2
e
t f
Rb
L
+
=
Although the policymaker commits to the fixed exchange rate, that does not mean that
expected devaluation
e
=0 as there may be little credibility to the official claims.
The policymaker devalues when the loss from fixing is higher than the loss from de-
valuing. That requires that:
( )
( )
( )
2 2
2
2
2
e
t
e
t t
Rb
c
R b

+
< +
+
+
, or
( )
0
2
2
>
+
> + k
c
Rb
e
t

The result is intuitive the policymaker devalues when expectations of devaluation or
fundamentals (inherited debt) are bad enough. But that is not the full story. Because
speculators are rational, we can distinguish three ranges of international liquidity. One,
which ensures devaluation (it would happen even if
e
=0). This requires that Rb
t
> k. In
such case, of course, fixing pledge has no credibility at all the exchange rate fixing is
bound to fail, and everyone expects the government to devalue.
- 32 -
We also know that rational speculators cannot expect any devaluation. Knowing the
governments optimisation problem they expect that if the government devalues, it does
so by
R b
t e
= . Plugging such formed expectations back into the inequality, we find
out that the policymaker may devalue only if

+
>
k
Rb
t
. If net debt is smaller than
that, no rational speculator can expect the government to devalue the regime enjoys
full credibility.
Finally, if the debt satisfies the condition

+
> >
k
Rb k
t
, the regime fails only if it is
expected to fail, but will stay unchanged otherwise. The problem is illustrated in Figure
4.
Figure 4 Devaluation and fixing loss functions under devaluation and fixing expec-
tations
20 40 60 80
netdebt b
0.5
1
1.5
2
2.5
lossL
L
f
, devaluation
expected
L
d
, devaluation
expected
L
d
, devaluation
not expected
L
f
, devaluation
not expected
B A

Source: Author, based on Sachs et al. (1996a) model
For level of net debt smaller than A, devaluation can be neither desired nor expected, as
the loss from devaluing is higher than from fixing, even under unfavourable expecta-
tions. Conversely, for the level of debt higher than B, devaluation is the only viable (and
- 33 -
therefore expected) option, as it pays to devalue, even if it is not expected by the public
(loss from fixing is higher, regardless of expectations). Multiple equilibria occur for
A<b<B, as the optimal choice of devaluation depends on the expectations.
The typical problem with this part of the model is that it does not explain how the public
sets expectations between zero and
R b
t e
= . So, the holy grail of leading crisis indi-
cators literature crisis probability as the function of fundamentals get only limited
support in second generation crisis models. The models say that the crisis cannot occur
when fundamentals are very good; they say that it must occur when fundamentals are
really bad, but in the immediate range we only learn that probability is greater than
zero
9
.
In the two-period version of the model, Sachs et al. show that although devaluation may
destroy all the credibility of the future pegs, it can also reduce the size of expected sec-
ond-period devaluation. Devaluation allows running down on net debt, which can relax
the budget constraint in t+1, even with depreciation expectations always higher than
zero as a result of lower credibility.

9
The problem will persist as long as the investors have the complete knowledge of the
state of the economy. Morris and Shin (1998, 2004) show how unique equilibrium could
be achieved when speculators have incomplete knowledge of the component of the gov-
ernments loss function. Chui et al. (2000) show a model merging this modification of
the second generation crisis models with Diamond and Dybvigs (1983) type of creditor
run. It yields an unique attack equilibrium for a threshold level of foreign exchange re-
serves.
- 34 -
Section 2.3 Asymmetric information as a cause of crises
Asymmetric information was quite early identified as an important factor behind finan-
cial crises. Asian crisis provided an example of how moral hazard (resulting from im-
plicit government guarantees) can cause over-investment, excessive risk taking and con-
tribute to a currency crisis. One of the advocates of the asymmetric information roots of
many financial crises was Mishkin (1998, 1999).
Mishkin argues that asymmetric information, a situation when only one party to a con-
tract have necessary information, was at the roots of most of the currency crises in the
1990s. He pointed to two main channels thorough which asymmetric information can
contribute to a crisis. First, the banking intermediaries and foreign lenders did not have
enough expertise, or motivation to manage the lending risk. Domestic institutions were
not prepared for the lending explosion which followed financial market liberalisation.
Foreign lenders, on the other hand did not have enough incentives to do so, which leads
to the second asymmetric information problem: moral hazard. Explicit or assumed gov-
ernments safety nets are an invitation for a reckless lending and borrowing.
Right after the eruption of the Asian crisis, Paul Krugman (1998) suggested a moral
hazard explanation to the crisis. His idea was that implicit public guarantees for the pri-
vate enterprises generated excess demand for risky investments. The firms (and their
foreign creditors) were confident that if their project failed, the government would bail
them out. Such logic can rarely work in the economy-wide scale. When things went
badly for East Asia (depreciation of the yen against the dollar, fall in semiconductor
prices, etc.) too many projects started to fail. The government was not able to bail out
everyone, short term foreign financing dried out and the currency plunged.
- 35 -
Corsetti et al. (1999) present a formalised version of this model. In their formulation,
the countrys economic population consist of lite agents (with access to capital mar-
kets), the government, and the rest of the country (who live out of labour and do not
have access to capital). Rest of the country provides labour, lite borrows money abroad
to finance risky production (production function is a standard Cobb-Douglas formula-
tion, with the random production technology parameter). The utility of the elite depends
on consumption, which in turn depends on the amount produced, debt costs, taxes, and
possible government transfers. Several assumptions are made:
The government is always able to service its liabilities: either through taxes or
through seignorage, and subsequent inflation and devaluation.
The governments initial policy is of a fixed exchange rate, balanced budget, and
negative net liabilities (foreign exchange reserves higher than liabilities). This as-
sumption can be relaxed to show the importance of early fiscal reforms and reserve
build up
Entire capital stock of the country is financed externally.
The governments utility falls to its lowest level if it pursues a laissez-faire policy,
and lets its lite go bankrupt. In other words, regardless of the governments prom-
ises of no bailout, the companies can rationally expect positive transfers from the
government.
The latter assumption is crucial for the dynamics of the crisis. The lite agents, knowing
about the full bailout as soon as the foreign creditor stop evergreening their losses, pen-
cil in the government transfer contingent on the negative productivity shock, equal to
the difference between the bad pay-off from capital and the cost of borrowing. With this
- 36 -
assumption, marginal return from capital is not equal to the international interest rate r
(as it would be in the distortion-free world), but is higher by the marginal amount of
bail-out.
As a result, equilibrium investment level is higher than optimal (from the point of view
of the economy). This results in sub-optimal return on capital.
When the state of the nature turns negative the elite accumulate losses (on balance lar-
ger than without bail-out presumption, due to excessive investments). But these can be
covered by further borrowing, as long as the rest of the world provides credit. The rest
of the world does provide credit at a riskless rate, because up to a point it is fully in-
sured by the government. The additional borrowing shows as trade deficit, positive even
with the balanced budget.
The financial crisis comes as soon as the foreign investors see that their liquid collateral
(official reserves) reach some critical fraction of the total level of corporate losses fi-
nanced by evergreening loans. This critical level is not endogenous in the model. It
would be possible to extend the model to allow for uncertainty regarding the critical
level of reserves, which would allow for financial crisis probability being a function of
the foreign exchange reserves.
Corsetti et al. distinguish between financial crisis and a currency crisis. Financial crisis
means that the implicit governments obligations become explicit: creditors of the lite
firms refuse to roll their debt, which requires the government bailout. This may, but
does not have to lead to a currency crisis. The latter happens if the government is unable
to raise enough funds through taxes, and must resort to the money-printing, which leads
to the collapsing peg, in a first-generation spirit model.
- 37 -
Two important outcomes of the model concern the benefits of financial market repres-
sion and tight fiscal policy ahead of the crash. The former increases costs of capital to
the lite, lowering the excess rate of investments
10
. Tax on foreign borrowing counter-
balances biased upwards (perceived) return on capital for the firms, and is justifiable.
This way firms internalise the contingent liability of the government towards the foreign
creditors.
Higher taxes overall (on labour) are worse, as they do little to prevent financial crises
(bailouts), but they still do help in stemming currency crises government debt gets
lower with higher tax intake, allowing to bailout elite firms without resorting to money
printing. If reserves grow at a sufficient rate (higher than the rate of growth of exter-
nally-financed corporate losses), the crisis may never turn into a currency crash. High
budget surplus alone is not enough to guarantee immunity from a currency crisis. It de-
pends on the relative rates of public debt reduction and loss accumulation by elite firms.
Presumably, the latter depends on the quality of corporate governance and the overall
stage of development: in the early stages the risk of failed investments could be quite
high, due to political disturbances, border conflicts, quality of education, etc. East Asian
economies were on the other side of the spectrum: the return on capital already de-
creased towards developed countries levels, while the inflow of money continued.
Dooley (1997) shows a similar, yet less encouraging story in his insurance model. It is
especially interesting as it suggests that high international liquidity can actually cause a

10
Aizenman and Turnovsky (1999) show that introduction of reserve requirement in ei-
ther lender or borrower country could increase both countries welfare, thanks to lower
default risk.
- 38 -
deterministic cycle resulting in a violent crisis. The mechanism suggested by Dooley
works as follows.
Once (1) the government of a country has incentives to bail out domestic borrowers, (2)
the government has a positive net worth, and (3) capital account is sufficiently liberal-
ised, the crisis cycle starts. Domestic residents compete to borrow foreign money
(knowing that the government will provide free insurance, and will bail them out any-
way if they fail to pay see (1) above), driving the domestic yield upwards. Foreign
creditors seeing that the government is (1) willing and (2) able to pay the insurance
premium if their borrowers fail to pay use (3) the liberalised capital account to pump in
the funds. As soon as the overall liabilities (including the implicit liabilities) of the gov-
ernment match available assets (these are not growing in line with liabilities because of
moral-hazard induced excessive yield
11
), the foreign creditors rush to claim their insur-
ance premium. Regardless of the exchange rate regime, resulting sudden outflow of
capital causes severe fiscal costs.
Section 2.4 Liquidity and balance sheet models
In the models described above the international liquidity played a prominent role, but it
was not the key, driving factor behind crisis-creation. Recent years brought to the light
several models dealing explicitly with (lack of) international liquidity as an ultimate fac-
tor behind foreign exchange crises. Typical model of this kind is presented in Chang
and Velasco (2000). The model is based on the work on bank runs of Diamond and

11
One could ask why competition for foreign funds drives yields up, while foreign com-
petition to lend to counterparties with government guarantees does not drive yields
down. The answer to that could be a difference in the governments ability to service
private debt risk assessment by foreign creditors and domestic corporations.
- 39 -
Dybvig (1983). In the models, the banking sector works as a term-structure transformer,
and as such has a structural asset-liability term mismatch. Banks are needed, because
private agents have incomplete knowledge of other agents inter-temporal consumption
preference and because the production technology is illiquid. With individual consump-
tion preference unobservable, the risk of the investment needing to be liquidated before
its normal yield is uninsurable. In the absence of banks, the agents must settle for less
profitable, but liquid technology.
Because banks deal with many clients, they can use law of large numbers to optimise
their term structure, amount of reserves held, and long-term investments undertaken.
The optimised (in terms of expected profit) amount of reserves, however, usually gives
rise to a multiple equilibrium solution. Either an outcome superior to the private com-
petitive (without bank inter-mediation) equilibrium prevails, or run on banks happens.
Because the small liquidation value of the non-liquid assets, this outcome of a run is
usually worse than that without bank intermediation.
The translation of such a model of a bank run to the world of foreign exchange crises is
then quite straightforward. If foreign depositors decide to run on the (insufficiently liq-
uid) local banking sector, either banks fail (if the central bank does nothing), or fixed
exchange system collapses (if the central bank provides liquidity to the sector by print-
ing money after using up insufficient foreign exchange reserves). The level of interna-
tional liquidity is crucial, the more international reserves the central bank has, the less
severe banking/currency crisis is.
The class of models does not only explain how runs on insufficiently liquid banking
sectors can translate into currency crises. It also shows that the overall liquidity level
held by the sector may be optimal from expected return point of view, but it may still
- 40 -
give rise to a switch to crisis equilibrium. While it is quite easy to remain liquid, it is
rational (certainly for individual banks, but also often for the economy as a whole after
taken into account the social cost of the systemic crisis) to have some maturity mis-
match. Similar argument applies to the term structure high short-term indebtedness
may be individually rational (although it can be socially inferior to long-term debt). A
very simple model of this kind is provided by Rodrik and Velasco (1999).
The domestic investor (or a bank which represents several homogeneous investors, the
profit or loss of which depends on the performance and fate of the real economy) in a
three period world has access to an illiquid technology which yields kR > k for k units
invested after two periods, but in case of earlier liquidation of the part of the investment
l k gives only l < l. Consumption (linear function of which is the investors utility)
occurs in period 2, in which the investors pay back all the remaining debt and consume
the rest. Foreign financing of the project can take two forms long term (LT, equal to k-
d) and short term (ST, equal to d), up to the total limit of k. Debt principal cannot ex-
ceed the investment in any period. Holders of the short term debt may choose not to
roll-over their loans in period 1 (before the illiquid investment matures), which will be
called a run.
Runs occur with a positive probability p. Rodrik and Velascos model share the problem
typical to most of the multiple equilibrium models p is exogenous. The reasons why
the lenders suddenly panic are outside the realm of the model.
While the world risk-less rate is zero, the ST and LT interest rates r
s
and r
l
faced by the
domestic investor are endogenous as shown below.
- 41 -
Two scenarios can be considered: no-run and run. In the optimistic case of no run, the
domestic investors revenues are:
(R k) d r
s
(k-d) r
l

When d, or ST debt is positive, a run may occur in period 1, resulting in the need to liq-
uidate a part of the investment (equal to
) 1 (
s
r d +
)
12
. Three things may happen, depend-
ing on the amount of short-term debt and the degree of illiquidity . If d is small and/or
is close to 1, ST debt holders are repaid, and so are LT debt holders in period 2. Inves-
tors revenue is smaller (proportionally to the size of the run). If d is larger, (the critical
size requires, that
( )
( ) ( )
k
r r R
r R
d
l s
l
1 1
1
+ +
+
> ) after the liquidation satisfying the ST
debt holders, there is not enough money to repay the LT creditors and the investor bank-
rupts. With sufficiently illiquid technology, or sufficiently large ST debt, the investor
goes bust as early as in period 1, which requires the total investment
) 1 (
s
r d
k
+
< .
The run equilibrium is welfare inferior to both domestic investors and foreign creditors.
The costs of winding down of the illiquid project are the reason for it. The short-term
debt, unleashes the potential for the crisis.

12
There seems to be a trivial mistake in the Rodrik and Velascos model: the total
amount the foreign currency short-term lender gets in period 1 (if it runs) and in period
2 (if it does not) is exactly the same! If p were greater than zero, it would be suboptimal
to ever roll-over short-term debt. A simple correction could be adjusting the term in
brackets to
1
2
x
r
d
| |
+
|
\
, where
2
1 1
2
x
s
r
r
| |
= +
|
\

- 42 -
The term structure of the interest rates is derived on two assumptions. First is the risk
neutrality of the foreign creditors. Second is the assumption that if funds of the bankrupt
domestic investor do not suffice to serve all the creditors, the remaining sum is evenly
divided among them. It is an equivalent (for risk neutral creditors) to the situation when
the probability of getting the full amount is directly proportional to the ratio of available
funds to the total debt. LT creditors want to have expected return from lending to the
domestic investor equal to the foreign interest rate of zero. That requires:
( )( )
( )( )
( ) 1 1 1 , 0 ,
1
1 1 = +
(
(
(
(
(
(
(
(
(
(
+
|
|
\
|

+ +
l
l
l
r
d k r
d
k R
Min pMax r p

, which means that:
( )
( )
k d
R
R
k
k d p
d k
d
k pR
p
R
R
k d
r
l

< <
>
(
(
(
(
(
|
|
\
|

|
|
\
|
<
= +
1
for ,
for , 1
1
1
1
1
for , 1
1
1

ST debt holders face risk-less return of their money if d < k, so in such case r
s
is zero
(which is world interest rate). Otherwise, the short term rate follows:
( )( ) 1 1 1 = + +
d
k
p r p
s
, so
( ) |
\
|

|
|
\
|
= +
d
p
p
r
s
1
1
1
1
The bottom line is that the short-term interest rate is always lower than long term inter-
est rate (unless ST debt is very small, then both are at the world level). This is a danger-
ous situation. Although in the world of the model, it is optimal for the domestic investor
- 43 -
(or the economy there is only one borrower) not to have short-term debt whatsoever
(the risk of the run is internalised, as shown in Figure 5), it would be easy to extend the
model to allow for borrowers wanting to take advantage of ST credit. There may be
several issues preventing the individual investor from choosing LT debt. One is that
normally, there are many investors (as opposed to just one in the basic model), who do
not internalise the impact of ST debt size on the price of credit. Then, if both interest
rates, and the overall maturity structure of the foreign debt are taken as given, it be-
comes optimal to borrow as much as possible in the short bonds (r
s
<r
l
unless, the as-
sumed overall share of ST debt is zero). Rodrik and Velasco argue the problem is
strengthened by the lending policy of sovereign ceilings, where the overall risk of the
sovereign lending in a country takes precedence over the individual creditors risk. This
meant that no corporation can enjoy better credit rating than the sovereign bonds of the
country it is based in. The policy started to be relaxed recently, especially for middle-
income countries, by differentiating sovereign rating from a country ceiling, see
FitchRatings (2004).
Other reasons why ST debt may prevail could be regulatory framework favouring ST
debt, implicit bail-out guarantees, which alter the consumption function of the investor
and make it much less worried about the risk of the run, and subsequent bankruptcy.
- 44 -
Figure 5 Expected profit of domestic economy/investor as a function of short-term
debt

0.2 0.4 0.6 0.8 1
d
0.1
0.2
0.3
0.4
0.5
Profit

Source: Author, based on Rodrik and Velasco (1999) model
While the model is very simple and does not take into account such issues as exchange
rate, the reason behind the crash, etc., it yields several interesting results about the im-
portance of short term debt (or low international liquidity):
Large short term debt increases the severity of the prospective crisis, as in case
of a run more real assets have to be liquidated
Amount of short term debt influences the price a country must pay for long-term
capital. When liquidity is really low, the ST interest rate is also affected by
growing of ST debt.
An economy, which internalises the above-mentioned impact of ST debt on the
yield curve should choose to have as high liquidity as possible. Individual bor-
rowers optimal decisions, however, could easily prove to be sub-optimal from
the social point of view.
Other models explicitly dealing with liquidity include: Goldfajn and Valdez (1997),
Chang and Velasco (1999 and 2000), and Krugman (1999).
- 45 -
Krugman (1999) present a simple crisis model dealing not so much with how, and when
depreciation happens, but with the costs to the real economy, and how the multiple ex-
change rate equilibria can occur. His modified (and simplified) Mundell-Fleming model
consists of three equations.
|
\
|
+
|
\
|
=
+ +
y s NX s y i D y , , , ,
where y is output, D is domestic demand, and NX is net exports. Signs over domestic
interest rate i and real exchange rate s indicate first derivatives. Output equation differs
from the standard Mundell-Fleming setup, with the dependence of domestic demand D
on the exchange rate. In Krugmans model exchange rate has dual effect on domestic
firms. On one hand, weaker currency allows the firms to compete and export. On the
other, large depreciation cripples the firms ability to invest through adverse impact on
their balance sheets. Plunging currency enlarges dollar denominated debt, shrinking the
net value of the domestic companies, and severely restricting their ability to invest, thus
the adverse impact of depreciation (rising real exchange rate s) on domestic demand D.
Krugman does not specify the exact functional form of the equation, the idea is, how-
ever, that
s
D
is only significantly negative for intermediate values of the real exchange

rate change. For extremely weak currency, big (indebted abroad) firms would all be al-
most all dead anyway, so further depreciation would not depress investments further;
for extremely strong currency, some depreciation could hardly harm the firms. In other
words, liquidity (at least domestic corporations liquidity) is the key, if not for currency
crash prevention, certainly for ensuring the crisis does not cost too much. Highly lever-
aged economy will suffer a lot more as a result of a plunge.
- 46 -
Two remaining equations of the simple model, representing money market equilibrium
and interest rate parity are as follows:
|
\
|
=
+
y i L
P
M
, , where M is the nominal money supply, P is the price level, L is the de-
mand for the real money balances, which in a standard way depends on the interest rate
i and the real income y.
i = i*, is the final, interest parity equation, which assumes static expectations about the
exchange rate. This implies that domestic interest rate is equal to its foreign counterpart
i*.
The three equation setup is enough to determine the balance between the (real) ex-
change rate and real income, as shown in Figure 6:
Figure 6 Modified Mundell-Fleming model
s
y
A
A
G
G

Source: Krugman (1999)
Because of the adverse impact of real depreciation on investments and domestic de-
mand, the GG curve, representing goods market equilibrium has a back bending seg-
ment. As a result the GG curve crosses the AA curve (representing interest parity) sev-
eral times. There are multiple real income-real exchange rate equilibria. An equilibrium
with strong local currency with poor exports and large investments can, via an exchange
- 47 -
rate collapse (as a result of market speculation, or a bout of financial market contagion)
switch into equilibrium of bankrupt indebted corporate sector but thriving small-time
exporters.
The important caveat coming out of this model is that net foreign debt, and low interna-
tional liquidity of the real sector makes multiple equilibria and large depreciations pos-
sible. Lowering the level of foreign-currency denominated debt would straighten the
backward bending section of the GG curve. The role of the official reserves, however, is
somewhat problematic. Do they influence the risk of the equilibrium switch? If the poli-
cymaker is willing to tighten monetary policy (leave foreign exchange interventions un-
sterilised), it should. The speculative attack will result in AA curve moving to the left,
which will hurt the real economy, but the exchange rate should remain close to the
original levels. Sterilised interventions leave us in the indeterminate region if they
help to restore confidence the economy may remain in the strong peso equilibrium, if
not, the currency plunges.
The model differs from the earlier Krugman (1998), which stressed the importance of
moral hazard, and excess investments in Asian crisis economies. In the newer model,
excess investments and resulting inefficiencies are not necessary to create a crisis. They
aggravate the backward bending feature of the GG curve, but basic shape of the goods
market equilibrium curve may remain even without moral hazard high corporate for-
eign currency gearing for whatever reasons suffices.
Section 2.5 Inventory model of foreign exchange reserves
There are few models addressing the issue of foreign exchange reserve holding deci-
sions. Frenkel and Jovanovics (1981) inventory model of foreign exchange reserves is
- 48 -
one. Although it is not directly connected with foreign exchange crises, it does not even
assume fixed exchange rate (some need for foreign exchange reserves suffice), its modi-
fied version may be used to predict the holdings of reserves for a country under a threat
of a speculative attack.
The model rests on three reasonable assumptions: 1) some reserves are necessary; 2) the
restocking of the foreign exchange reserves is costly; 3) holding reserves bears some
opportunity costs. The model assumes that the reserves follow a random process, and if
they fall below a certain threshold, they must be restocked (via domestic demand
squeeze, monetary tightening, etc). Holding more reserves reduces the risk of bearing
the costs of restocking, but is usually costly on its own account (difference between lo-
cal and foreign bond yield, according to Frenkel and Jovanovic). In the original model,
the stochastic process governing the reserve fluctuations is a drift-less Wiener process,
which ensures an easy solution and no discrete jumps in the stock of the foreign ex-
change reserves. In such case, the solution of the model is
r
C
R

=
0
,
where R is the optimal reserve level, following a restocking, is volatility of reserve
changes, C is a country-specific constant representing costs of restocking (e.g. persis-
tence of the current account deficit, reliance on imports, etc), and r is the opportunity
cost of holding foreign exchange reserves. Log transformation of the result yields an
easy to estimate form:
ln R
0
= c + 0.5 ln 0.25 ln r,
where c is the country-specific constant, representing costs of restocking.
- 49 -
The empirical application proved surprisingly successful. Flood and Marion (2002) re-
port the Frenkel and Jovanovics model parameters as nothing short of miraculous:
the sample of 22 developed countries in 1971-1975 yields ln and ln r parameters at
0.505 and 0.279 respectively. As Flood and Marion note, though, there are several
problems in both the empirical application of the original model, and the theoretical as-
sumptions.
The assumption of the smoothly changing (Wiener process) foreign exchange reserves
are at odds with both the theory of the currency crises and the recent experience of both
developed and developing and emerging countries. Most of the currency crises models
point to a rapid depletion of remaining reserves when a crisis hits (Krugmans classic,
Dooleys insurance model, liquidity crisis models).
Second problem was the positive bias of the reserve volatility created by restocking ac-
tions by the policymakers. Restocking increases volatility, but that increase should not
be taken into account by the policy makers pondering the risk of reserves hitting the
lower limit.
The two effects described above are not negligible. Flood and Marion report skewness
tests showing 41% of countries exhibiting non-normal positive shocks to reserve hold-
ings, and 21% of countries suffering from negative skewness (crises). Therefore, using
the original functional form of the optimal reserve equation is invalid. Flood and Marion
propose using a shadow exchange rate concept known from the 1
st
generation crisis lit-
erature instead: if the shadow exchange rate crosses the market rate (somehow regu-
lated, or influenced by the policymaker), the reserves flow out, forcing the authorities to
pay for the restocking of the reserves. This is the equivalent of the reserves hitting the
lower-threshold value, but allows to substitute modelling of irregularly changing foreign
- 50 -
exchange reserves by smoother-looking shadow exchange rate model. This has one ma-
jor drawback. In order to properly model shadow exchange rate, the underlying floating
exchange rate must be modelled as well, a difficult (and restricting) task to say the least.
Thirdly, neither the original model, nor the subsequent extensions addressed the possi-
bility of the level of reserves influencing the risk of their sudden depletion. In a Sachs et
al. (1996a) type of model, the level of reserves enter the equation as driving variable: if
reserves are large, they never have to be restocked, because there is never a speculative
attack. Having very little of them is useless, because they do not last a single period. In
an intermediate range, the original model may (almost) applicable we know little why
the switch in investors sentiment happens, so it may well be modelled as a purely ran-
dom process. But even then, the reserve volatility must be replaced with some other
measure of crisis risk. The actual reserve volatility explain only a risk of reserves reach-
ing the threshold of the sure crisis zone, but does not have to be directly related to the
crisis risk in the self-fulfilling crisis range.
Finally, some of the empirical applications of the model (Frenkel and Jovanovic, Flood
and Marion) used local currency bond yields, or local currency bond yield minus US
interest rates as a proxy for opportunity cost of holding international reserves r. The
costs of obtaining foreign exchange reserves is not the local currency interest rate, it
should be the foreign currency bond yields (less equivalent yield of the instrument in
which the reserves are held). Therefore, it is more appropriate to follow Edwards
(1985) path, using eurocurrency markets, or Eurobonds and Brady bonds for the emerg-
ing markets in the 1990s.
- 51 -
Although the inventory model of foreign exchange reserves is only loosely related to the
crisis literature, it does provide a very useful and flexible tool for analysing foreign ex-
change reserve adequacy.
Section 2.6 Summary: liquidity in crisis models
Foreign exchange reserves or international liquidity appears in every class of the ex-
change rate crisis models. In the basic first generation model foreign exchange reserves
are like sand in the hourglass, which dribbles out as the crisis comes nearer. Foreign ex-
change reserves are a useful crisis prediction tool, but usually they cannot serve as a
prevention mechanism excessive fiscal deficits are at the root of the problem.
Setting net debt as a fundamental variable, a model within the second-generation
framework can be constructed, which allows for multiple equilibria for some ranges of
international reserves (net of debt), and single equilibrium with very high and very low
liquidity. The level of reserves is therefore relevant for the countrys susceptibility to a
bout of financial market panic.
International liquidity has a dual role in moral hazard models of financial crises. On one
hand, higher official reserves may prevent the currency crisis from happening, in a
sense offsetting the artificially high corporate sector debt. On the other hand, liquid
government welcomes the abuse of the implicit insurance it offers to the countrys
firms. High reserves net of government debt mean that there is plenty of space for risk-
free lending. It may lead to a problem similar to the first generation crisis, with high re-
serves only postponing the crisis, but not eliminating the ultimate cause of it the build
up of contingent liabilities. The ultimate importance of prudent fiscal policy and foreign
exchange reserves depends on the quality of local investments.
- 52 -
Models explicitly dealing with insufficient international liquidity as a source of crises
point to the inherent risk for developing countries, which rely on external financing ef-
fectively being liquidity transformers. The risk is similar to the one faced by a bank, al-
ways threatened by a run on deposits. Banks are protected by the institution of the
lender of the last resort, reserves (not necessarily mandatory) and capital adequacy ra-
tios. Countries can benefit from only a limited support from international rescue lenders
(like IMF), they should, therefore ensure that their liquidity does not fall too low. Li-
quidity crisis literature is just one strain of the new balance sheet approach to the cur-
rency crises. Another model of this broad class is represented by Krugman (1999), who
points to the exchange rate-corporate balance sheets-investments channel of exoge-
nously determined depreciation. Foreign currency borrowing by firms makes their bal-
ance sheets (and subsequently, the ability to borrow and invest) vulnerable to deprecia-
tion. High foreign exchange reserves and an unsterilised intervention, while hurting
output, could prevent the jump-depreciation from happening.
Finally, buffer-stock models of foreign exchange reserves can, in principle, break away
from exchange rate modelling and the exact mechanism of reserve depletion. In its
original form, the policymaker simply attempts to minimise the risk of reserves hitting
the lower threshold, simply by observing its volatility, and costs of potential restocking
(necessary when reserves do hit the threshold). The problem is that probability distribu-
tion of the reserve changes itself requires powerful and restrictive assumptions regard-
ing the process driving the whole process.
- 53 -
Chapter 3 Leading indicators literature
The currency crisis models described above tried to explain the crises which had hap-
pened. Assuming the underlying forces behind crises do not change too much (not every
crisis is different), they should also help in predicting crises, or in setting up policies
preventing them. This chapter reviews the leading indicators empirical literature, which
attempts to find how reliable the models are for predicting crises (and to find out which
other variables should the theoretical research be focused on). There is a long way from
being able to predict crises to being able to prevent them. There are two problems caus-
ing this divergence. One is the difference between a leading indicator, and the actual
cause of crises (Flood and Jeanne, 2000 show how countries addressing low liquidity
problem by higher borrowing can hasten the crisis increasing their fiscal burden). Sec-
ond issue is political problems relating to addressing the causes of crises, even if they
can be correctly identified.
There are several ways to categorise the leading indicators of currency crises literature
(also called as early warning systems). One is by time and country range of the sample.
Second is by the methods used. Third is by the crisis definitions the leading indicator
of what is being searched for. Fourth and final categorisation is the results what vari-
ables were used, and which are statistically significant in predicting crises. Figure 8 on
page 86, which in part bases on surveys in Kaminsky et al. (1998) and Abiad (2003)
summarises the recent efforts. The four sections below describe the different approaches
and results of the leading crisis indicator literature.
- 54 -
Section 3.1 When and where
While most research is essentially cross-country, pooled studies, the scope of the analy-
sis differs.
The timeframe of the analysis varies, with the longest studies spanning from the 1950s
(Bilson, 1979; Edwards and Santaella, 1993; Kamin, 1988), most of the recent studies
concentrate on the last 15-25 years. The empirical application of the model in Chapter 5
and the model in Chapter 6 both fall in the latter category.
Several studies (including Sachs et al., 1996b) concentrate on just one bout of market
volatility, across several countries: e.g. Mexican crisis of 1994, Asian crisis of 1997 etc.
The idea behind such an approach is that currency crises differ over time theoretical
literature also follows this pattern: first generation crisis model was inspired by the de-
faults of the 70s, EMS and Mexican crises heralded the advent of second-generation
models, and the Asian crisis shifted attention to the balance sheet models. If each cri-
sis bout is different, it makes sense to evaluate them in clusters.
Important consequence of such estimation method is that the results speak about the
probability of the crisis (or depth of the crisis) conditional on it happening somewhere
else (Mexico, the EU, Russia, East Asia). Thus, the resulting model is unable to provide
answers to the question of crisis risk in any given year. It can, however, tell about the
impact of a set of variables in preventing infection by a contagious crisis elsewhere.
Such restriction helps to improve the fit of the probit models. In long time series pooled
regressions, ones on the left-hand-side of the equation happen extremely rarely, but the
meaning of the parameters is different. If a policymaker is concerned of the costs related
to the crises, it should take into account the global probability, not just conditional risk
estimates.
- 55 -
Frequency of the data depends on the country sample and timeframe used most of the
recent studies use monthly data. On one hand it does not allow to use some of the more
exotic variables (like Ghosh and Ghoshs, 2003 structural factors), on the other it pro-
vides an opportunity to find dynamic dependencies in the data, precisely pinpoint the
time of the crisis and provide a functional early warning signal for financial markets.
Four classes of country range can be found in the literature. The narrowest include just
one country. In order for the numerical analysis to be meaningful in such case, the coun-
try must have quite a turbulent currency history. tker and Pazarbaiolu, 1995 analyse
Mexico between 1982 and 1994. In that period the authors find 4 devaluations and 7
exchange rate regime shifts.
Many studies concentrate on a region. Latin America (Sachs et al., 1996b; Goldstein,
1996; Herrera and Garcia, 1999), East Asia (e.g. Moreno, 1995; Nag and Mitra, 1999;
Kwack, 2000; Zhang, 2001), transition economies (Krkoska, 2001; Bruggeman and
Linne, 2000), FSU countries, ERM-2 members (tker and Pazarbaiolu, 1997; Marti-
nez-Pena, 2002) are the main subjects of such studies. As regional clustering tends to
imply trade linkages, and sharing the same investment sources, the studies of this kind
make it impossible to assess the influence of (potentially powerful) effects of trade-
related or bandwagon effect contagion (all countries in the sample share similar charac-
teristic).
Third class of research sample scope is the broad country class. Emerging markets
(Vlaar, 2000; Weller, 2001), developed countries (Eichengreen et al. 1995), or develop-
ing countries (Frankel and Rose, 1996) are the main classes of this kind. There may be
two reasons for keeping the groups separate. One is the data reliability and availability.
For example, data on market interest rates (necessary for some crisis definition calcula-
- 56 -
tions) may not be available for non-industrialised countries. Second reason is the suppo-
sition that there are other drivers causing currency crises in developed and emerging
markets.
The final sample size is all countries in the world (subject to data availability). Exam-
ples of such studies include Edison (2000), Collins (2001), Caramazza et al. (2000).
Section 3.2 Methods used
Most of the studies use one of the three approaches of evaluating crisis risk
logit/probit analysis of the crisis probability, OLS regression of the continuous crisis (or
devaluation) variable, and signals method, popularised by Kaminsky et al. (1998).
Section 3.2.1 Quantal response techniques
Logit/probit technique analysis requires a binary (or otherwise discrete) definition of
the crisis probability of its occurrence is the dependent variable. Explanatory variables
are a set of the leading indicators, usually chosen using the general-to-specific tech-
nique.
Because most of the studies are panel regressions, fixed effects are a potential problem.
If individual, unobservable country characteristics are correlated with explanatory vari-
ables (or there-is a time-varying element, correlated with explanatory variables), the es-
timators are biased
13
. The studies, which address it, however, are quite rare (Esquivel
and Larrain, 1998; Hawkins and Klau, 2000 do deal with it) the degrees of freedom
costs are large if sample spans across many countries.

13
The problem concerns also OLS-type regressions
- 57 -
Autoregressive Conditonal Hazard model (based on Hamilton and Jorda, 2002) ex-
tends the probit-type model by incorporating the time, which passed since the previous
crisis as an explanatory variable.
Fisher discriminant analysis (McLachlan, 1992) is another form of quantal response
model, which translates a set of explanatory variables into several discrete states of the
explanatory variable. Burkart and Coudert (2000) claim that this method is less prone to
the multicollinearity problem than the logit.
Section 3.2.2 Standard regression
Equivalent analysis explaining continuous crisis variables requires simple OLS regres-
sion. Bussire and Mulder (1999ab), Kwack (2000) are the recent examples of such
studies.
A variant of this approach is a non-linear regression technique (Bussire and Mulder
1999b) addressing the interactions between explanatory variables. A non-linearities in
parameters specification allows some variables to act as triggers e.g. fundamental
weaknesses only matter if coupled with low international liquidity. Similar way to ad-
dress the interaction between explanatory variables is the slope dummies regression
used by Sachs, Tornell and Velasco (1996b), and Nitithanprapas and Willett (2000).
The method is to add a new variable being a product of an indicator already included in
the regression and a dummy of e.g. sufficient reserves. If high international liquidity
makes country invincible to the excessive current account problem then sum of the two
coefficients should be zero. Nitithanprapas and Willett (2000) also specify a composite
indicator to test the Lawson doctrine (current account is irrelevant as long as govern-
- 58 -
ment balances its books) their current account deficit variable is greater than zero only
if budget deficit is greater than 3% of GDP.
Section 3.2.3 Signals approach
The third technique requires a little more elaboration. The signals approach of Kamin-
sky et al. (1998), and later utilised in many more studies is essentially univariate and
non-parametric. The authors using this method first identify the binary crisis occur-
rences using one of the techniques described in the Section 3.3 below. This allows dif-
ferentiating between tranquil and crisis periods in a country. Then they set an arbi-
trary signalling window. This is the time frame within which the switch from tranquil to
crisis state should occur, once an indicator issues a warning signal. Kaminsky et al.
(1998), and Goldstein et al. (2000) use 24 month as a signalling window.
The idea behind the technique is that the macroeconomic indicators issue signals before
the crisis occurs. For example, if lending-deposit interest ratio increases above a certain
threshold, a currency crisis within the following 24 months becomes likely. The signal
threshold (in the example, to what percentile lending-deposit spread would have to
grow relative to its country-specific distribution) is estimated to minimise noise (N) to
signal (S) ratio for each variable. The authors wanted to find such a level of variables
which will constitute a signal issuing as little false alarms as possible. Specifically,
Kaminsky et al. minimise:

B
N
B D
A
S
A C
+
=
+
(3.1)
- 59 -
where A is the number of cases where crisis occurred after the indicator issued a signal,
B is the number of cases with no crisis after signal, C shows unsignalled crises and D
are no-signal no-crisis occurrences. Noise is thus only type I errors. Another indicator,
used by Goldstein et al. (2000) is proportion of crises actually called PC=C/(A+C).
This indicator concentrates on type II errors
14
.
Thresholds minimising these indicators are set in percentiles, not absolute values of the
early warning variables, so the signals are different for different countries.
There are several options from then on. One is simply counting the number of the vari-
ables that issue crisis signals at any given time. The higher the number, the higher the
crisis risk in the next 24 months. A more sophisticated approach is creating a composite
index, and weighing the crisis signals by their reliability: noise/signal ratio (see e.g.
Goldstein et al. 2000, p. 58).
The procedure has since been applied in numerous papers including Edison (2000),
Berg and Patillo (1999), Bruggemann and Linne (2000) and Hawkins and Klau (2000).
A variant of such study is informal graphical presentation of the behaviour of various
indicators around the crisis period. Aziz et al. (2000), Osband and Van Rijkeghem
(2000) pursue this strategy. One advantage of such non-parametric descriptive exercise
is that it allows to look beyond the crisis. Baszkiewicz and Paczyski (2003) attempt to
evaluate the social and economic consequences of currency crises in several transition
and emerging market economies.

14
Another version of the measuring the fit would be sum of type I and type II errors
relative to properly predicted crises and calm periods: (B+C)/(A+D).
- 60 -
Another variant of the signals approach is Binary recursive tree (Ghosh and Ghosh,
2003 apply it to in the crisis risk research) method which leads the ranking procedure
several steps forward. After setting the thresholds to minimise the noise to signal ratio
(Ghosh and Ghosh use a sum of type I B in the formulation of Kaminsky et al. and
type II errors C), the most reliable indicator (e.g. high current account deficit) is cho-
sen. It splits the sample into subsamples of high and low deficit countries. Then the
same procedure is repeated for the two subsamples (branches of the tree). The procedure
is continued as long as it brings significant improvement to the fit (otherwise it could be
continued until all observations are placed). Figure 7 shows a result from Ghosh and
Ghosh (2003). The most reliable indicator (Public Sector Governance) is the first node.
Countries with poor public sector governance stand 4.8% chance of suffering a currency
crisis. The indicator which best signals crises among counties with poor public sector
governance is current account deficit (second node on the left-side branch). Countries
with poor public governance and current account deficit above 2.6% of GDP stand 9%
chance of suffering the currency crisis. The procedure then continues for all branches
and sub-branches until the addition of another node brings little new information (at the
limit, all nodes in the bottom of the tree give conditional probability of 0 and 100; all
observations are then included in the tree).
The benefit of this procedure is the fact that it captures the interactions between the
variables well. It allows to differentiate between the influence of e.g. high budget deficit
under high and low international liquidity. This could help choosing non-linear interac-
tion terms in probit models. On the negative side the statistical properties of such an in-
dicator are not very well known.
- 61 -
Figure 7 Binary recursive tree estimation result
(1)
Good Public Sector
Governance?
2
(6)
Corp
Debt/Equity
< 380 pct?
(2)
CA/GDP < -2.6
pct?
(3)
Corp.
Debt/Equity
< 96 pct?
(5)
REER < 2.5
pct?
(4)
Ext. Debt/
Reserves
< 20
Yes
0
No
14.7
Yes
0
No
7.0
Yes
0
No
28.6
No
100
No
4.8
Yes
0.7
Yes
9.0
No
2.2
Yes
3.0

Source: Ghosh and Ghosh (2003), page 497.
Section 3.2.4 Other methods
Apart from the three main methods of constructing early warning systems, other ap-
proaches have also been attempted.
Artificial Neural Networks (ANN) Nag and Mitra (1999) try to apply this technique
(Kuan and White, 1994 provide a survey of ANNs applications in economics). The
ANN approach is similar to binary recursive tree technique: input signals are weighted
and trigger a binary output if certain input threshold is exceeded. The signals can then
- 62 -
be used as input for further evaluation producing final output. The approach is flexible,
but if there are too many nodes overfitting could be a problem (the model is then cali-
brated to react to noise in the data).
VAR restricted vector autoregressive estimation was applied by Krkoska (2001). The
technique requires the use of a continuous crisis variable, and under normal data avail-
ability circumstances, arbitrary choices regarding exogenous variables and restrictions.
In Krkoskas work it was especially important, as the transition economies sample
leaves very little degrees of freedom.
Section 3.3 What is a currency crisis?
The sample and the methodology used to construct an early warning system touched an
important problem in measuring the crisis vulnerability definitions of the crucial vari-
ables. The problem starts very early: how do we define a currency crisis? A few ways to
define a currency crisis are used in the literature. The problem is real, as the choice of
the dependent variable can influence the results. Eichengreen at al. (1995) get opposite
results on the importance of fundamentals depending if the crisis is defined using the
exchange market pressure indicator or by a regime switch. The following section de-
scribes the most important ones.
Section 3.3.1 Exchange rate definitions
Currency crisis must concern the value of a currency. This is why many authors define a
crisis as extreme movements in exchange rate. Frankel and Rose (1996) is a good ex-
ample of such a definition: a crisis is said to occur when local currency depreciates rela-
tive to the US$ by 25% in one year. In order to filter out hyperinflationary currencies,
additional condition of 10% higher depreciation than in the preceding year is added.
- 63 -
Other measures involve taking into account real, instead of nominal depreciation (see
e.g. Goldfajn and Valds, 1997 this is also a convenient way of dealing with hyperin-
flationary countries), or the exchange rate regime change. The latter definition, while
close to what is generally considered a currency crisis in much of the crisis literature
(most of the first, and second generation models), cannot deal with floating exchange
rate cases.
Section 3.3.2 Capital flows definitions
Less often, authors resort to capital flow definitions, defining crisis as a severe outflow
of capital from the concerned country. An example of such a definition is Rodrik and
Velasco (1999) and Radelet and Sachs (1998b). One of their crisis indicators is equal to
1 if net private annual capital flow changes from positive to negative by at least 5 per-
centage points. This kind of definition can (among others) easily detect speculative at-
tacks of the first generation type, which are characterised not by a major jump in ex-
change rate, but instead a fall in foreign exchange reserves (pure exchange rate defini-
tion would not necessarily capture such a crisis). Such a definition would not, however,
detect a crisis preceded by a year of slow leak of capital.
Another type of capital flow which could be associated with currency crises is domestic
capital movement. Banking crises are often analysed in conjunction with currency crises
for two reasons. First, systemic bank runs put a severe strain on monetary policy and
may lead to the collapse of pegs if foreign exchange reserves are not sufficient. In such
case, the only way to provide liquidity to the banking system is to increase money sup-
ply. Theoretically, a purely domestic bank run, in which deposits are converted to local
currency and held in that form by households should not put any pressure on the ex-
change rate. Increase in money supply is the right (and safe) response to thus increased
- 64 -
money demand. In practice, however (Turkey 2001, Russia 1998), bank runs in devel-
oping countries result in conversion of savings into foreign currency. Opportunity cost
of holding local-currency is often high due to inflation (Turkey), and rational domestic
agents can expect lower confidence and capital outflow as a result of banking system
distress. Still, banking crises, while often associated with currency crashes, are separate
events, and most of the research dealing with both, differentiate between them (Gold-
stein et al., 2000; Kaminsky and Reinhard, 1999; Aziz et al., 2000)
Section 3.3.3 Exchange Market Pressure (EMP)
A measure joining the two previously mentioned definitions is the exchange market
pressure indicator. It was developed by Girton and Roper (1977), and since then used by
numerous authors in empirical studies.
EMP indicator is defined as.

1 2
t
t t
t
R
EMP w e w
M
| |
= +
|
\
(3.2)
where e is the log exchange rate, R
t
is the stock of foreign exchange reserves, and M
t
is
the money supply. Weights w
1
, and w
2
, are usually set to equalise the variance of the
two components.
The idea behind the indicator is that the simple rate of change of exchange rate is not
the best gauge of speculative pressure, especially when analysing countries with a
mixed exchange rate regime. In particular, a furious speculative attack could be parried
by e.g. unsterilised intervention. As Krugmans (1979) model shows, even successful
attack may not lead to a rapid depreciation there is no jump in exchange rate, only a
hike of the interest rate and the fall in reserves. The latter point is especially important,
- 65 -
as it shows that exchange rate depreciation alone cannot serve as a reliable crisis scale
(there is no question that first generation currency crisis is a crisis, while it is not associ-
ated with a jump in exchange rate).
In its simplest form, EMP indicator is the measure of the domestic money supply and
real money demand. Tanner (1999) shows a monetary model:
( , )
t t t
md i Y m = (3.3)
*
t t t
e = (3.4)

1
t t
t
t
R D
m
M

+
= (3.5)
(3.3) describes money market equilibrium with real money demand (md) growth equal
to nominal base money supply percentage change (m) corrected for inflation . All the
abovementioned variables are in logs. (3.4) is the purchasing power parity; in what fol-
lows, foreign inflation () is normalised at zero. Finally percentage change in base
money supply can be split to nominal change in domestic assets (D) and reserves (R)
change relative to nominal money supply level. Putting (3.5) and (3.4) in (3.3) yields:

1 1
( , )
t t
t t
t t
D R
md i Y e EMP
M M

= (3.6)
The right hand side of Equation (3.6) is EMP (Equation (3.2) with weights equal to 1) -
the reduced form of EMP, which shows the difference between growth of the domestic
part of the monetary base, and money demand growth. Depending on the exchange rate
regime, excessive domestic money supply growth (not counterbalanced by higher
money demand) should translate into reserve outflow or exchange rate depreciation.
- 66 -
As Flood and Marion (1999) show, the problem with the EMP as a crisis indicator used
for early warning system, is that it is biased towards showing unpredictable crises. The
argument applies also to the reduced-form EMP measures the ones taking into account
solely exchange rate or capital outflow. If the collapse of the exchange rate regime is
anticipated, the reserves start to flow out fast early on, in a sense smoothing the actual
impact. The problem disappears with lower data resolution, but so does the usefulness
of the predictive power of the tests based on such models.
In the empirical literature, crisis is usually defined as an extreme value of EMP. Abiad
(2003) points that authors use the different thresholds varying from 1.5 (Eichengreen et
al. 1996, Aziz et al., 2000), through 1.645 (Caramazza et al., 2000), 1.75 (Kamin et al.
2001), 2.5 (Edison, 2000), and 3 times standard deviations (Karmen et al. 1998) of the
pooled EMP. Odd crisis definition thresholds appear, as some authors maximise good-
ness of fit of their models by varying the threshold parameters (Kamin et al. 2001). Oth-
ers (Caramazza et al., 2000) set it to qualify 5% of observations as crises (Abiad, 2003).
When developed countries are included in the sample, a third component of EMP in-
terest rate spread is sometimes added.
Abiad (2003) points to two more technical problems related to the use of the EMP
thresholds as crisis definitions, advocating Markov-switching approach (see Hamilton,
1994). First, past crises may disappear as volatility of the EMP goes up (together with
the cut-off level of EMP). Second, common procedure of registering only one adjacent
instance of a crisis leads to a serial correlation problem crisis in t cannot be followed
by a crisis in t+1. Researchers set windows of exclusion between one quarter and 3
years (Frankel and Rose, 1996).
- 67 -
Another problem of this approach lies in the weighing of the reserve outflow and depre-
ciation. Typical practice of equalising the variance of two components hardly has any
theoretical underpinning. Basic monetary model of exchange rate determination and
Equation (3.6) suggest equal weighs (for a more general approach, see Weymark, 1998).
Exchange market pressure itself and the policymakers response to it was a subject of
numerous studies including Connolly and Da Silveira (1979), Wohar and Lee (1992)
and Burkett and Richards (1993) and Tanner (1999).
Section 3.3.4 Discretionary definitions
Another common way of defining currency crisis is the you will know what a crisis is
when you see it method. In other words, financial press and academic papers and sub-
jective judgement are used to compile a list of crisis-inflicted countries. Examples of
empirical papers, which use such a definition, include Glick and Rose (1999) and Van
Rijckeghem and Weder (1999). Although in cross-country studies such definition is less
frequent than the ones relying on a precise description, it is prevalent in single-country
studies. In particular most of the post-mortem analyses do not include a detailed, nu-
merical explanation why the episode analysed is considered a crisis. The authors simply
assume that it was (by considering it worth taking about), and rarely anyone is willing to
argue with it (even if exchange market pressure was closer to the mean than 1.5 stan-
dard deviations).
The argument for such a method is that you directly get the results, which other methods
aim at indirectly. One can argue that the crisis thresholds of the numerical methods are
set in such a way to include all the commonly recognised crisis episodes (your crisis
indicator is not worth much if it does not count X in 1997 as a crisis!). Goldstein at al.
- 68 -
(2000) boast that their EMP-based crisis criterion map well into the dates that would be
obtained if one were to define crises by relying exclusively on events (p. 20). Instead
of doing it, and facing numerous data collection problems, why not just identify the epi-
sodes manually?
There are two main drawbacks of the method. First, because it is discretionary, some
episodes may be questionable. An example of such a crisis is the Czech depreciation
of 1997, seen by some
15
as a currency crisis, and considered by others as insignificant
market volatility. Second drawback is the judgement on the more exotic countries ex-
perience. It is not easy to find out information in neither financial press nor academic
papers on countries like Kyrgyzstan or Moldova. It is sometimes easier to use numerical
indicators in such cases, as data (although still possibly questionable) is more readily
available than popular investors opinion on these countries.
Section 3.3.5 Other definitions
Other crisis definitions include measuring GDP losses. This method, while usually fol-
lowing strict numerical thresholds, is similar to the discretionary one, as it involves
judging the outcome of the foreign exchange market disturbances. Especially in case of
floating exchange rate regimes, GDP loss can be the determinant factor in judging if a
depreciation represented a crisis or not. The problem with this approach, however, is
that a currency crisis can, in principle, be beneficial for both short term and long term
growth prospects (while still constituting significant distress to many economic agents).
The UK and Sweden are classic examples of such a case. Depreciation of the British

15
Mostly politicians and analysts from neighbouring Central and Eastern European
countries, boasting that their currency was never subject to a crash
- 69 -
pound in 1992 was generally seen as a currency crash (a change in regime, 15% reserve
outflow and 15% depreciation), but it ended the period of slow, -1.4 to 0.8% growth,
which lasted for the previous 3 years. Sometimes, short-term GDP losses are accompa-
nied by major structural reforms, which provide for a stable long-term growth for the
years to come. Bulgarian crisis of 1996 could be an example, where severe crisis was
followed by establishment of a currency board, fiscal reform, an average 4.1% growth
in 1999-2003, and likely EU accession mere 11 years later. Also, in transition econo-
mies the effect of transition dynamics may be difficult to disentangle from the crisis im-
pact (Baszkiewicz and Paczyski, 2003). Chapter 6 deals with the output costs of cur-
rency crises.
Finally, default criterion is often used in empirical crisis literature. This, strictly speak-
ing, is not necessarily a symptom of a currency crisis, but a debt crisis. The two are of-
ten connected, just as banking crisis may be a result or precedent of a currency crash.
Section 3.4 What works?
This section provides a survey of the explanatory variables found to be statistically sig-
nificant in predicting currency crises. The crisis definition problem applies also to the
explanatory variables. In a sense, the problem is deeper here, as it involves not only sub-
jective view of what we call a crisis (as in the previous case), but also the economic the-
ory.
Section 3.4.1 International liquidity
We can broadly define adequate international liquidity as the ability of a central bank or
the economy to survive a temporary capital flow reversal without serious macroeco-
nomic (e.g. exchange rate or GDP growth) consequences. Translating such a definition
- 70 -
into the world of available indicators is difficult. One side of the equation (international
assets available on short notice) is quite easy to determine in a vast majority of cases it
is defined as the stock of international reserves. Even there, however the simple statistic
does not tell the whole truth. Sometimes an international support may effectively in-
crease the international liquidity. Regression results in Bussire and Mulder (1999b)
show that IMF support programmes reduce the currency crisis vulnerability of the
emerging market economies. On the other hand, the official foreign exchange reserves
are sometimes more then the actual available assets. For example, central banks do not
report their off-balance sheet obligations. Simple forward transactions (an obligation to
e.g. sell foreign exchange in the future) are often not represented in official reserves sta-
tistics this artificially boosted Thai reserve assets in 1997. Central banks may also in-
vest their foreign exchange in illiquid, or excessively risky assets. Blejer and
Schumacher (1998) advocate the use of Value-at-Risk approach to assess the central
bank vulnerability. The strategy comes down to risk-weighing the central banks assets
e.g. fellow-emerging market government bonds would be worth less than US Treasur-
ies, even though both technically qualify as foreign reserve assets. Aizenman and
Marion (1999) present some statistics on discrepancy between official reserves and ac-
tually available assets in the East Asian countries.
The real problem starts with the definition of hot liabilities. How many obligations the
central bank may be forced to honour depend on many factors. For example, in the ex-
treme case, under a fixed exchange rate regime the central bank should be able to buy
all the money stock (M2/M3/M4) for dollars (or other reserve currency) from the public
to preserve the peg. How much the central bank should actually be ready to buy out de-
pends on e.g. the level of dollarisation of the economy. In countries like Bosnia and
Herzegovina, or Montenegro, euro can easily be used for transactional purposes, thus in
- 71 -
times of foreign exchange distress, the transactional demand for local currency will be
close to zero. Therefore in such country, the central bank committed to defending the
exchange rate must be ready to buy out the entire money stock, not only from the for-
eigners, but also from the residents. That is one of the reasons why Montenegro decided
to officially accept the euro as a legal tender the country was effectively euroised
anyway! On the other hand, the costs (ignoring reputation damage) of the fixed ex-
change rate collapse in such a country is likely to be small private savings are likely to
be in foreign currency, local-currency prices (and wages) tend to adjust very quickly in
such an environment.
Floating exchange rate regime (and currency bands to a lesser degree) reduces the im-
portance of local currency liabilities of the central bank. The stylised fact is that floating
exchange rate regimes tend to be more self-regulating, allowing for smoother exchange
rate adjustments. Arguably, the only recent occurrence of a floating currency crisis was
Bulgaria (1996). Without the peg, speculators face not only the interest rate spread play-
ing against them, but also the currency risk (lack of free FX option as Krugman, 1979
points out).
Weak banking sector enlarges the potential liability of the central bank. Bank sector
panic and the subsequent rescue operation by the lender of the last resort requires a
boost in money supply, which may lead to depreciation if it is accompanied by conver-
sion of local savings into foreign currency. Turkish experience of 2000-2001 serves as a
warning. Sweeping disinflationary reforms are prone to confidence crises if resources to
defend both the nominal exchange rate anchor and the banking system are not large
enough.
- 72 -
Banking system rescue operations are generally accepted as one of the functions of the
central bank. But they are just one example of implicit or explicit guarantees of the
(widely defined) government to the private or public sector. All guarantees, implicit or
explicit, that the corporate sector would be spared by the government in the face of in-
solvency increases requirements for the overall liquidity of the government/central
bank. Asian difficulties, modelled in Krugman (1998), Dooley (1997) and Corsetti et al.
(1999) are good examples of this.
Thus, concentrating on sovereign short-term foreign debt alone is not enough. Private
sector foreign liabilities, are just as important, as they drain the reserves in case of a
confidence loss. The importance of the local currency debt depends on the exchange
rate regime (pegs make such debt more important), and on other factors, like inflation,
foreign short-term investments or the extent of dollarisation of the economy.
Probably, the most often used measure of hot liabilities is Bank for International Settle-
ments (BIS) statistic of short-term debt in the foreign banking sector. This measure is
available for most of the emerging market counties in semi-annual frequency, which
makes it the statistic of choice for most of the cross-country estimations of international
liquidity (Bussire and Mulder, 1999b; Tornell, 1999; Radelet and Sachs, 1998b;
Rodrik and Velasco, 1999
16
). Even disregarding the domestic liabilities of the central
bank, this short-term debt measure is biased downwards. For example, a five year treas-
ury bond held by a foreign fund is not included (the liability is more than one year, and
moreover it is not versus the foreign banking sector). Similarly, portfolio equity invest-

16
The latter also use IIF statistics on external indebtedness, which includes also non-
banking debt
- 73 -
ments can flow out of the country in minutes, but they are not included in the BIS statis-
tic as a short-term liability
17
.
If the policymakers are fully determined to defend the peg (as is assumed in the Krug-
man 1979 model), the total money stock is the absolute upper limit for the short-term
liabilities of the central bank. This limit, however, has little informational power. Ar-
guably, on one hand the only central banks which could have to be forced to provide
foreign currency in exchange of all the domestic money are the ones from countries
where local currency is little more than a symbol of past sovereignty (Iraq is a recent
example). But in the countries where transaction demand for local currency would re-
main positive even in view of a major credibility decline (so some of the M2 could re-
main in local currency), interventions become sterilised at some stage (see Tanner, 1999
and case studies in Chapter 4), which makes the initial M2 limit move outward making
seemingly adequate reserves insufficient.
The variables used in the leading indicator literature to take into account the liquidity
issues include reserves/GDP, reserve change, reserves/M2, reserves/base money, re-
serves/M1, reserves to ST debt, reserves/imports. At least one of the indicators of such
kind is present, and significant in the vast majority of the studies described in Figure 8.
The following paragraphs we name just a few of the studies.
In an extensive research of 117 currency crashes Frankel and Rose (1996) concluded
that variables important for predicting currency crises (defined as 25% depreciation of
the local currency) include FDI/debt ratio, level of international reserves, high domestic

17
Sarno and Taylor (1999b) try to measure the degree of capital flows persistence, or
hotness of different types of capital flows. Not surprisingly they find portfolio flows
- 74 -
credit growth, increase in world interest rates, real exchange rate overvaluation, and re-
cessions. Current account and fiscal deficit were found to be insignificant.
A study in a similar, univariate spirit was conducted recently by Aziz, Caramazza and
Salgado (2000). In the study based on 50 countries in a sample spanning from 1975 to
1997 they found that out of the most of the 157 crises recorded were preceded by a fall
in international liquidity (international reserves/M2).
Sachs, Tornell, and Velasco (1996b) also show that M2/international reserves coupled
with weak fundamentals rendered the countries vulnerable to contagion effects follow-
ing the Mexican crisis.
In another study, Tornell (1999) presents three determinants of the vulnerability of
economies to the currency crises: weakness of the banking sector, real appreciation of
the local currency and international liquidity. Tornell found that some non-linear de-
pendencies between the variables. For example, if international liquidity is high enough,
than even significant real appreciation or banking sector fragility do not matter.
Bussire and Mulder (1999) point to the importance of international liquidity (defined
as short term foreign debt to reserves ratio) in predicting the depth of a currency crisis.
This variable, together with real appreciation of the local currency over the preceding
four years, current account deficit and lack of an IMF support programme was able to
explain much of the depreciation of the emerging markets currencies during the recent
contagious crises. What is more, multiplicative specification of the model (where inter-

(bond and equity) the least persistent, and FDI flows the most long-term.
- 75 -
national liquidity dominates the overall vulnerability index when it is very low or very
high) seemed to perform even better.
Rodrik and Velasco (1999) present yet another proof that low international liquidity ac-
tually welcomes a currency crisis (defined as a sharp reversal of capital flow)
18
. Their
probit analysis shows that short-term debt/reserves ratio (especially short term debt to
foreign banks) significantly increases the probability of a crisis. Interestingly, the level
of long-term and medium-term debt is significantly negatively correlated with the prob-
ability of a crisis. The explanation for this could be that long-term debt is associated
with other, positive, country attributes (omitted from the analysis). Rodrik and Velasco
also find out that short-term debt to international reserves ratio helps in explaining the
severity of the foreign exchange crises (measured as a GDP cost or depreciation).
Limiting the scope of the research to just international liquidity would lead to an omit-
ted variable problem. Few currency crisis models exist (Bilson, 1979 is one), in which
international liquidity is the sole variable determining the likelihood, or the scale of the
collapse. The following section describes the main variables other than international li-
quidity, which could influence the probability of a currency crisis occurring in the speci-
fied timeframe.

18
Radelet and Sachs (1998b) reach similar conclusions in their study, which employs
similar methodology.
- 76 -
Section 3.4.2 Money supply
In Krugman's 1979 model, crisis occurs when the fundamental value of the currency
falls below the official fixing. The country heads for the crisis, because of monetised
fiscal deficits. Thus, given the uncertainties around the crucial variables, money demand
functions, etc, one can argue that risk is higher for countries with higher budget deficits,
or, more directly, with faster growing domestic money supply. Apart from liquidity in-
dicators listed above, monetary policy sustainability is proxied by various indicators:
money demand-supply gap, change in bank deposits, central bank credit to banks,
money stock, shadow exchange rate, parallel market exchange rate premium, the posi-
tion of the exchange rate within the official band. These variables are included in a large
array of empirical studies, with mixed success. Money supply growth variables usually
enter as significant, provided the reserve variables are not in the equation.
Section 3.4.3 Budget deficit, public debt
Budget deficit can feed as a crisis factor through various channels also. 1
st
generation
interpretation of budget deficit is that it is equivalent to the drift in reserves.
Second channel through which fiscal deficit can increase vulnerability is less direct, and
related to current account. High budget deficit reduces the amount of domestic savings
available to the economy, and stimulates current account deficit. This is fine, provided
the fiscal spending is justifiable from the intertemporal consumption / investment
smoothing point of view. The prevailing view in the eighties
19
was that it is fiscally-

19
Known as the Lawson Doctrine from British Chancellor Nigel Lawson who claimed
that current account are not problematic if they result from private investment decisions.
See IMF (1988).
- 77 -
promoted current account deficits, which are dangerous. While the Mexican, and Ko-
rean crisis showed that private investments could be just as perilous, fiscal deficits still
do increase dependence from external financing, and create debt.
Budget deficit can serve as a proxy for future worsening of the international liquidity -
higher budget deficit means higher rate of growth of public debt, which at some stage
provide liquidity problems. It could be argued that, as in the case of current account
deficit, sustainability is all what for the survival of a currency peg. Even large budget
deficit, likely to be replaced by surpluses in the future are acceptable from solvency
point of view. But, as in the current account case, the notion of sustainability is tricky at
best, and impossible to calculate at worst. Also, lack of sustainability and ultimate in-
solvency are not necessary for the currency crisis to happen. Insufficient liquidity is just
as problematic. Large financing requirements, large amounts of debt maturing, even if
perfectly viable from the longer perspective, could prove fatal if the wind shifts.
Krugmans (1999) model underscoring the balance-sheet impact of sudden depreciation,
Sachs et al. (1996a) second generation model in which indebtedness increases incen-
tives to devalue(understood by the currency speculators), finally the literature based on
bank-run models, where costly liquidation of investments could validate a run all con-
firm that even sustainable debt creation could contribute to a currency crisis. In reality,
however, the hypothesis that a perfectly viable budget deficit or current account could
be prone to collapse due to liquidity problems is very difficult to verify empirically pre-
cisely because it is impossible to judge decisively on fiscal sustainability.
Large debt-taxation substitution may also have influence on longevity of a fixed ex-
change regimes, provided the taxes can be raised in a timely manner. Policymakers in
developed countries, which could yield large tax revenues to replace debt financing,
- 78 -
may still be constrained politically, but their chances of success are much higher than it
is the case in countries with thriving black economy, in which major tax hikes translate
into higher tax evasion.
Even if the central bank does not provide direct financing for the government on a regu-
lar basis, it often ends up doing so in the debt financing crisis-which is thus turning into
a currency crisis. Ukraine, Russia, Moldova provided examples of such behaviour in
1998. Such a risk is especially important for countries without credibly independent
central banks. High local currency debt increases profits from devaluation, which in-
flates away public debt.
Public debt structure variables are a link between liquidity and fiscal indicators. They
indicate at what stage the potential problems may become the actual liquidity problems.
Finally, budget deficit is often a symptom of structural problems of a country. Db-
rowski (1999) in his account on Ukrainian transformation process writes:
Experience of transition process gives a lot of evidence that fiscal policy perform-
ance reflects a quality of economic policy and systemic reforms in the specific coun-
try. Any inconsequence of the conducted policy, delay in transition on the microeco-
nomic level, weakness of government institutions and favourable political climate for
intensive rent seeking negatively influence fiscal balances. Thus fiscal equilibrium
depends not only on the fiscal policy itself but also on the speed, quality and conse-
quence of overall reform process.
The variables of this class, which enter the leading-indicators literature equations in-
clude budget deficit/GDP, government consumption, credit to public sector, public debt,
shares of concessional debt, foreign aid, share of commercial bank loans, share of vari-
able-rate debt, share of short-term debt, share of multilateral development bank debt.
Budget deficit was found significant in some, but not all of the research. Kaminsky et al.
(1998) report two (out of five tried) cases when the budget deficit was found to be in-
significant in the pre-1997 research. Budget deficit was found to be a significant leading
- 79 -
predictor of currency crises in seven of the 34 studies surveyed by Hawkins and Klau
(2000).
Section 3.4.4 Other balance of payments variables, real exchange rate
High current account deficit, regardless of its causes, becomes a problem when foreign
financing dries out. If the exchange rate is floating, high external imbalance forces de-
preciation as soon as capital inflow slows down. If the exchange rate is fixed, the poli-
cymaker must spend reserves, tightening monetary conditions enough to reduce domes-
tic savings-investments imbalance. Recessionary costs of such actions often prove to be
too much, and the exchange rate is allowed to depreciate nominally.
Apart from international reserve changes other balance of payments indicators have
been used in the literature. While the size of the capital flows can just as well be ap-
proximated by the sum of current account deficits and reserve changes, capital account
variables can provide valuable information on the structure of current account financing,
and its volatility. Large foreign direct investments, low short-term capital flows are in-
dicators of higher international liquidity.
Variables such as current account deficit and real exchange rate (overvaluation) serve a
similar role. High current account deficit indicates that the economy as a whole gets in-
debted quickly (or runs out of reserves), while overvalued exchange rate shows in-
creased risk of such a process. By definition, real exchange overvaluation must be cor-
rected somehow (the exchange rate could not be called overvalued if it could stay that
way indefinitely). It can either happen through slower price growth relative to rest of the
trading partners, or through nominal depreciation. Goldfajn and Valdez (1999) find that
the nominal depreciation (usually dramatic) is by far more likely way to correct the
overvaluation if the real exchange rate misalignment is large.
- 80 -
Also, it is much easier to reach the decision to float if the exchange rate is considered to
be fundamentally too strong. This is a standard second generation government optimi-
sation problem: the gains from floating / devaluation are likely to be larger with the
strong currency. The related costs could be smaller too, as the example of Brazil of
1999 showed depreciation of the Real was followed by stock market boom, not the
devastating financial markets panic.
The variables of this class used in the empirical research include real exchange rate, the
current account balance, the trade balance, exports, imports, the terms of trade, the price
of exports, savings and investment, short-term capital flows, foreign direct investment
(sometimes relative to CA), or the differential between domestic and foreign interest
rates.
Section 3.4.5 The real sector
In many second-generation crisis models, e.g. Obstfeld (1994, 1996), real sector influ-
ences the crisis likelihood, as it determines the balance of costs and benefits of defend-
ing the peg. Second generation models stress the fact that it may be sub-optimal not to
devalue. This makes countries with high unemployment, ailing economy, and incoming
elections more vulnerable. Weak economy may make hiking interest rates or cutting
money supply impossible politically. UK in 1992, Moldova in 1998, and Argentina in
2001 experienced all this.
Apart from this crisis creation channel, which could work for wide range of fundamen-
tals (they do not have to be very bad if the policy makers would not be willing to touch
domestic interest rates, afraid of political costs), real economy can serve as a proxy for
external imbalances troubling the economy. Unemployment, GDP growth data can
- 81 -
greatly supplement information inferred from the balance of payments. High current
account deficit itself needs not to be a dangerous sign. A fast growing country could
well exhibit high current account deficits, without negative effects on stability ever,
provided it imports foreign savings investing it in future growth and exports (see e.g.
Rybiski and Szczurek, 2003). If a country grows slowly, has low investment growth
and high current account deficit, the odds are that sustainability of the current account
deficit is low, and that an external balance correction is due.
Real sector variables have been added to the leading-indicators models since the begin-
ning of such research. Real GDP growth, estimates of the output gap, employ-
ment/unemployment, wages, and changes in stock prices are the variables of choice in
this class.
Section 3.4.6 Contagion variables
Currency crises tend to be contagious. In particular, 1992, 1994, 1997 crises inflicted
quite a broad damage to the financial systems not only on a regional scale, but some-
times globally (1998 Russian crisis did require quite a substantial rescue operation in
the US banking system as well, due to the near-collapse of the LTCM hedge fund).
There are numerous channels of contagion. Masson (1999) distinguishes between sev-
eral related effects.
Monsoonal effects, or common shock influencing many countries, eventually leading to
currency crises in each. Such events could include terms of trade shocks (e.g. fall in mi-
croprocessor prices or oil price shocks), or world growth slowdown. Similar impact on
the country's vulnerability may have an increase in world interest rates. Higher world
interest rates tend to increase the overall debt service costs (for the new debt and floater
- 82 -
bonds), and aggravate the current account, budget deficit and public debt-financing
problems for almost all countries in the world.
Spillovers, worsening of economic conditions in one country as a result of a crisis in
another. Trade contagion, or competitive devaluation
20
, is the prime example of such
events. Trade competition can be measured as in Glick and Rose (1999)
21
. But other
types of spillovers are documented in the literature. Political contagion, when devalua-
tion in one country reduces the political cost of such move in another (everyone deval-
ued already, dont expect us to keep the peg) was described by Drazen (1999). Another
way of propagation is through common creditor. Currency crash in one country could
prompt margin calls investment fund clients withdrawing their money. Heavily lever-
aged fund, may thus be forced to liquidate positions in other countries, prompting in-
creased market pressure in all or a group of emerging markets.
The last type of crisis propagation through financial markets was termed pure conta-
gion, or crisis propagation with no relation to macro fundamentals. Apart from invest-
ment funds, or banks liquidity considerations, shifts in market sentiment (being a
code word for market risk aversion) can also promote crisis propagation. Almost by
definition such type of contagion must be modelled by a dummy of a crisis happening

20
Central and Eastern Europe witnessed a completely different type of competitive pol-
icy changes competitive interest rate reductions. Aggressive interest rate reductions in
Hungary, Poland and Slovakia were perceived by some commentators (see e.g. ING,
2003) as competition to deter speculative inflows and nominal exchange rate apprecia-
tion. It resulted in a backlash for Hungary, which just few months later had to hike rates
by several percentage points to stem forint depreciation.
21

0 0
0 0
1
ik k k ik
i
k
i ik k
x x x x
Trade
x x x x
( | | | | +

( | |
+ +
( \ \
i , where x
ik
is exports from country i to coun-
try k (different than i and ground zero country 0), and x
i
is total exports from country i.
- 83 -
elsewhere. Common creditor linkages may be approximated using BIS data on external
indebtedness (see e.g. Van Rijckeghem and Weder, 1999) countries dependent on bor-
rowing from the same country as the crisis-hit economy should be more vulnerable.
Other researchers define contagion as an increase in cross-country correlation between
key financial markets variables, such as stock market returns or exchange rate move-
ments, conditional on crisis happening somewhere (see e.g. Forbes and Rigobon, 1999,
and Baig and Goldfajn, 1998).
In practice it is hard to disentangle the contagion concepts empirically. In particular, the
financial market spillovers (being a rationally justifiable result of liquidity shifts) are
likely to show up in the same circumstances as pure contagion, resulting from irra-
tional investors fear that a country of similar broad macroeconomic characteristics
could also fall a victim of a currency crisis. Eichengreen et al. (1996) and Glick and
Rose (1999) try to judge relative importance of trade links and macroeconomic similari-
ties, and conclude trade links are important in crises propagation. Rijckenhem and
Weder (1999), Kaminsky and Reinhard (1998) and Frankel and Schmukler (1996) find
that spillovers through common financing centre can be just as significant as spillovers
through a common trade partner.
Section 3.4.7 Institutional and structural factors
Institutional and structural indicators can describe various aspect of the currency crisis
vulnerability. One set of variables concern the strength of the banking sector. High
credit growth, apart from its relation to the monetary sustainability is often associated
with relaxation of the prudential procedures within the banking sector. A country may
lack skills and resources to properly monitor credits in the middle of a lending boom.
- 84 -
Change in the money multiplier variable can also serve as a proxy for the speed of evo-
lution of the banking sector. Financial liberalisation often means competition. More
competition translates into lower value of the banking license. This could increase the
banks risk taking incentives the shareholders have less to lose in case of a failure.
Low deposit-lending spread is another variable of this kind.
The variables just mentioned are of early-warning type. They do not represent foreign
exchange problems, they help to predict problems. High real interest rates, or a banking
crisis itself are directly related to the foreign exchange crises. Weak banking sector re-
quires tough choices for the policy maker, which must choose between saving the peg
and saving the banking sector.
Other structural variables relate to the financial openness of the economy. Existence of
multiple exchange rates, exchange controls, or foreign exchange restrictions on one
hand can insulate the economy from external imbalances, allowing to pursue independ-
ent monetary policy, on the other indicate propensity to irresponsible (e.g. hyperinfla-
tionary) policies.
Finally, duration of the fixed exchange rate period, past foreign exchange market crises,
and past foreign exchange market events show how attached the policymakers are to the
peg. In the second-generation world such variables are a proxy for the costs of floating
(both political and real Argentine crash of 2001 showed how long spells of fixed ex-
change rates can make a country very vulnerable, at least in a short-run, to any nominal
depreciation).
- 85 -
Section 3.4.8 Political variables
Politics can influence sustainability of the exchange rates either because of the policy
some government are thought to pursue (leftist governments are usually associated with
high budget deficit and slacker monetary policy), or because of the economic/social
chaos related to the illegal government transfers (coups, wars, etc).
Entirely legal power transfers may also be dangerous for three reasons. First, new gov-
ernment brings some policy uncertainty, thus prompting the investors to require higher
premium. This increases debt service costs, or could lead to an outright speculative at-
tack. Outgoing governments have little to lose, and often go for very expansionary fiscal
policy (correlation of the Hungarian budget deficit with the election cycle in the past 13
years is striking). Finally, new government face a temptation to blame everything on its
predecessors. Thus, even if the fiscal policy is not very bad in the run-up to elections,
the new government, complaining on all the skeletons in the cupboard they inherited
could spend as much as it can before the budget they are responsible for comes
22
.
Variables of this class used in the empirical studies include dummies for elections, in-
cumbent electoral victory or loss, change of the government, legal executive transfer,
illegal executive transfer (coups etc), left-wing government, and new finance minister;
degree of political instability (qualitative variable based on judgement). An example of
the latter variable is INGs Political Stability Index. More points are scored for countries
with long time remaining ahead of the elections, which have majority, non-coalition

22
Poland in late 2001 is one example the new cabinet announced another budget revi-
sion would be necessary, after which it functioned effectively without any budget for
three months, before the official 2001 budget revision took place in December 2001.
- 86 -
governments and in which the ruling party leads comfortably in the polls (see eg. ING,
2004).
Figure 8 Leading indicator literature summary: methods, datasets, results (sorted
by publication date)
Article Countries, time, fre-
quency
Method Crisis definition Results
Bilson (1979) 32 countries, focus on
LATAM. Annual data
1955-1977
Bivariate analysis 5% devaluation 1-yr ahead Crisis probability with grows from 5 to
40% when Reserves/base money falls from 30 to
10%.
Kamin (1988) 107 crisis cases. Annual
data 1953-1983
Graphical analysis of
indicators 3-yrs
before and 4-yrs after
crisis against control
group
15% devaluation
against US$
Trade balance/GDP, export and import growth, real
exchange rate, real GDP growth and inflation found
to behave statistically different in crisis countries
prior to the event.
Edwards
(1989)
39 devaluations, 24 long-
lasting pegs in develop-
ing countries (control
group). Annual and quar-
terly data, 1962-1982
Analysis describing
stylised facts.
15% devaluation
against US$
Central banks foreign assets/base money, net
foreign assets/M1, domestic credit to public sec-
tor/total credit, bilateral RER, parallel market pre-
mium influence probability of devaluation. Growth
of total and public sector credit, CA deficit/GDP,
budget deficit/GDP all behave differently in the
crisis countries.
Edwards and
Montiel (l989)
20 devaluations, Annual
data, 1962-1982
Analysis describing
stylised facts in the
3-yr window ahead
of the crisis.
15% devaluation
against US$
Budget deficit growing, large domestic credit to
public sector, large terms of trade shocks, falling
net foreign assets/money, worsening current ac-
count/GDP, black market premium herald devalua-
tion
For some countries real wages follow inverted U
Cumby and
Van Wijen-
bergen (1989)
Argentina 1979-1980,
monthly data
Probability of peg
collapse calculated
on the base of crisis
model, in which risk
of collapse depends
on probability of
credit exceeding a
threshold throwing
reserves below un-
known critical level
in t+1
Regime shift single
event
Model parametrised to take into account money
demand function and credit growth trends yields
plausible monthly estimate for the probability of the
peg collapse.
Humberto,
Julio and
Herrera
(1991)
Colombia. Monthly data One-step ahead
probability of de-
valuation
Regime change Credit growth, parallel market premium
Edwards and
Santaella
(1993)
48 developing countries
devaluations including 26
under IMF programme.
Annual data 1948-1971
Descriptive statistics
analysis. Probit of
IMF assistance like-
lihood
14%+ devaluation
after at least 2-years of
fixing. 14-page ap-
pendix describing the
crisis episodes.
More focus on the consequences of devaluation,
whether it leads to improvement in economic condi-
tions. Politically unstable countries, with worse
current accounts and net foreign assets are more
likely to approach IMF for endorsement of their
plan.
Political instability makes real devaluation, and
subsequent stabilization reforms less likely to suc-
ceed. IMF assistance results in tighter post-
devaluation policies, but does not markedly help to
keep RER adjustment.
Edin and
Vredin (1993)
Nordic countires, 16
devaluations. 1978-1989,
monthly data.
Shift in the target
zone.
Crisis size measured
as a % change in the
central parity
Money, output growth and import coverage of
international reserves help predicting realign-
ments. Size of the shift depends on money supply
and output growth, as well as on the real exchange
rate.
Klein and
Marion (1994)
17 Latin American coun-
tries. 1957-1991,
monthly data.
Logit Month in which ex-
change rate depreci-
ates after at least 3
months of fixing.
Real exchange rate appreciation vs US$ (simple and
squared), net foreign assets/M1 fall, higher trade
openness increase probability of the peg collapse. In
specifications with year dummies (some significant
for post-1982 period) and individual country dum-
mies, political variables (regular government
changes and coup dummies) became significant.
Devaluations are more likely in early years in
power.
- 87 -
quency
tker and
Pazarbaiolu
(1994)
Denmark, Ireland, Nor-
way, Spain, and Sweden.
15 devaluations and 10
realignments. 1979-1993,
monthly data
Probit Regime change shift
in the band, or switch
to the float
REER, foreign-domestic interest rate spread, unem-
ployment rate, German inflation and exchange rate
position within the band were significant in the
pooled regression.
Significant variables varied for individual countries.
Eichengreen,
Rose and
Wyplosz
(1995)
22 industrialised counties
1967-1992, monthly data,
sample split into ERM
and non-ERM
Non-parametric
distribution equality
test (Kolomogorov-
Smirnov, Kruskal-
Wallis)
EMP and events (offi-
cial devaluations and
realignments) results
for one were the oppo-
site for the other.
Fundamentals (credit, fiscal deficits) mattered in
pre-ERM period for market pressure predictions,
but did not for ERM comparing crisis and non-crisis
countries. The opposite was true when analysing
countries experiencing realignments.
tker and
Pazarbaiolu
(1995)
Mexico. 1982-1994,
monthly data
Probit Regime change
discrete devaluation or
switch to float
Widening of Mexican-US CPI differential, real
exchange rate appreciation, sharp reserve losses,
central bank credit to banking system, fiscal deficit,
financial sector reform dummy significant in ex-
plaining probability of a crash. Credit to banking
system more gaining importance, budget loosing
significance prior to 1994.
Collins (1995) 18 countries, annual data
1979-1991.
Model of distance
from critical thresh-
old at which country
devalues and speed
of approaching it.
Probabilities of ex-
change rate adjust-
ments 6-60 months
ahead.
Regime change, col-
lapse of the peg.
International reserves/GDP and GDP growth are
key determinants of the distance from devaluation
threshold. Inflation a good proxy for mean rate of
approaching the threshold.
Countries adjusting their peg showed on average
46% probability of adjustment, the rest implied 28%
probability of peg collapse within 12 months.
Moreno
(1995)
East Asian countries,
including Japan. 1980-
1994, monthly and quar-
terly
Statistical compari-
son of macro indica-
tors in calm and pre-
crisis periods
Three-variable EMP. M2 growth relative to the US, fiscal deficit, output,
inflation are statistically different one month before
the crisis.
Dornbusch,
Goldfajn, and
Valds (1995)
Argentina, Brazil, Chile,
Finland, Mexico. 1975-
1995, annual and quar-
terly
Descriptive statistics Expert opinion Patterns in real exchange and interest rates, GDP
growth, inflation, fiscal deficit/GDP, credit growth,
trade balance and CA/GDP, international reserves,
and debt/GDP prior to the crisis.
Milesi-Ferretti
and Razin
(1996)
Chile, Mexico, Ireland,
Israel, South Korea,
Australia. 1970- 1994,
annual
No formal testing Debt service/GDP adjusted for GDP growth and
changes in the real exchange rate, exports/GDP, real
exchange rate deviation from historical average,
savings/GDP, budget deficit, banking sector fragil-
ity indicators, political instability, composition of
capital flows compared for crisis and no-crisis coun-
tries.
Frankel and
Rose (1996)
105 developing coun-
tries, 117 crashes. 1971-
1992 annual data
Multinomial probit 25% depreciation vs.
US$ + 10% higher
depreciation rate than
a year before
FDI/debt ratio, low reserves, high domestic credit
growth, increase in world interest rates, RER over-
valuation, recessions matter. CA and budget deficit
do not.
Eichengreen,
Rose and
Wyplosz
(1996)
20 industrialised econo-
mies. 78 crises (45 de-
fended). 1959-1993,
quarterly data.
Probit, contagion
dummy (1 if crisis
somewhere else).
Descriptive statistics,
graphs.
Crisis when an index
of weighted average
of exchange rate,
interest rate differen-
tial and reserve/M1
differential change
(weights to equalise
variance of the three
components), reaches
mean+1.5 std. Devia-
tion
Inflation, employment growth, current ac-
count/GDP, capital controls, government loss, past
foreign exchange market crisis influence probability
of crises.
Calvo and
Mendoza
(1996)
Mexico. 1984-1994,
monthly and quarterly.
M2/reserves, money demand-supply gap
Sachs, Tor-
nell, Velasco
(1996b)
20 emerging markets in
1995.
OLS with slope
dummies
Continuous EMP
index of reserve loss
and depreciation
(country-specific
weights)
RER appreciation between 1986-89 and 1990-94,
growth of bank credit to the private sector between
1990 and 1994, M2/reserves in 1994, and dummies
for weak and strong fundamentals to capture non-
linearities.
Goldstein
(1996)
Latin American coun-
tries. 1994 crisis case.
Annual and monthly data
Descriptive statistics Expert judgment International interest rates, M3/reserves, CA/GDP,
boom in bank lending, RER, short-term debt, bank-
ing sector strength trends are used to discover why
some countries did, and some did not fall victim of
the Mexican crisis.
- 88 -

quency
Kaminsky and
Reinhart
(1999),
Kaminsky
Lizondo and
Reinhart
(1998), Gold-
stein, Kamin-
sky and
Reinhart
(2000)
15 industrial, 5 develop-
ing countries. 1970-1995,
monthly data.
Signals approach EMP with reserve loss
and depreciation.
Threshold of 3 times
full sample standard
deviation. Separate
calculation done for
hyperinflationary
countries.
Export growth, bilateral real exchange, rate--
deviation from trend, terms of trade changes,
changes in reserves, money demand/supply gap,
real interest rates, M2 money multiplier,
M2/international reserves, growth in domestic
credit/GDP, changes in stock prices, output growth,
banking crises help predicting crises. M2/reserves,
export growth and real interest rate have the highest
share of correctly predicted crises. Real exchange
rate leads in noise/signal ratio
Krugman
(1996)
France, Italy, Sweden,
UK. 1988-1995, annual,
quarterly, daily.
Descriptive statistics Subjective judgment Trends in unemployment, inflation, public
debt/GDP, and output gap do not support self-
fulfilling nature of the EMS crisis
Flood and
Marion (1997)
17 Latin American coun-
tries. 1957-1991,
monthly data.
OLS, non-linear
specifications reflect-
ing the model.
Month in which ex-
change rate depreci-
ates after at least 3
months of fixing.
Explanatory variables
are continuous and
include size of real
depreciation (also
nominal depreciation),
and time on peg
(months)
Speed of real appreciation, high volatility of real
exchange rate increase the size of exchange rate
adjustment following the peg collapse. Strong real
appreciation drift reduces and high real rate volatil-
ity increases the life expectancy of the peg.
Goldfajn and
Valds (1997)
26 countries. 1984-1997
monthly survey data,
Logit Three measures: 25%
depreciation (as in
Frankel and Rose,
1996), 2 std.dev from
the mean jump in real
effective exchange
rate, exchange rate
market pressure index,
as in Kaminsky and
Reinhart (1996)
Crises not well predicted in survey data. Either
predictions wrong, or crises due to rapid changes in
fundamentals, or not fundamentals-related at all.
Overvaluation does increase probability of crisis.
tker and
Pazarbaiolu,
(1997)
Probit Crisis if there is a
regime change (de-
valuation, widening of
the band, a switch to
flexible rates).
interest rate differential, deviation from the parity,
log(reserves) and %ch in reserves. Exchange
market pressure index predicts regime change well
Milesi-Ferretti
and Razin
(1998)
105 middle and low
income countries. 1970-
1996
Probit, graphical
analysis of variables
in the crisis window
As in Frankel and
Rose (1996)
Crisis probability increases when reserves/M2 are
low, REER high compared to the historical average,
US interest rates are high, OECD growth is slow,
terms of trade are not favourable
Osband and
Van Ril-
ckeghem
(1998)
31 emerging markets.
1985-1998 monthly.
Identification o
safe indicator
ranges
10%+ depreciation
which is more than
prev. year mean plus
two std. deviations
from previous two
years
External debt and reserve adequacy are the main
filters, which allow to classify period as safe.
Radelet and
Sachs (1998b)
1994-1997
Probit Sharp switch from
positive to negative
capital flow
BIS-reported ST debt/reserves, private
credit/GDP important. CA deficit marginally, real
exchange appreciation rate not important.
Esquivel and
Larrain (1998)
15 developed and 15
emerging markets. 1975-
1996 annual data.
Panel probit, random
effects
15% depreciation in
real exchange rate, or
2.54x std deviation
jump greater than 4%.
Change in reserve money/GDP, RER deviation
from previous 5-yr average, CA deficit/GDP,
M2/reserves, %change in terms of trade, per capita
income fall dummy, regional contagion dummy all
increase probability of crises
Kaufmann,
Mehrez and
Schmukler
(1999)
58 countries. 1996-1998,
annual data.
Unique data on local
managers private
information, ex-
tracted using ordered
probit. OLS
Continuous variable of
fx volatility (standard
deviation of monthly
exchange rate
changes).
Private information of local managers help predict-
ing exchange rate volatility after controlling for CA,
reserves import coverage, change in reserves/credit,
inflation, growth in domestic credit, change in terms
of trade, budget deficit, GDP growth, re-
serves/deposits, ST debt/reserves, M2/reserves and
lagged volatility.
- 89 -

quency
Rodrik and
Velasco
(1999)
1988-1998
Probit Crisis if net private
capital flow/GDP
changes from positive
to negative by at least
5 percentage points.
Also, fall in GDP in
the year of the crisis,
and depreciation (both
conditional on the
crisis).
IIF ST debt/reserves, debt/GDP, CA/GDP, RER
appreciation over three years increase probability of
crises. Budget deficits, M2/reserves, credit
growth/GDP are insignificant.
ST debt/reserves also increases the severity of the
crises as measured by GDP loss.
Bussire and
Mulder (1999)
23 emerging economies
(incl. Hong-Kong). 1994
and 1997 crises episodes
only (2x23 observations).
OLS, non-linear
specification
Weighted average of
nominal depreciation
and reserve outflow
Current account deficit, BIS-reported short term
debt/reserves, real exchange rate appreciation over
preceding two years, IMF support dummy. ST
debt/reserves parameter in a non-linear specification
suggests that high (or low) liquidity makes funda-
mentals almost irrelevant.
Tanner (1999) 23 emerging markets.
Mexican and Asian crisis
episodes.
OLS, non-linearities
in explanatory vari-
ables.
Depreciation + reserve
loss/money supply
weighted by relative
country-specific vari-
ances.
Weakness of the banking sector (lending boom),
real appreciation, low M2/reserves . if international
liquidity is high enough or banks are OK, then
REER and banking sector fragility doesnt matter.
Glick and
Rose (1999)
142 countries. 1971,
1973, 1992, 1994, and
1997 crises episodes.
Probit, OLS Financial Times,
journalistic and aca-
demic histories sug-
gesting if the country
was, or was not a
victim of a particular
crisis episode. EMP,
end depreciation vs.
the ground zero cur-
rency for OLS regres-
sion.
Trade linkages with the first hit country very impor-
tant, even after controlling for fundamentals
(growth of credit, budget deficit, CA, real growth,
M2/reserves, inflation).

Van Ri-
jckeghem and
Weder (1999)
BIS-reporting emerging
economies. Subset of 48
emerging markets. Mexi-
can, Asian and Russian
episodes.
Probit, OLS, as in
Glick and Rose
(1999)
Binary variable (as in
Glick and Rose,
1999), or market
pressure (weighted
average of deprecia-
tion, % decline in
reserves, and normal-
ised change in interest
rates)
Common bank lender channel (similar country of
credit origin to the ground zero country) more im-
portant than trade links, macro control variables less
significant.
Gelos and
Sahay (1999)
12 transition economies.
1990s, monthly, daily
data.
Study concerns co-
movements in mar-
ket pressure. Macro
similarities, trade
linkages. VAR on
daily fx data
Arbitrary identifica-
tion of crisis episodes.
Continuous dependent
variables: EMP (incl.
interest rates), ex-
change rate, stock
market returns
Correlations in market pressure relatively weak in
1990-1998. Hard to explain by fundamentals other
than trade (mostly indirect) linkages.
Berg and
Pattillo (1999)
20 developing and indus-
trial countries. 1970-
1995, monthly data

Replication of sig-
nals approach of
Kaminsky, Lizondo
and Reinhart (1998),
probit of Frankel and
Rose (1996), and
Sachs, Tornell and
Velasco (1996).
Weighted average of
exchange rate and
reserve changes:
threshold is 3 country-
specific standard
deviations above the
mean. Hyperinflation-
ary countries treated
separately
Kaminsky et al. (1998) variables in probit specifica-
tion with M2/reserves, CA level included perform
relatively well. Frankel and Rose (1996) and Sachs,
Tornell and Velascos (1996) models performed
very poorly in predicting the 1997 Asian crisis.
Nag and Mitra
(1999)
Three Asian countries.
1980-1998 monthly
Artificial neural
network approach.
Weighted depreciation
and reserve loss
higher than 2 times
country-specific std.
Deviation over mean
12 indicators, plus lags enter the ANN system,
which is able to predict 80% of crisis occurrences in
the sample.
Herrera and
Garcia (1999)
8 LATAM countries.
1980-1998, monthly.
Composite indicator EMP, reserve, interest
rate and exchange rate
not weighted. Crisis
threshold at 1.5 stan-
dard errors. Hyperin-
flation countries
treated separately.

- 90 -

quency
Aziz,
Caramazza
and Salgado
(2000)
20 industrial and 30
developing countries.
1975-1997, monthly and
annual.
Graphical analysis,
comparison of tran-
quil and crisis peri-
ods.
Crisis when an index
of weighted average
of detrended fx and
reserve change
(weights to equalise
variance of two com-
ponents), reaches
mean+1.5 std. Devia-
tion
Overvaluation, terms of trade, inflation, domestic
credit growth, M2/reserves, world real interest
rates, current account all behave significantly differ-
ent in the crisis periods.
Bruggemann
and Linne
(2000)
7 EU accession candi-
dates (including Turkey)
and Russia. 1993-2000,
monthly
Composite indicator
approach of Kamin-
sky et al. (1998)
20% depreciation
against US dollar
within ten trading
days.

Real exchange overvaluation, reserve losses, bank-
ing sector weakness indicators help predicting cri-
ses.
Burkart and
Coudert
(2000)
1980-1998, quarterly.
Fisher discriminant
analysis
Combination of EMP
threshold, Milesi-
Ferretti and Razin
(1998) threshold, and
amendments "in light
of expert judgment."
Reserves/M2, reserves/debt, short-term/total
debt, overvaluation, contagion indicator, and infla-
tion help predicting crises.
Caramazza,
Ricci, and
Salgado
(2000)
41 emerging and 20
industrial countries.
1990-1998, monthly.
Probit for EMS,
Mexican, Asian and
Russian crisis
Crisis if weighted (to
equalize variances)
average of reserve
losses and detrended
currency depreciation
drifts 1.645 pooled
standard deviations
from the pooled mean.
High-inflation (150%)
cases are excluded.
Real exchange rate appreciation, the current account
deficit, real output growth, the maturity of bank
lending, the common creditor, and ST
debt/reserves significantly increase the probability
of falling victim of contagious crisis. Trade spill-
overs only relevant when CA is weak.
Cerra and
Saxena (2000)
Indonesia, 1985-1997,
monthly
Markov-switching Determined as part of
the Markov switching
model
Evidence of contagion not related to the 8 funda-
mental variables analysed
Edison (2000) 20 developing and indus-
trial countries. 1970-
1998, monthly.
Signals approach of
Kaminsky et al.
(1998)
As in Kaminsky et al.
(1998)
Same as Kaminsky et al. (1998). Robust results,
false alarms remain a problem.
Hawkins and
Klau (2000)
1993-1998, quarterly
Arbitrary scoring
system, verified by
panel probit with
fixed effects
Score system from 2
to +2 based on quar-
terly and annual ex-
change rate, real inter-
est rate and reserve
changes.
Real exchange rate appreciation from 1990-98
average, CA deficit/GDP, export growth accelera-
tion from 1990-98 average, international bond and
bank debt/GDP level and % change over two years,
BIS-reported short term debt/reserves, domestic
bank credit to private sector/GDP growth, growth of
liabilities to BIS banks, real interest rate enter the
scoring system
Kwack (2000) 7 Asian countries. Total
of 14 annual observations
from 1995-1997.
OLS Continuous variable of
weighted average of
exchange rate and
reserve changes.
LIBOR and the NPL ratio (and the debt- equity ratio
of firms the key factors. ST debt/total, CA/GDP,
credit to private sector not significant
Nitithanprapas
and Witlett
(2000)
Asian and Mexican crisis
(52 observations)
OLS, slope dummies
regression
Continuous index of
1:4-weighted ex-
change rate and re-
serve changes. Dis-
cussion of weighing
Real exchange rate, enters the equation differently,
depending on FDI and CA. High reserves reduce
crisis risk.
Vlaar (2000) 31 emerging markets.
1987-1996, monthly data
Separate models for
crisis index, index
volatility and
weights of tranquil
and crisis distribu-
tions of the crisis
index.
Continuous variable of
weighted average of
exchange rate and
reserve changes. For
evaluation purposes
some thresholds are
used
Contagion, past exchange rate, reserve behaviour
are the key indicators.
Eliasson and
Kreuter
(2001)
1990-200, monthly.
Multinomial logit Continuous crisis
variable, based on
exchange rate depre-
ciation and interest
rate changes estimated
using a 5-step proce-
dure. of fitting an
extreme value distri-
bution function to the
difference of vari-
ables actual and
Gaussian distributions.
Falling equity markets, high domestic credit/GDP,
high monthly growth of private credit, high M2/FX
reserves, high short-term debt to FX reserves and
M2/banking reserves are the key leading indicators
in Asia.
Falling equity markets, high monthly growth of
private credit high short-term debt to FX reserves
work in Latin America.
- 91 -
quency
Apoteker and
Barthelemy
(2001)
40 developing countries.
1970-2001, monthly and
quarterly.
Graphical analysis of
variable pairs, identi-
fying dangerous
interactions
20% change in real
exchange rate in one
quarter, 30% in two
quarters or 40% in 3-6
quarters.

Grier and
Grier (2001)
25 developing countries
in 1997.
OLS of fx regime
and control variables
on depreciation and
stock market
Continuous indicators
of exchange rate de-
preciation and stock
market returns
After controlling for 1996 depreciation, current
account deficit, M2/reserves, external debt/GDP,
lending boom and real exchange rate appreciation,
fixed exchange rate regimes resulted in deeper
exchange rate adjustments and lower stock market
returns
Kamin,
Schindler and
Samuel (2001)
1981-1999 annual data
Probit Weighted two month
real exchange rate and
reserve fall exceeds
1.75 times standard
deviations over coun-
try specific mean.
Deficit/GDP, M2/reserves change (but not ST
debt/reserves change), RER appreciation over 1980-
97 average, CA/GDP, terms of trade shock, and
world GDP growth change
Krkoska
(2001)
Czech Republic, Hun-
gary, Poland and Slova-
kia. 1994-1999, quar-
terly.
VAR with crisis
variable as one of the
endogenous vari-
ables. Many restric-
tions
Unweighted average
of exchange and inter-
est rate, and reserve
changes. Crisis de-
fined (but not used in
numerical exercises) 2
times standard devia-
tion of the pooled
sample in the past 3
years (to take transi-
tion into account)
CA-FDI gap is the most significant variable influ-
encing speculative pressure index. Poor EU growth,
and RER appreciation are also significant.
Weller (2001) 26 emerging economies.
1973-1998, monthly data.
Logit for pre, and
post financial liber-
alisation samples.
Standard 2-variable
EMP, 3 times country
specific std dev
threshold
Risk pattern for post-liberalisation countries differ-
ent. Overvaluation and short-term debt increase
vulnerability more after liberalisation
Zhang (2001) Four ASEAN countries.
1993-1997, monthly data
Autoregressive Con-
ditional Hazard
(probit with past
dependent variables
entering the right-
hand side)
Crisis if reserve loss
or depreciation ex-
ceeds 3 times standard
deviation over mean
(std deviation calcu-
lated over 3 previous
years
Duration of calm/crisis spell and contagion vari-
ables dominate all the macro indicators. Fit is re-
portedly better than the probit.
Detragiache
and Spilim-
bergo (2001)
69 countries, 1971-1998 Probit Debt crisis if arrears
or rescheduling of
more than 5% of debt
to commercial credi-
tors
Short term debt, debt repayment due and re-
serves, large external debt, share of debt to multilat-
eral lenders, exchange rate overvaluation, smaller
trade openness are all significant
Kumar, Moor-
thy, and Per-
raudin (2002)
1985-1999, monthly,
quarterly.
Panel logit. The
model is successfully
tested through trad-
ing strategies based
on probability read-
ings
Depreciation of 5 or
10% over the uncov-
ered interest parity.
Second definition is 5
or 10% depreciation
doubling the previous
period depreciation
(total crash).
Twelve-month percentage changes in foreign
exchange reserves, real GDP expressed as a devia-
tion from trend, and the regional contagion dummy
are the key variables.
Import coverage, portfolio investments, official
debt as a proportion of total debt, and the lagged
exchange rate are significant in at least one of the
regressions.
Martinez Peria
(2002)
7 EMS members. 1979-
1993, monthly data.
Markov-switching Endogenously deter-
mined through
Markov-switching
Budget deficit and expectations (proxied by in-
terest rate differential) are significant in increas-
ing probability of a switch to the crisis state
Ghosh and
Ghosh (2002)
42 countries. 1987-1999
annual data
Binary recursive tree
(see text above)
Deep crisis: EMP
more than 2 times
country specific std.
deviations and GDP
growth rate falls at
least 3 percentage
points following the
crisis.
See Figure 7 on page 61
Mulder, Per-
relli. and
Rocha (2002)
1991-1999 monthly.
Extension of Berg
and Pattillo (1999)
probit and Bussire
and Mulder (1999)
OLS approaches
As in Berg and Pattillo
(1999) (binary) and
Bussire and Mulder
(1999) continuous.
Both based on reserve
changes and deprecia-
tion.
ST debt/reserves ratio, CA deficit, RER apprecia-
tion, high leverage and short maturity structures,
shareholder rights indicators influence both prob-
ability and depth (OLS estimate) of the crises.
Sources: Papers in the first column, Kaminsky et al. (1998), Abiad (2003).
- 92 -
Chapter 4 Recent currency crises: liquidity perspective
Section 4.1 Introduction
This chapter gives a description of the recent currency crises from the perspective of
international liquidity. It aims at clarifying several issues related to the liquidity and cri-
ses. This introductory section sets up the main questions to be answered and describes
the general approach of the chapter. The individual case studies of the recent currency
crises which follow are then structured to give answers to the points described here.
The first question to be addressed in each of the crisis case studies concerns the
link between international liquidity and the recent foreign exchange crises. How
a particular instance of a crisis be categorised? How the crisis fits into the exist-
ing currency crises models literature?
Many authors attempted answering such questions. In fact, most of the currency crisis
models were devised as a response to a particular crisis bout (Obstfelds 2
nd
generation
to the EMS crisis, newer ones following the East Asian crises). In this piece, the answer
will be the drawn from the evolution of macro and structural variables around the crisis
period compared with the expected evolution of the variables as suggested by the mod-
els.
First-generation crises should be characterised by high budget deficits, high domestic
money supply growth, steady leak of foreign exchange reserves ahead of the crisis, pos-
sibly current account deficits and real appreciation, and local interest rate climbing
ahead of the attack. The models do not imply a change in monetary policy (leaving ex-
change rate policy aside) following the attack.
- 93 -
Second-generation crises, being self-fulfilling should provide less obvious hints of crisis
brewing. Policy (both fiscal and monetary) does not have to be expansionary in the
lead-up to the crisis. It becomes expansionary conditional on the crisis happening. The
basis for the crisis happening could be weak growth, high unemployment, high private
or sovereign leverage (which makes it politically impossible, or fiscally unprofitable to
tighten monetary conditions in case of an attack).
Asymmetric information models indicate problems with corporate governance, corrup-
tion, implicit government guarantees, high growth of debt, worsening banks portfolios,
amid falling productivity growth.
Finally liquidity crises put stress on short-term debt/reserves and total foreign debt. This
makes liquidity crises impossible to distinguish from a class of 2
nd
generation crisis
models (in fact, one could argue that in its macro form, liquidity currency crisis is a 2
nd

generation model: foreign creditors refusing to roll-over their debt create incentive to
alter the monetary policy in order to bail out the banks). Similarly, balance sheet-type
crisis in which decisive interest rate defence of the peg impossible because of the dam-
age to the general (also non-bank) private sector can be, in fact seen as a variant of self-
fulfilling 2
nd
generation model: optimising government lets the peg fail not because it
has no other options, but because it is (politically) cheaper to do so.
Because most of the crisis models of 2
nd
generation require only a certain range of a
fundamental to enable the self-fulfilling mechanism to work, the actual trigger may be
completely separate from the underlying fundamental. So, the changes in the indicator
within a country may give false impression reduced vulnerability, whereas in fact, there
may be strong nonlinearity in the impact of the fundamentals change on crisis probabil-
- 94 -
ity. One way to get around this problem is to resort to cross-country studies, thus com-
paring the levels, not trends of crucial variables.
Another problem with identifying liquidity-related crises and the 1
st
generation type
ones is that money supply to reserves ratio is a crucial indicator for both deterministic
peg collapse occurring as a result of unsustainable monetary policy and of a potential
vulnerability in case of a liquidity run. It may be hard to judge if foreign investors re-
fuse to roll over their credit, decide to liquidate their equity investments (and require to
change their proceeds into foreign currency), even accepting losses because they are
afraid others would do the same, or because they see foreign exchange reserves become
small relative to domestic currency, and that the monetary policy is unsustainable. To
make matters worse, growth of domestic money could be a result of other issues, only
remotely related to currency crises. Money demand function shifts resulting from eco-
nomic transition, development and competition in the financial sector, or even increas-
ing confidence in local currency following a stabilisation programme could all increase
domestic-to-foreign money ratio. Such effect, in turn, could prove to be indistinguish-
able from a sign of unsustainable monetary and exchange rate policy.
The problem is serious enough to ensure that the same indicator (M2/reserves) in the
same crisis is being interpreted either as a sign of illiquidity (Chang and Velasco 1998),
or as a sure example of a policy collision course (Chinn et al. 1999). A crisis following
a period of falling M2/reserves is a sign of a self-fulfilling run. A crisis after a period of
growing M2/reserves could mean domestic money growth related to financial system
development and relaxed regulations, and a path towards new equilibrium (possibly fi-
nancially unstable). It could also be a result of monetised fiscal expansion (quite easy to
- 95 -
identify) or otherwise monetary policy too slack to be compatible with fixed exchange
rates.
The second problem is the exact role of international liquidity. Is it just a help-
less leading indicator, or a variable, the management of which could prevent the
crisis altogether?
One way of answering that question is checking how international liquidity was chang-
ing ahead and during the crisis. Slow leak of foreign exchange reserves could indicate
the first-generation-type problems in which the issue to be addressed is not liquidity it-
self, but the process which causes its reduction over time deficit monetisation, or gen-
erally too loose monetary policy. If the fall in liquidity is rapid, there are two possibili-
ties: either the reserves do not matter at all for the crisis prediction (the government
finds it too costly to avert the crisis, even though it could have the means to do so) or
they were not sufficient to start with, they created the vulnerability to financing stops,
and targeting them would have reduced the risk of a crisis.
The third question concerns the choice of liquidity measure in evaluating vul-
nerability. In particular, on what type of short-term obligation should research
concentrate? Is it domestic money supply, or just short-term foreign obligations?
The choice of denominator of the liquidity measure best reflecting currency crisis vul-
nerability depends on the exact crisis mechanism. Broad money coverage by official
reserves should be the indicator to watch in highly developed, open countries with solid
banking sector and deep inter-bank market (allowing for large short positions against
local currency). Same indicator is likely to be viable in high-inflation, dollarised coun-
tries with weak banking sector. In such countries potentially very low demand for
- 96 -
money in a crisis requires policymakers to consider all domestic money a callable liabil-
ity in case of a currency crisis.
Short-term foreign debt and portfolio investments (in countries with open capital ac-
count) are both measures of vulnerability to financing stops and liquidity runs in all
economies.
In choosing the liquidity measure, tracking the in-country evolution of various liquidity
measures, or cross-county comparisons must be supplemented by qualitative judgement
of the behaviour of local firms and individuals, as well as foreign investors during the
crisis. Mass conversion of local savings into foreign currency would suggest concentrat-
ing on short-term foreign debt would have given a downwardly biased picture of crisis
vulnerability. On the other hand, a sudden depreciation resulting from foreign financing
stop, with limited consequences to the domestic deposit base, would mean short-term
debt/reserves ratio was a sufficiently broad measure of international liquidity in that par-
ticular crisis instance.
The final of the four questions is when does increasing liquidity become too
expensive to be useful?
The cost of liquid assets can approximated by high-frequency foreign-currency bond
yield data. Too expensive is hardly a precise statement, as foreign currency long-
duration bond spreads faced by some countries on a regular basis would be considered
extraordinary market development related to a crisis by others. Malaysias sovereign
spreads reached 250bp in the middle of the East Asian currency crisis, while such cost
of credit would be unusually low for Mexico in the relatively calm 1992-early 1994 pe-
riod (see Figure 47 on page 131 and Figure 25 on page 112 in the East Asian and Mexi-
- 97 -
can sections below, respectively). A major upward shift in foreign currency long-bond
yields could indicate cut-off for explicit reserve acquisition possibility financed by long-
maturity foreign currency bond sale.
But liquidity can also be understood as liquid assets net of, or relative to liquid liabili-
ties. Thus liquidity could also be influenced by the choice of budget deficit financing
instruments, capital controls, or anything that influences the stock of short term debt.
To avoid issuing short-term debt, the government can either cut budget deficit (at cer-
tain political costs), issue long maturity bonds (at the alternative cost related to the slope
of the sovereign foreign currency yield curve) or resort to non-debt creating financing
altogether. The latter method is usually
23
means selling non-liquid assets (via privatisa-
tion, radio frequency auctions, mobile telephony licences).
The policymakers could also try to influence the composition of capital inflows, to re-
duce the dependence on short-term capital. The evolution of the costs of such policies,
however, is next to impossible to estimate.
The answer to the fourth question will be based mostly on the evolution of high-
frequency long-bond spreads, which approximate the cost of acquiring foreign exchange
reserves. Whenever possible, reference to capital controls influencing maturity structure
of the capital account will be made.

23
But not exclusively: a common way of non-debt budget financing is usage of liquid
assets held at the turn of the fiscal year. Such non-debt creating financing reduces gov-
ernments, and potentially also overall international liquidity, and can only last as long
as governments cash holdings do. But the same can be said of using up the less liquid,
privatised assets.
- 98 -
While answering all the questions above, in case study analysis of this kind, there is a
trade-off between econometric rigour of the analysis and breadth of the data sample.
Following Mussa (2002), Radelet and Sachs (1998a), Chang and Velasco (1998), and
Chinn et al. (1999) (all of which still concentrate on a much smaller sample of 1990s
currency crises), in this chapter, the former was sacrificed in exchange for the latter.
Risking accusation of chart-pointing I decided to cover as many currency crises of the
last 15 years as possible, with heavy weight given to the transition economies crises,
which have been subject to much less extensive studies in the literature. The chronolo-
gies of the crises are provided in the Appendix 1.
Section 4.2 1992 EMS crisis
Section 4.2.1 Crisis identification
The EMS crisis spanned throughout the second half of 1992 and caused severe depre-
ciations, reserve losses, and short-term interest rate spikes in Italy, Ireland, the UK,
Spain, Finland and Sweden. The actual dynamic of the crisis variables was quite differ-
ent for the six countries, as shown in Figures 9-20. Reserves in the UK, and Spain were
rising between 1990 and the attack; they were stable in Ireland, and unstable, but trend-
less in Sweden; all speaking against the 1
st
generation crisis interpretation. Finnish, and
especially Italian pattern of reserve loss starting over two years ahead of the collapse
much better reminded the Krugmans original model (see Figures 12 and 14). Re-
serves/broad money developments reflected changes in official reserves in most of the
countries (growth in Spain, roughly stable in Ireland and Sweden and falling in Finland
and Italy), with the exception of the UK, where domestic money expansion was over-
shadowing foreign exchange reserves growth in the final year ahead of the crisis. Re-
serves/broad money in the UK, at around 4.5%, was the lowest in the group, with the
- 99 -
exception of Italy, where this ratio declined from 12 to 4% between 1990 and 1992 (see
Figures 15-18).
Similar pattern can be seen in the local currency bond spreads over benchmark German
bund yields (not reported), which should reflect exchange rate expectations of the cur-
rency depreciation in the deterministic crisis framework. The spreads had been falling
in the UK, Ireland, Spain, Sweden, but jumping 300bp in early 1991 in Italy, and
slightly later and less in Finland, again confirming the first-generation-type mechanism
at work in the latter two countries.
Cross section look at the budget deficits in crisis-hit counties (Figure 19) reveals simi-
larly mixed picture: Italian deficit was consistently the highest in the group, averaging
10.3% of GDP in 1990-1992, Ireland run the smallest average deficit of 2.3% of GDP,
which coupled with 4.4% GDP growth in the period, was consistent with public debt
reduction, not expansion. GDP growth was slowing down across the board (Figure 20),
with the UK, Finland and Sweden in outright recession, and Italy and Spain with less
than 1% growth, the smallest in years. Ireland enjoyed the fastest growth in the run-up
to the crisis (and afterwards), but it was plagued by over 20% unemployment
24
.
In general, the data findings are consistent with crises of a self-fulfilling type in the UK,
Ireland (especially so), Spain and Sweden, but the case of Italy and Finland look coher-
ent with 1
st
generation speculative attack model. The channels through which specula-
tors could bring the governments of the first group into submission could be a combina-
tion of weak growth or outright recession everywhere, extremely high unemployment in

24
Buiter et al. (1998) provide a comprehensive survey of the crisis. Another survey of
EMS countries fundamentals can be found in Eichengreen and Wyplosz (1993).
- 100 -
Ireland, Swedish banking sector weakening by September 1992 attack episode leading
to short-term interest rates exceeding 80%, and finally, relatively low (albeit rising)
level reserves compared to money supply in the UK.
Falling political costs of devaluing, thanks to other governments doing the same, made
the decision of the British, Swedish, or Irish governments and central banks even easier.
Section 4.2.2 The role of reserves
1992 crisis gave a boost to the 2nd generation crisis models, as they seemed to provide a
perfect example of authorities being forced to devalue, but not because they had no
other choice, but because speculators rightly predicted it would be not worthwhile for
the governments to defend the peg. This puts the importance of international liquidity in
question. The countries suffering the peg collapses in 1992 had relatively good access to
foreign currency. Obstfeld (1994) argues that the November 1992 collapse of the Swed-
ish corona peg was the result of a major fall in political costs of devaluation (English
and Italian exit from the EMS, Spanish and Finnish devaluation, low French support for
Maastricht treaty) and mounting real economy costs of the peg defence: a bout of high
interest rates during the speculative attack in May 1992 strained the domestic banking
system, budget deficit was at 7% of GDP, and recession was in full swing. All this made
a real non-sterilised monetary defence of the peg very costly for the Swedish govern-
ment. All the sterilised intervention in November 1992 achieved was a massive drop in
foreign exchange reserves.
The picture sketched could suggest that the swings in foreign exchange reserves were
not the most important feature of the crisis. They were merely a symptom of the real
(literally, real economic) crisis, which made the defence too costly politically. This
- 101 -
would imply that no reserves would have been sufficient to save the fixed exchange rate
regime. But why the foreign exchange reserves had to fall below zero in Sweden in or-
der for the peg to collapse (Obstfeld 1994, page 199)? Why the unofficial comments of
people linked with the Bank of England hint at the physical impossibility of the sterling
defence, despite the credit lines with numerous European central banks (see e.g. Lall,
1997)? Several issues arise.
Can sterilised intervention influence exchange rates in crisis? If it cannot, then the level
of foreign exchange reserves is indeed irrelevant for the countries like Britain, Italy, or
Sweden of 1992. In such case, if a country believes monetary tightening is unaccept-
able, the reserves are useless. However, if the sterilised intervention can influence ex-
change rate (e.g. due to the portfolio balance arguments), then the level of reserves
(relative to domestic-denominated bonds, money supply) can influence the crisis prob-
ability and severity.
If the latter is true, the policymakers of the 1992 crisis-inflicted countries could have
hoped the massive sterilised intervention would shift the portfolio balance in favour of
the domestic currency denominated bonds. Apparently the amount of reserves available
was not enough to achieve this. What level would be sufficient then?
Finally, in case of the EMS members, the actual amount of reserves at disposal of the
central banks was arguably larger than what was officially reported as a stock of foreign
exchange reserves: credit swap agreements with European peers allowed them to spend
more than they had. Still, apparently, it was not enough. Lall (1997) argues that the
amount of reserves that can be borrowed at any given day was limited, and therefore the
peg could have collapsed even with virtually unlimited credit lines. Similar argument
can be applied to the IMF support programmes: the money is available but not at a short
- 102 -
enough notice (in that case, it is a matter of months rather than a day), so the peg can
collapse anyway.
This shifts attention to the very core of the liquidity problems: the difference between
the liabilities and assets that can be withdrawn at a one-day (spot value date, strictly
speaking) notice. The focus on the liabilities side is then not on the standard credit due
within a year line, but instead the depth, liquidity, and openness of the swap and bond
markets. Poor credit quality of the domestic counterparties, capital flow restrictions, low
domestic currency bonds outstanding reduce the need for high foreign exchange re-
serves. If the foreign investor is unable to find a price for the local currency bond it
holds, and short selling is not allowed, the crisis mitigates itself the panic may actually
slow down the outflow of capital
25
. Similarly, it is difficult to open a short currency po-
sition, if the trading counterparty limits the investor has for local banks is low. The de-
veloped countries have usually the opposite characteristics (excellent credit quality of
domestic banks, resulting in huge counterparty limits, no capital restrictions, and enor-
mous bond and swap markets).
This is a paradox developed countries have cheaper and easier access to reserves, but
each unit is worth less as a crisis protection, precisely because of the depth of their fi-
nancial markets. The central banks must worry about the whole money supply, not just
foreign debt in such countries. Less developed markets, regardless of their policy, have
a form of capital controls built in by default. They work in two ways: by limiting in-
flows due to country exposure limits, and by locking out outflows during panic (limited

25
Several investment fund managers suggested the market impact of the December 2004
Ukraine election chaos was limited precisely because of the low liquidity and lack of the
secondary market for Ukraine government bonds.
- 103 -
liquidity). The protection does not work well for floating exchange rate regimes (liquid-
ity difficulties result in choppier trade, and higher volatility). This sort of protection
does not come for free: the cost is dearer financing for the government and the private
sector of a country, and higher dependence on foreign currency debt.

Figure 9 GBP/ECU rate and UKs reserves

Figure 10 ECU/SEK rate and Swedens reserves
1.2
1.25
1.3
1.35
1.4
1.45
1.5
1.55
1.6
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
-
9
0
J
u
l
-
9
0
J
a
n
-
9
1
J
u
l
-
9
1
J
a
n
-
9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
30000
32000
34000
36000
38000
40000
42000
44000
46000
EUROS PER POUND STERLING: PD.AVG.
TOTAL RESERVES MINUS GOLD

7
7.5
8
8.5
9
9.5
10
J
a
n
-
9
2
A
p
r
-
9
2
J
u
l
-
9
2
O
c
t
-
9
2
J
a
n
-
9
3
A
p
r
-
9
3
J
u
l
-
9
3
O
c
t
-
9
3
J
a
n
-
9
4
A
p
r
-
9
4
J
u
l
-
9
4
O
c
t
-
9
4
J
a
n
-
9
5
A
p
r
-
9
5
J
u
l
-
9
5
O
c
t
-
9
5
10000
12000
14000
16000
18000
20000
22000
24000
26000
28000
30000
SWEDISH KRONA PER EURO:PD.AVG.
Source: ING Source: ING
_

Figure 11 ECU/ESP rate and Spanish reserves

Figure 12 ECU/LIT rate and Italian reserves
120
125
130
135
140
145
150
155
160
165
170
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
-
9
0
J
u
l
-
9
0
J
a
n
-
9
1
J
u
l
-
9
1
J
a
n
-
9
2
J
u
l
-
9
2
J
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3
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4
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5
J
u
l
-
9
5
30000
35000
40000
45000
50000
55000
60000
65000
70000
75000
SPANISH PESETAS PER ECU PD. AVG.

1400
1500
1600
1700
1800
1900
2000
2100
2200
2300
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
-
9
0
J
u
l
-
9
0
J
a
n
-
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1
J
u
l
-
9
1
J
a
n
-
9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
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-
9
4
J
a
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5
J
u
l
-
9
5
20000
25000
30000
35000
40000
45000
50000
55000
60000
65000
70000
ITAL.LIRA PER ECU; PD.AVERAGE
_
- 104 -

Figure 13 IRP/ECU rate and Irish reserves

Figure 14 ECU/FIM rate and Finnish reserves
1.2
1.22
1.24
1.26
1.28
1.3
1.32
1.34
1.36
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
-
9
0
J
u
l
-
9
0
J
a
n
-
9
1
J
u
l
-
9
1
J
a
n
-
9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
ECU PER IRISH POUND:END PD.

4
4.5
5
5.5
6
6.5
7
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
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9
0
J
u
l
-
9
0
J
a
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1
J
u
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9
1
J
a
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9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
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-
9
4
J
a
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-
9
5
J
u
l
-
9
5
2000
3000
4000
5000
6000
7000
8000
9000
10000
11000
12000
MARKKAA PER ECU, END PD.
_

Figure 15 UKs reserves/M4

Figure 16 Swedish reserves/M3
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
6.5%
7.0%
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
-
9
0
J
u
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9
0
J
a
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-
9
1
J
u
l
-
9
1
J
a
n
-
9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
Reserves/M4

5%
10%
15%
20%
25%
30%
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
-
9
0
J
u
l
-
9
0
J
a
n
-
9
1
J
u
l
-
9
1
J
a
n
-
9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
Reserves/M3
_

Figure 17 Spanish reserves/M3

Figure 18 Italian reserves/M2
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
13.0%
14.0%
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
-
9
0
J
u
l
-
9
0
J
a
n
-
9
1
J
u
l
-
9
1
J
a
n
-
9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
Reserves/M3

2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
J
a
n
-
8
9
J
u
l
-
8
9
J
a
n
-
9
0
J
u
l
-
9
0
J
a
n
-
9
1
J
u
l
-
9
1
J
a
n
-
9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
Reserves/M2
_
- 105 -

Figure 19 General budget deficit (% of GDP)

Figure 20 Real GDP growth (YoY%) in ERM
-11
-9
-7
-5
-3
-1
1
3
5
1990 1991 1992 1993 1994 1995
Finland Ireland Italy Spain

-6%
-4%
-2%
0%
2%
4%
6%
8%
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995
Finland Ireland
Sweden Germany
Italy Spain
United Kingdom
_
Section 4.3 The Tequila crisis 1994
Mexican crisis looks totally incompatible with 1
st
generation crisis models. The evolu-
tion of both foreign exchange reserves (Figure 23) and of other liquidity indicators
ahead of the crisis looked like the exact opposite of the one suggested by Krugmans
formulation. Reserves to M4 and M1 were generally stable, while reserves to foreign
debt, or short-term foreign debt were rising (Figure 24). Budget was in surplus or bal-
ance in 1991-1994 (Figure 22). All liquidity indicators simply collapsed in March and
April 1994 (first bout of the attack, defended), and then again in December, after 6
months of stability.
The original variables unlocking the conditionality of the central banks and govern-
ments policies in response to the attack: low growth or high unemployment, were not
indicating the crisis either. Growth averaged 3.6% in 1991-1994 (Figure 21), while un-
employment stayed at 2.4% in 1993. Some other transmission factor must have been
responsible. One candidate had been the current account deficit, growing from 3 to 7%
- 106 -
of GDP in the 1990s (Figure 22). The Mexican experience alone could be seen like a
failed test of the Lawson Doctrine despite the budget surplus, large current account
deficit can be cause external stability problems.
The two important questions are why this could happen, what made the current account
unsustainable, and what is the transmission mechanism between current account rever-
sals and the exchange rate. Obstfeld and Rogoff (2000) addressed the second question in
their article on US current account. In a simple model they show, how sudden current
account reductions (for whatever reason) lead to relative price adjustments, which, un-
der sticky prices can only be accommodated through major nominal depreciation or un-
employment. As for the reasons behind the current account reversal, the possible causes
include political instability, growing US interest rates (which upped the lower limit for
foreign investments profitability in Mexico), and the overall level of debt reaching ex-
posure limit of the creditor countries institutions, as advocated by Atkeson and Ros-
Rull (1995). According to the Obstfeld and Rogoffs model, actual current account re-
versal is not necessary to generate the central banks policy dilemma (between deprecia-
tion and unemployment) and nominal devaluation pressure, so these factors leading to a
sudden stop could, in theory, be enough. However, if they are combined with low li-
quidity, the problem becomes even more acute, leading to forced depreciation and po-
tentially higher output costs
26
. In such case, not only the foreign debt must stop growing,
but also it needs to be repaid.

26
Both occurred in 1994-1995, but small current account surplus was only recorded in
2Q1995.
- 107 -
Having said this, the current account explanation of the origin, or necessary condition of
the crisis does not find confirmation in cross-section data. Sachs et al (1996b) found that
while real exchange appreciation, lending boom and M2/reserves were significant in
explaining the propagation of the Tequila crisis, current account (and budget deficit, for
that matter) were not. The findings could be matched with the following 2
nd
generation
explanation: real exchange rate appreciation ahead of the crisis reduces the real eco-
nomic cost of nominal depreciation, while the lending boom makes the banks more vul-
nerable, which, in the absence of ample liquidity, makes the interest rate defence of a
liquidity run too costly.

Figure 21 Real GDP growth in Mexico (YoY)

Fig 22 Mexican CA and budget balance (% GDP)
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
1991 1992 1993 1994 1995 1996 1997
GDP growth

-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
1990 1991 1992 1993 1994 1995 1996 1997
CA/GDP Budget deficit (% of GDP)
Source: IFS Source: IFS
_
- 108 -

Fig 23 Nominal exchange rate and reserves

Fig 24 Mexican international liquidity measures
2
3
4
5
6
7
8
9
10
J
a
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-
8
9
J
a
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-
9
0
J
a
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9
1
J
a
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9
2
J
a
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3
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a
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4
J
a
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5
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a
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6
J
a
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9
7
J
a
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-
9
8
0
5000
10000
15000
20000
25000
30000
35000
US$/Peso, monthly average Reserves minus gold (US$m)

0%
20%
40%
60%
80%
100%
F
e
b
-
8
9
F
e
b
-
9
0
F
e
b
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1
F
e
b
-
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2
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e
b
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3
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e
b
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9
4
F
e
b
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9
5
F
e
b
-
9
6
F
e
b
-
9
7
F
e
b
-
9
8
Reserves/M4 Reserves/M1
Reserves/BIS ST foreign debt Reserves/Foreign sovgn debt
_

Section 4.3.2 The role of liquidity
International liquidity got into the centre of the policy debate after the Mexican crisis of
November 1994. As early as in June 1995 Sachs, Tornell and Velasco (1996c), were
arguing that Mexico became vulnerable not only because of fundamental imbalances
(large current account deficit, overvalued currency), or domestic and foreign shocks in
1994 (US rates rise, domestic political trouble), but also because it allowed for a large
build-up of short-term debt. This created the situation when the survival of the fixed ex-
change rate was dependent on right mood of the investors:
In the aftermath of the March assassination the exchange rate experienced a nominal
devaluation of around 10 percent and interest rates increased by around 7 percentage
points. However, the capital outflow continued. The policy response to this was to
maintain the exchange rate rule, and to prevent further increases in interest rates by
expanding domestic credit and by converting short-term peso-denominated govern-
ment liabilities (Cetes) falling due into dollar-denominated bonds (Tesobonos). A fall
in international reserves and an increase in short-term dollar-denominated debt re-
sulted. The government simply ended-up illiquid, and therefore financially vulner-
able. Illiquidity exposed Mexico to a self-fulfilling panic.
- 109 -
Other authors also point to the low liquidity problem of the Mexican economy. Calvo
and Mendoza (1996) note not only huge M2 to reserves and short-term public debt to
reserves ratios, but also to the historical volatility of both
27
.
The dynamics of the reserve changes show that the usefulness of the standard liquidity
indicators as crisis early warning signal (in a time-series context) is very limited. Crisis
probability dictated by such a model would have to be declining, together with growing
liquidity, up until March 1994. The situation was different in April-November, period,
when most of the liquidity indicators were declining. The key finding in this context is
Sachs et al. (1996b) paper, which in a cross-section study shows Mexico-originated
panic spread only to those Latin American countries where generally international li-
quidity was lower, real appreciation was higher and bank lending experienced major
expansion. It was the level then, not the trend that was the indication of vulnerability,
suggesting self-fulfilling mechanism at work, unlocked by vulnerability to liquidity
runs.
Apart from the importance in crisis generation suggested by empirical research,
Obstfeld, Rogoff (2000) work implies that the reserves, if used wisely along with other
instruments of monetary policy, might make a difference in crisis management and
costs of speculative attacks in countries exhibiting high current account deficits. Due to
limited, in short-run, tradables-non tradables consumption and production substitution,
sudden fall in current account deficit requires much sharper relative price adjustments
than in the case of smoother current account shrinkage. This is where reserves, properly

27
For other sources on Mexican crisis see Leiderman and Thorne (1995), Edwards
(1997), Edwards and Naim (1997). More references, including view of the IMF, the
World Bank, Mexican authorities, can be found in Edwards (1999).
- 110 -
used, could come into play. With the speculative pressure starting, the appropriate re-
sponse is to smooth the financing mismatch with foreign exchange reserves, while
tightening the monetary conditions with higher interest rates, or (better yet) with tight
fiscal policy. The higher the reserves, the smoother can be the current account adjust-
ment and smaller the resulting relative price/unemployment/nominal depreciation
shock. In Mexican case, however, only the first part of this prescription was adopted.
Starting from March 1994, the central bank was financing the current account deficit (as
it normally does under the pegged exchange rate) by running down on its reserves in the
absence of foreign inflows. Monetary tightening, the second, crucial step, however, was
not fulfilled. Current account deficit continued its expansion throughout 1994, and the
step adjustment very drastic (from US$7.5bn deficit in 4Q94 to 1.3bn in 1Q95 and
350m surplus in the 2Q of that year).
Compared with the EMS fate, the Mexican crisis is an example of a much more con-
vincing case for keeping international liquidity high. Even if in between of the two cri-
sis bouts in 1994, the acquisition of the reserves were too expensive to make sense for
the government (it is not really confirmed in the spreads data, see Figure 25 and Section
4.3.3), lower short-term debt relative to reserves before the initial attack, could have at
least delayed the crisis (helping to survive the political violence), soften its real eco-
nomic impact if the current account adjustment would have been made less dramatic, or
could help to avoid it altogether if time bought were used to fix the banking sector and
cool down domestic demand.
Such interpretation points to two scaling variables. One is the short-term foreign debt.
The second is the current account deficit. The higher the current account, the higher re-
serves are needed to smooth out its adjustment.
- 111 -
Section 4.3.3 The cost of liquidity
A question must be addressed while analysing the importance of international liquidity.
Is the international liquidity problem the same during and before the crisis? Mexico
(similarly to Sweden, and, more recently, Argentina) was faced more than one specula-
tive attack. One occurred in April 1994, second happened in November of the same
year. While the first attack was quite unexpected, the second one was not necessarily so.
Sachs, Tornell and Velasco (1996a) argue that after the initial adjustment in following
Colosios assassination, the interest rates stayed unchanged up until the final collapse by
the end of the year. Indeed, foreign exchange reserves did stay flat between April and
November 1994. International liquidity fell due to high credit growth, making the crisis
look more like a 1
st
generation kind.
Between the two, the Mexican authorities tried to avoid the negative impact of capital
outflow on real economy by sterilising reserve losses. This led to further build-up of
short-term debt and a major fall in international liquidity. If indeed Mexico was guilty
of maintaining insufficient foreign exchange reserves, can it be blamed equally for the
poor liquidity standing in early 1994 and for the policy mismanagement in late 1994?
Sachs et al. (1996a) try to address the problem in their earlier mentioned model, so does
Flood and Jeanne (2000) in a first generation spirit structure. The conclusions of both of
the models may be read as follows: once the level of debt relative to reserves rise
enough to allow for a self-fulfilling attack (or if the underlying budget deficit trend sets
in place), the defence of the peg is futile. Credibility gained by not devaluing is lost due
to the worsened fiscal position. In Mexican case it would mean that the peso should
have been allowed to float or devalued substantially more than the original 10% in
- 112 -
1H94, while the risk of a sovereign debt default was relatively remote (before engaging
in the 6-month sale of short-term dollar-linked tesobonos).

Figure 25 Mexico Par Brady bond zerocoupon spread (bps)
0
100
200
300
400
500
600
700
800
900
J
a
n
-
9
3
M
a
r
-
9
3
M
a
y
-
9
3
J
u
l
-
9
3
S
e
p
-
9
3
N
o
v
-
9
3
J
a
n
-
9
4
M
a
r
-
9
4
M
a
y
-
9
4
J
u
l
-
9
4
S
e
p
-
9
4
N
o
v
-
9
4
J
a
n
-
9
5
M
a
r
-
9
5
M
a
y
-
9
5
J
u
l
-
9
5
S
e
p
-
9
5
N
o
v
-
9
5
J
a
n
-
9
6
M
a
r
-
9
6
M
a
y
-
9
6
Source: ING Financial Markets
_
But the evolution of sovereign spreads show that the costs of long-term borrowing was
not any more prohibitive than it was in early 1993 (Figure 25). This suggests that the
Mexican policymakers could have avoided, or at least alleviated the problems of low
liquidity by simply borrowing in longer maturities, instead of pursuing the self-
defeating strategy of stimulating sterilised short-term capital inflows.
Section 4.4 Bulgarian crisis of 1996-1997
Bulgarias lev collapse was an example a country with floating exchange rate experienc-
ing a currency crisis. Alternatively, the crisis was a typical case of hyperinflation bout,
caused by excessive budget financing needs fulfilled by the Bulgarian National Bank
(BNB). In his account of the crisis Ganev (2003) mentions a host of monetary and struc-
tural reasons for the 3500% depreciation in 12 months, including the pace of budget
- 113 -
deficit monetisation, bad loan problems, and real economy unable to provide the gov-
ernment enough taxes.
Instead of a typical first generation monetised budget deficits-slow outflow of reserves-
crash of the peg scenario, Bulgaria experienced long-lasting nominal depreciation,
which accelerated to crisis levels as the budget and social situation proved more diffi-
cult than usual. Budget deficits have been monetised for years in Bulgaria; it is just the
rate of change of money printing drastically increased as the fiscal situation deteriorated
in 1996. In that sense, the crisis was a natural consequence of simple flexible price
monetary model at work.
Data shortcomings prevent proper testing of the fully specified multivariate monetary
model. Still, attempts to find relationship between prices, domestic money demand and
local interest rate over 1993-1997, yield stable cointegrating vector representing money
demand function (see Figure 26. The hypothesis that price level coefficient is equal to 1
cannot be rejected with
2
(1)=0.0968). The results show that increase in deposit rates by
1% (higher opportunity cost of holding money) reduces real money demand by 0.4%.
At the same time, with interest rate constant, money supply growth translate one to one
to increased prices
28
.

28
The variables used are log of domestic money, log of consumer credit, and deposit
rate level, all from IFS. Attempts to find link money demand with real growth (as a
proxy for transaction demand for money) failed, the impact of quarterly consumption, or
GDP deflated by consumer prices is very sensitive to the sample size, and generally in-
significant. Quarterly inflation rate was also tried as an alternative measure of opportu-
nity cost, cash in circulation and total money supply was tried instead of domestic
money, all with similar results. The sample size does matter for the estimation results,
which is not surprising given the fact time series is so short and that Bulgaria went from
centrally planned economy to hyperinflation and to currency board, all potentially influ-
encing money demand functions, in just five years.
- 114 -
Figure 26 Bulgarian money demand function
ML estimates subject to over identifying restriction(s)
Estimates of Restricted Cointegrating Relations (SE's in Brackets)
Converged after 18 iterations
Cointegration with unrestricted intercepts and unrestricted trends in the VAR
*******************************************************************************
20 observations from 1993Q1 to 1997Q4. Order of VAR = 1, chosen r =1.
List of variables included in the cointegrating vector:
D P I
*******************************************************************************
List of imposed restriction(s) on cointegrating vectors:
a2=1 ; a1=-1
*******************************************************************************
Vector 1
D -1.0000
( *NONE*)
P 1.0000
( *NONE*)
I -.037886
( .035820)

*******************************************************************************
LR Test of Restrictions CHSQ( 1)= .096832[.756]
DF=Total no of restrictions(2) - no of just-identifying restrictions(1)
LL subject to exactly identifying restrictions= -79.3716
LL subject to over-identifying restrictions= -79.4200
*******************************************************************************
Source: Author
Purchasing power parity testing shows cointegrating relation between the exchange rate
and the price level (Figure 27). 70% of the exchange rate movement passes through to
prices
29
.

29
P, P* and S are logs of Bulgarian and German price levels, and log of DM/Lev ex-
change rate respectively. C is constant. 10% depreciation translates one-to-one into 10%
jump of the price level after just two quarters. As above, sample size does matter, and
the relationship is much weaker if estimated over extended period of time (spanning
into the currency board period).
- 115 -

Figure 27 Purchasing power parity test
Autoregressive Distributed Lag Estimates
ARDL(0,1,0) selected based on Schwarz Bayesian Criterion
*******************************************************************************
Dependent variable is P
21 observations used for estimation from 1992Q4 to 1997Q4
*******************************************************************************
Regressor Coefficient Standard Error T-Ratio[Prob]
S .48524 .10513 4.6156[.000]
S(-1) .59914 .10517 5.6971[.000]
P* 2.1884 2.1007 1.0418[.312]
C -2.1992 9.7645 -.22523[.824]
*******************************************************************************
R-Squared .99317 R-Bar-Squared .99197
S.E. of Regression .14309 F-stat. F( 3, 17) 824.1438[.000]
Mean of Dependent Variable 4.9604 S.D. of Dependent Variable 1.5964
Residual Sum of Squares .34807 Equation Log-likelihood 13.2510
Akaike Info. Criterion 9.2510 Schwarz Bayesian Criterion 7.1619
DW-statistic 1.9130
*******************************************************************************
Diagnostic Tests
*******************************************************************************
* Test Statistics * LM Version * F Version *
*******************************************************************************
* * * *
* A:Serial Correlation*CHSQ( 4)= 5.3844[.250]*F( 4, 13)= 1.1206[.389]*
* * * *
* B:Functional Form *CHSQ( 1)= 6.7734[.009]*F( 1, 16)= 7.6177[.014]*
* * * *
* C:Normality *CHSQ( 2)= .19073[.909]* Not applicable *
* * * *
* D:Heteroscedasticity*CHSQ( 1)= .82409[.364]*F( 1, 19)= .77606[.389]*
*******************************************************************************
A:Lagrange multiplier test of residual serial correlation
B:Ramsey's RESET test using the square of the fitted values
C:Based on a test of skewness and kurtosis of residuals
D:Based on the regression of squared residuals on squared fitted values

Estimated Long Run Coefficients using the ARDL Approach
ARDL(0,1,0) selected based on Schwarz Bayesian Criterion
*******************************************************************************
Dependent variable is P
21 observations used for estimation from 1992Q4 to 1997Q4
*******************************************************************************
Regressor Coefficient Standard Error T-Ratio[Prob]
S 1.0844 .046441 23.3498[.000]
CSTAR 2.1884 2.1007 1.0418[.312]
C -2.1992 9.7645 -.22523[.824]
*******************************************************************************
Source: Author

- 116 -

Figure 28 Bulgarian exchange rate and reserves

Fig 29 Bulgarian international liquidity measures
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
J
a
n
-
9
2
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
0
500
1000
1500
2000
2500
3000
MARKET RATE TOTAL RESERVES MINUS GOLD

0%
10%
20%
30%
40%
50%
60%
70%
80%
J
a
n
-
9
2
J
u
l
-
9
2
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
J
a
n
-
9
6
J
u
l
-
9
6
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8
0%
100%
200%
300%
400%
500%
600%
700%
Reserves/Money+Quasi-money Reserves/BIS ST debt (rhs)
_

Fig 30 Bulgarian monetary indicators (in logs)

0
1
2
3
4
5
6
7
8
9
D
e
c
-
9
1
J
u
n
-
9
2
D
e
c
-
9
2
J
u
n
-
9
3
D
e
c
-
9
3
J
u
n
-
9
4
D
e
c
-
9
4
J
u
n
-
9
5
D
e
c
-
9
5
J
u
n
-
9
6
D
e
c
-
9
6
J
u
n
-
9
7
D
e
c
-
9
7
J
u
n
-
9
8
-4.5
-4
-3.5
-3
-2.5
-2
-1.5
-1
-0.5
0
0.5
Price level Domestic credit DM/BGL

Source: IFS
_

Fig 31 Deficit monetisation and exchange rate

Fig 32 GDP, CA and unemployment in Bulgaria
-20%
-15%
-10%
-5%
0%
5%
10%
15%
1992 1993 1994 1995 1996 1997 1998 1999
-6%
94%
194%
294%
394%
494%
594%
Net central bank gov. financing
Budget balance
Average annual depreciation

-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
1991 1992 1993 1994 1995 1996 1997 1998 1999
0
2
4
6
8
10
12
14
16
18
CA/GDP GDP growth Unemployment (%)
_
- 117 -
The crisis was extremely costly real GDP fell by 17% in 1996-1997 following two
years of positive growth after the post-transformation recession (see Fig 32). But it
would be unfair to attribute the GDP loss to exchange rate depreciation itself. Lev
plunge, along with inflation and public finance chaos, was just a symptom of unfinished
stabilisation effort. On a positive note, the crisis did create a powerful stimulus for the
economic policy reform. Currency board paved way to stable exchange rate and prices,
low interest rates, faster growth, as well as EU accession negotiations. So far, the sys-
tem remains stable for 8 years, and Bulgaria looks set to enter both the EU, and the
EMU in a foreseeable future.
Section 4.4.2 Role of liquidity and the cost of reserves
Figure 28 above show that reserves fall did precede the lev collapse of 1996. The float-
ing exchange rate regime complicates interpretation of the data though. Domestic credit
expansion led to lev depreciation, and thus the local currency value of foreign exchange
reserves also went up. This, in turn, ensured reserves / money supply ratio varied but
generally stayed at around 15% level until the reforms in 2Q97 (Figure 29). Reserves
slowly flow out in the Krugmans model, here, reserves exhibited less volatility, thanks
to the floating exchange rate. The rate of depreciation was correlated with the rate of
money printing, which, in turn, was correlated with the rate of fiscal disintegration (Fig-
ure 31). Reserves to short term foreign debt first fell below 100% only in 4Q97, follow-
ing a rise to healthy 200% a year before.
With the underlying cause of the currency depreciation so clearly defined as caused by
rapid acceleration of money printing, it is hard to find a serious role for international
liquidity. The model above finds some evidence of price stickiness, which caused ex-
change rate overshooting. In such environment there could be some use of foreign ex-
- 118 -
change reserves to counteract exchange rate overshooting. Still, as a tool for crisis pre-
vention, or even a leading indicator, the reserves were useless. Even if that were not the
case, at 800-1000bps, the costs of borrowing externally were prohibitive for Bulgaria
before the collapse (see Figure 33).

Figure 33 Bulgarian Discount Brady bond zerocoupon spread (bps)
0
200
400
600
800
1000
1200
1400
1600
M
a
y
-
9
4
N
o
v
-
9
4
M
a
y
-
9
5
N
o
v
-
9
5
M
a
y
-
9
6
N
o
v
-
9
6
M
a
y
-
9
7
N
o
v
-
9
7
M
a
y
-
9
8
N
o
v
-
9
8
M
a
y
-
9
9
N
o
v
-
9
9
M
a
y
-
0
0
N
o
v
-
0
0
M
a
y
-
0
1
N
o
v
-
0
1
M
a
y
-
0
2
N
o
v
-
0
2
M
a
y
-
0
3
N
o
v
-
0
3
M
a
y
-
0
4
N
o
v
-
0
4
_
Section 4.5 East Asian crisis of 1997
Economists were not universally in accord on the key role of inadequate liquidity in the
Tequila crisis (see e.g. Calvo and Mendoza, 1996 or Flood and Marion, 1996 for alter-
native views), and the East Asian crisis was no different
30
. But large debt relative to in-
ternational reserves was cited from the beginning of the East Asian crisis. Perhaps the
most explicit accounts of such an interpretation are papers by Chang and Velasco
(1999), Radelet and Sachs (1998a) and Feldstein (1999).
- 119 -
In a sense it is quite disturbing that less than three years after the Latin American crises,
the same sources of the financial collapse were referred to. The crises are different but
some of their causes seem to return. Martin Feldstein (1999) concluded his Self-
protection for emerging market economies:
There is no substitute for sound economic policies [] But even those countries
that pursue such policies are at risk to the powerful forces of market contagion,
shifts in risk aversion, and irrational speculation
Because the IMF and other international organisations do not have the resources
to act as lenders of last resort, the emerging market countries that want to pre-
vent sharp currency declines must provide for their own protection through in-
creased liquidity. Reductions in the extent of short term capital inflows would
reduce the risk of balance sheet illiquidity. Much larger amounts of foreign ex-
change reserves than countries have traditionally held could be an important
source of protection, flexibility and confidence. Collateralized credit facilities
with private institutions might provide the rapid access to additional liquidity in
place of the missing (and infeasible) official lender of last resort. Each of these
options is expensive but prove far less costly than the damage of currency crises.
[pp. 22-23]
Similarly, Radelet and Sachs (1998) point to the importance of the liquidity ratios:
A particularly telling indicator of these risks is the ratio of short-term debt to
foreign exchange reserves. [] In mid-1997 in Indonesia, Thailand, and Korea
the three countries most severely afflicted by the crisis short-term debt also
exceeded available foreign exchange reserves. It is also instructive to note that
the ratio exceeded 1.0 in several other countries that were no affected by the cri-
sis (including the Asian countries in 1994). This suggests that short-term debt in
excess of reserves does not necessarily cause a crisis, but that it renders a coun-
try vulnerable to a financial panic.
As in the case of Mexico, a look at the typical vulnerability indicators revealed little of
the classic 1
st
generation crisis problems. Budgets in all five crisis-hit countries (In-
donesia, Korea, Malaysia, Philippines and Thailand) were in surplus in 1996. All but
Philippines and Malaysia moved into deficit a year later, but even the highest, Korean
deficit stood at a mere 1.3% of GDP (Fig 34).

30
Krugman (1998), Corsetti et al (1999) and Chinn et al. (1999) models are examples of
an alternative thinking, stressing the importance of moral hazard and contingent gov-
ernment liabilities build-up.
- 120 -
Widening of the budget deficits in the subsequent few years, is consistent either with
self-fulfilling nature of the currency crises (policy became expansionary as a result of
the speculative attack), or with a restrictive class of first-generation class models, in
which the shift in policy is not contingent on the crisis happening. In the latter models
speculators know the shift in policy invalidating the peg must occur, and so must the
speculative attack. This line of thinking is represented by Corsetti et al. (1998), Krug-
man (1998) (but not in Krugman, 1999), and Chinn et al. (1999). Observational equiva-
lence (where policy shift could be either contingent or deterministic) makes this di-
lemma impossible to resolve with certainty.
The most often called for arguments speaking for the deterministic explanation of the
crisis are the corruption, nepotism, implicit government guarantees for the corporate
sector and the banks, and otherwise falling profitability of investments
31
. Transparency
Internationals Corruption Perception Index
32
(1997) put the highest ranking Malaysia in
32 place and lowest ranking Indonesia in 46
th
place out of 52 countries reported in the
main poll, below Taiwan, Singapore and Hong-Kong, Chile, Poland, Hungary, emerg-
ing markets that did not suffer a crisis in late 1990s.
The mechanism of the crisis would then be as described in Dooley (1997) or Corsetti et
al. (1998) mounting corporate debts would ultimately be honoured by the government,
resulting in fiscal (and ultimately monetary) policy not compatible with the peg. But the
low liquidity of most of the East Asian crisis economies was too significant to ignore.

31
See Chinn et al. 1999, or Sasin 2001a
32
See Transparency International (2003) for details on methodology, and Transparency
International (1997) for the actual ranking
- 121 -
As the higher-resolution charts show (see Figures 36-40), reserves were increasing
Thailand, Philippines and Indonesia up until the moment of the crisis, a picture not con-
sistent with 1
st
generation crisis models. They started falling the earliest in Korea (June
1996), and were significantly below the 1994 peak in Malaysia, but rising.

Fig 34 Budget balances in ASEAN-5 (% of GDP)

Figure 35 ASEAN-5 Current account (%) of GDP
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Indonesia Korea Malaysia
Philippines Thailand

-10%
-5%
0%
5%
10%
15%
1992 1993 1994 1995 1996 1997 1998 1999
Indonesia Korea Malaysia
Philippines Thailand
_

Fig 36 Indonesian exchange rate and reserves

Figure 37 Korean exchange rate and reserves
2000
4000
6000
8000
10000
12000
14000
16000
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
J
a
n
-
0
0
10000
12000
14000
16000
18000
20000
22000
24000
26000
28000
30000

700
800
900
1000
1100
1200
1300
1400
1500
1600
1700
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
J
a
n
-
0
0
20000
30000
40000
50000
60000
70000
80000
90000
100000
_
- 122 -

Figure 38 Malaysian exchange rate and reserves

Figure 39 Philippine exchange rate and reserves
2
2.5
3
3.5
4
4.5
5
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
J
a
n
-
0
0
15000
20000
25000
30000
35000
40000

20
25
30
35
40
45
50
55
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
J
a
n
-
0
0
4000
5000
6000
7000
8000
9000
10000
11000
12000
13000
14000
__

Figure 40 Thai exchange rate and reserves

20
25
30
35
40
45
50
55
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
J
a
n
-
0
0
20000
22000
24000
26000
28000
30000
32000
34000
36000
38000
40000

Source: IFS
_
The evaluation of the reserves scaled by money supply reveals a picture (Figure 41-42)
more difficult to interpret (and interpreted differently by various authors: see Chang and
Velasco, 1998, and Chinn et al. 1999) but is not totally different from the outright re-
serve changes. The decline in liquidity in Malaysia is much more visible when reserves
are scaled by M2. The indicator had been falling since mid 1996 Korea and since late
1996 in Thailand, but in the 3 years leading to the crisis, a deterioration trend can only
- 123 -
be seen in Malaysia
33
. Chang and Velasco (1998) compare the level of the indicator with
that of other, mostly Latin American emerging markets, which survived the Asian crisis
untouched. However, a quick look at developed countries shows that the reserves/M2
below 10% (Indonesia, the lowest in the group) is quite common, also in the fixed ex-
change rate countries that did not have a crisis in the past 15 years. The ratio was 7.5%
the Netherlands, 8.5% in Belgium, and 2.8% in Germany in 1991.
There were two differences between East Asian economies and European ones exhibit-
ing even lower liquidity influencing the impact of low reserves/M2 ratio. First hypothe-
sis is that demand for money as a store of value in Western Europe is higher than in de-
veloping countries. Thus, the risk of a flight from local to foreign currency assets is
higher in emerging markets, calling for higher liquidity. When this is combined with
weaker banking system (which was the case in Thailand with its notorious finance com-
panies, and e.g. Indonesia, Sasin 2001b), the risk of domestic deposit withdrawal cou-
pled with higher perceived opportunity cost of keeping local currency cash makes the
fixed exchange system more vulnerable to sentiment shifts.
__

33
Philippine indicator is much higher than that reported by Chang and Velasco (1998),
whos source is also IMF. IFS money+quasi money, domestic credit + foreign assets
and seasonally adjusted indicators all yield liquidity higher by the order of 2, compared
with the paper. The differences for other four countries are negligible.
- 124 -

Figure 41 Reserves/Money+quasi-money

Figure 42 Reserves/Money+quasi-money
10%
15%
20%
25%
30%
35%
40%
J
a
n
-
9
4
M
a
y
-
9
4
S
e
p
-
9
4
J
a
n
-
9
5
M
a
y
-
9
5
S
e
p
-
9
5
J
a
n
-
9
6
M
a
y
-
9
6
S
e
p
-
9
6
J
a
n
-
9
7
M
a
y
-
9
7
S
e
p
-
9
7
J
a
n
-
9
8
M
a
y
-
9
8
S
e
p
-
9
8
Indonesia Korea Thailand

20%
30%
40%
50%
60%
70%
80%
90%
100%
J
a
n
-
9
4
M
a
y
-
9
4
S
e
p
-
9
4
J
a
n
-
9
5
M
a
y
-
9
5
S
e
p
-
9
5
J
a
n
-
9
6
M
a
y
-
9
6
S
e
p
-
9
6
J
a
n
-
9
7
M
a
y
-
9
7
S
e
p
-
9
7
J
a
n
-
9
8
M
a
y
-
9
8
S
e
p
-
9
8
Malaysia Philippines
_
Another, more specific, liquidity-related vulnerability was the countries dependence on
short-term foreign debt. BIS data on external indebtedness reveals that reserve/short
term foreign debt ratio in Korea, Indonesia and Thailand and Philippines were among
the lowest in the sample of 60 developing countries. Out of 10 crises identified using the
25% depreciation in 3 months rule in 1997, 6 concerned countries with reserves/short
term debt below, or very close to 1 (Korea, Indonesia, Zimbabwe, Thailand, Philippines,
Bulgaria). The other four included hyperinflationary Belarus, and Albania, effectively
cut off from external financing, which makes the indicator not meaningful. Malaysias
liquidity, with reserves at 2.4x the short-term debt, should be considered relatively high
in the group.
Another common factor, confirming the non-deterministic view and underscoring the
role of liquidity, is the geographical proximity of the countries involved. When more
than one country in the region is affected by a crisis, investors become very vigilant to
potential risks related to other similarly structured economies. Dedicated investment
funds clients then demand their money back, forcing funds to liquidate otherwise
healthy positions. It then pays for a country to be safe from temporary financing stops.
- 125 -
Short-term debt argument, cited by Radelet and Sachs (1998) and Chang and Velasco
(1999), could point to low liquidity as an important factor, but still not necessary, or,
even less, sufficient to generate the crisis. The top 20 countries includes Russia, which
suffered a crisis a year later, Mexico, still recovering from one in 1996, and Panama
which had the lowest liquidity (just 7% of short term debt covered by reserves), but was
dollarised. That still leaves 8 countries including Singapore and Hong-Kong that man-
aged to escape unhurt between 1997 and 2002.
Judging on current account sustainability is probably the ultimate answer to the di-
lemma of the origins of the crisis. If the current account deficits can be judged as repre-
sentations of intertemporal consumption smoothing, perfectly viable from the long-term
point of view, then the Asian crises should be considered self-fulfilling. But that is im-
possible to do, as the notion of sustainability requires knowledge of the stream future
investment returns. As always, there is a problem with evaluating the sustainability of
the current account in fast growing countries, as the crisis-hit East Asian economies
were. Current account deficit was between 3.4% in Indonesia (seen as sustainable by
Milesi-Ferretti and Rasin, 1996) and 8.2% in Thailand in 1996 (see Figure 35).
The fact that current account was in surplus in Singapore and Hong-Kong, which sur-
vived the 1997, could lead to an impression of the crisis being a direct consequence of
unsustainable external deficits. But, as argued in the previous chapter, the importance of
the current account deficit in crisis prediction is still far from judging on the sustainabil-
- 126 -
ity
34
. Indiscriminate and self-fulfilling investors reaction to any country with a current
account deficit and having low liquidity could also be at play.
The difference between the countries involved may be significant (reliance on short
term debt in Thailand and Korea, and on portfolio equity investments in Malaysia; Thai
finance companies solvency problems leading to the crisis, and Korean banks difficul-
ties resulting from the speculative pressure), but neither of the cases can convincingly
prove the final distinction if the crisis was self-fulfilling (pointing to asymmetric infor-
mation 1
st
generation type explanation) or not. What the indicators do show is that in-
ternational illiquidity was a potential source of trouble, which turned into real crisis.
The crisis identification section above shows that liquidity could have been at least a
crisis catalyst, even if not the main guilty party in the Asian crisis. At the same time it
was not a helpless predictor of a crisis: neither excessive base money creation by the
central banks, nor excessive budget deficits, nor even M2 growth relative to reserves
(with the exception of Malaysia) can be seen in the ASEAN-5 data.
This means that a policy targeting liquidity might have prevented the crisis altogether,
or, at least, influenced the scale of the crisis. Philippines and Malaysia, the countries
with the highest reserves/short term debt ratio suffered the smallest exchange rate col-

34
Real exchange rate measures are elusive for the same reason appreciation experi-
enced by Philippines (16.3% in 1996 relative to 1990 average), Malaysia (12.1%), Thai-
land (7.6%) and Indonesia (5.4%), reported by Chang and Velasco after JP Morgan, are
natural result of fast growth, productivity differential and current account deficits (see
Obstfeld and Rogoff, 2000). Chinn (2000) estimates much smaller appreciation, when
corrected by Balassa-Samuelson effect. Also, Korea showed 12.9% depreciation since
1990.
- 127 -
lapses (46 and 48% in 2H97, respectively, compared with 70-90% by the other three).
The speed of the recovery was better on average with 1999 GDP at over 106.7% of the
1996 in Philippines and Malaysia, but less than 100.1% in the other three
35
. This is con-
sistent with self-fulfilling crisis model by Chang and Velasco (1999), who argue, that
the impact of fundamental shocks (no doubt important in the case of the countries in-
volved), can be magnified by low liquidity, and that the detrimental effects of crazy
policies on liquidity is far more dangerous than the resulting loss of efficiency of the
investments.
Section 4.5.3 The cost of liquidity
It appears that the policymakers of the ASEAN countries had a choice in influencing the
maturity structure of their foreign debt. The problems influencing the liquidity of the
ASEAN-5 counties were twofold.
Because majority of the Asian countries borrowing was done by the private sector
(budget deficits were small), the policies could not come down to simply borrow less
and in longer maturities. But the governments and central banks themselves pursued
policies stimulating, or not preventing short-term debt accumulation. This exhibited it-
self in various forms.
Tax regulations in Philippines promoted foreign credit in general, while Thai and Ko-
rean policies introduced incentives promoting short-term debt. For example, as a result
of 1993 round of capital account and financial liberalisation, Korean banks were al-

35
Yet to be fair, Korea recovered the fastest in the group with 12% growth between
1996 and 1999.
- 128 -
lowed to lend long-term in foreign currency, but could only borrow short-term without
restrictions. Hesitance in allowing foreign direct investments into Korea, Malaysia,
Thailand and Indonesia (with slow opening of additional sectors for foreign invest-
ments, and frequent official interventions) was another factor stimulating short term
debt (Baszkiewicz, 2001; Poret, 1998).
Thai and Malaysian bank regulators failed to take into account bank stability risks re-
lated stock-exchange and real estate bubbles
36
. Malaysian banks growth of equity pur-
chase financing grew from 4 to 20%, while growth of manufacturing sector credits fell
from 30 to 14% in mid 1990s (Sasin, 2001a). Thai finance companies were strongly en-
gaged in real estate speculation, which was the direct cause of their troubles in 1H1997
(Antczak, 2001). While in principle there is no strong reason why equity-financed in-
vestments should be inferior to debt-financed corporate expansion, one could argue that
equity speculation is more likely to stimulate short-term debt. Investment projects are
inherently illiquid, and thus call for as long-term financing as possible. Equity invest-
ments, in turn, can be liquidated instantaneously and with negligible transaction costs.
Liquidity, or solvency problems and forced equity investment liquidations by one insti-
tution can create a violent snowball effect of collapsing stock exchange, worsening bal-
ance sheets of other borrowers, and further equity liquidations together with maturing
short-term debt. The speed of the effect depends on the average duration of debt. Thus
regulations limiting banks exposure to equity investment financing would reduce the
accumulation of short-term debt, and ultimately the speed of the collapse.

36
For formal testing of the bubble hypothesis see Sarno and Taylor (1999b)
- 129 -
Sterilising capital inflows, which kept short-term interest rate consistently above world
levels was the third policy-related problem. Such activity deprives the fixed exchange
rate system from self-regulating powers. Falling return on capital reduces local interest
rates, which, in turn, reduces capital inflows. From the local perspective, lower interest
rate differential reduces the incentives to borrow in foreign currency, while the carry
trade investing in short-term, local currency high yielding instruments with minimum
liquidity risk becomes less profitable for foreign investors. Lack of sterilisation also re-
duces quasi-fiscal costs for the central bank. The inflationary impact of lower local in-
terest rates in the environment of free capital flows would not be large (if at all visible).
Apart from regulation and policy issues, the worldwide trend towards short term financ-
ing (Chang and Velasco, 1998) was increasing the supply-related incentives to borrow
short. This resulted in nothing less than yield-curve speculation, where potentially long-
term problems Thai and Malaysian and Indonesian economies (yen appreciation, semi-
conductor price falls, falling return capital on capital) were attempted to be overcome by
refinancing.
Aside from correcting policy flaws described above, there was little, bar outright capital
controls (which Malaysia did resort to, following the crisis) that the policymakers could
do to influence private capital import structure. But they could try to counterbalance low
private sector liquidity by increasing the war chest available in times of a temporary
external financing halt. Such a war chest could not only be used to smooth-out the real
impact of current account reversals, but also to stabilise drops in asset prices
37
.

37
An example of such an action is Hong-Kongs governments intervention in the stock
market, on 14 August 1998 (see e.g. Far Eastern Economic Review 1998)
- 130 -
The fiscal cost of war chest building was not high, compared with the situation of
Mexico, Bulgaria, or later Russia or Argentina. International bond markets have been
extremely favourable for the Asian government (and affiliated agencies), as shown in
the bond spread charts in Figures 43-47. As late as in June 1997, Thailand, Indonesia,
Philippines, Malaysia and Korea had all access to borrowing only 100bp above the US
market swap curve. On top of this, budget surpluses made room for additional borrow-
ing costs. Up until the crisis month, the path to higher liquidity stayed open for all the
East Asian countries involved.
_

Figure 43 Philippines Brady spread (bps)

Figure 44 Indonesia Yankee 06 spread (bps)
0
100
200
300
400
500
600
J
a
n
-
9
3
J
u
l
-
9
3
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
J
a
n
-
9
6
J
u
l
-
9
6
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8

0
200
400
600
800
1000
1200
1400
1600
1800
2000
1
2
/
3
1
/
1
9
9
6
2
/
2
8
/
1
9
9
7
4
/
3
0
/
1
9
9
7
6
/
3
0
/
1
9
9
7
8
/
3
1
/
1
9
9
7
1
0
/
3
1
/
1
9
9
7
1
2
/
3
1
/
1
9
9
7
2
/
2
8
/
1
9
9
8
4
/
3
0
/
1
9
9
8
6
/
3
0
/
1
9
9
8
8
/
3
1
/
1
9
9
8
1
0
/
3
1
/
1
9
9
8
Source: ING Financial Markets Source: ING Financial Markets
_

Figure 45 Korea Dev Bank 06

Figure 46 Thailand 02 zerocoupon spread (bps)
0
200
400
600
800
1000
1200
5
/
2
2
/
1
9
9
6
7
/
2
2
/
1
9
9
6
9
/
2
2
/
1
9
9
6
1
1
/
2
2
/
1
9
9
6
1
/
2
2
/
1
9
9
7
3
/
2
2
/
1
9
9
7
5
/
2
2
/
1
9
9
7
7
/
2
2
/
1
9
9
7
9
/
2
2
/
1
9
9
7
1
1
/
2
2
/
1
9
9
7
1
/
2
2
/
1
9
9
8
3
/
2
2
/
1
9
9
8
5
/
2
2
/
1
9
9
8
7
/
2
2
/
1
9
9
8
9
/
2
2
/
1
9
9
8
1
1
/
2
2
/
1
9
9
8

0
100
200
300
400
500
600
700
2
7
-
F
e
b
2
7
-
A
p
r
2
7
-
J
u
n
2
7
-
A
u
g
2
7
-
O
c
t
2
7
-
D
e
c
2
7
-
F
e
b
2
7
-
A
p
r
2
7
-
J
u
n
Source: ING Financial Markets Source: ING Financial Markets
_
- 131 -

Figure 47 Malaysia 00 zerocoupon spread (bps)

0
50
100
150
200
250
300
2
/
2
7
/
1
9
9
7
4
/
2
7
/
1
9
9
7
6
/
2
7
/
1
9
9
7
8
/
2
7
/
1
9
9
7
1
0
/
2
7
/
1
9
9
7
1
2
/
2
7
/
1
9
9
7
2
/
2
7
/
1
9
9
8
4
/
2
7
/
1
9
9
8
6
/
2
7
/
1
9
9
8

_
Section 4.6 1998 Russian crisis
The rouble collapse can be seen as a classic example of a 1
st
generation crisis, with ex-
cessive private and unsustainable public spending, which led to an imminent collapse of
the exchange rate.
In fact, Russia experienced two currency crises in the 90s. The first one, in 1994, was
quite similar to the Bulgarian experience of 1996. In 1993-1994 IMF assistance was met
with only partial stabilisation effort. The rate of monetisation of budget deficits, reduced
in the first half of the years, tended to accelerate in the second half. With budget deficits
reaching 20% of GDP, large depreciation pressure was certain to occur. The Russian
central bank (CBR) was not only financing its own government, but also provided credit
facilities to the other Former Soviet Union (FSU) countries (until July 1993, when Rus-
sia started to issue new roubles and the old rouble area ceased to exist). With inflation
reaching 20% on a monthly basis, (in 4Q92, later falling to 4.5-6% per month in the
- 132 -
summer of 1994), an incidence of 20% depreciation of the rouble on 11 October 1994
should not be considered a big surprise. Antczak (2003) concludes:
The macroeconomic stabilization during 19921994 was characterized by the lack of
authorities' ability or will to sustain adjustment efforts. Fiscal policy remained ex-
pansionary and monetary policy monetized fiscal and quasi-fiscal deficits. None of
the IMF (and authorities') stabilization programs were successfully carried through.
Stabilization was not reached, as there was a systematic tendency to relax economic
policies in the second half of each year in face of political pressure, leading to accel-
eration of inflation. Inconsistencies in policy-mix resulted in "Black Tuesday" on Oc-
tober 11, 1994 when the rouble collapsed on the Moscow interbank market by over
20 percent against the U.S. dollar. The first currency crisis in Russia was a warning
indicator.

Figure 48 Russian exchange rate and reserves

Figure 49 Rus Reserves to short term debt (BIS)
0
5
10
15
20
25
30
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
J
a
n
-
9
6
J
u
l
-
9
6
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8
J
a
n
-
9
9
J
u
l
-
9
9
0
5000
10000
15000
20000
25000
OFFICIAL RATE TOTAL RESERVES MINUS GOLD

0.00
0.50
1.00
1.50
2.00
2.50
3.00
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Source: IFS Source: IFS, BIS

The second crisis of 1998 was slightly different. First, the exchange regime was more
rigid, evolving from a currency band (with a crawling central parity) in 1995 to effec-
tive peg at 6.2 new roubles/US$ in 1998. Secondly, central banks monetisation of
budget deficits in the run-up to the crisis, did not play such a huge role as in 1994.
Budget deficits remained large (between 6.1 and 7.7% of GDP in 1995-1997), but they
were mostly financed via short-term, local currency treasury bills (GKOs).
The outright budget deficit monetisation is not a necessary condition for the 1
st
genera-
tion-type crisis build-up. Another possibility is that growth of governments credit in-
creases broad money (instead of high-powered money). Only after the government faces
- 133 -
payment difficulties, the central bank either rescues the government (via deficit moneti-
sation), or the private sector (facing governments default). In both cases, the monetary
policy could become incompatible with prior exchange rate regime.
The first part of the mechanism was present in Russia. The monthly data on budget bal-
ance and reserves/M2 changes (Figure 50) show that the reserve to M2 ratio was corre-
lated with budget surplus. Several other indicators behaved in line with 1
st
generation
crisis theories. These include the stock of foreign exchange reserves, in downward trend
since mid-1997 (Figure 48), local currency yields (Figure 51), reflecting perceived
probability of the collapse was growing since mid 1997, as reflected in growing GKO
yield
38
.
__

Figure 50 Russian budget and reserves/M2

Figure 51 Russian GKO yield
-20000
-15000
-10000
-5000
0
5000
10000
15000
20000
J
a
n
-
9
5
J
u
l
-
9
5
J
a
n
-
9
6
J
u
l
-
9
6
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8
J
a
n
-
9
9
J
u
l
-
9
9
J
a
n
-
0
0
J
u
l
-
0
0
10%
15%
20%
25%
30%
35%
40%
45%
50%
Budget deficit (RBLm) Reserves/M2 (rhs)

0%
10%
20%
30%
40%
50%
60%
70%
80%
J
a
n
-
9
6
M
a
y
-
9
6
S
e
p
-
9
6
J
a
n
-
9
7
M
a
y
-
9
7
S
e
p
-
9
7
J
a
n
-
9
8
M
a
y
-
9
8
S
e
p
-
9
8
J
a
n
-
9
9
M
a
y
-
9
9
S
e
p
-
9
9
J
a
n
-
0
0
M
a
y
-
0
0
S
e
p
-
0
0
GKO rate
Source: IFS Source: IFS, Russia defaulted on GKOs, thus the gap in yield data

38
The scale or timing of the collapse was clearly not reflected in the local currency
yields of 60% in mid-1998, as Russia did not honour its local currency bills! In 4Q98,
brokers reported, that the market price of the securities fell at one stage to 0 (represent-
ing infinite yield). The explanation of this could be the reputation cost of having Rus-
sian GKOs in the portfolio that were exceeding expected pay-off for some fund manag-
ers.
- 134 -
Typically, the second part of the deterministic crisis explanation requires the central
bank ending up financing the government. But as the Russian local currency GKO bond
default proved, the government financing provided by the central bank was not suffi-
cient to avert debt crisis. The reason for this was the local banking system foreign cur-
rency exposure.
Both domestic banks and foreign investors had positions in GKOs, but local banks were
exposed the most to the foreign exchange risk and maturity mismatch. Local banks were
either borrowing abroad or using local foreign-denominated deposits to buy treasury
securities. Less than 4 years after the previous bout of hyperinflation and rouble col-
lapse, foreign currency deposits were still an important part of local savings. Foreign
currency deposits to broad money stood at 53% in 1997 and 43% in 1998 (Antczak,
2003).
Initially, the CBRs policy response to the foreign portfolio inflow came down to obliga-
tory forward contracts with the central bank, forcing foreign investors to swap the
GKOs (which they had to hold till maturity) local currency nominal interest rate into
foreign currency interest of 25% (in 1Q1996), reduced to 19% in April 1996. While un-
der the fixed exchange rate this does not increase vulnerability of the peg provided the
government is solvent (in case of a speculative run, the central bank would have to pro-
vide the dollars in exchange of the rouble GKO proceeds anyway), such policy provides
explicit guarantee of the central bank for the central budget governments insolvency
requires immediate money printing, undermining the exchange rate.
With capital account restrictions lifted in 1998, foreign investors, while actively partici-
pating in the local treasury market (50% of GKOs were owned by foreign funds), tried
to limit their local currency exposure, borrowing rouble funds from the domestic banks.
- 135 -
As a result, local banks short-term foreign currency liabilities to the non-residents were
twice as high as their short-term assets of US$5.8bn. 30% of all of the US$40bn foreign
currency liabilities had maturity lower than 1 month. On top of this, off-balance forward
contracts pointed to another US$10bn currency exposure.
Thus, by mid 1998, the Russian policymakers faced a dual problem. On one hand, half
of the sovereign papers were held by foreigners (Antczak, 2003 estimates it at
US$39bn), and maturity of the most of the debt was very short-term. US$1.2bn matured
every week in 2H98. This exposed the Russian government to the swings of global
market risk aversion (already lowered by the Asian crisis ten months before). Oil price
fall by 30%, leading to current account deficit (current account had been in surplus
since 1993) undermined investors faith in the ability of the Russian government to ser-
vice its debt.
But as described above, the foreign investors were not the only ones having rouble debt
exposure. Sovereign default would bear significant reputation loss, and would lead to
banking system problems, but averting the default by debt monetisation would have
similar consequences for the domestic banking system: the value of their liabilities (for-
eign currency debt and obligations) would grow relative to that of their assets (local cur-
rency GKOs).
By limiting monetary support for the government (and thus depreciation), the central
bank shared the negative consequences of the government insolvency between foreign
investors and local banks.
The Russian crisis was hence a result of a combination of two vulnerabilities. Unsus-
tainable budget deficit was, in a 1
st
generation crisis spirit model monetised, but only
- 136 -
partially, due to the foreign exchange exposure of the local financial system. Debt crisis
was thus added to a (reduced in scale) currency depreciation.
Interesting features of the Russian economy prevented a major balance sheet effect of
the depreciation that did happen. First, much of the monetary system of Russia was dol-
larised, as the statistics on foreign currency deposits cited above confirm. Second, raw
material exports constitute significant part of the Russian economy, with proceeds de-
nominated in foreign currency. With the exception of the banking system, real economic
impact of the currency depreciation was therefore positive: GDP fell 4.9% in the year of
the crisis (the figure was also influenced by falling oil prices, not only by the crisis), but
grew 5.4% and 10% in the two years that followed (and on average above 5% in 2001-
2003).
The identification of the crisis points to a variant of the 1
st
generation crisis model. The
balance sheet impact of the depreciation and default on the local banks was offset by the
positive impact of depreciation on non-bank private sector growth. Therefore, despite
the local bank foreign currency exposure, the crisis could not be described as of a bal-
ance sheet, or self-fulfilling type.
Section 4.6.2 Role of liquidity
In December 1997, the Russian reserves/short term foreign debt indicator at 40%
(Figure 49) was the 6
th
lowest in the sample of 60 developing countries (or the 3
rd
low-
est if dollarised Panama, and countries undergoing a currency crisis - Korea and Zim-
babwe are not included). Was low liquidity responsible for the crash? As argued above,
probably not. The Russian crisis was principally a debt and budget deficit issue. As
Antczak (2003) notes,
- 137 -
[] the contagion effect was weak as it only speeded up what was unavoidable the
deep correction of the exchange rate due to accumulated macroeconomic imbalances.
The Russian crisis of 1998 represents a typical case of the "first generation" model.
The balance of payments crisis led to the currency crisis with sovereign debt default
and, as a result of weak supervision of financial institutions and poor management in
the aftermath of rouble devaluation, resulted in a full-fledged financial crisis with
debt default and bank closures.
Just as in any first-generation models, insufficient foreign exchange reserves, while not
directly responsible for the crisis, could have served as a leading indicator for the crash.
The composition of debt, also facilitated the instant, probably randomly timed switch
into the expansive monetary regime and deficit monetisation. The regime could have
lasted longer if debt refinancing requirements had been lower compared with the avail-
able reserves. But the impact of a policy explicitly targeting level of reserves would de-
pend on the fiscal cost of such a policy.
Section 4.6.3 Cost of reserves
The debt maturity problem of Russian economy was an effect of still fresh transition
experience, and lack of credibility, rather than some specific regulations or policies,
which artificially boosted short-term indebtedness. An attempt to introduce law limiting
foreign involvement in energy sector by Russian Duma (parliament) as late as in May
1998 is one example of such a liquidity-detrimental policy.
On the other hand, between 1996 and 1998, the Central Banks of Russia (CBR) policy
did attempt to artificially lengthen the maturity of foreign obligations. From August
1996 onwards, foreign investors were allowed to participate in secondary GKO market
(which increased the temperature of the capital inflow the flows could reverse at
two days notice), but were obliged to purchase 3 to 6 month forward foreign exchange
contract (with local banks, which had do the offsetting forward with the CBR) before
repatriation of rouble proceeds. The policy was aimed at prolonging the stay of the in-
- 138 -
vestments in the country in case of a sudden reversal on one hand, and to know the day-
to-day flows well in advance. There are two problems with such policies. First, the 3 or
6 months gained is not enough to allow for policy response, aiming at, say, reducing
domestic demand, or for quick fiscal reforms. Secondly, a capital control targeting debt
maturity can only be effective if it is discriminate enough between short and long ma-
turities. If all GKOs are treated in the same way, the investors will simply take the con-
trol into account in its optimal debt maturity structure calculations, reducing the GKOs
maturity accordingly.
Making the long-term debt cheaper required nothing less than full transformation from
the centrally planned economy, increasing transparency, and reducing budget deficit. It
was not so much that liquidity was allowed to fall it was simply never allowed to
grow.
Section 4.7 1998 crises in other FSU counties: Ukraine and Moldova
Section 4.7.1 Crises identification
Russia was not the only FSU country suffering a currency crisis in 1998. It was the big-
gest, with highest foreign involvement, and thus the most well known. Most of the
countries with which Russia had significant trade relations suffered. Many FSU coun-
tries however, had their own macroeconomic or structural problems, and depreciation of
their currencies was merely triggered by the Russian rouble collapse. Budget deficit re-
lated problems were common denominator for a few countries involved.
Markiewicz (2003) shows that Ukraine followed a similar path to Russia in 1996-1998.
The central bank was not financing the government until 1997. The IFS does not pro-
vide any data on Ukrainian budget deficit, and for a good reason. The transparency and
- 139 -
accounting practices of the Ukrainian public finances were not up to international stan-
dards. In particular, privatisation proceeds were counted as budget revenue, the gov-
ernment allowed for in-kind tax payments, and cumulative budgetary arrears reached
9.5% of GDP in 1998 (Dbrowski et al., 1999).
Relatively favourable external financing conditions and Ukrainian banks willingness to
extend credit to the government were enough to finance budget deficit growing from
3.4% in 1996 to 6.1% in 1997 and over 7% in early 1998
39
. The currency remained sta-
ble; the foreign exchange reserves were growing (see Figure 52) as the central bank kept
hryvna from appreciating in real terms. 1997 inflation fell to 10.1%, despite money sup-
ply exceeding 30% YoY. The apparent growth in real money demand was occurring
despite the continuing recession.
As fiscal policy remained expansionary, Asian developments of 1997 proved monetary
policy asymmetric. When the capital was flowing into the country, the reserve money
was allowed to grow. When it started to flow out, the central bank started to supplement
money supply with credit to the government. It was effectively replacing foreign ex-
change reserves by Ukrainian government t-bills. Such a sterilised intervention, in times
of global retreat from emerging market debt (so portfolio balance arguments did not ap-
ply), was not effective. In a bid to regain credibility, the central bank replaced managed
float with a crawling peg with bands in May 1997. The bands were realigned five times
before February 1999, so no credibility was gained.

39
Markiewicz (2003). The problems described above lead to various estimates of the
budget deficit. Official figures point to deficits of 6.8, 4.8, 6.7, 2.0 and 1.5 in the 1995-
1999 respectively
- 140 -
Foreign exchange reserves halved from US$2.4bn in early 1998 to US$1bn by the end
of the year (see Figure 52). Over the course of 1998 hryvna depreciated 80%, and in
1999 and 2000 the government had to reschedule large part of its foreign debt (and de-
fault on the small part which was not rescheduled).
Apart from large budget deficit, the other 1
st
generation crisis indicators do point to the
crisis, but the problems start to be visible only in mid 1997, one year ahead of the crisis.
Reserves/M2 ratio fluctuated wildly, falling below zero (thanks to negative reserves in
May 1994) to over 40% in mid 1997 (Figure 53).
__

Figure 52 Hryvna rate and reserves (US$m)

Figure 53 Ukraines reserves/M2
0
1
2
3
4
5
6
1
9
9
4
M
1
1
9
9
4
M
7
1
9
9
5
M
1
1
9
9
5
M
7
1
9
9
6
M
1
1
9
9
6
M
7
1
9
9
7
M
1
1
9
9
7
M
7
1
9
9
8
M
1
1
9
9
8
M
7
1
9
9
9
M
1
1
9
9
9
M
7
2
0
0
0
M
1
2
0
0
0
M
7
0
500
1000
1500
2000
2500
3000

0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
J
a
n
-
9
6
J
u
l
-
9
6
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8
J
a
n
-
9
9
J
u
l
-
9
9
J
a
n
-
0
0
J
u
l
-
0
0

Moldovan experience of 1996-1998 displayed an extreme case of wrong policy mix.
The monetary policy of the National Bank of Moldova (NBM) was very effective. The
leu was introduced in late 1993, and, while floating in theory, in practice served as a
nominal anchor until 1998. Nominal depreciation fell from 15% in 1994 to 5.1 in 1995
and 0.2% in 1997. Real exchange rate to the US$ appreciated 250% (Radziwi, 2003
claims the leu-dollar exchange rate was initially undervalued at 3.85 in 1993). As a re-
sult inflation fell from 2000% in 1993 to 11.2% in 1997.
- 141 -
Despite huge budget deficits (25% of GDP in 1992, and 8.8% average in 1993-1998 on
commitment basis
40
), the NBMs budget deficit financing support was relatively small
after 1993 until August 1998. Foreign inflows and budget arrears were sufficient. Capi-
tal flight of late 1997 and 1998 resulted at first in a textbook example of exchange rate
defence. The central bank was intervening in the foreign exchange market, reducing
domestic money supply. According to Radziwi, cash in circulation fell so much, it be-
came a scarce asset in everyday transactions. As a result, inflation fell to zero in 2-3Q of
1998. Despite shortening the duration of the government debt and a spike in interest
rates, the budget deficit proved unfinanceable. In September NBM engaged in similar
activity to the Ukrainian central bank (providing liquidity to the government still de-
fending the leu) resulting in 80% depreciation two months later (see Figures 54 and 55).
__

Figure 54 Moldovan exchange rate and reserves

Figure 55 Reserves/M2 and deficit monetisation
0
2
4
6
8
10
12
14
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
J
a
n
-
9
6
J
u
l
-
9
6
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8
J
a
n
-
9
9
J
u
l
-
9
9
100
150
200
250
300
350
400

0%
20%
40%
60%
80%
100%
120%
J
a
n
-
9
4
J
u
l
-
9
4
J
a
n
-
9
5
J
u
l
-
9
5
J
a
n
-
9
6
J
u
l
-
9
6
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8
J
a
n
-
9
9
J
u
l
-
9
9
J
a
n
-
0
0
J
u
l
-
0
0
0
200
400
600
800
1000
1200
1400
1600
1800
2000
Reserves/M2 CLAIMS ON CENTRAL GOVERNMENT

The monetary policy up until mid 1997 in Ukraine and mid 1998 in Moldova could not
be considered particularly expansive. Consequently, no deteriorating trend in
M2/reserves could be seen until about a year ahead of the crisis (Figures 53 and 55).

40
As opposed to cash measure, which does not include budget arrears
- 142 -
Deficit monetisation started (or accelerated in case of Ukraine) only in the final months
before the crisis, validating the speculative attack.
Does this mean a second-generation explanation for the crisis, or rather that of the de-
terministic monetary policy switch? The persistent budget deficits, combined with cur-
rent account deficits and weak growth (Figures 56-57) speak for the latter the deficit
was unlikely to be sustainable at the exchange pre-crisis exchange rate.
__

Figure 56 Ukrainian growth and CA

Figure 57 Moldovan growth and CA
-13%
-11%
-9%
-7%
-5%
-3%
-1%
1%
3%
5%
1994 1995 1996 1997 1998 1999
CA balance GDP growth

-25.0%
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
1996 1997 1998 1999 2000
CA/GDP GDP growth
Source: IFS, Markiewicz (2003) Source: IFS, Jarociski (2000)

Section 4.7.2 Role of liquidity
Such crisis interpretation makes international liquidity almost useless in both predicting
and targeting crises. It was useless in predicting crises, because until one year ahead of
the Ukrainian crisis and 6 months ahead of the Moldovan leu collapse nothing wrong
could be seen in liquidity indicators. At the same time, the problems of high budget
deficit, opaque public finances, microeconomic foundations for growth (e.g. legal sys-
tem, bankruptcy law, see Dbrowski et al., 1999) were making liquidity targeting (issu-
ing long-term foreign currency debt) costly enough to be counterproductive. Russia,
Ukraine, Moldova consumed too much, run excessive budget deficit, which was fine as
- 143 -
long as external financing was sufficient. As budget spending did not lay enough foun-
dation for growth and future budget revenues, the collapse was bound to happen regard-
less of the liquidity position.
Section 4.8 2000-2001 Turkey default and lira collapse
17
th
IMF-supported Turkish stabilisation and disinflation programme since 1961 started
in January 2000. It was ambitious, as many reforms were attempted at the same time.
Turkey addressed simultaneously corruption, privatisation, social security (all three cre-
ating political tensions), banking supervision (resulting in several banks closures, and
loss of public confidence in the sector), and monetary prudence (which leaves confi-
dence as necessary condition for banking system and fiscal survival)
41
.
The programme lasted for mere 14 months, and the first serious crisis occurred as early
as November 2000. Either the crisis-generating process must have been very quick, or
the system had a built-in vulnerability.
Given the extent of the reforms, there were many potential issues that could undermine
the stabilisation effort. Political tensions over privatisation strategy started already in
August 2000. From September up until November speculative attack, steady flow of
negative news about the banking sector was undermining confidence of both local de-

41
For accounts of the crisis see e.g. Alper (2001), Akyz and Boratav (2002), Eichen-
green (2001), Sasin (2001), and Yeldan (2002) and references therein.
- 144 -
positors and foreign investors. Strengthened bank supervision and anti-corruption ac-
tions revealed problems in numerous banks balance sheets (Sasin, 2001).
The importance of the events is very high, as Turkey has a long history of large inflation
and monetised excessive fiscal deficits. Sasin (2001c) writes: Between 1961 and 1999,
Turkey signed 16 agreements with the IMF concerning disinflation and fiscal consolida-
tion and broke every one of them. Even though the reserves/M2 ratio at above 30%
in 2000 was high, compared with most developed and many emerging economies
(Figure 59), both transactional demand for money, and demand for Turkish lira as a
store of value were very fragile. The proof for the former is visible during a holiday trip
to Turkey: euro and US$ are just as readily accepted in everyday payments as the lira.
The proof of the latter is the share of foreign currency deposits in the broad money,
jumping from 41.7% in 3Q99 to 49.1% a year later, and then back to 43.9% in the next
three months. What it means for the currency stability, is that a liquidity run on the
banking sector cannot be harmlessly met with central banks liquidity injection, because
no-one is going to keep lira in cash with inflation consistently above 50%. So a confi-
dence run on the banking sector is equivalent to the run on the lira.
__
- 145 -

Figure 58 US$/TKL and Turkish reserves

Figure 59 Reserve/M2 and TCMB gov. financing
0
200000
400000
600000
800000
1000000
1200000
1400000
1600000
1800000
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8
J
a
n
-
9
9
J
u
l
-
9
9
J
a
n
-
0
0
J
u
l
-
0
0
J
a
n
-
0
1
J
u
l
-
0
1
J
a
n
-
0
2
J
u
l
-
0
2
15000
17000
19000
21000
23000
25000
27000
29000

20%
25%
30%
35%
40%
45%
50%
J
a
n
-
9
7
J
u
l
-
9
7
J
a
n
-
9
8
J
u
l
-
9
8
J
a
n
-
9
9
J
u
l
-
9
9
J
a
n
-
0
0
J
u
l
-
0
0
J
a
n
-
0
1
J
u
l
-
0
1
J
a
n
-
0
2
J
u
l
-
0
2
0
10000
20000
30000
40000
50000
60000
Reserves/M2 CLAIMS ON GOVERNMENT
Source: IFS, reserve jump in Dec-00 represents IMF disimbursement Source: IFS
__

Figure 60 YoY GDP growth and CA balance

Fig 61 Turkey Republic 30, zerocoupon spread
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
1
9
9
5
Q
1
1
9
9
5
Q
3
1
9
9
6
Q
1
1
9
9
6
Q
3
1
9
9
7
Q
1
1
9
9
7
Q
3
1
9
9
8
Q
1
1
9
9
8
Q
3
1
9
9
9
Q
1
1
9
9
9
Q
3
2
0
0
0
Q
1
2
0
0
0
Q
3
2
0
0
1
Q
1
2
0
0
1
Q
3
2
0
0
2
Q
1
2
0
0
2
Q
3
GDP (YoY%) CA balance (% of GDP, annualised)

200
300
400
500
600
700
800
900
1000
1100
1200
2
/
1
0
/
2
0
0
0
6
/
1
0
/
2
0
0
0
1
0
/
1
0
/
2
0
0
0
2
/
1
0
/
2
0
0
1
6
/
1
0
/
2
0
0
1
1
0
/
1
0
/
2
0
0
1
2
/
1
0
/
2
0
0
2
6
/
1
0
/
2
0
0
2
1
0
/
1
0
/
2
0
0
2
2
/
1
0
/
2
0
0
3
6
/
1
0
/
2
0
0
3
1
0
/
1
0
/
2
0
0
3
2
/
1
0
/
2
0
0
4
6
/
1
0
/
2
0
0
4
1
0
/
1
0
/
2
0
0
4
Source: IFS, Current account not seasonally adjusted Source: ING Financial Markets

In such case, the central bank has two options, both of which were tried in late 2000 and
in early 2001. The first one is to let the reserves flow out, without sterilisation, which is
what happened in November-December 2000. Reserves declined (Figure 58), short-term
interest rates shot up to above 1800%. Another disimbursement from the IMF calmed
the situation until February, when wrangling between the president and the prime minis-
ter on state owned bank supervision strategy resulted in another round of falling confi-
dence. The interest rates reached 6000% after which the central bank caved in, choosing
the second option, and deciding to let go the peg, and save the banking system.
- 146 -
The crisis looks either like a typical liquidity run transforming into currency crisis
(which would point to a self-fulfilling nature of the run), or like a bank solvency crisis,
in which case the programme was doomed to fail right from the beginning. Like in the
2
nd
generation crisis models, deficit monetisation, shooting up from March 2001 on-
wards validated the run (see Figure 59). But then, informational equivalence stressed
out by Flood and Hodrick (1986) means that the first generation class of models in
which fiscal and monetary expansion (due to ailing and undercapitalised banking sector)
was bound to happen, would point to exactly the same policy actions. As in the case of
the Asian crisis, even if the underlying problem was deterministic, the element of self-
fulfilling nature was also at play the banking system bailout costs after even a short
spell of 6000% interest rates were certainly higher than without it
42
.
Section 4.8.2 The role and cost of liquidity
From the Turkish policy perspective, the distinction between self-fulfilling and determi-
nistic nature of the crisis may not be so important. Regardless whether the banking sys-
tem required capital injection or a mere liquidity help, tightening of the banking super-
vision should be attempted before, or long into the stabilisation programme. Even if the
government is capable of dealing with the insolvent banks without deficit monetisation
(which would point to sustainability of the peg in the absence of a liquidity run), coun-
tries facing stabilisation programmes do not generally have resources for honour blanket
deposit guarantees for the whole banking system (the problem they deal with is break-

42
Alper (2001) blames the explosion of the current account deficit in 2000. CA deficit
stood at 21% of GDP that year. However, with growth averaging 7%, and with the
time span of the process so short, the responsibility of the current account deficit for the
crisis creation seems stretched. Both intra-year and annual CA volatility in Turkey is
high, 2001 bought the reversal to +8.8%, see Figure 60.
- 147 -
ing with deficit monetisation in day-to-day budgeting process, let alone systemic bank
failure). Longer spell of stable currency and lower inflation, on the other hand, increases
chances of resolving temporary banking confidence problem using liquidity injection by
the central bank, as the deposit run does not have to translate into a run of the local cur-
rency in such case.
The lifespan of the stabilisation plan - less than 14 months before the total collapse, and
less than 11 months before serious crisis suggests that a policy targeting liquidity may
have not played such a great role in the crisis, even if the direct reason of the collapse of
the Turkish 2000 stabilisation plan was a confidence crisis. With debt service burden as
it was, the only way to rebuild liquidity was to keep confidence high and watch the
capital flow in. In times of oil price jump and interest rate hikes in the US, this was ex-
tremely difficult, even without the added bonus of privatisation slips, political uncer-
tainty, and bank clean-up.
Foreign exchange reserves were an exogenous variable to the monetary policy, as they
usually are in an exchange rate anchor stabilisation programmes. Arguably, the central
bank could have issued Eurobonds for the sole purpose of increasing international li-
quidity in very early stages of the programme. This, however, would create competition
to the government financing, needed so much in the absence of deficit monetisation.
Section 4.9 The end of Argentine currency board
Argentines stabilisation attempt started in 1991, and thus lasted almost 10 years longer
than the Turkish one. There are two main hypotheses on the source of the Argentine cri-
sis. One, represented by Mussa (2002) is that the collapse was nothing else but a debt
- 148 -
crisis, caused by irresponsible fiscal policy pursued since the inception of the Converti-
bility Plan. Second explanation (see e.g. Eichengreen, 2001) blames exchange rate over-
valuation for the recession, fiscal problems, and the ultimate collapse
43
.
Mussa (2002) points to 12% of GDP public debt increase during the 1993-1998, years
of good, over 5% growth (with the exception of 1994). This happened despite signifi-
cant debt write-offs (Brady plan), and privatisation receipts. The public debt expansion
was faster than the sums of official budget deficits (scaled by nominal GDP growth)
could suggest. Off-balance sheet accounting was apparently prevalent, as in many other
countries. Such artificial lowering of the budget deficit could include denying sufficient
funding for state social security, local governments, health care, and other public of-
fices, and forcing them to borrow in the private sector (and outside of the central budget
accounting). Payment arrears are another method, but normally not used (with the ex-
ception of former Soviet Union countries) until serious crisis occurs
44
.

43
See the Appendix 1 for the extended chronology of the crisis, reproduced from Stan-
dard & Poors (2002), as well as Edwards (2002) for a more sketchy (but also more ana-
lytical) chronology.
44
The translation of budget deficits into debt accumulation is just one of concepts that
the budget deficit indicator tries to capture, which leads to additional difficulties. In
2003 Poland had five measures of budget deficit, all used in public debate on fiscal pol-
icy. First there were two official measures of deficit, and two European System of Ac-
counting 95 standard deficits (accruals-based) one of each not counting funded pen-
sion system subsidies. Then, there was the economic deficit, quoted by the central
bank (see e.g. NBP 2003) trying to capture the domestic demand impact of fiscal policy,
which treated G3 mobile telephony licence fees as financing items, similar to privatisa-
tion, and included estimates of social security and healthcare debt build-up, but did not
include government subsidies to the funded, obligatory pension plan. There is a debate
on the ways to account for the latter (see e.g. Eurostat 2004). There are three reasons
behind excluding such subsidies (filling the gap created in the pay-as-you go system by
directing some of the contributions to the funded part). One is that that pension fund
money represents savings, not dis-savings of the economy. Another is that in normal
times such subsidy is a self-financing item (pension funds keep up to 60% of their port-
- 149 -
The process of debt accumulation in Argentina, even if slower, looks remarkably similar
to the experience of Moldova or Ukraine. Hyperinflation and Brady plan helped Argen-
tina to start with relatively low public debt to GDP at 29% in 1993 (Mussa, p. 10).
While economic structure, and thus possibility of debt servicing of Moldova and
Ukraine had been far worse in than that of Argentina in early nineties, they started off
their independence with zero debt thanks to the fact Russia took over all communist era
debts (Radziwi, 2003). But both Ukraine and Moldova quickly caught up. Foreign debt
grew to 21% in 1993, 82% of GDP in 1998 and 129% in 1999 in Moldova (Radziwi,
2003), and to 38% in 1998 and 56% in 1999 in Ukraine. Argentina saw debt climbing to
41% of GDP in 1998 and above 50% in the following two years.
Mussa presents arguments why debt of that size was a problem for Argentina, while it is
generally considered not an issue for developed countries (average EU-12 debt in 2003
was some 10 percentage points higher than the 60% required by Maastricht), or coun-
tries aspiring to the developed market status (Poland and Hungary had 45.4% and 51%
debt-to-GDP ratios respectively in 2003, ING 2004).

folios in treasury bonds, see e.g. KNUiFE, 2004). The third reason is that the payments
(and the pension system reform) reveal implicit debt towards future pensioners, also
present in non-reformed systems of countries like Germany, or France. In judging rela-
tive compliance with e.g. Maastricht criteria, it makes sense to level the playing field,
and not punish the countries for pension system reforms. From the point of view of debt
sustainability though, the arguments are not valid, speaking for inclusion of the debt to
private pension funds in the public debt statistics. Private pension funds are not obliged
to buy government bonds (at least in Poland), so they could still refuse to roll-over gov-
ernment debt. Also, the implicit debt resulting from the promise of pension benefit pay-
ments is softer than the government obligation the regulations on the level of pen-
sions paid are not as clearly defined as the debt coupon and principal payments
(Rostowski, 2004).
- 150 -
First, the ability of the government to raise taxes in Argentina was low compared with
developed countries. Total tax revenue/GDP ratio was around 20% in Argentina, and is
close to 50% in both EU-12 and the converging Central European economies
45
.
As in the case of FSU countries, Argentine fiscal situation looked bad not only because
of the level of debt, but also the speed of debt accumulation. The fact that debt widened
by 12% of GDP in times of good growth, combined with higher growth risk characteris-
ing developing countries
46
, was making the situation look even less sustainable.
Second group of Mussas arguments concerned the fact that a large share of Argentine
debt was denominated in US$: Argentina faced the dual challenge of persuading credi-
tors that it was capable both of raising sufficient fiscal revenues to service its debt and
of being able to convert these revenues into foreign exchange with an exchange rate that
was rigidly pegged to the US dollar. (page 16). But this argument is wrong. Debt de-
nomination argument may have little relevance not only from the point of view peg sus-
tainability, but also, in the Argentine case, from the point of view of debt sustainability.
Standard view (see e.g. Eichengreen, 1997 p. 16) is that peso-denominated debt, for the
government, has the advantage of non-default exit strategy option of money-printing.
But it is not immediately clear, why investors losses coming from foreign currency
debt default should be bigger than losses coming from depreciation-induced fall in the

45
For this difference to influence crisis vulnerability it must be assumed that spending
can also be adjusted in the times of payments crisis. If the level of fiscalisation (spend-
ing to GDP) is sticky, the ability to raise more taxes increases the probability of a peg
survival only when the voters dislike for debt default could be higher than the prefer-
ence for cutting down on public healthcare, pensions, etc.
46
Growth variance in a sample of 55 non-industrial countries was 8.9 times higher than
in 22 industrial ones in 1990s
- 151 -
value of local currency debt. If the government is not able to generate enough real assets
to pay back, the investors will take losses either through depreciation or through pay-
ment arrears and debt rescheduling. Neither depreciation nor sovereign default is a bi-
nary event (see e.g. Easton and Rockerbie, 1999 for a model taking this into account),
and both the scale of monetary expansion and the extent of the arrears can be adjusted
gradually.
From the point of view of the local policymaker, conversely, it is not obvious that the
costs of deficit monetisation are lower than these of a sovereign debt default. The case
of Russia, which defaulted on its local currency debt underscores the dilemma the
Russian policymakers decided full-scale debt monetisation would be inferior to the de-
fault
47
. In short, restricting the definition of unsustainability of debt to outright default is
not the right strategy. The currency of denomination has little impact if we treat moneti-
sation of deficits as a partial default
48
.
What is the influence of the debt denomination on the peg sustainability? In the cur-
rency board case (or, in fact in case of any serious currency peg, entailing non-sterilised

47
The dilemma: monetise or default moves to another level when independent central
bank refuses to credit the government. Banking sector strain, resulting from defaulting
government can still force the central bank to bail-out the banking system, instead of the
government.
48
The typical way of disentangling the foreign exchange risk from the default risk is
comparing the dollar-denominated bond yields with local currency yields. The problem
with this approach is that the risk of outright default is smaller for peso-denominated
debt (the government may ask the central bank for local currency to pay back debt).
Foreign exchange risk internalises the default risk, provided the central bank does, at
some stage resort, to deficit monetisation. Therefore, foreign exchange risk estimated
this way would be biased downwards. The spread between the local and foreign cur-
rency debt is dependent on the non-default-related foreign exchange risks, and depre-
ciation expectations related to the monetary regime (e.g. in the crawling peg regime, the
- 152 -
interventions), withdrawal of funds from local treasury papers, either through their sale
to residents, or just refusal to roll them over, results in monetary tightening. This hap-
pens regardless of the currency of denomination of the debt. If the amount withdrawn is
higher than the stock of reserves available for non-sterilised intervention (which tends to
be less than the total stock of reserves Ukraine in 1994 and Sweden in 1992 were the
only countries in this case study which had the reserves falling to zero), the peg fails.
So, on a purely technical level, both foreign currency debt, and local currency debt
could trigger the peg collapse.
However, the composition of the public debt does make a difference for incentive struc-
ture for the government. While more foreign currency debt reduces government incen-
tives to devalue, more local currency debt increases incentives to do so. This simple re-
sult requires that the government has some degree of control over monetary, or ex-
change rate policy and that it considers the costs of default as higher than the costs of
inflation, but Mussas argument about conflict of foreign currency debt and a currency
board is not very convincing. Another reason why foreign currency debt is not making
the peg any less vulnerable is the fact that that the secondary market foreign-currency
bond transactions are neutral for the monetary policy. It does not need to be the case for
the local-currency bonds foreign investors getting rid of the sovereign local currency
assets are more likely to get rid of the local currency as well.
There is a long way from saying that the debt currency of denomination does not influ-
ence the probability of a peg collapse to saying that the existence of foreign debt does

change of the annual rate of parity devaluation should correspond to the lowering of the
local currency yields).
- 153 -
play a role in creating vulnerabilities. Falling governments creditworthiness translates
in such case translates into pressure on the currency (regardless of the denomination of
debt) capital flows out of the country via maturing foreign currency bonds or through
proceeds from the local currency bonds converted into foreign currency.
Fiscal problems were not the only ones troubling the Argentine economy. Eichengreen
(2001) lists several issues: poor growth, large exposure of local banks to sovereign debt,
and, the key issue, the real exchange rate. According to Eichengreen, inflation fell insuf-
ficiently fast given the nominal exchange rate anchor, which resulted in chronic current
account problems, later aggravated by /US$ and oil price movements. Wage rigidities
were too high for non-devaluationary adjustment of the real exchange rate. A quick look
at US$/peso exchange rate and annual inflation since 1995 reveals real depreciation: in
the seven years between 1994 and 2001, consumer price level rose mere 1.7% (with
constant US$/peso exchange rate). But these numbers do not give the full picture. Cu-
mulative inflation in the first three years following the 1991 stabilisation was 44% (yet
the currency board exchange rate set in Jan-91 was almost 70% weaker than a US$/peso
a month before), US productivity growth exceeded that of Argentina in the 1990s (Ed-
wards, 2002), the nominal DM/peso rate strengthened by over 20% in the period, and
Brazilian Real devaluation also undercut Argentine competitiveness in 1999.
While current account deficits in a fast-growing economy, following macroeconomic
reforms could well be sustainable, Argentina in the last three years ahead of the crisis
run an average 3% current account deficit amid investments falling on average 13.3%
per annum. This confirms the real exchange rate overvaluation problem.
Poor fiscal performance in the years of strong growth suggests that while both real ex-
change rate and fiscal policy factors were at play in generating the crisis, debt sustain-
- 154 -
ability problem was the most important in generating the crisis. A possible explanation
linking the two issues would be large budget financing needs resulting in crowding out
of private investments (resulting from upward pressure on real interest rates and compe-
tition for local bank funds). This slowed down productivity growth, making Argentine
economy vulnerable to external shocks hitting in 1999-2001 (/US$, oil prices, Real
devaluation). Resulting low growth accelerated debt accumulation, and further aggra-
vated interest rate burden on the private sector.
Argentines reserves/M2 measures were stable almost by definition. The currency board
ensured sufficient coverage of the monetary base. Reserves/M2 stayed between 25 and
30% between 1996 and 2000 to fall to 20% in the final run up to the crisis in 2001. De-
terioration of the reserves/short-term foreign debt indicator started one year earlier, fal-
ling to low 50% by the end of 2001. The level of short-term debt was below the 100%
danger level, throughout the nineties, which means that total loss of confidence would
force unlimited monetary contraction with the currency board intact.
The increasing prevalence of short-term debt in the run-up to the crisis could have
served as a vulnerability indicator, but the fiscal statistics makes the reliance on short-
term debt more similar to the FSU countries than to East Asian ones. Since the Mexican
crisis, reserves/short term debt fell below 75% and stayed there until the crisis. This was
happening despite the governments attempts to issue as much long-term bonds as possi-
ble, even as late as in 2000 (Mussa, 2002). In short, debt level and fiscal unsustainabil-
ity were inevitably leading to financing stops.
- 155 -
The Fig 62 shows that foreign currency spread on long US$ bond yields became totally
prohibitive only in mid 2001. The picture does not tell, however, how the spread would
change in response to increased borrowing. Argentina struggled with financing its
budget deficit starting from 2000, and additional debt, even for the sole purpose of pro-
viding liquidity, could push the cost of financing higher still.

Fig 62 Argentina Discount Brady bond zerocoupon spread (bps)
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
Jan
93
Jan
94
Jan
95
Jan
96
Jan
97
Jan
98
Jan
99
Jan
00
Jan
01
Jan
02
Jan
03
Jan
04
_
Section 4.10 Case study conclusions
The most striking feature of the recent currency crises is the existence of competing ex-
planation of the crises, the existence of several vulnerabilities reinforcing each other.
For example, Argentina and FSU countries were vulnerable to confidence reversals, re-
sulting from debt maturity structure, but the underlying problems were of a fiscal na-
ture.
Pure liquidity crises are rare; Ireland, Korea, possibly Malaysia and Indonesia could
be seen as such. It can be claimed that if everything is right in the country, low liquidity
does not have to be a problem. Without fiscal deficits (Bulgaria, Argentina, FSU coun-
tries, Italy, Finland), low growth (the UK, Finland, Sweden, Italy, Argentina), current
- 156 -
account concerns (Mexico, most of the East Asian crisis economies, Turkey, Argentina)
the crises would probably not happen. As Krugman points out, almost all countries are
guilty of one fundamental crisis cause or another; it is just that some of them are
unlucky to get hit by the crisis. Low liquidity makes luck dry out faster, especially if
some other countries experience crises at the same time.
But the cases described above do not convincingly show how to remedy the problem of
low liquidity. In the crisis extending liquidity is too costly. Before the crisis the possi-
bility of deliberate policy directed to keep liquidity high is there. But maturity structure
of the debt usually reflects fiscal, monetary and political trends. If these issues are not
addressed, extending maturity of the debt will only aggravate fiscal problems. For fis-
cally sound countries, however, there might be the case for policies explicitly targeting
liquidity: such countries included Mexico, Korea, Thailand, Indonesia and Malaysia
(with the latter taking into account foreign stock market investments as a potential
short-term liability of the central bank). Examples of such policies would be promotion
of foreign direct investments or explicit long-term sovereign borrowing to boost re-
serves relative to short-term debt.
- 157 -

Figure 63 Summary of the case studies
Country Main crisis cause Secondary issues Role of liquidity
The UK Overvalued exchange rate and weak
growth
Deep interbank markets,
vulnerability of the econ-
omy to interest rate hikes,
devaluations elsewhere
Ireland Pure self-fulfilling crisis, all exchange
rate consequences reversed in the next
two years.
Devaluations elsewhere,
high unemployment
Italy,
Finland
Excessive budget deficits, 1
st
generation
type
Growth collapse in Finland
Pure liquidity possibly an issue on a techni-
cal level (determining day and hour of the
collapse), but deliberate governments
bowing to the speculative pressure was
dominating any liquidity issues in the
longer horizon
Mexico Current account and real exchange rate
overvaluation
Low (albeit growing until
the first attack) re-
serves/short-term debt, low
reserves/M2. Accommoda-
tive monetary policy re-
sponse.
Level, not trends important for identifying
vulnerability before 1994. Reserves, used
up to finance current account deficit
throughout 1994 should have been supple-
mented by tighter monetary policy to allow
for smoother demand adjustment and
smaller depreciation.
Bulgaria Accelerating, monetised budget deficit.
1
st
generation crisis in a floating ex-
change rate environment.
Young transformation
economy, low trust in local
currency.
Very low reserves facilitated 1:1 transmis-
sion of monetised budget deficit into depre-
ciation. Managed floating impossible with
reserve level so small.
Thailand Capital account reversal sped up by
very high short-term external debt used
by finance companies for property
investments.
Poor bank and finance
companies supervision;
international trade compe-
tition, overvalued ex-
change rate.
Finance companies exposed to major matur-
ity mismatch with construction investments
collateral and short-term liabilities.
Indonesia High total private dollar debt with
short-term debt and annual debt service
costs exceeding 3x the available re-
serves leading to vulnerability to fi-
nancing stops
Political concerns, banking
sector supervision, falling
return on assets.
Reserve growth inconsistent with 1
st
genera-
tion crisis models, but reserve to M2 and
reserve to short term debt ratios low. Micro
fundamentals seem more problematic than
liquidity in crisis creation.
Malaysia High overall leverage and short term
debt of local companies making interest
rate defence of the peg too costly. Port-
folio capital outflow validated currency
weakness through its impact on stock
exchange, local balance sheets, and thus
investments.
High current account defi-
cit, crises in the rest of the
region.
Short-term foreign debt limited to the bank-
ing sector, and relatively small overall.
Foreign equity investments created vulner-
ability through the corporate and private
balance sheets
Korea Extremely low international liquidity,
and foreign debt made the financing
stop self-fulfilling through investments
crippled by shrinking balance sheets in
case of the falling stock exchange and
depreciating won.
Yen depreciation, falling
investment efficiency,
crises elsewhere in the
region
Central, short-term debt stimulated by bar-
riers for FDIs
Russia Excessive budget deficits Terms of trade shock,
Asian crisis a year before
Extremely high short-term debt/reserves;
trends in M2/reserves consistent with 1
st

generation models.
Ukraine Large public debt accumulation, ulti-
mately monetized
Crisis in Russia Very low short-term foreign debt.
Moldova Large public debt accumulation, ulti-
mately monetized, despite textbook
defence of the leu.
Crisis in Russia Very low short-term foreign debt relative to
reserves
Turkey The economy exposed to self-fulfilling
runs due to limited confidence in the
lira, bank confidence loss, political
uncertainty over stabilization pro-
gramme.
Oil price jump, US interest
rates hike, high current
account deficit.
Stabilisation period very short, not allowing
for liquidity targeting policy actions. High
reserves/M3 counterbalanced by low trans-
action demand for money and high oppor-
tunity cost of holding cash.
Argentina Excessive budget deficits soft budget
constraints for the provinces, leading to
fiscal sustainability problems
Real exchange rate over-
valuation, continuing re-
cession, /US$ fall
High reserves/M3, but relatively low re-
serves/short-term foreign debt (below 75%
in the 90s) accentuated refinancing prob-
lems in 2001.
Source: Author
- 158 -
Chapter 5 International liquidity targeting: a model
49

In this chapter I attempt to utilise an optimising policymaker model taking into account
costs and benefits of holding foreign exchange reserves to determine what level of li-
quidity countries should hold if reserves do protect from currency crises.
Section 5.1 Crisis and its costs
The model stands on somewhat empirical assumption, which, on one hand, may be
questionable from the strictly theoretical point of view, but on the other, is the most
widely used formulation in the literature on the leading indicators of the currency crises.
The assumption is that the probability of a currency crisis happening in time t (y
t
=1) is
equal to:

1 1 1
1 1 1
( )
( )
( 1)
1
t t t
t t t
l REER G
t l REER G
e
prob y
e

+ + +
+ + +
= =
+
(5.1)
where l is international liquidity (defined as a ratio of foreign exchange reserves to
short-term debt), REER is real effective exchange rate overvaluation, and G is the
budget deficit
50
. , , >0, <0.
While no foreign exchange crisis model yield the exact probability function, the formu-
lation above can be justified on two grounds. First, because most of the multiple equilib-
ria models say nothing about what contributes to the switch between them (a crisis),
such an ad-hoc assumption is not inappropriate; given the fundamental/liquidity vari-
ables are in the indeterminate region (see e.g. Chang and Velasco, 1999, Sachs et al.

49
An early version of this model was published as Szczurek (2003)
50
The function can be trivially extender to include other leading indicator variables
- 159 -
1996). Secondly, because the function is so widely used in the empirical study, it can be
claimed that it is believed by both policy-makers and the creditors to be true representa-
tion of the currency crisis risk. It suffices for the analysis of the policy-makers optimi-
sation that follows.
The functional form of the crisis probability function has powerful implications for the
policy options faced by the government/central bank. In particular, regardless of how
bad the fundamentals are, the central bank could come up with liquidity in t-1 suffi-
ciently high to prevent the crisis in time t, as shown in Figure 64. Probability of a run
[P(y=1)] is close to one when liquidity is low and fundamentals are bad (upper left cor-
ner of the graph). The ability to survive (for a short period of time) a massive specula-
tive pressure, even with bad fundamentals is a plausible assumption. It can be done,
provided the government has enough liquidity (and is willing to engage in unsterilised
foreign exchange interventions).
Figure 64 Probability of a crisis vs. international liquidity and a budget deficit
0
2.5
5
7.5
10
0
2
4
6
0
0.25
0.5
0.75
1
0
2.5
5
7.5
10
Budget deficit
liquidity
P(y=1)

Source: Author
More questionable is the policymakers ability to choose any desired level of liquidity.
The subject is discussed in the following section.
- 160 -
A crisis in period t results in real depreciation in the same period
51
. This is the only ef-
fect of the crisis on the fundamental variables. The scale of the crisis-triggered deprecia-
tion is assumed to be a function of the liquidity and the other country-specific variables
in t-1.
( )
1 1 1 1 t t t t t t
REER REER y l REER G

= + + + (5.2)
where , > 0; < 0 and y
t
is one when crisis occurs, and zero otherwise.
In the model this is the only possibility for the real exchange rate to move. A crisis and
devaluation/depreciation is possible even with undervalued real exchange rate, provided
international liquidity, or other fundamentals are bad enough. Formulation above en-
sures that the two consecutive crises in a country are possible, yet unlikely the worse
the fundamentals leading to the first crisis, the bigger the depreciation, and bigger the
improvement in the external stability outlook in the following period.

Here, I explicitly assume lack of three effects, which could make a crisis in subsequent
period more likely after a crisis in t. First is the feedback effect on the international li-
quidity. Even though crisis in t usually results in the outflow of reserves, this does not
have to result in a lower liquidity and higher probability of the crisis in t+1. If interna-
tional liquidity is defined (as in the empirical exercises that follow) as a ratio of reserves
to short term debt, the feedback effect depends on the scale of the capital outflow and
relative amounts of reserves and debt due. In fact, in the sample used, international li-
quidity increases one year after a crisis. While the numerator of the liquidity ratio (re-

51
Real depreciation is just one example of the reverse feedback from the crisis itself to
the crisis driving variable. It could also be current account, budget balance, or interna-
tional liquidity itself. The empirical study below shows that current account deficit
could easily replace (or supplement) the real exchange rate here.
- 161 -
serves) decreases during the crisis, so does the denominator short term foreign debt
usually falls very quickly towards zero.
Second ignored effect here is the loss of reputation of the policy makers. A currency
crisis, and subsequent devaluation/major depreciation can cause a severe loss of credi-
bility of the exchange rate regimes that follow. This can cause either runaway inflation
and further large depreciations or unsustainability of any exchange rate commitments,
and thus could make subsequent crisis more likely. An effect of a similar kind, but
working in the opposite direction is facilitation of reforms in the face of a currency cri-
sis, which could reduce the scope of crises in the future. Such a purgatory effect of a
currency crisis can be implemented by the government of the concerned country, which
can justify unpopular or painful reforms by either grave economic situation, or the con-
ditionality of IMF rescue packages. The recent experience, however, shows that the cri-
ses rarely have significant positive impact on the policies of the affected countries.
Antczak, Markiewicz and Radziwi (2003) argue that IMF was not very effective in
enforcing the effective use of its funds in the Former Soviet Union countries in the
1990s. Bulgaria and Hungary are probably the only examples of successful reforms fol-
lowing crises in the region.
Finally, the third ignored potential effect is the impact of the currency crisis on the
budget deficit. Crises could be related to increased pressure on some government spend-
ing, e.g. related to social support, bailouts, bank rescue operations, riot control, public
debt service costs. However, IMF conditionality and financing problems usually offset
the spending pressure. The assumption is justified by the estimations shown in Figure
73, which failed to confirm a significant link between crisis occurrence and future
budget deficits.
- 162 -
Apart from algebraic complication, waiving the first and the third assumption above
would increase the long-term value of foreign exchange reserves. Preventing a crisis in
time t would also help to prevent the crisis in time t+1 (international liquidity and
budget surplus would both stay higher without a crisis than with it), so any factor pro-
tecting from the crisis goes a longer way protecting also from subsequent disturbances.
The empirical data does not indicate the need to enhance the model by the inclusion of
the two effects. The credibility loss, while making future depreciations more likely,
would, in real world also reduce the social and economic costs of the future crises, as
economic agents get used to the increased depreciation and inflation risk.
A crisis in time t results in certain costs
t
to the economy and the policy makers. One
could argue that the cost should be some function of the severity of the crisis (or mis-
alignment of the fundamental variables and insufficient liquidity), reflecting the adjust-
ment costs (presumably higher with high current account deficit, high public debt grow-
ing in line with real exchange depreciation), distress to the banking system, etc. This
type of cost can be observed empirically as, e.g., the deviation of the post-crisis GDP
growth from its long-term trend. In some cases, the real economy part of cost
t
could
even be negative, as the UKs 1992 example showed.
The overall crisis cost to the policy-maker, however, includes a second type of cost:
reputation loss. It is much more difficult to assess empirically in an explicit way, no ex-
plicit form of the total crisis cost function will therefore be considered here. Presuma-
bly, the reputation cost is the function of the degree of the rigidity of the foreign ex-
change regime, and the length for which the regime was maintained, past inflation ex-
perience, but also personality of the central banker, behaviour of the countries consid-
ered similar (political contagion modelled by Drazen, 1999) etc.
- 163 -
The actual expected gain from the additional unit of reserves in t-1 is therefore:

( )
( )
1 1 1
1 1 1
( )
2
( )
1 1
( 1)
1
t t t
t t t
l REER G
t t
t t
l REER G
t t
E
P y e
l l
e

+ + +
+ + +

=
= =

+
, where
t
<0, (5.3)
which is the decrease in expected value of the policy makers crisis cost in t as a result
of the higher international liquidity in t-1. The convention adopted here sets crisis cost
t
below zero (so that higher liquidity would bring positive effects for the policymaker).
Apart from the liquiditys influence on the financing costs (considered in the following
section), this is the only benefit from international reserves in the model.
The marginal gain reflects the shape of the probability surface, and looks as in Figure 65
(assuming cost independent of REER).
Figure 65 Marginal return to international liquidity vs. liquidity and REER
0
2
4
6
liquidity
0
0.2
0.4
0.6
0.8
1
overvaluation
0
0.05
0.1
0.15
0.2
US$ c
0
2
4
6
liquidity

Source: Author
- 164 -
The peak of the marginal return to reserves is reached for higher levels of liquidity, as
the fundamentals get worse. The reason is that when fundamentals are really bad, a
marginal increase in liquidity from zero will not markedly reduce the probability of the
crisis. Alternatively, if the fundamentals are really good, an increase in already high li-
quidity will not reduce the probability of a crisis, because it is very close to nil anyway.
The level at which the surface is located depends on the expected crisis cost
t
.
Section 5.2 International liquidity and its cost
At each non-crisis point of time, the policy maker faces the following choice: he can
either keep his foreign exchange reserves (receiving international yield i* and benefiting
from the increased security it brings), or it can get rid of a portion of them using the
cash to pay off his foreign debt, avoiding paying interest i. I assume that when there is
no run on the currency, the policy maker can both easily borrow on the international
bond markets and lower its international debt up to the size of foreign exchange reserves
(to allow a possibility to vary international liquidity between zero to infinity)
52
.
The real alternative cost of the foreign exchange reserves is thus the difference between
the countrys international bond and US treasury yield, equal to i-i*, which is the coun-
try risk premium over the international borrowing rate. This is the only direct cost of
holding foreign exchange reserves. The way the reserves are acquired does not matter
for the policy makers choice it can always run down or increase reserves holding af-
terwards.

52
Concentrating on the policymaker avoids institutional complications, and division
of powers between the central bank and the government. In practice, the former has con-
trol over foreign exchange reserves, the latter over debt.
- 165 -
The formulation leaves open two important constraints. One is the ability to run down
on debt in every moment. In a hypothetical situation of all the debt maturing in a distant
future, and creditors unwilling to be paid back earlier (one of the reasons why this could
be the case is local institutional arrangements in creditors countries; some of the Paris
Club members debt agencies, including Belgium and France would have to pay taxes on
profits on debt paid back earlier), a country would not be able to freely reduce its inter-
national liquidity
53
. Also, a country with no external debt at all (and some foreign ex-
change reserves) would enjoy infinite liquidity with no way of running down on it! Even
more difficult would be influencing private external debt. In practice, because sovereign
debt does play significant role for most of the countries, there is a room for manoeuvre
in liquidity targeting. For countries that do not have long term sovereign debt to get rid
of, the alternative cost of their foreign exchange reserves for the policymaker is low
there is no way to save money by running down on liquidity. Optimum reserve holdings
would then be higher than predicted by the model in such case.
Second problem is the ability to borrow long term in order to boost international liquid-
ity. Countries in the middle of financial markets distress can rarely sell long-term for-
eign currency debt. From the model point of view, however, it is not a serious issue: the
ability to issue debt comes down to the proper (meaning high preceding the crisis)
yield, reflected in the market prices for existing debt.

53
Selling foreign exchange reserves for local currency is possible, but it complicates
monetary policy. Such option could indeed save money for countries suffering from
structural overliquidity in the banking system (where the central bank must constantly
extract cash from the market to keep desired monetary policy). In such case, selling re-
serves reduces the costs of regular central bank liquidity drainage operations.
- 166 -
Because of the definition of the international liquidity (reserves/short-term debt ratio),
the actual liquidity cost also depends on the total stock of short-term debt. Higher short-
term debt requires more long-term borrowing to cover it
54
.
The risk premium faced by the policy makers depends on the credit assessment by the
foreign investors, which is directly related to the probability of the crisis:
* ( 1)
t
i i P y = + = (5.4)
The rationale for this formulation is that currency crisis, while not affecting the foreign
currency debt directly, tends to be related to sovereign defaults. Local-currency value of
foreign debt rockets up in such case, which threatens the solvency of the government, if
the tax base does not follow. Liquidity problems are often in the roots of the currency
crashes and lack of local currency financing affects the external solvency as well. The
overall spread may also be affected by country-specific factors not related to the prob-
ability of the currency crisis (), likely to reflect past default cases, etc. This is a very
simplistic formulation; however, what really matters for the argument below is only the
average impact of higher liquidity on the spread. In the empirical research, the actual
data on interest rate spreads can be used, so the would be both country- and time-
specific to account for the set of factors other than the risk of a currency crisis
55
.

54
We ignore the fact that long bonds become short-term obligations, leading to a tempo-
rary increase in short-term debt in the future.
55
Another way would be to model the spread directly as a function of international li-
quidity. This, however would presumably have to be highly non-linear function of for-
eign exchange reserves (investors do not care if a county has US$200bn or US$230bn
reserves, whereas the difference between zero and 30bn makes all the difference be-
tween safe and an unstable economy.
- 167 -
Because an improvement of the credit assessment makes servicing the existing foreign
debt cheaper, the marginal, immediate cost of reserves
t
consists of two elements. One
is the cost of additional reserves, the other is the impact of lower interest rate (thanks to
lower crisis probability) on existing debt.

( ) ( ) ( )
( )
1 1 1
1 1 1
1 1 1
1 1
2
1
1 *
1
t t t
t t t
t t t
l REER G
t t t t
l REER G
t
l REER G
t
e l D i i l D
e
l
e

+ + +

+ + +
+ + +
( + + + ( +

= = +
+
(5.5)
where D
t
is the amount of foreign debt to be rolled over in t. It is the change in the total
cost of debt as a result of acquiring additional unit of liquidity. Because is less than
zero, it is possible that
t
falls below zero, given the existing debt is high enough. For
that to happen, the improvement of the countrys reputation, resulting from better li-
quidity, would have to offset the costs of keeping the borrowed funds as a war-chest.
Large financing needs increase the gains from lower sovereign bond spreads (as was
experienced by e.g. Italy in the final stages of nominal convergence ahead of the EMU),
but they also tend to pump up the spreads themselves.
I assume the level of taxation is constant, so an increase in international liquidity in t-1
increases G
t
by the cost
t
.
The immediate cost of reserves is not the only cost faced by the policy maker. Second-
round effects also play a role. There are two dynamic problems to worry about. First, is
the negative impact of debt servicing costs on budget deficit in the subsequent period
56
.

56
This cost can be negative in a special case, when marginal costs are also negative, i.e,
when the benefits of cheaper financing outweigh the cost of the additional unit of re-
serves.
- 168 -
To keep probability of the crisis in the following period unchanged, higher reserves
must offset the higher budget deficit, in line with the crisis probability equation (5.1). It
can be done by reserve borrowing higher by
t
, where and are parameters relat-

ing probability of the crisis with budget deficit and international liquidity respectively.
The cost of this offsetting operation is
r
t
+
+
1
1
, where r is the policy makers discount

rate.
Second cost is much less straightforward, and is related to the fact, that crises in t and
t+1 are not independent events. A crisis in t makes the subsequent crisis less likely, be-
cause of the real depreciation assumed in (5.2). Therefore, by borrowing reserves in or-
der to protect the country from a crisis in t, we make the crisis in t+1 more likely, be-
cause the probability of the cleansing effect of the crisis in t decreases. The amount of
the reserves needed to counterbalance the effect is equal to:

[ ]
1 1 1
1
( 1)
t t t t
t
l REER G
P y
l

+ + +
=
(5.6)
(5.6) is a probability weighted equivalent to (5.5); If the liquidity increase were to fully
protect from the otherwise certain crisis, real exchange rate overvaluation REER in the
following period would be higher by
1 1 1 t t t
l REER G

+ + + , in line with (5.2).
This makes the crisis in the following period more likely. As in the case of higher
budget deficit, to offset for this, the future reserves must be higher by the amount de-
pending on the probability-weighted lack of real exchange rate adjustment, scaled by
the parameters linking crisis probability with real exchange rate and international liquid-
ity ( and respectively).
- 169 -
To complete the analysis one should take into account higher debt service cost in subse-
quent periods caused by the above-mentioned additional borrowing. The cost of re-
serves in the future periods require additional borrowing in the periods to follow. The
marginal total cost MTC of reserves, therefore, is equal to:
( )
( ) ( ) ( )
1 1 1
1
0
( 1)
1 1 1
t
n
t t t
t t
t t
n
P y
l REER G
l
MTC
r r r

=
= | |
+ + +
|
| |
| = +
|
|
+ + +
|
\
|
\
(5.7)
The first term (
t
) is the immediate marginal cost of reserves; the second
( )
( )
1 1 1
1
( 1)
1
t
t t t
t
P y
l REER G
l
r

= | |
+ + +
|
|
+
|
|
\
is the cost of postponing the cleansing
effect of the crisis the term is positive with increasing reserves (provided the crisis
leads to real depreciation), as both and the probability of the crisis are smaller than
zero; the third term
( ) 1
t
r
+
is the cost of higher deficit associated with increased
reserves (it is again positive). Finally, the last part of the equation
( )
0
1
n
n
r
=
| |
|
|
+
\
takes into account the impact of the costs above on future budgets
57
.

57
The total marginal cost equation can be expanded to following,
( )
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
( ) ( )
2
4
2 2 1 2 2
1
L REER G
L REER G
e r G L REER r Cosh L REER G L Cosh L REER G Sinh L REER G
e r

+ + +
+ + +
2 + + + + + + + + + + + + + + + + + + + + +
+ + +
- 170 -
The discount rate r matters for the cost equations. Large r means that the effects of fu-
ture budgetary costs, and the lack of cleansing effect of the quick crisis do not bother
the policy maker much. The optimal r, which should be close to the inter-temporary
consumption discount rate (probably related to the average real interest rate), may be
completely different to the policy makers r. For example, if the government is on its
way to lose the elections, it could risk postponing the (almost) inevitable currency crash,
by borrowing foreign exchange reserves at a large cost, and making the crisis virtually
certain, but only after the elections. In such case, (5.7) collapses to (5.5).
Section 5.3 Optimisation problem
Combining the marginal benefit equation (5.3) and marginal cost formula (5.7) we are
able to complete the analysis. Optimising policy maker tries to minimise the following
loss function by targeting the liquidity level:
( )
( )
1 1
1 1 1
1 0 0
t t
l l
t
t t t
t
E
L l MTCdl dl
l
= +

(5.8)
First term of (5.8) is the total cost of reserves (the area below the cost curve in Figure
66), while the second is (minus) total benefit from a particular level of reserves (or li-
quidity).

where sinh(x) and cosh(x) are hyperbolic sine
2
x x
e e
| |
|
\
and cosine
2
x x
e e
| | +
|
\
respec-
tively
- 171 -
Figure 66 Optimal international liquidity marginal cost and benefit
1 2 3 4 5
Reserves/GDP
50
100
150
200
250
300
350
400
US$m
Cost
Benefit

Source: Author
Both definite integrals in the loss functions are solvable, but the result is totally intrac-
table, which makes algebraic solution to the optimisation problem impossible. Because
of this, the minimum must be sought numerically (see Appendix 2 for the Mathematica
5 code for minimising the loss function subject to liquidity parameter).
In the example above (and all of the empirical cases tried below), there are two local
minima. One is at international liquidity equal to zero. It is the global solution, if in-
creasing liquidity costs more than it brings (fundamentals are too bad for a slight im-
provement of liquidity to change the probability of a crisis). Countries in the middle of a
crisis fit in that category the borrowing costs for their long-term debt are likely larger
than the benefit of reduced likelihood of a crisis they could ever bring. The second loss
function minimum is at the point where downward sloping marginal benefit and mar-
ginal cost curves cross. The second local minimum is a global minimum only if L(l
t-
1
)<0. In the example above, this is the optimal level of liquidity: the total gain (which is
the surface below the marginal benefit curve) exceeds the total cost.
The model has several advantages:
- 172 -
It takes into account not only the obvious costs of liquidity, but also the dynamic
effects the costs of postponing the crisis. The effect is likely to be negligible
for relatively healthy economies, but significant for the ones faced with major
overvaluation of the real exchange rate. Admittedly, in the model formulation
estimated below, the effect was not sizeable. For an extreme case of zero poli-
cymakers discount rate, the effect would top 0.1% of GDP for the most affected
countries. For the more plausible 10% discount rate, the effect would be 0.09%
of GDP annually. This is because the fall in marginal crisis probability resulting
from higher liquidity is small. The secondary effects thus differ between the
countries solely due to the differences in costs of external borrowing.
Despite the complexity of the loss function, the model is relatively simple to es-
timate numerically. The benefit function (logit analysis of the reserves impact
on the probability of the crisis) is deeply rooted in the existing literature on lead-
ing crisis indicators. Similarly, data for the depth-of-crisis function, and interest
rate premium relationship is available for a broad range of countries.
Assuming the model is correct, it allows for an estimation of the reputation cost
of the foreign exchange crisis (which is the only residual variable in the whole
structure).
Section 5.4 Empirical application: Introduction
The above model was used for two empirical applications. First, we tried to estimate
what is the optimal (safe, and reasonably cheap best value for money) holding of
international liquidity. This requires assumptions regarding the perceived cost of the
currency crisis. This application requires estimation of the logit crisis probability equa-
- 173 -
tion, with binary crisis variable as the dependent variable, and a vector of explanatory
variables, including international liquidity, budget surplus, and a range of control vari-
ables. As a result, the marginal crisis probability decrease resulting from higher liquidity
could be evaluated - it would presumably be dependent not only on the level of liquid-
ity, but also on the range of other fundamental variables). In order to receive the fully
specified gain from reserves, this function must be multiplied by an unknown cost to
policymaker.
Second function needed to evaluate the optimal reserves holding is the liquidity cost.
Dependent variable is the spread of the foreign currency denominated sovereign bonds
of the country in a particular period of time, while the explanatory variables include the
fitted crisis probability, and a combination of control variables. The results of the esti-
mation are then plugged in the dynamic version of the cost equation (5.7).
Because it is not possible to solve the loss function analytically, the solution to the prob-
lem of optimal reserve holding requires finding the minimum of the loss function nu-
merically for a range of crisis cost parameter (see below).
Second application involve finding out what is the perceived cost of the currency crisis
to the policy-maker. By assuming the countries analysed hold optimal (from the point of
view of the policy maker and the model) international liquidity, we are able to estimate
how much the crisis is feared, or the total expected cost the currency crisis (including
the reputation cost), as viewed by the policymaker.
Section 5.5 Model calibration
The sample of the countries used for the empirical application of the model included a
panel of non-industrial economies in the 1990-2002. The exclusion of the developed
- 174 -
countries was dictated by the experience of the EMS crisis, in which the dominant li-
quidity variable was likely different than in the case of most developing or emerging
economies (reserves/M2 ratio rather than reserve/short-term external debt). Also, the
institutional arrangements of the EMU and cooperation between central banks of other
developed countries make the foreign exchange reserve stock a non-meaningful indica-
tor of assets available at a short notice. Data concerns on one hand, and lack of access to
the world bond markets led to exclusion of the least developed countries. For the final
estimation only the countries for which foreign currency bond prices were available
were used. See the Appendix 4 for the full country list used.
Section 5.5.1 Data
The macro data for the empirical section comes mostly from the IMF IFS CD-ROM.
The variables used were:
Crisis, crisis dummy. Two main classes of this variable have been tried (see Section 3.3
What is a currency crisis? above for references). The first was based on an exchange
rate depreciation threshold. In the benchmark case, Crisis equalled one if two conditions
were met. First, local currency had to depreciate at least 25% QoQ against the US$ in
one of the quarters of the year. Secondly, the depreciation had to be at least 10 percent-
age points larger than the average depreciation in the preceding four quarters. This con-
dition is necessary to filter out hyperinflation cases.
Second group of crisis definitions is based on EMP, exchange market pressure index,
defined as a weighted average of quarterly reserve loss (scaled by money+quasi
money), and exchange rate depreciation. In the base case, the weights were chosen to
equalise global variance of the two components (as in as in Eichengreen and Rose, 1997
- 175 -
and numerous other studies). Other specifications with equal weights given to reserve
losses and exchange rate movements were also tried. Crisis indicator was 1 when EMP
exceeded the country-specific mean by a threshold value (1.75% country-specific stan-
dard deviations in the base specification).
REER, a measure of exchange rate overvaluation. In the base specification REER
t
is as a
percentage deviation from a trend calculated using annual data until t-1. Restricting the
trend estimation period to the years preceding the period in question prevents spurious
importance of the real exchange rate overvaluation as a predictor of a crisis. After all,
crises do result in real exchange rate depreciation (as shown in the estimation of equa-
tion (5.2), shown in Figure 72). If the depreciated local currency persists long enough,
the REER ahead of the crisis would have to be higher than trend by construction. How-
ever, if the crisis is just a violent mean of bringing the exchange rate back to the funda-
mental value, there is no particular reason to restrict the estimation to the period ahead
of the potential crisis. Thus, an alternative specification included the whole 1980-2003
period (shorter for if data was not available) in trend real exchange rate estimation.
Positive value of REER means real exchange rate overvaluation.
CA, is the current account balance, as a percentage of GDP. It is a more direct measure
of external imbalance than the REER indicator above. Higher current account surplus
should reduce the risk of a crisis, while higher real exchange rate overvaluation should
increase the risk.
LLBIS, a measure of international liquidity, calculated as a ratio of foreign bank debt
maturing within one year (taken from BIS/OECD/WB/IMF database) to foreign ex-
change reserves. Alternative versions of the variable include M3/reserves (defined as
- 176 -
money+quasimoney, rebased to US$ at the year-end exchange rate). All liquidity meas-
ures are expected to reduce the probability of a crisis.
G, is budget balance as a percentage of GDP. Higher surplus is expected to result in
lower crisis risk.
Elections, is a dummy variable which is 1 when the country faces elections in a particu-
lar year. The data comes mostly from ElectionGuide.org and Psephos Adam Carr's
Election Archive.
GDP is real YoY GDP growth (in percent). The working assumption is that higher GDP
growth reduces the risk of a crisis by giving more political power to the policymakers,
helping to tackle fiscal problems or outright speculative attack.
SPREAD, benchmark bond spread over US treasury of the same maturity. This variable
was taken from ING Financial Markets database. For each country, a governments, or
semi-governments (like Korean Development Banks) bond with a longest maturity
was chosen. Year-end spread to the US zero-coupon yield curve was used.
Section 5.5.2 The results
The first step is to estimate the impact of international liquidity, budget deficit, and
other, control variables on the probability of a currency crisis. In the base specification,
the model uses FXCrisis (25% quarterly depreciation as a crisis definition).

- 177 -
Figure 67 Probability of a crisis as a function of key variables only
Logit estimates Number of obs = 366
LR chi2(4) = 13.11
Prob > chi2 = 0.0107
Log likelihood = -97.221245 Pseudo R2 = 0.0632

------------------------------------------------------------------------------
fxcrisis | Coef. Std. Err. z P>|z| [90% Conf. Interval]
-------------+----------------------------------------------------------------
llbis | -.0027063 .0016151 -1.68 0.094 -.0053629 -.0000498
reerlag | .0081712 .008348 0.98 0.328 -.0055601 .0219024
budgettogdp | -.0992664 .0490675 -2.02 0.043 -.1799754 -.0185575
catogdp | -.0255196 .0148287 -1.72 0.085 -.0499106 -.0011285
_cons | -2.171212 .3928533 -5.53 0.000 -2.817398 -1.525026
------------------------------------------------------------------------------

Marginal effects after logit
y = Pr(fxcrisis) (predict)
= .06603458
------------------------------------------------------------------------------
variable | dy/dx Std. Err. z P>|z| [ 90% C.I. ] X
---------+--------------------------------------------------------------------
llbis | -.0001669 .00009 -1.81 0.070 -.000318 -.000015 219.383
reerlag | .0005039 .0005 1.01 0.314 -.00032 .001328 -14.7304
budget~p | -.0061222 .00301 -2.03 0.042 -.011075 -.00117 -1.86167
catogdp | -.0015739 .00091 -1.73 0.084 -.00307 -.000077 -2.00767
------------------------------------------------------------------------------

Source: Author

Figure 68 Crisis probability as a function of all main variables

LR chi2(7) = 20.63
Prob > chi2 = 0.0044

------------------------------------------------------------------------------
-------------+----------------------------------------------------------------
llbis | -.0025036 .0018589 -1.35 0.178 -.0055613 .0005541
reerlag | .0083855 .009764 0.86 0.390 -.0076748 .0244458
budgettogdp | -.0787541 .0574131 -1.37 0.170 -.1731902 .0156821
catogdp | -.027093 .0152823 -1.77 0.076 -.0522301 -.0019558
gdpgrowth | -.0490748 .0516475 -0.95 0.342 -.1340274 .0358777
elections | -.3129361 .6040235 -0.52 0.604 -1.306466 .6805942
m3yoy | .0018843 .0009914 1.90 0.057 .0002535 .003515
_cons | -2.090355 .5260962 -3.97 0.000 -2.955706 -1.225004
------------------------------------------------------------------------------

= .05988693
------------------------------------------------------------------------------
---------+--------------------------------------------------------------------
llbis | -.000141 .0001 -1.44 0.151 -.000302 .00002 221.021
reerlag | .0004721 .00053 0.89 0.375 -.000404 .001348 -15.9713
budget~p | -.0044339 .00324 -1.37 0.172 -.00977 .000902 -1.92409
catogdp | -.0015253 .00086 -1.78 0.075 -.002933 -.000118 -2.05457
gdpgro~h | -.0027629 .00289 -0.96 0.339 -.007514 .001988 4.15183
electi~s*| -.016223 .0286 -0.57 0.571 -.063274 .030828 .192073
m3yoy | .0001061 .00006 1.75 0.080 6.4e-06 .000206 42.8585
------------------------------------------------------------------------------
(*) dy/dx is for discrete change of dummy variable from 0 to 1
Source: Author
- 178 -
Figure 69 Final benchmark model of crisis probability
LR chi2(5) = 19.33
Prob > chi2 = 0.0017

------------------------------------------------------------------------------
-------------+----------------------------------------------------------------
llbis | -.002734 .0017002 -1.61 0.108 -.0055305 .0000626
reerlag | .0045443 .0070016 0.65 0.516 -.0069723 .0160609
budgettogdp | -.0909478 .0507733 -1.79 0.073 -.1744624 -.0074332
catogdp | -.0246133 .014945 -1.65 0.100 -.0491956 -.000031
m3yoy | .0018947 .0009874 1.92 0.055 .0002705 .0035189
_cons | -2.267834 .4159016 -5.45 0.000 -2.951931 -1.583736
------------------------------------------------------------------------------

= .06640829
------------------------------------------------------------------------------
---------+--------------------------------------------------------------------
llbis | -.0001695 .0001 -1.76 0.079 -.000328 -.000011 222.707
reerlag | .0002817 .00043 0.65 0.513 -.000427 .00099 -15.1208
budget~p | -.0056386 .00311 -1.81 0.070 -.010752 -.000525 -1.88757
catogdp | -.001526 .00093 -1.65 0.100 -.003052 -1.5e-07 -2.10491
m3yoy | .0001175 .00007 1.79 0.073 9.7e-06 .000225 41.5509
------------------------------------------------------------------------------

-------- True --------
Classified | D ~D | Total
-----------+--------------------------+-----------
+ | 3 3 | 6
- | 26 314 | 340
-----------+--------------------------+-----------
Total | 29 317 | 346

Classified + if predicted Pr(D) >= .3
True D defined as fxcrisis != 0
--------------------------------------------------
Sensitivity Pr( +| D) 10.34%
Specificity Pr( -|~D) 99.05%
Positive predictive value Pr( D| +) 50.00%
Negative predictive value Pr(~D| -) 92.35%
--------------------------------------------------
False + rate for true ~D Pr( +|~D) 0.95%
False - rate for true D Pr( -| D) 89.66%
False + rate for classified + Pr(~D| +) 50.00%
False - rate for classified - Pr( D| -) 7.65%
--------------------------------------------------
Correctly classified 91.62%
--------------------------------------------------
Source: Author
The results above show three models. The simplest version includes only the variables
mentioned in the theoretical model (with the addition of the current account deficit). Us-
ing (lagged values of) REER, LLBIS, BUDGET deficit, CA surplus, the sample size is
the biggest: 366 observations, with 29 crisis occurrences. Current account, budget defi-
cit, international liquidity are all significant at 10%, all with proper signs (higher budget
and current account surplus, and higher international reserves relative to short-term debt
all reduce the probability of the crisis). Marginal effects (reported below the estimation
- 179 -
results) show that an increase of reserves by 1 percent of short-term debt at the sample
mean of 219% reduces the probability of the crisis by 0.017%. 1 percent of GDP lower
budget deficit reduces the crisis risk by 0.61% and 1% of GDP lower current account
deficit cuts the risk by 0.16%.
Adding control variables, lagged GDP and M3 growth and non-lagged elections dummy
does not change the parameters values much, but it does reduce significance of the key
variables. Removing GDP growth and election dummy (the former had the right sign,
but both were totally insignificant), yields the final version of the baseline crisis risk
equation reported in Figure 69.
The marginal effects are similar to those reported above, with budget having slightly
lower impact (0.56%), and LLBIS losing some significance. Money supply growth
faster by 1 percent increases the crisis risk by 0.011%. It is worth noting, that this effect
stands despite the crisis definition excluding the cases of long-lasting hyperinflation.
The results are not very strong (neither of the variables is significant at 5% level), and
the scale of effects is not economically dramatic at the sample mean. Money supply
growth and budget deficit are the most significant variables influencing crisis risk in the
model. The model suggests that a country with foreign exchange reserves at 30% of the
short term debt, and 6% budget and current account deficits has over 16% chance of ex-
periencing a currency crisis in any given year. However, the results, especially concern-
ing the liquidity indicator variables, are quite robust in terms of parameter value, which
is important for this calibration exercise
58
.

58
The liquidity impact on the crisis probability here is smaller by a factor of four, com-
pared to the results reported in Szczurek (2003). The difference between the two comes
- 180 -
Neither of the driving variables above (money supply growth, budget and current ac-
count deficits) is significantly influenced (unconditionally on the crisis occurrence) by
previous periods level of liquidity LLBIS. Figure 67 is a sample test for this. Current
account in t is autoregressive, tends to show a smaller deficit when budget is in surplus,
and, unsurprisingly a bigger deficit when GDP growth is higher. A currency crisis sig-
nificantly lowers the current account deficit. The international liquidity, however, is to-
tally insignificant in influencing the current account (as is the case with REER or M2
growth, not reported). This ensures the theoretical model does not underestimate the
benefits of the international liquidity by ignoring potential pass-through from liquidity
to other driving variables.

down to sample selection. Szczurek (2003) evaluates the crisis probability during the
crisis bouts (1994, 1997 and 1998). The sample here is not restricted to the global or
regional contagious emerging markets episodes.
Varying the crisis depreciation threshold from 25 to 20% reduce the significance of the
current account, while reducing the z statistics of budget and liquidity measures. The
parameter values remain robust. Stress testing of the model also involved using a differ-
ent crisis variable, which would take into account also the reserve changes. The results,
showed similar (and more significant) size of liquidity effect on crisis probability, twice
as high, but insignificant effect of the budget, and current account giving way to REER
as a more important crisis predictor. Reserves/M3 are generally a less reliable measure
of international liquidity than the reserves/BIS debt.
- 181 -

Figure 70 OLS results of the impact of liquidity, lagged fundamental variables and
crisis dummy on the current account (full sample)
Source | SS df MS Number of obs = 292
-------------+------------------------------ F( 8, 283) = 34.83
Model | 65379.0414 8 8172.38017 Prob > F = 0.0000
Residual | 66399.6141 283 234.627612 R-squared = 0.4961
-------------+------------------------------ Adj R-squared = 0.4819
Total | 131778.655 291 452.847613 Root MSE = 15.318

------------------------------------------------------------------------------
dca | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
empcrisis | 8.584769 2.504711 3.43 0.001 3.654541 13.515
reerlag | .0017893 .0234412 0.08 0.939 -.0443518 .0479305
m3 | -.0012467 .0044009 -0.28 0.777 -.0099093 .0074159
llbis | -.0018082 .0044923 -0.40 0.688 -.0106507 .0070344
budget | .3965856 .2369456 1.67 0.095 -.0698138 .8629851
ca | -1.056518 .0645418 -16.37 0.000 -1.183561 -.9294752
gdp | -.4788246 .1979822 -2.42 0.016 -.8685291 -.0891201
elections | -.9059621 2.517093 -0.36 0.719 -5.860563 4.048639
_cons | -.0934417 1.864917 -0.05 0.960 -3.764311 3.577428
------------------------------------------------------------------------------
Source: Author
Crisis dummies (defined both as major depreciation, and significant exchange market
pressure) significantly influence budget deficit, the current account, real exchange over-
valuation, and GDP growth, as expected. This seems to allow to use the general specifi-
cation of equation (5.2) (REER in response to crisis), extended to include other vari-
ables than just real exchange rate measure.
The OLS estimates in the sample restricted to the crisis occurrences are different to
those estimated for the whole sample. In particular, current account deficits increases
(CA goes down) with higher GDP growth and tend to revert to zero (significantly nega-
tive sign of the previous period current account parameter); but these variables become
insignificant and utterly dominated by the crisis occurrence (which reduces the current
account deficit by 4.5% of GDP). Of all the variables tried, the crisis dummy (constant
in the reduced sample) was the only one significant influencing the current account
change.
- 182 -
Real exchange rate overvaluation falls by one half, and the constant parameter points to
the additional 29 percentage point reduction of the REER variable in the crisis year. In-
terestingly, the current account deficit parameter has a wrong sign (pointing to faster
depreciation in a crisis for countries with smaller current account deficits) and is insig-
nificant.
Budget deficit is not significantly affected by the crisis (regardless of the sample size).
Unsurprisingly, elections in the year of the crisis worsen the fiscal position by an aver-
age of 7% of GDP. The result, while significant statistically, must be taken with caution,
as there were only three elections in the crisis sample.
On average, GDP growth falls in the year of the crisis, by about 7% in the sample be-
low. The following chapter deals with the output costs of the currency crises in more
detail. In particular, the output growth loss in the crisis year reported here is heavily af-
fected by pre-crisis growth trends. Taking into account long-term trends yields a much
lower growth impact of crises.
the current account (crisis sample)
-------------+------------------------------ F( 3, 18) = 0.78
Model | 24.5691127 3 8.18970423 Prob > F = 0.5200
-------------+------------------------------ Adj R-squared = -0.0323
Total | 213.358177 21 10.1599132 Root MSE = 3.2386

------------------------------------------------------------------------------
dca | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
m3 | -.0012952 .0011542 -1.12 0.277 -.0037202 .0011297
llbis | -.0078299 .0092843 -0.84 0.410 -.0273356 .0116757
elections | -1.7809 2.024014 -0.88 0.391 -6.033196 2.471396
_cons | 4.458154 1.551277 2.87 0.010 1.199041 7.717266
------------------------------------------------------------------------------
Source: Author
- 183 -

the real exchange rate (crisis sample)
-------------+------------------------------ F( 5, 16) = 4.64
Model | 6286.58182 5 1257.31636 Prob > F = 0.0083
-------------+------------------------------ Adj R-squared = 0.4642
Total | 10623.6907 21 505.890032 Root MSE = 16.464

------------------------------------------------------------------------------
dreer | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
reerlag | -.5310663 .2247821 -2.36 0.031 -1.007583 -.0545495
m3 | .0042323 .0061753 0.69 0.503 -.0088587 .0173233
llbis | .0625423 .0561286 1.11 0.282 -.056445 .1815295
budget | -.2260036 .7740251 -0.29 0.774 -1.866864 1.414856
elections | 29.14448 10.34971 2.82 0.012 7.204073 51.08489
_cons | -29.24335 9.112382 -3.21 0.005 -48.56074 -9.925965
------------------------------------------------------------------------------
Source: Author
budget deficit (crisis sample)
-------------+------------------------------ F( 5, 16) = 2.63
Model | 365.03143 5 73.006286 Prob > F = 0.0644
-------------+------------------------------ Adj R-squared = 0.2790
Total | 809.950897 21 38.5690903 Root MSE = 5.2733

------------------------------------------------------------------------------
dbudget | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
reerlag | -.0912139 .071995 -1.27 0.223 -.2438365 .0614086
m3 | .0002624 .0019779 0.13 0.896 -.0039304 .0044553
llbis | -.0163527 .0179773 -0.91 0.377 -.0544629 .0217575
budget | -.6599344 .2479109 -2.66 0.017 -1.185482 -.1343868
elections | -7.851061 3.314888 -2.37 0.031 -14.87831 -.8238128
_cons | .5140572 2.918586 0.18 0.862 -5.673068 6.701183
------------------------------------------------------------------------------
Source: Author
GDP growth (crisis sample)
-------------+------------------------------ F( 5, 16) = 0.67
Model | 176.683746 5 35.3367491 Prob > F = 0.6508
-------------+------------------------------ Adj R-squared = -0.0848
Total | 1018.49316 21 48.4996743 Root MSE = 7.2535

------------------------------------------------------------------------------
dgdp | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
reerlag | -.0753639 .0990304 -0.76 0.458 -.2852989 .1345712
m3 | .0021651 .0027206 0.80 0.438 -.0036023 .0079325
llbis | .0210043 .0247281 0.85 0.408 -.0314169 .0734256
budget | -.208041 .3410058 -0.61 0.550 -.9309411 .514859
elections | -2.028263 4.559687 -0.44 0.662 -11.69437 7.637841
_cons | -7.61359 4.014566 -1.90 0.076 -16.12409 .8969103
------------------------------------------------------------------------------
Source: Author
In light of the results above, the theoretical model should be revised to include either
current account alone, or a combination of current account and real exchange as the ad-
ditional variables both driving the crisis probability, and being influenced by it.
- 184 -
The final step is evaluating how sovereign spreads depend on the fundamentals and in-
ternational liquidity. For this purpose MODEL variable was created from the fitted val-
ues of the crisis probability equation. The results do not confirm the prior hypothesis,
showing that the direct impact of international liquidity on international bond spreads is
rather insignificant. Foreign public debt as a percentage of GDP is relevant though,
which alters the potential direction of the borrowing to increase liquidity on costs. 10%
of GDP higher foreign debt increases the costs of additional borrowing by 40 basis
points. The dominating factor by far, however, is the incident of a currency crisis not
surprisingly, international bond spreads go up by over 400bps in the year of the crisis.
Other variables tried included JP Morgans Emerging Market Bond Index+ as a meas-
ure of world borrowing conditions. The index proved to be insignificant in the annual,
panel formulation, even though much of the intra-year variations of the individual coun-
tries spreads can be explained to a large extent by the emerging market investors over-
all sentiment (not reported). Including the fixed effects for the annual data restricted the
within samples too severely. Measures of international liquidity, and the composite
measure of the crisis probability (model) had right signs, but proved insignificant in ex-
plaining the borrowing costs.
Figure 75 International bond spreads as a function of liquidity, currency crises and
foreign debt
-------------+------------------------------ F( 3, 76) = 6.61
Model | 3513981.28 3 1171327.09 Prob > F = 0.0005
-------------+------------------------------ Adj R-squared = 0.1757
Total | 16978575.8 79 214918.68 Root MSE = 420.91

------------------------------------------------------------------------------
laggedspread | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
llbis | -.1473485 .2761847 -0.53 0.595 -.6974181 .402721
laggedcrisis | 435.042 138.295 3.15 0.002 159.6036 710.4804
foreigndeb~p | 4.11251 1.895304 2.17 0.033 .3376851 7.887334
_cons | 252.1734 94.4107 2.67 0.009 64.13823 440.2087
------------------------------------------------------------------------------
Source: Author
- 185 -
The results thus require yet another amendment to the theoretical model. Increasing li-
quidity by means of additional, long-term borrowing is costly not only because of the
additional debt service costs, but also because of widening spreads. Paying back debt
with reserves, on the other hand, while reducing liquidity, tends to cut the costs of new
borrowing.
Two additional assumptions should be made for the final implementation of the model:
first, the policy makers discount rate r was set to 10% (the results were not very re-
sponsive to the changes in this variable, see below), and the reasonable cost of the
currency crisis. The latter was much more difficult to choose, as indicated in the Section
5.1 Crisis and its cost section above. We avoided the problem by presenting the whole
curve of optimal liquidity holding, dependent on the estimation of the prospective crisis
cost.
Section 5.6 Model application: best value for money liquidity
Before answering this question it is worth showing how much is at stake. Figure 76 pre-
sents an estimate of alternative cost of liquidity maintenance as percent of GDP. It is
calculated as the integral of the Equation (5.7) between zero and actual value of interna-
tional liquidity held. The figure is mostly correlated with the sovereign spreads, and to a
much lesser degree to the state of the fundamentals (responsiveness of the crisis risk to
liquidity changes). Venezuela, Bulgaria and Philippines pay the most for their reserve
stock, between 0.8 and 0.95% of GDP. Croatia pays the least, about 0.1% of GDP annu-
ally.
- 186 -
Figure 76 Annual costs of keeping foreign exchange reserves
0.2 0.4 0.6 0.8
%of GDP
Argentina
Brazil
Bulgaria
Chile
China
Colombia
Croatia
Dominicana
Hungary
Mexico
Philippines
Poland
Singapore
Slovak-Republic
Thailand
Uruguay
Venezuela
Median

Source: Author
What is the right level of international liquidity to hold? The answer depends very much
on the cost of the crisis the reserves are to protect from on how much the policymak-
ers risk. While the GDP cost of the crisis may be similar in all exchange rate regimes
(albeit the results of the following chapter deny even that) capital outflow, real depre-
ciation costs, etc. are also dangerous in a float (yet one could argue that some sort of FX
risk illusion keeps the real economys exposure to the foreign exchange risk larger in
fixed exchange rate countries), the reputation cost should be different. In the extreme
float case, the central bank ignores the foreign exchange fluctuations, however rapid and
large they are; the reputation cost should thus be set to zero. Another complication
arises due to the fact that the governments loss function is something completely dif-
ferent to the economys loss function, the former being influenced by the political cy-
cle.
The results of the next section do support expectations that currency regime choice in-
fluences policymakers aversion to the currency crises.
The models answers to the question what liquidity to hold is summarised in Figure 77.
Horizontal scale represents optimal liquidity (as reserves/short-term debt ratio) corre-
- 187 -
sponding to the assumed cost of the currency crisis on the vertical axis (as a percentage
of GDP). The figure includes charts for the sample analysed (the choice of the sample
was dictated by availability of foreign currency denominated bond spread data in the
snapshot year, which allowed for the calculation of reserve costs). The last chart is the
median country which is characterised by median current account, short term debt,
GDP, foreign exchange reserves, cost of borrowing, etc. The vertical line represents the
actual level of foreign exchange reserves relative to BIS-reported short term debt.
The calculation of the curves requires numerical integration of the cost and benefit
curves (see Figure 66) and finding the global minimum of the loss function (5.8) for a
range of crisis cost parameter (from 0 to 80% of GDP). For low values of crisis cost, the
optimum level of liquidity is zero (the negative results can hardly be implemented, as
negative value of liquidity happens only in the most extraordinary circumstances). Total
costs of keeping reserves are always higher than the benefits they bring in such case. If
borrowing costs are high enough, there is thus a discontinuity in the curve: the global
loss function minimum falls to zero for a range of small crisis cost values.
The results allow to judge the Guidotti rule
59
of keeping foreign exchange reserves
stock equal to the short-term foreign debt. First, for a median country the recommenda-
tion implies about 7% of GDP total crisis cost. This is in line with several crisis cost
studies (see references in the following chapter), and also in line with average GDP
growth loss in the year of the crisis estimated in Figure 74.

- 188 -
Figure 77 Optimal liquidity holding versus cost of the crisis, sample average.
16 18 20 22 24 26 28 30
-200
-150
-100
-50
0
50
100
150
Uruguay
10 15 20 25 30 35 40
-200
-100
0
100
200
300
Venezuela
6 8 10 12 14 16 18 20
0
100
200
300
400
500
Median
50 60 70 80 90 100
-100
-50
0
50
100
150
Singapore
6 8 10 12 14 16 18 20
-100
0
100
200
300
400
500
Slovak-Republic
6 8 10 12 14 16 18 20
200
300
400
500
600
700
Thailand
0 5 10 15 20
-200
0
200
400
600
800
Mexico
10 15 20 25 30
-200
-100
0
100
200
Philippines
6 8 10 12 14 16 18 20
200
300
400
500
600
700
Poland
0 5 10 15 20
-250
0
250
500
750
1000
1250
Croatia
10 12 14 16 18 20
-250
-200
-150
-100
-50
0
50
Dominicana
0 5 10 15 20
0
200
400
600
800
Hungary
6 8 10 12 14 16 18 20
-200
-100
0
100
200
300
400
Chile
0 5 10 15 20
400
600
800
1000
1200
China
6 8 10 12 14 16 18 20
200
300
400
500
600
700
Colombia
10 15 20 25 30
-300
-200
-100
0
100
200
Argentina
0 5 10 15 20
-600
-400
-200
0
200
Brazil
10 15 20 25 30
0
100
200
300
400
500
600
700
Bulgaria

Note: % of GDP crisis cost on horizontal axis, international liquidity as % of short-term debt on vertical
axis
Source: Author

59
Named after Pablo Guidotti, ex-Argentine deputy finance minister, who is credited
with it. The rule was later mentioned by Alan Greenspan, who advocated weighing re-
- 189 -
The 100% short-term debt reserves coverage rule, however, is too general, as both bor-
rowing conditions, and the state of the fundamentals varies considerably across the
countries in the sample (and, presumably, so does the expected total cost of a crisis).
The charts above show that the costs of keeping 100% liquidity can suffice to cover
from less than 1% potential crisis costs (Croatia) to over 80% of GDP (Singapore).
Section 5.7 Model application: How much policymakers fear the crisis?
The final empirical application of the model involves finding the cost of the crisis as
seen (or expected) by the policymaker. Assuming that the amount of international li-
quidity held by the central banks is rational (in the model sense), we can find out what is
the expected crisis cost by the policymakers. The process involves finding out the value
of - (implicit estimation of crisis cost by the policymaker) for which marginal cost
curve of the liquidity crosses marginal benefit curve of the liquidity at the level of actu-
ally held international reserves. The answer is given in the horizontal scale at the point
of intersection of the two lines in Figure 77.
Figure 78 Expected crisis cost to the policy maker, as of 2001
Country Implied crisis cost Country Implied crisis cost
Argentina 21% Mexico 4%
Brazil 11% Philippines 25%
Bulgaria 29% Poland 8%
Chile 11% Singapore 90%
China 3% Slovak Republic 11%
Colombia 6% Thailand 7%
Croatia 1.1% Uruguay 26%
Dominican Republic 19% Venezuela 31%
Hungary 4% Median country 9%
Note: Countries in Bold have fixed exchange rates, countries underlined have managed
exchange rates
Source: Author

serves and short term debt by their volatility.
- 190 -
Figure 78 shows the summary of the results, cost of the currency crises expected by the
governments and central banks of the countries listed, as of end-2001. Figure 79 shows
graphs of the 4Q01 liquiditys marginal cost and benefits curves of the countries in the
sample, as well as implicit expected crisis cost - (as percent of GDP).
Figure 79 Marginal liquidity cost and benefit curves in emerging markets
100 200300400 500600 700
LLBIS
0.002
0.004
0.006
0.008
%GDP
Uruguay
Actual Desiredliquidity: 76.9 82.9472
crisis cost at 26%of GDP
100200300 400500 600700
LLBIS
0.001
0.002
0.003
0.004
0.005
0.006
0.007
%GDP
Venezuela
100 200300 400500 600700
LLBIS
0.0005
0.001
0.0015
0.002
0.0025
%GDP
Median
100 200300400 500600 700
LLBIS
0.001
0.002
0.003
0.004
0.005
0.006
0.007
%GDP
Singapore
100200 300400 500600 700
LLBIS
0.0005
0.001
0.0015
0.002
0.0025
0.003
0.0035
%GDP
Slovak-Republic
100200 300400 500600 700
LLBIS
0.00025
0.0005
0.00075
0.001
0.00125
0.0015
%GDP
Thailand
100 200300 400500 600700
LLBIS
0.0002
0.0004
0.0006
0.0008
0.001
%GDP
Mexico
100200300 400500 600700
LLBIS
0.001
0.002
0.003
0.004
0.005
0.006
%GDP
Philippines
100 200300 400500 600700
LLBIS
0.0005
0.001
0.0015
0.002
%GDP
Poland
100200 300400 500600 700
LLBIS
0.00005
0.0001
0.00015
0.0002
0.00025
0.0003
0.00035
%GDP
Croatia
crisis cost at 1.1%of GDP
100200300 400500 600700
LLBIS
0.001
0.002
0.003
0.004
%GDP
Dominicana
100 200300 400500 600700
LLBIS
0.0002
0.0004
0.0006
0.0008
0.001
0.0012
%GDP
Hungary
100 200300 400500 600700
LLBIS
0.0005
0.001
0.0015
0.002
0.0025
%GDP
Chile
100200 300400 500600 700
LLBIS
0.0002
0.0004
0.0006
0.0008
%GDP
China
100200300400500600700
LLBIS
0.0005
0.00075
0.001
0.00125
0.0015
0.00175
0.002
0.00225
%GDP
Colombia
100 200300400 500600 700
LLBIS
0.001
0.002
0.003
0.004
0.005
0.006
%GDP
Argentina
Actual Desiredliquidity: 65. 68.1016
100200 300400 500600 700
LLBIS
0.0005
0.001
0.0015
0.002
0.0025
0.003
0.0035
%GDP
Brazil
100200 300400 500600 700
LLBIS
0.002
0.004
0.006
%GDP
Bulgaria

Source: Author
- 191 -
The results show a wide disparity of implied currency crisis cost to the policy makers.
The figures range from 90% for Singapore to 1.1% for Croatia. As should be expected,
currency board and fixed exchange rate countries do exhibit higher than average aver-
sion to currency crises: Argentina (21%), Bulgaria (29%) or Venezuela (31%) all had
fixed exchange rates. China is the exception here with its 3% implied crisis cost. Three
CE countries listed (Poland, Hungary and Slovakia) show close to average aversion to
crises (4,8 and 11% of GDP respectively). Singapore, with its managed float is by far
the most crisis-averse country in the sample (90%).
The power of the result confirming peggers aversion to the crises is lessened by the
dominance of financing costs in the implied crisis costs determination. Figure 81 shows
very high correlation of implied crisis costs and the cost of sovereign borrowing. Singa-
pore really stands out confirming its aversion to crises.
Singapore also stands out in another aspect the total marginal benefit that can be
bought by keeping higher reserves is the lowest in the group (because Singapore has
both current account and budget surplus). The cumulative gains from reserves for Sin-
gapore (integral of the lowest curve in Figure 80) are about one fourth of the average
country in the sample, and one fifth of Colombia, which is represented by the uppermost
curve in the chart below. Assuming 10% of GDP expected crisis cost, reserves being
seven times higher than short term debt bring almost 1.4% of GDP annually.
- 192 -

Figure 80 Marginal benefit from international liquidity for sample countries

100 200 300 400 500 600 700
LLBIS
0.00005
0.0001
0.00015
0.0002
0.00025
0.0003
0.00035
%GDP
Colombia
Singapore

Source: Autor
Still, the results below could suggest some other mechanism at work here. High correla-
tion of implied crisis costs and sovereign spreads could indicate countries targeting the
level of reserves or liquidity, rather than crisis probability, as assumed in the model.
Figure 81 Implied crisis costs and sovereign spreads
y = 0.0002x + 0.0967
R
2
= 0.0795
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
0.0 200.0 400.0 600.0 800.0 1000.0 1200.0
Reserves/BIS ST debt (%)
I
m
p
l
i
e
d

c
r
i
s
i
s

c
o
s
t
Singapore
Bulgaria

Source: Author
- 193 -
If the central banks do not hold the reserves for the sole purpose of crisis protection, the
governments/central banks of the countries are not rational in the models sense. Model-
rationality may be far from the rationality though. Four interpretations (model short-
comings) immediately come to mind.
One is that the alternative cost of reserves is lower than suggested by the model. This
could happen if the policymakers had no control over the level of liquidity (no sover-
eign debt to pay back using reserves, or side-effect of countries attempts to combat
capital inflow - Singapore is a good example here again). In such case, the alternative
cost of the keeping reserves would be close to zero and the implied crisis aversion
would be biased upwards.
Second possibility is that international liquidity is actually much higher than suggested
by the data, e.g. thanks to international arrangements, stand-by agreements, etc.
The third possibility is that the policymakers discount rate is much higher than as-
sumed in the calculations. The second round effects included in the model, however do
not influence the cost of borrowing enough to explain the dependence of implied costs
on sovereign spreads. The impact of second round effects on expected crisis costs does
not exceed two percent of GDP.
Fourthly, the cost of holding official reserves is not always equivalent to the sovereign
spread. For example, Government of Singapore Investment Corporation has a mandate
to invest the countrys reserves in much higher-yielding (and more risky) bonds than the
US Treasuries. In such case, a country could actually earn on some of its official re-
serves, again, resulting in an upward bias in implied crisis cost.
- 194 -
Finally, and most importantly, crisis protection is not the only purpose of foreign ex-
change reserves and international liquidity. In particular, reserves are likely to be held
for operational purposes in the currency board countries, as modelled by Frenkel and
Jovanovic (1981).
Section 5.8 Conclusions
The chapter presents a model of optimal liquidity holding by the policy maker in the
spirit of Frenkel and Jovanovics (1981) inventory model of foreign exchange reserves,
in which optimal liquidity held depends on the fundamentals, international borrowing
costs, and the potential cost of the crisis to the policy maker.
The model presented in the paper appears to be a promising way to deal with costs and
benefits of international liquidity in the face of currency crises risk. The calibration of
the parameters (estimated over the sample of emerging market countries) confirmed in-
ternational liquidity (defined as a percentage of short-term BIS-reported debt) does in-
fluence crisis probability, as indicated in the majority of the leading-indicators litera-
ture. Other variables helpful in crisis prediction include budget deficit, money supply
growth and current account.
Estimation of the curve of reasonable holdings of the foreign exchange reserves, de-
pendent on expected crisis costs showed that the Guidotti rule of holding 100 percent
reserve coverage of short term debt is reasonable for a median country. It implies 7-8
percent of GDP crisis costs, which is on the upper end, but within the empirical esti-
mates range of post-crisis output loss (see Chapter 6). But the 100 percent rule gives
varying results for different countries, mostly due to borrowing cost differences. In par-
ticular, following the rule blindly would unlikely to be optimal for the countries with
- 195 -
easy access to world debt markets. Such countries could afford cheap protection by ex-
tending their debt duration by issuing long bonds for the sole purpose of liquidity man-
agement.
The model also allowed estimating the weight the governments/central banks attach to
the risk of a currency crisis. We found out that the policymakers of the countries ana-
lysed, behave, as if they predicted the prospective crisis would cost between 78% (Sin-
gapore) and 1.5% (Croatia) of the GDP. This result includes not only explicit budgetary
costs of the currency crisis, but also the reputation loss of the central bank, or political
losses of the government. To our knowledge it is the first estimation of this kind. The
range of the implied crisis cost for the analysed countries is extremely wide, and it while
it is related to the exchange rate arrangements (fixed exchange rate countries tend to
have higher implied crisis loss, in line with higher expected reputation loss of a large
currency depreciation), but it is also strongly related to the costs of external borrowing.
The extremely high Singapore result can be explained not only by high crisis aversion
of the authorities predicted by the model, but also by the macroeconomic and opera-
tional policies in the country.
The chapter leaves scope for further research. Main issues worth addressing include
enlarging the data sample (it was limited to the IMF IFS data in the paper, which re-
duced the sample to 24 in some equations), and combining the original Frenkel and
Jovanovics models specification (which takes into account reserve volatility) with the
one including the reserves as the crisis risk reduction tool.
- 196 -
Chapter 6 The output cost of currency crises
Section 6.1 Introduction
This chapter tries to evaluate the cost of recent currency crises. As indicated in the sec-
tion above, the notion of cost can include a wide range of issues, from output, through
political effects.
Fiscal and quasi fiscal costs can come from many different sources. One is higher debt
service cost related to higher local interest rates, increasing country risk premium, and
falling value of local currency. The actual long-term impact of crisis on debt service is
not totally obvious though, weakening of the nominal exchange rate accompanied by
equivalent jump in price level leaves real value of foreign debt unchanged, while wiping
out a portion of local-currency debt
60
. A currency crisis can (but does not have to) bring
lower tax intake due to output disruptions (if present). Finally, the crisis can force
higher spending as implicit and explicit government guarantees become due. The latter
issue includes banking sector bail-outs as well as corporate rescue operations.
Social consequences of currency crises could include higher unemployment and fall in
real wages (reported in most of the countries analysed by Baszkiewicz and Paczyski,
2003, with the exception of Latin American economies), decrease in wealth, health stan-

60
See e.g. Froot and Rogoff (1991) for an explicit model taking this into account. In the
sample of non-G7 countries analysed above, the crisis was related to the depreciation of
the real exchange rate, so this argument would not necessarily apply, depending on the
currency composition of debt. For example, debt to GDP rose more than quadrupled
between 1997 and 2001 in Indonesia (Baszkiewicz and Paczyski, 2003)
- 197 -
dards, education as a result of the above, or inflation-related wealth changes
61
. Argen-
tine placateiros movement of 2001-2004 show how crises can result in social unrest.
Many of the issues mentioned above occur only if output loss is associated with the cur-
rency crisis. The question of the GDP cost of currency crises is therefore of key impor-
tance. If the currency crises are violent, but still optimal way of removing imbalances in
the economy, there is little reason for the policy makers to worry about them (albeit
hedge fund managers would still have to care). Generalising such situation, however,
would be extreme there are strong theoretical reasons why crises do bring unnecessary
costs
62
.
Section 6.2 Crises and output: the theory
Balance sheet approach to currency crises (see Jeanne and Zettelmeyer, 2002 for the
framework encompassing several models of this kind) provides several possible chan-
nels of transmission between exchange rate depreciation and output loss. One channel,
described in Chang and Velasco (2000), and Rodrik and Velasco (1999) stresses real
investment liquidation costs associated with sudden reversal of confidence and capital
account reversals. In a sense, output loss and the currency crisis occurs simultaneously

61
Cutler et al. (2000) show rise in mortality rates followed currency crises in Mexico in
1980-2000, McKenzie (2003) analyses household survey data on various social groups
income impact of currency crises; Oxfam (1999) describes the effect of the Asian crisis
on education in the region
62
Which still makes it possible that there is no viable way to avoid crises. For example,
if insurance were not available, full protection against bank runs would require one to
one backing of the deposits with reserves. This would probably be suboptimal for the
economy.
- 198 -
in the crisis of this kind; both are influenced by the foreign creditors run on domestic
institutions. For this channel to work, a maturity mismatch is necessary.
Second channel (see e.g. Krugman, 1999) does not require maturity mismatch, but is
based on currency mismatch. It stresses the impact of exchange rate on corporate net
worth, and, consequently, the ability of firms to borrow and invest. Depreciating real
exchange rate increases the value of foreign-currency liabilities relative to the assets (or
stream of future income, denominated in the local currency). Even if affected firms do
not collapse, their investment potential falls together with their net worth, and so does
the subsequent output. A variant of such a source of economic contraction is banking
sector problem created by sudden depreciation. Bank losses resulting from large swings
in asset markets could translate into credit crunch, as banks capital adequacy becomes a
problem.
The third channel through which the balance of payments crisis could hit the output was
described by Obstfeld and Rogoff (2000). Sudden reversal or reduction of the current
account deficit results in traded goods becoming scarce forcing relative price adjust-
ments under plausible assumptions on short-term consumption and production trad-
ables-non tradedables substitutability. Because relative wages in non-traded sector can-
not easily adjust to the lower level necessary to avoid unemployment, and due to in-
complete short-term purchasing power parity adjustments of the import prices, only an
extreme depreciation can ensure full employment and lack of output costs. Current ac-
count financing stops are not equivalent to currency crises, but often (see Goldfajn and
Valdez, 1999) associated with them, so the mechanism is relevant. However, in this
case, the larger the depreciation, the smaller the output impact of the crisis.
- 199 -
This underscores the fact that currency crises impact on output does not have to be
negative at all. The ERM-2 crisis of 1992 was a very good example of this in all cri-
sis-affected countries GDP grew faster in 1994 than it did in 1992 (albeit Italy, Spain
and Ireland did experience slowdown in 1993). The mechanisms described above show
that the balance sheet effects of even a quick depreciation could be positive: export ori-
ented economies, or otherwise ones not exposed to the currency mismatch can only
benefit from the depreciation. The positive reaction of the Brazilian stock exchange in
the day following the peg collapse in 1999 was the best example of the mechanism at
work.
As Forbes (2002) calls it, at the firms level, the crisis means that cheap labor meets
costly capital. The net impact depends on relative labour and capital intensity on one
hand and on the firms customers and prices on the other.
Osakwe and Schembri (1999) use a stochastic version of the Dornbush (1976) model to
show that a fixed exchange rate regime (long in place, but not collapsed yet) becomes a
source of increased output volatility. The argument goes that the prediction errors on the
future exchange rate increase together with the time spent under the peg and increased
probability of the collapse. Exchange rate prediction errors influence the output gap,
through its impact on the price level, not backed by eventual exchange rate movements.
Section 6.3 Empirical treatments
The empirical research on the impact of is much less common than the studies on the
causes, or leading indicators of the currency crises (Baszkiewicz and Paczyski, 2003).
There are several methods to approach the problem.
- 200 -
First is descriptive statistics: tracking the evolution of various variables in the crisis
window, run-up and in the period following the crisis. The data can then be aggregated
at different levels (regional, global, by the time of occurrence), and compared with the
evolution in countries not affected. The advantage of the method is the ability to analyse
the dynamics of a very wide range of variables with short track records, which is espe-
cially useful for transition economies. It allows for addressing the problem of underly-
ing trends masking the crisis impact (e.g. sharp recession in the run-up to the crisis
makes falling GDP after the crisis much less significant). The non-parametric nature of
the analysis may be a disadvantage, as little quantitative conclusions can be reached this
way. The examples of such analyses include IMF (1998), Bordo and Schwartz (2000),
Milesi-Ferretti and Razin (1998) or Aziz et al. (2000) and Baszkiewicz and Paczyski
(2003). The latter found out, that the output losses following currency crises in Latin
America tend to be much smaller than the ones observed as a result of currency crashes
in other regions. Their hypothesis explaining this regularity was that the economies in
South America are much better used to the bouts of hyperinflation and rapid devalua-
tions than those of e.g. South East Asia.
Second method is a detailed study concentrating on a particular episode of a crisis (pos-
sibly in various countries), or several episodes in a particular country. The use of com-
parable data, and the ability to use all the data available for a particular country is cer-
tainly an advantage, but overfitting (inability to generalise the results) is a problem in
such an analysis. Examples of such studies include Calvo and Mendoza (1996), Lane
and Philips (1999).
Finally, there is a group of various regression studies trying to explain output changes
by a combination of crisis and other variables. Such studies can be divided into two
- 201 -
groups, based on sample selection. One includes all countries in an extended time
frame, and tries to explain growth using a combination of crisis variables and other fac-
tors. Second group restricts the sample to the countries stricken by a crisis. In effect,
such studies try to explain the variation of growth impact conditional on the crisis hap-
pening, not necessarily the impact of the crisis itself, relative to the influence of other
factors. Rodrik and Velasco (1999) and Calvo and Reinhard (1999) are examples of
such a study.
The important issue that must be addressed in modelling the impact of crisis on output
are the underlying growth trends, and the influence of exogenous or country specific
variables on growth. The typical approach for tackling the possible autoregressive na-
ture of growth is to analyse changes in deviation from trend, instead of the growth level
(albeit it does make interpretations of the results slightly more difficult). Taking into
account lagged growth, country specific fixed effects, or both, are other ways, more
suitable for countries with extremely short track records (what really was the growth
trend in Russia in the 1993-1994 period, between the start of the transformation and the
first crisis?).
Apart from past growth trends, other factors, like world interest rates, real exchange rate
changes, openness, or budget deficits could be responsible for growth variations, and
they must be taken into account in the overall calculations.
Even though the majority of the studies focus on growth rate losses (either as a sum of
differences between actual and trend GDP growth level, the sum of differences between
actual and average in the period before the crisis as in Bordo et al., 2001, or as a pa-
rameter in the GDP growth equation), the approach is not the only one possible. First, if
the crisis is a result of unsustainable growth, the output losses calculated that way will
- 202 -
overestimate the real, long-term impact of the currency crashes. On the other hand, as
Mulder and Rocha (2000) argue, if the cut-off time for measuring crisis impact is in the
year when output growth rate gets back to the trend level, output will remain depressed,
compared with the theoretical value implied by no crisis and sustained trend.
Barro (2001) estimates his 5-year grouped panel regressions including a wide range of
fundamental growth factors, like education, health, investments, rule-of-law index. In-
clusion of the 5-year-group time effect constant is a way to (relatively cheap statisti-
cally) address the problem of exogenous global factors influencing growth. The non-
crisis variables are meant to provide a benchmark average growth estimate within the 5-
year window and the divergence from that level can be attributable to the crisis occur-
rence (and random error). Barro finds that in the sample of 67 countries the average
GDP growth was 2 percentage points lower for countries with the crisis during a 5-year
period. Hutchinson and Neubergers (2001) interpretation of the result (10% cumulative
output loss) is problematic though, because of the problem with such grouped panel ap-
proach: the crises occurring by the end of the 5-year window would presumably influ-
ence growth in the following 5-year period (luckily, with the exception of Brazil, 1999
was quite a quiet year in that respect).
Bordo et al. (2001) use the longest sample, spanning from 1880 to 1997 to find out that
the cumulative impact of currency crises stayed between 5 and 10 percent of GDP in
emerging markets, and around 2-3% in the industrial economies throughout this long
- 203 -
period. Interwar years were the exception with over three times higher average crisis
costs for both type of economies
63
.
After estimating a model explaining output deviation from Hodrick-Prescott filtered real
GDP (level), trend with real depreciation, money supply changes, budget deficit, world
output, and US interest rates, Moreno (1999) adds crisis dummies to the model. Real
depreciation in 6 East Asian countries under study proved to be contractionary in the
1975-1998 period, and the added currency crisis dummy was only marginally signifi-
cant in explaining output falls in East Asia.
Hutchinson (2001) looks at a group of 67 non-industrial countries, to find that crisis re-
duces GDP growth by less than one percentage point in the year of the crisis and
slightly more than one percentage point in the year after the crisis.
Hutchinson and Neuberger (2001) concentrate on emerging markets alone (with easier
access to capital) to find the effect of crises on growth higher in such countries. Balance
of payments and currency crises result in a (relatively evenly distributed) GDP growth
falls in the two-three years by the total of 5-8 percentage points. The authors control for
real exchange rate, world growth, budget surplus/GDP, money supply growth, and trade
openness, and a country-specific dummy.
Gupta et al. (2001), in a sample restricted to crisis episodes find that over 40% of the
crises in developing countries in the last 30 years have been expansionary. Average cri-
sis resulted in 1.2 percentage point lower growth in the two years following the crisis,
compared with the 3-year average tranquil period before.

63
Bordo et al. did not, however, include many structural growth-driving control vari-
- 204 -
The crisis output cost estimates thus vary from 1.2 to 10% of GDP, with the lowest cost
in industrial countries, and the highest in emerging market economies.
Section 6.4 Research concept and data used
This chapter is meant to accompany the liquidity holding analysis from Chapter 5
above. The aim is to contrast the currency crisis costs implied by the model (applied to
the set of emerging market economies) with the actual GDP losses modelled as a func-
tion of control variables in the sample of crisis-hit countries. The model can then be ap-
plied to the snapshot of counties in their recent (2001) state, showing the GDP loss in
case of a potential crisis. The results can then be deducted from the numbers in Figure
78, showing the goodwill loss expected by the policymakers in case of a prospective
crisis (expected crisis cost minus expected output loss).
This line of research suggests an analysis in the spirit of Rodrik and Velasco (1999),
Gupta et al. (2001) or Hutchinson and Neuberger (2001), with the sample restricted to
the crisis episodes. The idea also requires the sample selection mechanism to be identi-
cal to the one employed in Chapter 5 above. In particular, in the baseline study, 25%
depreciation within a quarter is the threshold required for the crisis to happen.
Second complication is the issue of consecutive crises. While it was not crucial to deal
with it when choosing international liquidity (on the contrary, the model stressed the
importance of the cleansing effect of crises and falling probability of subsequent ones),
it is not quite clear how to account for the costs of subsequent crises. Using the 25% de-
preciation threshold supplemented by the condition of depreciation higher than 10%

ables in their samples
- 205 -
compared with the average in the previous four quarters still yielded several cases of
multiple, escalating crises. These happen if the pace of depreciation increases fast
enough to jump over the 10% acceleration threshold.
64
In the analysis below, we assume
that the crisis costs cumulate. It is quite a strong assumption, and an unusual one (in
most of the early crisis warning, and crisis output impact studies, the data points includ-
ing the second occurrence of the crisis are simply excluded: see e.g. Frankel and Rose
(1996) or Kaminsky and Reinhard (1999)). But the cost cumulating assumption can be
defended. For example, the banking sector weakened by the depreciation could be fin-
ished off by the subsequent depreciation; credit crunch resulting from liabilities value
growing with depreciating local currency could well be aggravated with subsequent
step-depreciation. The same applies to the consecutive crisis defences, and related
jumps in nominal interest rates. Inclusion of a previous year crisis dummy variable
showed a significant and negative impact on output relative to trend, confirming that
two consecutive crises are worse for growth than one.
The dependent variable is a measure of output loss, calculated as a sum of deviations
from the Hodrick-Prescott (1980) filtered real output levels (estimated over the period
up to the year before the crisis) in the year of the crisis and the year after that.
Deviation of the output from long-term, country specific trend does eliminate the need
for substantial number of the control variables, or structural growth determinants.
Savings rate, investments ratio, population growth, workforce education, state of the

64
The cases of multiple currency crises included Belarus in 1997-2000, Brazil in 1991-
1994, Ghana in 1999-2000, Indonesia in 1997-1998, Mexico in 1994-1995, Mongolia in
1991-1993, Venezuela in 1994-1996 and Zimbabwe in 1997-1998. Some of them, due
to the data shortages did not make it to the final sample (including Belarus and Mongo-
lia).
- 206 -
legal or political system, should all be taken into account by medium-term output trends
(and, the intra-country time variations in fundamental growth-influencing variables
should not be substantial for the 15-years long sample).
The control variables should include either the factors changing rapidly and which could
have an exogenous but significant impact on growth, or the indicators of vulnerability to
sudden depreciation or speculative attack. The first group include world growth or in-
terest rates, domestic monetary policy stance (proxied by the level of real interest rates),
and the fiscal policy (budget deficit). The second group included international liquidity
(higher liquidity reduces the need to liquidate physical investments if financing stops
temporarily), foreign debt level (increasing the balance sheet impact of depreciation on
investments), exports to GDP ratio, imports to GDP (the former increasing the positive
output impact of depreciation, the later working in the opposite direction), and a meas-
ure of real exchange rate overvaluation ahead of the crisis. Bigger real exchange over-
valuation ahead of the crisis could offset the costs of the crisis with the benefit of re-
gained competitiveness.
Section 6.5 The results
The results confirm the common opinion that currency crises are costly in terms of out-
put. They are not universally costly though, as shown in the histogram of output loss
(compared with the trend). The average output loss in the year of the crisis was 0.56%
(with the hypothesis of zero output loss rejected at 92% significance level in favour of
negative output impact), while the average cumulative loss in the two years was 2.15%
(zero output loss hypothesis rejected at 99.98% level). The crises resulted in output loss
in 62% of the cases. Figure 82 shows a histogram of the output loss (dependent vari-
able) results in the sample.
- 207 -
Figure 82 Output loss in first and two first years of a crisis
0%
5%
10%
15%
20%
25%
30%
35%
40%
-14.7 -11.6 -8.5 -5.4 -2.2 0.9 4.1 7.2 More
Cumulative ouput relative to trend (%)
crisis year
first two years

Source: Author
The results of an OLS regression including all the variables are not very encouraging,
even though the model is significant overall (F=1.95). Just two variables stand out in
their significance: bisdebt being the (total, not just short-term) debt in the foreign bank-
ing system as a percentage of GDP, and the occurrence of a crisis a year before.
Figure 83 Output crisis cost in 2 years of the crisis; all variables
-------------+------------------------------ F( 9, 28) = 1.95
Model | 293.855467 9 32.6506075 Prob > F = 0.0850
-------------+------------------------------ Adj R-squared = 0.1880
Total | 762.240081 37 20.6010833 Root MSE = 4.09

------------------------------------------------------------------------------
cummloss | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
realrates | .0017254 .0033499 0.52 0.611 -.0051366 .0085874
budget | -.1362304 .1701797 -0.80 0.430 -.4848278 .212367
worldrates | .2279289 .7446795 0.31 0.762 -1.297478 1.753336
bisdebt | -.1056256 .0377298 -2.80 0.009 -.1829116 -.0283395
llbis | .0030208 .0044966 0.67 0.507 -.0061902 .0122317
ca | .1163642 .243194 0.48 0.636 -.381796 .6145244
importstogdp | .0515411 .1125727 0.46 0.651 -.1790535 .2821357
exportstogdp | .0458459 .1186125 0.39 0.702 -.1971208 .2888125
conseq | -2.373483 1.363342 -1.74 0.090 -5.100170 0.353201
_cons | -2.275739 4.200282 -0.54 0.592 -10.87963 6.328147
------------------------------------------------------------------------------
Source: Author
A more parsimonious version of Figure 83 is shown in Figure 84. It shows the overall
regression significant at 96.1% level, and earlier mentioned two variables: debt and past
- 208 -
crises being joined by exports to GDP as the most important drivers of output crisis
costs. Countries with 10% of GDP higher exports tend to suffer 0.9% lower GDP loss
during the crisis. Debt has an impact similar both in terms of size and the significance.
Foreign debt higher by 10% of GDP boosts the potential cumulative output loss during
and year after the crisis by 0.7% of GDP. Finally, contrary to the general research prac-
tice, currency crises effects do tend to cumulate: past crisis occurrence deepens the out-
put loss by almost 2%.
Figure 84 Output crisis cost in 2 years of the crisis; parsimonious version
-------------+------------------------------ F( 3, 39) = 3.74
Model | 182.417467 3 60.8058223 Prob > F = 0.0187
-------------+------------------------------ Adj R-squared = 0.1637
Total | 816.419427 42 19.4385578 Root MSE = 4.0319

------------------------------------------------------------------------------
cummloss | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
bisdebt | -.0746998 .0293192 -2.55 0.015 -.1340035 -.015396
exportstogdp | .0855215 .0315668 2.71 0.010 .0216717 .1493714
conseq | -1.967618 1.464066 -1.34 0.073 -4.928971 .993736
_cons | -.6731593 1.123671 -0.60 0.553 -2.945998 1.599679
------------------------------------------------------------------------------
Source: Author
Interestingly, the initial output costs (deviation of real GDP from the long-term trend in
the year of the crisis) model results point to a different set of variables. Figure 85 shows
the kitchen sink version of the model, equivalent to Figure 83, but with the dependent
variable including output deviation from the trend only in the year of the crisis. This
time, trade, current account, debt and liquidity indicators prove to be insignificant.
- 209 -

Figure 85 Output crisis cost in the year of a crisis; all variables
-------------+------------------------------ F( 9, 28) = 2.41
Model | 210.424325 9 23.3804806 Prob > F = 0.0363
-------------+------------------------------ Adj R-squared = 0.2551
Total | 482.283055 37 13.0346772 Root MSE = 3.116

------------------------------------------------------------------------------
growthloss | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
realrates | .0040934 .0025521 1.60 0.120 -.0011344 .0093213
budget | .229804 .1296517 1.77 0.087 -.0357754 .4953835
worldrates | 1.020454 .5673352 1.80 0.083 -.1416792 2.182588
bisdebt | -.0234258 .0287445 -0.81 0.422 -.0823063 .0354548
llbis | -.0015578 .0034258 -0.45 0.653 -.0085752 .0054595
ca | .1518196 .1852777 0.82 0.419 -.2277046 .5313437
importstogdp | .052898 .0857636 0.62 0.542 -.1227809 .2285768
exportstogdp | .0405455 .0903651 0.45 0.657 -.144559 .22565
conseq | -3.739563 1.350276 -2.77 0.010 -6.505477 -.9736487
_cons | -4.952114 3.199991 -1.55 0.133 -11.507 1.60277
------------------------------------------------------------------------------
Source: Author
Eliminating the insignificant variables showed results as in Figure 86. Exports to GDP
show the same impact as in the 2-year analysis, albeit the significance of it tends to be
higher. This result supports a view that emerging market economies export competitive-
ness gains appear quite quickly, but die out, due to domestic inflation.
Figure 86 Crisis year output loss; final model
-------------+------------------------------ F( 5, 34) = 4.25
Model | 186.777579 5 37.3555158 Prob > F = 0.0042
-------------+------------------------------ Adj R-squared = 0.2938
Total | 485.964165 39 12.4606196 Root MSE = 2.9664

------------------------------------------------------------------------------
growthloss | Coef. Std. Err. t P>|t| [90% Conf. Interval]
-------------+----------------------------------------------------------------
realrates | .0041487 .0022702 1.83 0.076 .0003099 .0079875
budget | .2263584 .1135088 1.99 0.054 .0344236 .4182932
worldrates | .7841101 .456905 1.72 0.095 .0115183 1.556702
exportstogdp | .0757109 .0243872 3.10 0.004 .034474 .1169477
conseq | -3.533595 1.226914 -2.88 0.007 -5.608214 -1.458977
_cons | -4.434481 2.423432 -1.83 0.076 -8.532321 -.3366406
------------------------------------------------------------------------------
Source: Author
1% of GDP lower budget deficit tend to be associated with smaller (by 0.23%) severity
of currency crises. This could have two explanations. One is that there are some non-
- 210 -
Keynesian fiscal effects at work: lower deficit increases private demand due to expecta-
tions for less taxation and higher external stability. Second, and a more plausible expla-
nation is that lower budget deficit brings less real economy disturbances in case of a
sudden financing stop (as suggested by e.g. Corsetti et al. 1999). Countries with sounder
public finances can afford to support the banks weakened by the crisis, or to ease the
pressure on the private sector by higher spending. Government facing default has little
choice but to tighten the fiscal policy in case of a crisis.
More intriguing is the positive effect of both world and domestic real rates on the crisis
year output. Domestic real interest rates influence on post-crisis performance is not
particularly large and could be a result of hyperinflationary countries distorting the
overall picture. Eliminating such observations reverses the sign, and reduces the signifi-
cance level of realrates parameter (while keeping other parameters mostly unchanged).
The influence of world interest rates is both significant and large, though: crises occur-
ring with world interest rates at a one percentage point higher level, result in costs lower
by almost 0.8%. While it could be argued that currency crises do occur more frequently
when world interest rates go up (as foreign financing becomes scarcer), the same argu-
ment apparently cannot be translated into higher crisis costs. One rationalization of this
result is that countries hit by a crisis in times of low US interest rates have deeper prob-
lems (years of missed investments stimulated by wrong policies, political crisis). High
world interest rates-induced crises are merely a symptom of portfolio reweighing, not
leaving as much influence on growth as the crises brewed internally. Monsoonal effects
(Mason, 1999) seem to matter more for exchange rate volatility than for growth.
- 211 -
Finally, conseq dummy, carries higher significance and weight than in the case of year
zero analysis than it was in the cumulative output impact model. This is because gen-
erally higher 2
nd
year previous crisis output loss adds to the initial year number.
Section 6.6 Crisis costs conclusions
The results of the study show that currency crises do bring non-negligible output costs
for the countries involved. In the emerging market sample analysed, the rapid 25% de-
preciation wiped out over 2% of the GDP on average. This result falls on the lower-end
of the past research results, partially because the sample used includes transition
economies, for which underlying (positive) fundamental changes often mask the nega-
tive crisis consequences. The main determinants of total crisis costs (estimated here as a
cumulative 2-year deviation from long term output trend) are external indebtedness (in-
creasing potential costs) and openness of the economy (decreasing it). Contrary to find-
ings of Rodrik and Velasco (1999), international liquidity had a much less significant
influence on crisis costs than the total amount of foreign debt. The results show the im-
portance of trade competitiveness, that can be regained by devaluation, and of the bal-
ance sheets problems, which could be aggravated by large external debt inflation. In
other words, Forbes (2002) cheap labor meets costly capital is confirmed by these
results.
The short-term impact of the crises seems depend on a different set of causes. In par-
ticular, higher budget deficit prior to the crisis, and lower world interest rates signifi-
cantly boost the year-zero output loss. Worse shape of public finances makes the gov-
ernment unable to address e.g. banking sector problems, while crises occurring with US
interest rates at a low level tend to indicate deeper adjustment needs troubling the coun-
try in question.
- 212 -
Combining the results of estimation with the results of the previous chapter yields the
non-output loss related implied total gain from holding foreign exchange reserves. For a
median country, such an implied goodwill loss from a crisis (which could include,
among others all the non-crisis related benefits of holding foreign exchange reserves,
reputation and political costs of potential crisis, the policymakers not actively managing
the level of liquidity) is over 7% of GDP, or over three times above the average output
loss in a crisis.
Figure 87 Expected output loss, and total implied crisis cost (% of GDP)
Estimated output
loss
Implied cost to
policymakers
Implied goodwill
loss
Argentina 3.8 21
17.2
Brazil 2.0 11
9
Bulgaria 2.5 29
26.5
Chile 1.5 11
9.5
China -0.4 3
3.4
Colombia 1.9 6
4.1
Croatia 2.5 1.1
-1.4
Dominicana 0.6 19
18.4
Hungary -1.3 4
5.3
Mexico 0.0 4
4
Philippines 1.3 25
23.7
Poland 0.1 8
7.9
Singapore 2.8 90
87.2
Slovak Republic -3.0 11
14
Thailand -0.4 7
7.4
Uruguay 3.2 26
22.8
Venezuela 0.3 31
30.7
Median 1.4 9
7.6
Source: Author
- 213 -
Chapter 7 Final conclusions
Since the early days of currency crisis literature, international liquidity took prominent
role in crisis modelling. Subsequent studies, both theoretical and empirical, showed li-
quidity is related one way or another to many kinds of currency crises. Low liquidity
can be a signal of incoming crisis (Krugman, 1979, Russia 1998), it can be a factor ena-
bling the crisis (Sachs et al., 1996a, Mexico 1994), or can be a key reason for the crisis
(Chang and Velasco, 2000, Korea 1997).
But the knowledge about importance of foreign exchange reserves gained in the last 15
years does not leave easy policy prescriptions. International liquidity is not a remedy for
countries patching their fiscal problems with money printing; neither is it a way out of
an ongoing crisis. The common reason for this is the cost of liquidity, which could eas-
ily aggravate fiscal problems, or to worsen the access to debt markets. The costs of
maintenance of the reserve stock could exceed potential output losses from a currency
crisis.
This work presents a model framework enabling the optimisation of the international
liquidity level subject to the foreign borrowing costs, and the countrys crisis vulnerabil-
ity. The results suggest the Pablo Guidotti rule of full coverage of short term debt with
foreign exchange reserve is not without merit, but it can lead to suboptimal results espe-
cially for countries facing either extremely steep or very low borrowing costs. On aver-
age the emerging market policymakers are willing to pay 0.3% of GDP to finance their
reserves, behaving as if they were pricing in 9% of GDP crisis costs, but the countries in
the sample pay from 0.05 to 0.9% of GDP annually to maintain international liquidity,
with the revealed crisis aversion ranging from 1 to 90% of GDP.
- 214 -
The model, despite considerable complication, still leaves several deficiencies which
could be addressed in further research. One is the assumption that the policymakers are
free to choose international liquidity as they please. In particular, decreasing liquidity is
not always feasible in a way described in the model, if a country has a low stock of
long-term debt. Another issue worth addressing is adding the risk of increased future
debt service costs as an additional, dynamic benefit of higher reserves, as suggested by
the simple sovereign spread determinants model. Finally, an extension including reserve
volatility as a factor calling for higher liquidity would constitute a promising way to
merge with Frenkel and Jovanovic (1981) approach to reserve level modelling.
The discussion about appropriate foreign exchange reserves is not an easy one not only
because of modelling or cost issues. Additional difficulty comes from the conflict be-
tween governments (worried about fiscal costs) and central banks (concerned about
monetary stability). It could explain the wide discrepancy between probability and ex-
pected output costs of currency crises and the costs of reserve maintenance. But the lat-
ter makes the debate worthwhile. If a developing countrys central bank pays its foreign
creditors 0.5% of GDP annually in order to keep the war-chest for bailing them out dur-
ing a crisis, it should at least know how bad the crisis would have to be for the invest-
ment to pay back.
- 215 -
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Appendix 1. Chronology of recent currency crises
Chronology of the Mexican crisis
January 1994 peasant rebellion in the Chiapas province.
February 1994 U.S. interest rates increase
23 March 1994 Assassination of the presidential candidate of the ruling party.
end of March April Financial turbulence in Mexico: exchange rate depreciates by
around 10% reaching the ceiling of the band, Bank of Mexico reserves shrink by 9
billion USD, interest rate rise significantly.
April December 1994 Government substitutes its short term peso denominated
debt with dollar indexed debt
21 August 1994 Ernesto Zedilo wins the presidential elections; interest rates fall
28 September 1994 Assassination of the ruling party leader
October November Capital outflow continues, Bank of Mexico reserves decline
by further US$4.7bn
1 December 1994 president Zedilo takes office.
20 December 1994 Finance Ministers announces widening of the exchange rate
corridor by 15%.
22 December 1994 Under pressure from financial markets the authorities announce
free floating the peso.
29 December 1994 Appointment of the new Finance Minister, a few days later an-
nouncement of the government economic program.
3 January 1995 IMF expresses its support for the program, announces the estab-
lishment of the Exchange Stabilisation Fund.
1st quarter 1996 economic growth (0.1%) resumes to average at close to 7% during
the follwing three quarters
Source: Paczyski (2001)
Chronology of the Bulgarian Crisis
March 1990 - Unilateral default of Bulgaria on its official foreign debt.
February 1991 - Beginning of partial reforms in Bulgaria: liberalization of some
prices, interest and exchange rates. Initial drop in output, beginning of rent seeking
through soft budget constraints due to lack of financial discipline and property rights
enforcement.
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28 July 1994 - First payment to the London Club according to the renegotiated for-
eign debt service agreement. Bulgaria started facing serious payments every six
months. The first major post-transformation instance of a hard budget constraint.
30 November 1995 - Acquisition of Agrobusinessbank by the BNB for BGN 1. Be-
ginning of explicit banking crisis, to be followed by many other liquidations of
banks.
March 1996 - Grain and bread crisis. Caused by rent seeking operations preying on
state controlled prices, the crisis led to loud public outcry and exacerbated the politi-
cal position of the government.
19 April 19 - The Bulgarian lev loses 2 percent of its value against the dollar in one
day. The beginning of the currency crisis, during which the Bulgarian lev depreciated
by 3500 percent in approximately 300 days.
17 May 1996 - The BNB put Mineralbank, a large state owned bank, and First Pri-
vate Bank, the largest private bank, under receivership. The banking crisis enteres its
trough. Trust in the system was shaken, flight from the Bulgarian lev began.
August 1996 - First tranche from a new agreement with IMF received. Temporary
slowdown in exchange rate depreciation and a pick up in privatization, predomi-
nantly of separate parts rather than of whole enterprises.
23 September 1996 - The BNB puts another 9 banks under receivership and adopts a
set of measures for recovering the financial stability. The set of measures announced
by the BNB did not remove the fundamental factors for the crisis and had no impact
on economic agents behavior and on macroeconomic turbulence.
26 October 2 November 1996 - Two rounds of presidential elections. The opposi-
tion candidate wins by a large margin.
6 November 1996 - An IMF mission proposes introduction of a Currency Board Ar-
rangement (CBA) as a was out of the crisis. A heated public debate in which the
government claims it had capacity to implement a CBA, while the opposition denied
the existence such capacity and political will.
22 December 22 1996 - Resignation of the government of the Bulgarian Socialist
Party. Beginning of a political crisis, in which the Socialist Party was trying to form
a government and the opposition and the public demanded early elections.
27-28 December 1996 - The Parliament votes to provide three BNB loans for a total
of BGL 115 bln., 6 % of 1996 GDP, to the Ministry of Finance. The stage was set for
hyperinflation during the first six weeks of 1997.
4 February 1997 - After a month of public protests and strikes, the Socialist party
gives up its attempts to form a new government. The newly elected President ob-
tained the opportunity to appoint a caretaker government and to set a date for early
elections.
12 February 1997 - Caretaker government appointed, new elections scheduled. Be-
ginning of a recovery program enjoying high public confidence and international
support.
14 February 1997 - Peak of the BGN/USD exchange rate. End of the currency crisis.
The US$/BGL starts falling.
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21 May 1997 - A new center-right government, enjoying an absolute Parliamentary
majority sworn in. Beginning of implementation of the reform package, starting with
the legislation setting up a CBA.
1 July 1997 - Official start of the Currency Board in Bulgaria.
Source: Ganev (2003), pp. 217-218
Chronology of Thai crisis
March 1997 - First explicit sign of trouble. BoT and MoF announce that 10 unnamed
finance companies would need to raise capital.
March-June 1997 - Public confidence in finance companies erodes. Deposit with-
drawals. Large and secret liquidity support from the authorities to 66 finances com-
panies.
June 1997 - BOT suspends 16 finance companies and announces that their creditors
are expected to bear part of companies losses.
2 July 1997 - The baht is floated, then it depreciates by 32 percent against U.S. dollar
during July. In the context of IMF program negotiations, BoT and MoF issue a joint
statement
August 1997 - detailing measures to strengthen confidence in the financial system.
Additional 42 finance companies have their operations suspended (altogether 58 out
of 91 finance companies) and are given 60 days to present rehabilitation plans to the
authorities. Government announces blanket guarantee to banks and remaining fi-
nance companies backed by unlimited FIDF support (in baht).
14 August 1997 - First Thailands IMF Letter of Intent.
20 August 1007 - The IMF Executive Board approves a three-year Stand-By Ar-
rangement, amounting to 4 billion U.S. dollars (505 percent of quota).
17 October 1997 - Emergency Financing Procedures by the IMF.
25 November 1997 - Second Thailands IMF Letter of Intent. MoF announces a clo-
sure of 56 finance companies.
December 1997 - BoT intervention at Bangkok Metropolitan Bank - capital of exist-
ing shareholders is written down, management is changed, and the bank is recapital-
ized by authorities via debt-equity swap.
8 December 1997 - First quarterly review of the policy package. Strengthening of the
program, implementation of addi-tional fiscal measures. Indicative range for interest
rates is raised, and a specific timetable for finan-cial sector restructuring is an-
nounced.
January 1998 - First Bangkok City Bank and Siam City Bank are intervened and
dealt with the same fashion as BMB in the previous month. These three banks ac-
count for about 10 percent of banking system deposits. A new state-owned commer-
cial bank, Radanasin Bank, is established in order to take control over the higher-
quality assets. A majority stake in Thai Danu Bank is acquired by foreign investors
(Development Bank of Singapore). Baht begins to strengthen against the U.S. dollar
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as improvements in the policy settings revived mar-ket confidence. Contracting do-
mestic demand helps to keep inflation in check and contributed to larger-than-
expected adjustment in the current account.
24 February 1998 - Third Thailands IMF Letter of Intent.
February May 1998 - Strengthening of baht.
March 1998 - Agreement on compensation reached with creditors of 42 finance
companies under rehabilitation program. Cautious reduction of interest rates viewed
as consistent with exchange rate developments.
4 March 1998 - Second quarterly review of the policy package. Under the revised
program, monetary policy contin-ues to focus on the exchange rate stabilization, with
interest rates to be maintained high until evidence of a sustained stabilization
emerged. The program includes measures to strengthen financial sector.
March April 1998 - Banks start to recapitalize with many foreign deals. New loan
classification and provisioning rules are introduced.
May 1998 - Additional 7 finance companies are intervened and merged with KTT (a
large government owned finance company).
26 May 1998 - Fourth Thailands IMF Letter of Intent.
June 1998 - Bank of Asia acquired by ABN-AMRO Bank.
10 June 1998 - Third quarterly review of the policy package. International reserves
strengthen in the larger-than ex-pected scope, but recession deepens. Adjustment in
fiscal policy allows for an increase in the fiscal deficit target for 1997/98 from 2 per-
cent to 3 percent of GDP.
June July 1998 - The exchange rate weakens. Fiscal and monetary policies have
been tighter than programmed, activ-ity is weaker than expected, and exports fail to
pick up. The large adjustment in current account re-flects a sharp compression of im-
ports. Growing difficulties in corporate sector.
August 1998 - Union Bank of Bangkok and Laem Thong Bank are intervened. Laem
Thong Bank is merged with Radanasin Bank. Union Bank of Bangkok together with
12 intervened finance companies merged with Krung Thai Thanakit (KTT), the state
owned finance company and subsidiary of the state-owned Krug Thai Bank (KTB).
First Bangkok City Bank is merged with KTB. Introduction of financial sector re-
structuring package..
25 August 1998 - Fifth Thailands IMF Letter of Intent.
11 September 1998 - Fourth quarterly review of the policy package. Foreign ex-
change market conditions are relatively stable (in spite of the Russian crisis), provide
room for interest rates lowering to pre-crisis level.
19 October 1998 - As of this date, 12.2 billion of U.S. dollars of total financing
package for Thailand (17 billion of U.S. dollars) has been disbursed, including 3 bil-
lion of U.S. dollars from the IMF and 9.2 billion of U.S. dollars from other multilat-
eral and bilateral sources.
1 December 1998 - Sixth Thailands Letter of Intent.
23 March 1999 - Seventh Thailands Letter of Intent.
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April 1999 - Establishment of Bank Thai from merger of Union Bank of Bangkok
and 12 finance companies.
May 1999 - Siam Commercial Bank raises over 1.5 billion of U.S. dollars in new
capital.
July 1999 - Nakomthon Bank is intervened.
August November 1999 - Auctions and further asset of finance companies sales to
the state owned Asset Management Com-pany.
September 1999 - Nakomthon Bank is sold to Standard Chartered Bank.
21 September 1999 - Eighth Thailands Letter of Intent.
November 1999 - The sale of Radanasian Bank to United Overseas Bank of Singa-
pore is finalized.
8 May 2000 - The IMF completes Final Review of the Thai stabilization program.
Source: Antczak (2001), pp. 52-53
Chronology of the Malay crisis
1997
28 March - Malaysian central bank restricts loans to property and stocks to head off a
crisis.
early-May - Japanese officials, concerned about the decline of the yen, hinted that
they might raise interest rate. Investors start gradual withdrawal from South East
Asian markets.
mid-May - The BNM defends ringgit with few days of very high interest rates.
2 July - Thai baht collapses.
8 July - Malaysian central bank, Bank Negara, has to intervene aggressively to de-
fend the ringgit. The intervention temporarily works (the currency slightly appreci-
ates).
14 July - Malaysian central bank abandons the defence of the ringgit and engages in
stabilizing domestic money market with relatively loose monetary policy.
24 July - Ringgit hits 38-month low of 2.65/US$.
26 July - Prime minister Mahathir blames George Soros and other "rogue specula-
tors" for the attack on the ringgit.
4 September, Ringgit breaks through 3.00/US$.
20 September - Mahathir tells the public, that speculation is immoral and should be
stopped.
1 October - Mahathir repeats his call for tighter regulation, or a total ban on forex
trading. The ringgit falls 4% in less than 2 hours to a low of 3.4/US$.
17 October - Malaysia tightens budget.
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5 December - Malaysia finally and radically changes its policy and imposes tough re-
forms in order to deal with a crisis. These include an 18% cut in government spend-
ing, restriction on large-volume import, on bank credit and in stock market regula-
tions. There were to be "no question of bailout" for financially ailing companies.
1998
January-February - Several increases in BNM's intervention interest rate were
planned to stop the currency from depreciating and restrict inflationary pressures
March - The severity of the crisis is gradually recognized and the fiscal policy
changes to more expansionary. The fiscal package of MYR3bn (1% of GDP) is an-
nounced and a drastic revision of federal budged aims the deficit of 2.6% of GDP.
July - Another additional fiscal package (MYR7bn, 2.5% of GDP) announced in or-
der to stimulate the economy.
January-August - Despite the austerity fiscal measures and firm monetary policy the
crisis and the capital outflow continues.
1 September - Malaysia introduces capital controls; financial investment can be repa-
triated only after a 1-year period. Rental and profits from sales can be repatriated.
1999
5 February - Malaysia replaces one year holding period with exit tax. Repatriation of
principal and profits will be subjected to a maximum levy of 30%.
Source: Sasin (2001b), p. 75
Chronology of the Indonesian crisis
1997
May - Thai currency comes under speculative pressure.
July - Thai, Malaysian, Philippine, and Indonesian currencies all depreciate.
14 August - Indonesia abolishes its system of a managed exchange rate. The rupiah
starts to depreciate
16 September - 15 government "mega-projects" are postponed.
8 October - Indonesia says it will ask the IMF for financial assistance.
31 October - Indonesia's IMF package is unveiled. It provides for more than
US$23bn in aid.
1 November - Sixteen banks are closed as the first step in IMF package, what causes
panic and bank runs among depositors.
5 November - IMF approves a US$10 billion loan for Indonesia as part of the mas-
sive international package.
5 December Aging president Soeharto takes 10 days rest after a 12-day world tour
and misses ASEAN summit.
9-12 December - The finance minister fails to negotiate the debt rollover in Wash-
ington.
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1998
6 January - Indonesia unveils an expansionary 1998/99 budget, contrary to IMF de-
mands of a budget surplus. The rupiah loses half its value over a five-day period.
9 January - Ratings agency Standard & Poor downgrades Indonesia's currency to
sub-investment grade status.
mid-January - Calls start for a change of the political regime.
15 January - Soeharto signs new IMF agreements.
January till mid-February - Anti-Chinese food riots take place in at least a dozen
places throughout Indonesia.
mid-January - All but 22 of the 286 companies listed on the Jakarta stock exchange
are technically bankrupt. Property companies are the worst shape.
27 January - Government announces a moratorium on repaying debts and interest,
and promises to guarantee all deposits of commercial banks.
February - Soeharto proposal of a currency board is announced, criticized and finally
turned down.
February - Talks with a steering committee of private bank creditors concerning the
restructuring of interbank and corporate debt begin
10 March - Soeharto is re-elected to a seventh five-year term with Habibie as vice
president.
4 May - Fuel prices are increased by up to 71 percent. Three days of riots follow.
9 May - Soeharto leaves for a week-long visit to Egypt.
12 May - The army troops shoot four students at Jakarta protest.
13-14 May - Rioting spreads throughout Jakarta. Estimated 1200 people die in two
days. When Soeharto returns from Egypt, he faces a flood of calls to resign.
21 May - Soeharto resigns and hands power to Habibie.
4 June - Agreement concerning debt restructuring is reached in Frankfurt.
17 June - The rupiah hits 17,000 against the dollar again.
29 July - The central bank certificates auctions system was improved and changed in
attempt to regain control over monetary aggregates.
24 September - Paris Club reschedules US$4.2 billion of sovereign debt. Annual in-
flation rises to 82.4 percent in September.
29 September - Indonesia strengthens bank recapitalization scheme.
October - Monetary stability gradually returns, inflationary pressure eases and the
rupiah stabilizes around 9000/US$.
10 November - Special session of the Parliament begins to discuss election and po-
litical reforms.
1999
13 March - Government closes 38 insolvent banks.
7 June - Indonesia holds first democratic election since 1955.
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6 August The finance minister admits there were "irregularities" in loan-recovery
process. The scandal prompts IMF and World Bank to threaten loan suspension.
1 October - Indonesia announces seventh month of deflation, with annual inflation of
1.25 percent.
20 October - Wahid elected as the president.
Source - Sasin (2001c), p. 99
Chronology of the Korean crisis
1997
January - The 14th largest conglomerate Hanbo Steel Co. goes bankrupt. The long-
term rating of three Korean banks with high exposure to Hanbo was lowered. Yet,
the sovereign risk for Korea did not deteriorate, indicated the clear separation of the
sovereign rating and rating related to the private financial institutions' problem.
March-April - Further defaults including those of the top thirty chbols including
Sammi Steel on 19 March and Jinro Group on 21 April.
July - Kia Motors asked its creditors for the workout agreement on its debt of US$8
billion to avoid receivership.
August - In spite of the intervention, the National Bank of Korea was not able to de-
fend the won exchange rate at the level of 900/US$. At the same time the govern-
ment announced its readiness to guarantee foreign currency liabilities of Korea's fi-
nancial institutions. This materialized on the 14 October, when the government in-
jected with money Korea First Bank and some other merchant banks.
Early October - various credit rating agencies downgrade Korea (S&P, Euromoney,
Moodys), because of the governmental decisions to rescue Korea First Bank and
undertake Kia Motors.
27 October - Bloomberg reports the free fall of Korean won raised concerns the
country would need IMF assistance. The government denies it.
29 October - Korean newspapers announce the bond market would be opened from
1998 to attract foreign investors. It did not prevent the currencys further deprecia-
tion.
30 October - Foreign press speculates that the Bank of Korea official reserves of
US$30bn did not include dollars sold through forward transactions as the Korean
government ordered banks to stop accumulating dollars.
8 November The government accuses foreign press of spreading unjustified ru-
mours about Korea.
18 November - Bank of Korea makes emergency loans to 5 major commercial banks
worth US$1bn, still denying it would need IMF assistance.
20 November - The currency band widened from 2.5 to 10 percent daily.
21 November - The minister of finance and the economy announced it would ask a
rescue package from the IMF.
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4 December - IMF Executive Board approves a US$21 billion stand-by credit for
Korea which, together with the World Bank, ADB and individual government loans
constituted US$58 billion.
Source - Baszkiewicz (2001), p. 121
Chronology of the Russian Crisis
2 July 1997 -Devaluation of Thai baht, beginning of the Asian Crisis.
July 1997 February 1998 - Containment of the main wave of the Asian crises, con-
tagion and spill-over effects. Devaluation or depreciation of currencies in Indonesia,
Malaysia, Philippines, South Korea.
October 1997 - Withdrawal of foreign funds from Russia. Dropping stock market in-
dices, increase in the CBR (Central Bank of Russia) and market interest rates.
11 November 1997 - Pressure on foreign exchange market. Widening the band of
rouble-dollar exchange rate fluctuation from 5 to 15 percent and introduction of
rouble central parity based on three-year average at the level of 6.2/US$. Heavy in-
terventions of the CBR in the foreign exchange market leading to decline in official
reserves by US$5.9 billion in 4Q1997.
February April 1998 - Preliminary arrangements reached among IMF and the
Asian countries, a new inflow of foreign capital to Russia. Lessening pressure on the
Russian markets. Decline in interest rates starting from mid-March, increase in stock
market indices. Foreigners in possession of approximately half of GKO/OFZ mar-
kets.
May June 1998 - Stock market crash in Moscow. Main RTS index drops by 40 and
21 percent in dollar terms in May and June, respectively.
End-June 1998 Major outflow of foreign capital from Russia. A decline in CBR re-
serves by over US$8 billion, increase in GKO/OFZ yields to 130 percent.
16 July 1998 - Signing a memorandum between the Russian government and the
IMF, which implied an introduction of radical stabilisation package under Prime
Minister Sergei Kiriyenko. Improvements in market moods in Russia.
11 August 1998 - Publication of report by the Japanese Agency of Planning warning
on the danger of crisis in Japan. Yen reaches the lowest level of 147.64/US$ and
Dow Jones Industrial Index drops by 300 points.
13 August 1998 - George Soros publishes a critical letter to the Russian government
in the Financial Times on the IMF program suggesting devaluation of the rouble
by 15-25 percent, introduction of currency board, and warning about the possibility
of crisis. Band wagon effect of withdrawal investors from Russia.
17 August 1998 - Devaluation of exchange rate band by over 33 percent, announce-
ment of 90-day moratorium on private external obligations and compulsory restruc-
turing of the domestic public debt. Trading of GKO/OFZ suspended, the rouble starts
to depreciate the beginning of currency crisis.
23 August 1998 - The government of Prime Minister Sergei Kiriyenko dismissed. In-
creased volatility in the markets.
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2 September 1998 - Abandoning of the exchange rate band. Depreciation of the rou-
ble by 20 percent to 12.8/US$ on 3 September.
September to end-October 1998 - Banking panic, bankruptcies of banks and financial
institutions. Industrial production down by 15 percent, import halve in dollar value,
rouble depreciates by 150 percent (since August), increase in CPI inflation to 7 per-
cent monthly. Beginning of full-fledged financial crisis.
Source - Antczak (2003), p. 255
Chronology of the Ukrainian crisis
Before the crisis
Mid 1997 Beginning of foreign portfolio capital outflows.
Autumn 1997 The NBU (National Bank of Ukraine) starts to participate in primary
market of government securities. Depletion of foreign exchange reserves of the NBU
from US$2,854m in August 1997 to US$2,374, in the end of 1997 and US$900m in
the end of August 1998.
October 1997 and January 1998 Changes in the parameters of the crawling band
(before the final abolishment of the system). Increase in general government deficit
from 3.4% of GDP in 1996 to 6.1% of GDP in 1997 and 7% in the first quarter of
1998.
November 1997 the NBU increases discount rate from 16% to 23.4%, then to 25%,
and finally to 35%
March 1998 IMF halts disbursement of its Stand-by credit due to the lack of pro-
gress in reforms and failure to meet the performance criteria.
17 August 1998 Beginning of the currency crisis in Russia
28 August 1998 Hryvna exchange rate reaches upper band of the corridor (sched-
uled for a change on 1 January 1999)
4 September 1998 IMF approves three-year Extended Fund Facility for Ukraine of
US$2.2bn
5 September 1998 The parameters of the exchange rate corridor realigned
Fall 1998 government and the NBU approve anti-crisis measures; restructuring of
government debt takes place
31 December 1998 Parliament approves 1999 budget
Q4 1999 Real GDP growth turns positive
July 2000 The last restrictions in the foreign exchange market abolished. A free-
floating exchange rate regime starts.
Source: Markiewicz (2001), p. 62
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Chronology of the Moldovan Crisis
January - August 1998 - macroeconomic situation in Moldova aggravated by declin-
ing GDP; interventions of National Bank of Moldova (NBM) supporting exchange
rate of leu; weak fiscal revenues and increasing interest rates on T-bills; inflation is
oscillating around zero.
August 1998 - Russian crisis results in capital flight from Moldova
August - October 1998 - National Bank of Moldova intervenes massively, selling
USD 81 million out of the total initial stock of USD 224 million of its gross interna-
tional reserves, exchange rate depreciates from 4.7 leu per dollar in the beginning of
August to 5.0 in mid-October, in real terms leu appreciates strongly against devalued
currencies of major trade partners (Russia and Ukraine).
September 1998 - monthly exports to Russia decrease by 80% in comparison to the
same month of the previous year, industrial output in Moldova down by 32.5%.
August - December 1998 - several ad hoc budget expenditures cuts introduced.
September-October 1998 - dramatic fall in the demand for government securities, de-
spite issuing 7-14 day T-bills rolling-over maturing T-bills becomes impossible;
NBM provides liquidity to the government in order to prevent the default on T-bills.
Second half of October 1998 - reserve requirement ratio raised from 8% to 25%,
commercial banks required to invest 10% of their assets into T-bills; leu continues to
depreciate, approaching 6.0 leu per dollar by the end of October.
2 November 1998 - NBM stops interventions at the Interbank Currency Exchange,
the official exchange rate being set as a weighted average of rates on banks' foreign
exchange transactions.
November 1998 - exchange rate depreciates to 9.5 leu per US$ and stabilizes; until
the end of 1998 it temporarily appreciates to 8.3/US$
November - December 1998 - monthly inflation rates averages 8%.
End of 1998 - beginning of 1999 - new reformist government appointed, memoran-
dum of economic policies signed with the IMF, situation on the foreign exchange
and T-bill markets stabilizes.
Source - Radziwi (2003), p. 291
The chronology of the Turkish crisis
1 January 2000 - The beginning of the 3-year disinflation program
August - Disagreement among ruling coalition, mainly over privatization issues
September - The anti-corruption drive accelerates, 2 banks are taken over, total num-
ber of banks closed within 2 years reaches 10
October-November - More shocking revelations about alleged asset mismanagement
in the banking sector.
November - The stock market begins to gradually decline
- 238 -
mid-November - Liquidity squeeze on the market, unnerved foreign investors start
selling Turkish assets
17 November - The central bank decides to intervene on the interbank market, inter-
est rates ease, but investors lose confidence, stock market collapse, panic begins
22 November - Panic reaches its peak, Turkish assets are dumped, capital outflows is
counted in several hundreds million USD daily
29 November - The central bank has already pumped US$3bn more than it was al-
lowed by the IMF agreement
30 November - The central bank decides to cut off liquidity support to save disinfla-
tion program, interest rates explode
2 December - Turkish government negotiates with the IMF
4 December - Interest rates reach unimaginable 1950%, while cumulative capital out-
flow exceed US$7bn
5 December - Rating agencies downgrade Turkey and Turkish banks, first news
about the IMF agreement leak to the public
6 December - Larger than expected IMF aid package is announced. The aid amounts
to US$7.5bn in addition to already available 2.9bn
mid-December, Capital markets calm down and investors regain confidence, interest
rates go down
16-22 February 2001, President Ahmet Necdet Sezer accuses the Prime Minister Bu-
lent Ecevit of challenging his decision further to investigate state-owned banks sus-
pected of corruption. The prime minister issues a statement that read - "The president
had directed a serious allegation at me () Of course, this is a serious crisis ()".
Within minutes, the Istanbul stock exchange dropped 10%, and overnight interest
rates jumped to from 40% to 100%. Turkish bankers immediately recognized that the
political crisis would bring an end to the ambitious disinflation program. ().
Around US$7.5bn withdrawn from Turkey in a single day.
The IMF warned that no new emergency loans would be granted for Turkey and ad-
vised devaluation but the government decided to continue defending the peg. Over-
night interest rates reached 6000%. Another 3 billion USD left the country before,
prompted by bankers' warnings against possible financial system collapse, the gov-
ernment finally decided to float the currency on Thursday, 22 February. The lira de-
preciates approximately 40%.
Source: Sasin (2001c), p. 97
Chronology of the Argentine crisis of 2001
This is a full text of the report reproduced from Standard & Poor's RatingsDirect, avail-
able at http://www.standardandpoors.com/europe/francais/Fr_news/Argentine-Chronology-of-
Events_12-04-02.html
- 239 -
Nov. 6, 2001Sovereign Default. The sovereign credit rating was downgraded to SD
on Nov. 6, 2001, following the government's decision to carry out a distressed debt
exchange.
Nov. 30, 2001Deposit Run. Total collapse of confidence resulted in the acceleration
of the deposit run. During the day, deposits decreased $1.8 billion (2.7%) and inter-
bank rates reached 900%.
Dec. 3, 2001Bank Deposit Freeze ("Corralito")/Foreign Exchange Controls. The De
la Rua administration imposed restrictions on deposit withdrawals, limiting with-
drawals from checking and savings accounts to $1,000 per month, although the funds
deposited could be used as a means of payment (electronic transfers, credit and debit
cards, and checks). All new lending granted by local banks had to be dollar denomi-
nated. Cross-border transfers were restricted to foreign trade transactions and credit
card international clearing, while transfers abroad to honor financial obligations were
subject to consent from the Central Bank of Argentina. No authorizations were
granted (decree 1570/01).
Dec. 7, 2001Foreign Exchange Controls: Export Repatriation Requirement. Pro-
ceeds of exports had to be transferred to Argentina, though funds could be main-
tained in the original currency, with no need of conversion into pesos. Central Bank
regulation specifically established that while certain cross-border transfers would
have "automatic" approval by the Central Bank (i.e., public debt service, delivery
versus payment operations resulting from securities brokerage), some others would
require Central Bank authorization (trade finance, private debt service; CB res.
3382). Still, no authorizations were granted.
Dec. 11, 2001Foreign Exchange Controls. The Central Bank communicated to fi-
nancial entities that they were authorized to make payments abroad to honor their fi-
nancial obligations due in December (CB telephone res. 3893).
Dec. 13, 2001Foreign Exchange and Trade Regulations. Some of the trade-related
transfer regulations were changed again. Proceeds of exports destined to pay the debt
service of future-flow transactions were exempted from the requirement of transfer to
Argentina, as was payment of obligations originated in prefinance and finance of ex-
ports with inflows into the Argentine financial system after Dec. 6. The changes fa-
cilitated the payment of exporters' financial obligations, while paying imports was
made more cumbersome. Under certain conditions, transfers abroad of funds that
were introduced into the financial system after Dec. 3 were authorized (CB res.
3394).
Dec. 20, 2001Presidential Resignation. Following riots, looting, and demonstra-
tions, Minister of the Economy Cavallo and President De la Rua resigned within a
few hours.
Dec. 21-26, 2001Banking Holiday. Banking operations were virtually nonexistent,
and clearing of operations was unavailable, as the Central Bank established bank and
foreign exchange holidays between Dec. 21 and Dec. 26, and then extended the for-
eign exchange holiday.
Dec. 24, 2001Presidential Appointment/Debt Moratorium. The National Assembly
appointed Rodriguez Saa as new president. In his inaugural speech, he stated that
payments on the Argentine external debt were to be suspended, and that devaluation
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and dollarization were not under consideration. Mr. Saa's economic plan included the
issue of a second currency (the "argentino").
Dec. 30, 2001Presidential Resignation. After a new round of demonstrations trig-
gered by the appointment of officials believed to have been involved in illegal activi-
ties in the past, as well as other worrisome political and economic signs, Rodriguez
Saa resigns.
Jan 2, 2002Presidential Appointment. Eduardo Duhalde was appointed president.
His term was scheduled to end in December 2003.
Jan. 6-10, 2002Banking Holiday/Peso Devalued. Banking operations were virtually
nonexistent and clearing of operations was unavailable as the Central Bank estab-
lished bank and foreign exchange holidays. Mr. Duhalde's new administration pro-
moted the end of the convertibility regime and established a dual foreign exchange
market. The official parity was fixed at Argentine peso (ArP) 1.4 per dollar (Eco-
nomic Emergency Law 25.561). Other provisions of the law include:
Pesification of most debts with original amounts below $100,000.
Freeze of tariffs and other obligations emerging from private contracts origi-
nally in dollars for 180 days, during which agreements and renegotiations
were to take place.
The government is to implement measures to preserve the dollar-denominated
savings of depositors trapped in the financial system. The law also entitles the
government to restructure the maturity of deposits as the financial system's
solvency evolves.
The government is entitled to impose a tax on oil exports to compensate
banks for the cost of pesification of assets.
The official market coexisted with a free market, although the government claimed
that its ultimate goal was a floating exchange-rate regime. Although the legal frame-
work was not clear-cut, according to some interpretations of the Central Bank regula-
tion of foreign exchange markets issued on Jan. 10, 2001, (CB res. 3425) cross-
border transfers were not prohibited as long as the issuers acquired the dollars in the
"free market"; that is, if the transfer did not imply a reduction in the Central Bank re-
serves. The free market was not deep, however, with scarcity of dollar bills and small
operations, which made it virtually impossible for companies to acquire the neces-
sary amounts of dollars to pay obligations abroad. In any case, because the free mar-
ket price of the dollar was much higher than the official parity (although the Central
Bank injected small amounts in the free market to cap the increase), this alternative
became increasingly costly for private entities. Additionally, the Central Bank in-
creased restrictions on the use of bank deposits as a means of payment, compulsorily
converting into long-term CDs (extending maturities up to four years) most deposits
(CB res. 3426).
Jan. 11, 2002Foreign Exchange Holiday Lifted. The government lifted the ban on
foreign exchange transactions that had lasted three weeks.
Jan. 23, 2002Bankruptcy Bill Passed by Senate. The Senate approved a new bank-
ruptcy bill, which if finally enacted, would not only unilaterally impose a morato-
rium on most private-sector foreign debt, but would provide debtors with significant
incentives and legal protection to default and restructure both local and foreign cur-
- 241 -
rency debt, leading to an indefinite delay in the restoration of credit for Argentine
firms. Moreover, the attempt to modify the Bankruptcy Law, a fundamental law,
through an improvised emergency bill, added uncertainty to the already critical eco-
nomic environment.
Jan. 30, 2002Bankruptcy Bill Modified by Lower Chamber. The Lower Chamber
approved the bill reforming the bankruptcy law that had been passed by the Senate
on Jan. 23. There was considerable pressure by multilaterals and other governments
for the Argentine government to veto the law.
Feb. 1, 2002Supreme Court Ruling on Deposits. The Supreme Court ruled against
the restrictions on deposit withdrawals in response to claims filed by certain indi-
viduals. On prior occasions, the Supreme Court had ruled in favor of the restrictions,
but after a period of continuous demonstrations against the court's members, and the
initiation of impeachment proceedings by the Argentine Congress, the Supreme
Court finally ruled in favor of lifting restrictions.
Feb. 3, 2002Banking Holiday/Economic Plan Announcement/Pesification of the
Economy. The Central Bank established a banking holiday for Feb. 4-5 to gain time
to solve the problems raised by the Supreme Court's ruling of Feb. 1, and to prepare
the banks to adjust to the new economic plan. The day's announcements included the
plan to fully float the peso starting Feb. 6, to lift restrictions on cross-border transfers
once multilateral financial assistance is granted, to lift restrictions on cash withdraw-
als of payroll accounts, to target a fiscal deficit of $3 billion for 2002, not to exceed a
monetary target of an additional $3.5 billion (newly printed currency) for the whole
year, and other measures concerning the pesification of the economy (decree
214/2002). The most important measures included in the decree were:
Pesification of all debts at the 1:1 parity, regardless of original amount or na-
ture, within or outside the financial system, including those transferred to
trusts. They are to be indexed according to inflation and a maximum interest
rate will be established by the Central Bank;
Pesification of dollar deposits at the 1.4 parity, also to be indexed according
to inflation. A minimum interest rate to be established by the Central Bank;
Despite the adjustment of debts and deposits to preserve purchasing power,
new contracts or obligations are not allowed to include indexation clauses;
The government will issue a bond to compensate banks for the difference be-
tween the rate of conversion into pesos of assets and deposits;
Depositors have the option to require the replacement of their dollar deposits
with a new dollar government bond, up to a maximum of $30,000. Banks will
have to transfer assets to the government sufficient to finance the obligation;
Dollar bills held by banks will have to be deposited in the Central Bank and
converted into pesos at a 1.4 parity. This clause effectively prevented banks
from selling dollars once banking activities restarted, and sought to make the
realization of the populace's desire to escape from the peso more difficult. Af-
ter considerable protests, this provision was reversed by a new decree the fol-
lowing day; and
All legal actions against the deposit restrictions are suspended for 180 days.
Although the government devised this provision to counter the Supreme
- 242 -
Court ruling, allegations of its unconstitutionality had already been filed in
local courts by Feb. 4. In any case, the legal framework remained uncertain
and from this date on, banks started to suffer considerable additional with-
drawals (estimated at $30 million per day for the system) when depositors
who had previously initiated legal actions approached banks with a court rep-
resentative to seize funds.
Feb. 5, 2002Banking Holiday. The Central Bank extended the banking holiday for
the rest of the week (until Feb. 8).
Feb. 8, 2002Foreign Exchange Controls and Trade Regulations. The Central Bank
issued new regulations on the foreign exchange market and trade-related transac-
tions, effective on Feb. 11. The most important measures concerning the foreign
exchange market were the following (CB res. 3471):
There will be only one foreign exchange market, in which the price of the
dollar will result from the free interaction of supply and demand.
Authorized entities will be able to sell dollars against peso bills.
Foreign currency will be sold against money deposited in the financial system
only when the transfer abroad is originated by expenses related to the promo-
tion of exports, trade-related transactions, the payment of financial obliga-
tions that don't require Central Bank authorization or in which the authoriza-
tion has been granted, or dividends with Central Bank's specific authoriza-
tion.
Cross-border transfers destined to meet the payment of the principal of finan-
cial obligations require Central Bank authorization for the following 90 days.
Indebtedness involving multilateral creditors is exempted from this require-
ment. As no reference is made to interest payments, cross-border transfers to
pay interest no longer require Central Bank authorization.
The most important measures concerning the trade related transactions were (Com
3473):
Collections resulting from exports, net of prefinancing loans, are to be liqui-
dated in the free foreign exchange market within the period established by
other regulatory entities. The pesos resulting from the liquidation of exports
proceeds will be deposited in sight accounts in the local financial system.
Imports will require a minimum financing period (from 180-360 days). Criti-
cal goods (i.e., medicine, certain raw goods, etc.) will be exempted from this
requirement and will be subject to be paid in advance.
Feb. 11, 2002Floating Exchange Regime. The peso started to float, the restrictions
on deposit withdrawals were effectively lifted for payroll accounts, and banks re-
sumed almost normal activity. The Central Bank suspended payment and prepayment
of loans for Feb. 11-13, however, with the sole exception of credit card financing.
The exchange rate closed at 2.15 pesos per dollar.
Feb. 14, 2002Duties on Oil Exports. Although strong lobbies against the tax on oil
exports created by the Economic Emergency Law 25.561 (Jan. 6) suggested that it
was not going to be implemented. The government finally signed a decree (decree
310/02) establishing a 20% duty on oil exports.
- 243 -
Feb. 15, 2002Bankruptcy Law Partial Veto and Signed into Law. The reform of the
bankruptcy law was signed into law by the president, after he vetoed some of the
provisions included in the bill approved by the Congress. In general, the new law
opted for the protection of debtors' rights over those of creditors, which, combined
with the pesification and restructuring of debts instructed by Decree 214 (Feb. 3,
2002), virtually forced all issuers into default, destroying the incentive structure
needed for a healthy credit culture and indefinitely delaying the restoration of credit.
The most relevant measures of the law were:
The exclusivity period during which firms that have filed for reorganization
proceedings (similar to filing for protection under Chapter 11) are entitled to
submit proposals to their creditors is extended from 30 to 180 days, and the
ceiling that the previous law set on the reduction in the original amount owed
that debtors could present was eliminated.
Judicial or extra judicial foreclosures are suspended for 180 days, including
those of mortgages and other pledged loans, and those provided for in the Se-
curitization Law. New bankruptcy requests were also suspended.
The section of the Bankruptcy Law governing "cram down" is eliminated.
This was an alternative that provided for the acquisition of troubled compa-
nies by creditors, which besides being a valid option for debtors and credi-
tors, discouraged abusive behavior on the part of debtors during the negotia-
tion period.
Feb. 27, 2002Agreement Between Federal Government and Provinces. An agree-
ment between the federal and the provincial governments was finally signed. The
agreement included the removal of the fixed amount that had to be transferred to
provinces (with the objective of sharing the costs of Argentina's deteriorating eco-
nomic activity with the provinces), the inclusion of 30% of the financial transactions
tax in the revenues shared, and the restructuring of the provincial debt. The last in-
cluded a plan to issue a central government bond to assume the provincial debt
(while debt service was to be discounted from coparticipation revenue), the pesifica-
tion of the debt at the exchange rate of ArP1.4 per dollar, and the instrumentation of
a still-undefined foreign exchange hedge for provincial multilateral debt. It was also
agreed that provincial debt issued in foreign markets was to receive the same treat-
ment as central government foreign debt. A precondition for the debt restructuring
was a reduction of about 60% in the provincial fiscal deficit. The new Coparticipa-
tion Law was to be passed by the end of 2002. A highly controversial issue that was
not included in the agreement regarded limiting the issuance of provincial currencies.
Feb. 28, 2002Inflation. During February, consumer prices and wholesale prices in-
creased 3.1% and 11% respectively, despite the continuing deep recession.
March 1, 2002Liquidity Reserve Requirements. The Central Bank changed liquidity
regulations, imposing a requirement of 40% for most deposits (CB res. 3498). Prior
to this change, "old deposits" had an average 18% requirement, while deposits ac-
quired from other institutions had a 100% requirement, since the Central Bank
needed funds to grant repos in the context of a flight-to-quality within the financial
system. With the new regulations, the Central Bank estimated a similar amount of li-
quidity reserves for the whole system, but ensured that banks would be more willing
to attract funds as they would not have to place 100% of new deposits in reserves.
- 244 -
March 4, 2002Government Bonds for Depositors and Banks/Pesification of Public
Debt/Duties on Exports/Foreign Exchange Controls/Other Economic Measures An-
nounced. The Minister of Economy announced a new set of measures. Most rele-
vant were:
Depositors will have the option to receive new government bonds in ex-
change for rescheduled deposits up to $30,000. Dollar depositors will be enti-
tled to choose between a peso bond or two dollar-denominated bonds. Both
new dollar bonds will have 10-year maturities: one with an interest rate of 2%
and principal payable in annual installments; the other with an interest rate of
Libor + 1%, both interest and principal payable at its maturity. The peso bond
is to be issued with a five-year maturity, indexed with inflation and a 3% in-
terest rate. The period to choose government bonds in exchange for resched-
uled deposits expires April 15. Banks will be able to reduce their exposure to
the Argentine government. In exchange for the reduction of liabilities that
will result from depositors choosing government bonds instead of deposits,
banks will transfer part of their public sector holdings to the Treasury. The to-
tal amount of original dollar deposits subject to be exchanged by dollar gov-
ernment bonds is approximately $35 billion.
A new peso government bond will be issued to compensate banks for the
asymmetric pesification of assets and liabilities (dollar loans were converted
into pesos at the 1:1 parity, whereas deposits were converted at 1:1.4). The
total amount of the compensation for the financial system is approximately
$15 billion.
All government debt issued under Argentine law (municipal, provincial, and
federal indebtedness) will be converted into pesos at the 1.40 parity and in-
dexed to inflation. Loans that replaced government securities in last Novem-
ber's debt exchange are also included. The total amount of public sector debt
subject to this pesification was aproximately $52 billion. Individual investors
and local pension funds afterwards filed legal actions against this measure.
Pesified loans will have maximum interest rates of 4% for individuals and 7%
for corporates.
Futures and forward markets will continue operating in dollars.
Banco Nacin is to establish a $1 billion credit line to finance certain produc-
tive activities (export financing, SME working capital, tourism, agricultural
sector, etc.). Other initiatives of this kind were said to be under implementa-
tion.
A general tax on exports was established (10% for primary goods and 5% for
manufactured goods). Collections of this new tax were estimated at about
$1.4 billion annually.
A new Central Bank regulation (CB res. 3501) removed the need to request Central
Bank authorization to make transfers to meet principal payments on cross-border
debt, if at least 80% of the maturing principal amount was refinanced for at least 180
days. This regulation provided both debtors and creditors with significant incentives
to restructure principal, as creditors could feel compelled to enter into these renego-
tiations to avoid the uncertainties regarding Central Bank approval to transfer funds.
- 245 -
March 5, 2002Federal Budget Approved. The Congress approved the federal budget
for 2002. The main assumptions of the law included a decrease of GDP and tax col-
lections of 4.9%, a fiscal deficit target of $3 billion (1% of GDP), and inflation of
14%. These assumptions did not seem realistic at the time of the approval, since tax
collections had already fallen by 20% both in January and February, and consumer
prices had increased 5.4% in the first two months of the year.
March 12, 2002Government Bonds for Banks. The government issued a decree (N
494) describing the new government bonds to be issued to compensate depositors up
to an amount of $30,000 (see description of terms and conditions under the set of
measures announced on March 4, 2002), and to compensate banks for the pesifica-
tion, including the reduction in equity caused by the banks' dollar-denominated
cross-border debt, which was no longer backed by dollar assets after the pesification
of the economy. Banks will be compensated by a peso bond for the difference of 0.4
that resulted from the conversion of dollar assets into pesos at the 1:1 parity, while
dollar deposits were converted at the 1:1.4 parity. Banks will be entitled to receive a
dollar bond to compensate the loss in equity caused by the dollar liabilities that were
not subject to pesification (mainly cross-border debt).
March 13, 2002Pesification of Economy Regulated. The Central Bank issued regu-
lations implementing the conversion into pesos at the 1:1 parity of most dollar-
denominated debts or contracts within the financial system or among private parties
(Com 3507). Besides the pesification itself, other important provisions of this
regulation were the following:
Debts originated from foreign trade transactions, future and forwards con-
tracts, and obligations issued under or ruled by foreign law are not subject to
pesification, and remain dollar denominated.
For a period of six months (from April 2 to Aug. 3, 2002), ongoing debt ser-
vice (both interest and principal) will maintain its original schedule and in-
stallments will be converted into pesos at the 1:1 parity. After this period,
these payments will be complemented by an additional amount that will result
from the application of the coefficient adjusting for inflation (CER), and from
then on, all new payments will be adjusted according to inflation.
From April 2 to Aug. 3, 2002, bullet principal payments will be granted a six-
month grace period and will be adjusted according to inflation.
Annual interest rates will be capped at 3.5% for pesified mortgages and 6%
for other guaranteed loans to individuals and companies. Annual interest rates
will be capped at 5% and 8% for other pesified unsecured debt.
Interbank loans will be converted into pesos at the 1.4 parity, except for those credit
lines destined to provide foreign trade financing, which will remain dollar denomi-
nated.
March 25, 2002Measures to Control Dollar Price/Foreign Exchange Controls. The
rising exchange rate (reaching ArP4 per dollar at one point) led the government to
impose a series of measures (mostly through the Central Bank) to control the price of
the dollar by inducing sales of foreign currency in the local foreign exchange market
by exporters and banks. Main measures were:
- 246 -
The Central Bank reduced the hours during which exchange houses could
open (CB res. 3530; which seemed counterproductive to the objective of
calming the population's desperate demand for dollars).
A Central Bank regulation established that the conversion of the export pro-
ceeds into pesos could not take longer than 10 days after the foreign currency
funds were deposited in the local bank involved in the trade transaction or
were made available in foreign accounts (CB res. 3534).
The Central Bank announced that all banks whose net foreign exchange hold-
ings exceeded 5% of equity had to reduce their position before Apr. 19, or
would be subject to penalties and prevented from operating in the foreign ex-
change market (CB res. 3511 and 3512).
A new Central Bank regulation established that the payment of both interest
and principal external financial obligations required Central Bank authoriza-
tion. In previous regulations, the restrictions were on the cross-border trans-
fers to meet principal payments of financial obligations (interest payments
did not require authorization), and not on the payment of the obligations
themselves. Therefore, if the bank or corporation had funds abroad, they
could be used to pay the obligations without requesting authorization. Al-
though the new language of the regulation would not leave room for that al-
ternative, when contacted, Central Bank representatives said that it had not
been their intention to require authorization for the "payment" of obligations,
but for making "transfers" to pay the obligations. Although the regulation was
addressed to banks, because corporations operate in the foreign exchange
market through financial institutions, all firms were potentially affected by
these new restrictions. In any case, the ambiguity of the text added to the
general uncertainty. The regulation also emphasized that the authorization
had to be granted for "financial obligations," implying that foreign trade
transactions were excluded from this new requirement (CB res. 3537)
March 26, 2002Foreign Exchange Controls. The Central Bank announced that the
regulation that had been issued the day before regarding new restrictions on cross-
border transfers (CB res. 3537) was to expire 30 days after its publication (CB res.
3543). This announcement was just another indication of the degree of improvisation
in the implementation of new measures.
March 29, 2002Inflation/Tax Collections. During March, consumer prices and
wholesale prices increased 4% and 11.2%, respectively, accumulating increases of
5.9% and 25.7% for the first quarter and seriously diminishing the purchasing power
of salary, thus contributing to increased social tensions. Tax collections decreased
only 7.3% against the previous year, which implied an improvement from January
and February figures (negative 20%).
April 3, 2002Social Plan Announced. The government announced a plan of subsi-
dies for the unemployed (decree 565/02), which would amount to $3 billion (appar-
ently to be financed with new duties on exports), in an attempt to ease social tensions
and stimulate a reactivation of the economy through consumption.
April 4, 2002Deposits to be released. The Central Bank issued a regulation stating
that, from January 2003, banks would be entitled to give all rescheduled deposits
back to investors if they chose to (CB res. 3555). Apparently, the Ministry of Econ-
- 247 -
omy was not in agreement, and rumors of the measure being withdrawn started to
gain strength.
April 5, 2002Duties on Exports. The Ministry of Economy established new duties
on exports. The export tax on grains and vegetable oils was raised to 20% (grains and
processed oilseeds increased from 10%, vegetable oils and meals increased from
5%). The government estimated the tax increase could raise additional collections of
$1 billion. There were no changes on taxes on industrial and agro-industrial exports,
which remained at 10% and 5%, respectively, nor on petroleum exports, which re-
mained at 20%.
Source: Standard and Poors (2002)
- 248 -

Appendix 2: Alternative set of model equations
The set of model equations below take into account the results of the calibration exer-
cise. The main differences are the form of the crisis reverse feedback to fundamentals,
and different and simpler sovereign spread equation (debt dependent, not crisis prob-
ability dependent, and basing on the exogenous country, and time-specific spreads).
Probability of the crisis now negatively depends on international liquidity, current ac-
count surplus, budget surplus and negative of M3 growth in the previous periods.

1 1 1 t-1
1 1 1 t-1
( 3 )
( 3 )
( 1)
1
t t t
t t t
l CA G M
t l CA G M
e
prob y
e

+ + + +
+ + + +
= = =
+

Current account surplus increases (or deficit falls) in case of a crisis, by a fixed percent-
age of GDP, .

1 t t t
CA CA y
= + , where > 0

The cost of the reserves is equal to the spread between local and foreign interest rates.
The spread depends on a set of country-specific factors
c
, and grows with the total
amount of external debt, D
c,t-1
( )
, 1
*
c t
i i
D

Increasing international liquidity l requires long-term borrowing higher by a multiple of
short-term debt. This means the marginal cost of reserves equals to
- 249 -

, 1 c t
BIS BIS
MC
GDP GDP

| |
= +
|
\
,
where
c, t-1
is the actual foreign currency long bond spread faced by country c in the
previous period, BIS is the stock of short-term debt, and GDP is the nominal GDP.
The marginal costs of reserves extended including the dynamic effects of postponing the
crisis and quasi fiscal costs of additional borrowing are then:

( ) ( )
0
1
1 1 )
n
n
MC r
MC
MC l
l
TMC MC
r r r MC

=
| |
| |

+ |
| | |

\
= + =
| |
|
+ +
| \
\
,
where MC is immediate marginal cost of reserves, is the impact of crisis on the cur-
rent account, while , , are the parameters setting the impact of, respectively, current
account, budget, and international liquidity influencing the probability of the currency
crisis .
The policymaker tries to minimise the loss function L, subject to liquidity stock l
t-1

( )
( )
( ) ( )
1 1
3 1
1
1 1
1 1 1
1 0 0
2
1
2 2
t t
M t
t
t t
l l
t t t
t
l
e MC r MC Sinh
MC r l
l l
Cosh Cosh CA G
L l MTCdl dl
l r MC
| |
+ +
|
\
+
| | | |
+ + + +
| |
\ \
= =
+

MC is the immediate marginal cost of reserves, is the (positive) crisis cost, and sinh(x)
and cosh(x) are hyperbolic sine
2
x x
e e
| |
|
\
and cosine
2
x x
e e
| | +
|
\
respectively.
- 250 -

Appendix 3: Model optimisation Mathematica
5 code
Variable and libraries initialisation, setting calibrated parameter (params) values, ini-
tialising a set of median country variable values (ceteris) for testing.

Setting up the model. is the probability of the crisis, CA is the current account fol-
lowing the crisis.

Loading the data from kbn2.txt and setting up variable substitution tables.
- 251 -

Setting up evaluated marginal cost (koszt[country number]) and marginal benefit
(zysk[country number]) functions with the variables and parameters substituted with
actual data. kosztsmall function excludes the second round fiscal effects of reserve
borrowing and postponing the crisis.

Key function definitions. Zyskkoszt takes the country number and crisis cost as in-
puts, and produces the chart of marginal costs and benefits. International liquidity is
on the horizontal axis. The headers show crisis cost used, actual liquidity, and im-
plied liquidity for the assumed . The function does not display the chart (it retains it
for use in the chart sets).
NCalka[optimum] function embedded in the definition of zyskkoszt is numerical defi-
nite integration of marginal cost between zero and optimum international liquidity.
Later, FindMinimum[NCalka] function is used to find the liquidity value minimising
the loss function.
- 252 -

Opticurve takes the country number and minimum and maximum values of interna-
tional liquidity as inputs, and produces optimal liquidity chart, with crisis costs on the
horizontal axis and suggested liquidity on the vertical axis. A horizontal line is added,
indicating actual liquidity held by the country. As above, minimum of the loss func-
tion is found numerically by a combination of NCalka and FindMinimum.

Optitable is a text version of Opticurve, used for finding the crisis cost value closest
matching the one implied by the actual policymakers' decisions on international liquid-
- 253 -
ity. It takes the country name and minimum value of crisis cost as input, and returns
single value of the crisis cost, representing intersection of Opticurve and horizontal
line of the actual country's liquidity.

The following (rather inelegant) code displays the set of marginal liquidity cost and
benefit charts for the countries in the sample. Zyskkoszt function uses the output of op-
titable as input, so that the charts represent marginal cost and benefit curves for the
crisis costs implied by actual international liquidity of the country in question.

The code below shows optimal liquidity curves for all the countries in the sample, in a
similar way as the code above.
- 254 -

The following displays the costs of liquidity for the countries in the sample, being the
definite numerical integration of the marginal cost curves between zero and actual in-
ternational liquidity held.
Second chart is the set of marginal benefit curves for the countries in the sample.

The final command produces a table including the size of dynamic effects (fiscal im-
pact of reserve borrowing, and costs of postponing the crisis) in % of GDP

- 255 -

Appendix 4: The list of countries used for estimations in
Chapter 5
Albania
Algeria
Argentina
Bangladesh
Belarus
Bolivia
Botswana
Brazil
Bulgaria
Chile
China
Colombia
Costa Rica
Cte d'Ivoire
Croatia
Cyprus
Czech Republic
Dominicana
Ecuador
Egypt
Estonia
Georgia
Ghana
Honduras
Hong Kong
Hungary
India
Indonesia
Israel
Jordan
Kazakhstan
Kenya
Korea
Latvia
Lithuania
Malaysia
Mauritius
Mexico
Moldova
Morocco
Mozambique
Nigeria
Pakistan
Panama
Peru
Philippines
Poland
Romania
Russia
Singapore
Slovak Republic
Slovenia
South Africa
Sri Lanka
Tanzania
Thailand
Tunisia
Turkey
Ukraine
Uruguay
Venezuela, Rep.
Bol.
Zimbabwe

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Currency Crises and Optimal

is only significantly negative for intermediate values of the real exchange

, where and are parameters relat-

, where r is the policy makers discount

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