Financial Fragilities in Developing Countries

Interim Report

Edited by MITSUO Hisayuki
Published in June 2007
Chapter 1
Banking crises which occurred frequently in developing countries for the past quarter century are sometimes associated with output decline and interest rates liberalization. This paper introduces representative models which explain how banking crises are associated with output decline and interest rates liberalization. First, we introduce two bank runs models, based on uncertainty in liquidity demand, and on a low return of investment. Second, we introduce two models of financial collapse, where asymmetric information between bank and borrowers and between bank and depositors is a source of banking crisis. Third, we introduce a model that explains relationship between financial liberalization and a possibility of bank insolvency as a result of risky investment by bank.
Chapter 2
I construct a simplified but complete version of Krugman (1999) model, derive a closed-form solution, and make sure that there are two dynamic equilibria, one of which is the steady-growth one and the other of which is the currency-crisis one accompanied by balance-sheets crisis as Krugman suggested. I examine conditions for the existence of self-fulfilling crisis equilibrium and find that an economy may be faced with such crises if (1) propensity to import is low, (2) propensity to consume is low, (3) world interest rate is low, (4) borrowing constraint of private sector is moderate, (5) financial market is restrictive and there is high entry barrier, (6) price elasticity of export is low, and (7) wage elasticity of labor supply is low. I also show how the excess liabilities cause a large but temporal depreciation of exchange rate inevitably in the model.

Tightening monetary policy aiming to avoid a sharp depreciation of nominal exchange rate causes a deflation and makes the balance-sheet problem worse. Expansionary fiscal policy can avoid the crisis only if the government raises a sufficient fund from abroad, but the required amount of fund may be extraordinary large if the borrowing constraint is moderate.
Chapter 3
This paper develops a model of a small open economy whose corporate sector has foreign currency debts that cannot be refinanced or repudiated. The model shows that the presence of foreign currency debts will make the firms more vulnerable to real exchange rate depreciation, possibly causing them to refrain from lowering the output price (relative to the nominal exchange rate) to boost the sales volume. When such a financially constrained economy is hit by a negative shock to the exports demand, price adjustment (through real exchange rate depreciation) alone may fail to eliminate the excess goods supply. In this case, the excess goods supply has to be eliminated through quantity adjustment, and the economy will be entrapped in a low-employment/output equilibrium with a negative output gap. In a way, foreign currency debts could destabilize the economy by limiting the scope of price adjustment.
Chapter 4
Although a number of emerging market economies have recently adopted inflation targeting, their relatively large foreign exchange reserves and frequent exchange market interventions suggest that the monetary authorities remain concerned about sudden reversals of international capital flows and large swings in exchange rates. This paper shows that large stocks of foreign exchange reserves and frequent exchange market interventions expose the balance sheet of the central bank to the type of risk that is beyond its control and can generate undesirable macroeconomic outcomes, a problem that can be further complicated by the bank’s desire to avoid interference from the government. The paper then discusses an institutional design for the management of exchange rates and foreign exchange reserves, stressing the need for a broad but explicit policy guideline, a clear division of labor between the central bank and the government, and consistency between internal and external policy goals.
Chapter 5
Indonesia and other Southeast Asian countries introduced the drastic financial deregulation policies during 1980s, which enhanced financial sector development and domestic savings and investment in these countries. However, the financial deregulation policy together with economic boom led massive capital inflows. This massive capital inflows and reversal caused serious financial crisis. We conclude that massive capital inflows continued because the interest arbitration equation did not work in these countries and wide interest rates differentials remain for nearly 10 years. We highlighted that the wide interest rates differentials were caused by the inefficient and weak banking sector. In addition, we also discussed the policy responses and their effectiveness. The Indonesian government relied mainly on the monetary policies, which were not effective in pegged and open economy. On the contrary the fiscal policies and the external debt management policies, which were effective, were not fully utilized. It should be reminded that the major donor such as the World Bank and the Japanese government could have played critical roles in fiscal and external debt management policies.