A MODEL OF FINANCIAL CRISES IN EMERGING MARKETS [*].

We develop a model in which financial crises in emerging markets may occur when domestic banks are internationally illiquid. Runs on domestic deposits may interact with foreign creditor panics, depending on the maturity of the foreign debt and the possibility of international default. Financial liberalization and increased inflows of foreign capital, especially if short term, can aggravate the illiquidity of banks and increase their vuinerability. The primary role of illiquidity is consistent with the existence of asset price booms and crashes and of government distortions.

I. INTRODUCTION

Recent events in Mexico, Asia, Russia, and Brazil have underscored that a satisfactory explanation of financial crises in emerging markets remains elusive. Not too long ago, the prevailing view was that crises were the inevitable outcome of ongoing fiscal imbalances coupled with fixed exchange rates. But this first generation view, pioneered by Krugman [1979], has fallen out of fashion because in many crises the crucial fiscal disequilibria were absent. And, as Obstfeld [1994] has argued, currency crises have sometimes occurred even though central banks had more than enough resources to prevent them: witness much of Europe in the early 1990s.

Obstfeld put forward a second generation view in which central banks may decide to abandon an exchange rate peg when the unemployment costs of defending it become too large. This new perspective implied that crises could be driven by self-fulfilling expectations, since the costs of defending the peg may themselves depend on anticipations that the peg will be maintained. But Obstfeld's emphasis on mounting unemployment and domestic recession, while appropriate for the ERM 1992 crisis, was at odds with the facts in Mexico in 1994 and East Asia in 1997. Asian countries, in particular, were growing quickly until shortly before their financial meltdown.

Instead of fiscal imbalances or weakness in real activity, recent crises in emerging markets have featured troubled local financial institutions and sudden reversals of short-term international capital flows. In most cases, the currency crashed along with the financial system. [1] This suggests that a third generation model of crises should assign a key role to financial structure and financial institutions, especially the domestic banking system. The purpose of this paper is to develop a model in that spirit and investigate its implications. [2]

The model places international illiquidity, which may result in outright collapse of the financial system, at the center of the problem. Illiquidity, defined as a situation in which the financial system's potential short-term obligations exceed the liquidation value of its assets, may emerge naturally as an optimal response of the banking system to some features of the economic environment. However, it may also make the system vulnerable to costly runs.

Any model in which financial institutions issue demandable debt, therefore placing themselves in a potentially illiquid position, is a useful vehicle for our purpose. For concreteness we focus on an open economy version of the celebrated banking model of Diamond and Dybvig [1983]. [3] In that model banks are essentially maturity transformers that take liquid deposits and invest part of the proceeds in illiquid assets. In doing so, they pool risk and enhance welfare, but also create the possibility of self-fulfilling bank runs.