Sequential Financial Crisis Scenario

Sequential Financial Crisis Scenario ^*

Global imbalances in financial markets, especially the current account deficit in the US and the high foreign reserves in Asian countries, are considered to have influenced the housing bubble in the USA and other Western countries. This research proposal establishes a link between the twin crises in Asia starting in 1997 and the current need of central banks in this region to accumulate so called „hard currencies“ like the US Dollar and the Euro. In the following we focus on the theory of sudden stops and introduce a second element that describes a run on the foreign reserves of the central bank. Firstly, agents in the economy run on domestic banks and change bank deposits into domestic currency. Secondly, they escape into hard currencies because they fear that exchange rate movements lower the real value of the domestic currency. This challenges foreign reserves of central banks, such that the central bank finally cannot provide any additional foreign reserves to the domestic banking system. To guarantee that foreign reserves are sufficient for all agents in the country central banks started building up large foreign reserves to self-insure against financial fragilities.

Keywords: Bank run, Financial Crises, Global Imbalances, Lender of Last Resort, Sudden Stop

1 Global Imbalances in Financial Markets

During the last years an increasing number of policy makers and academics started to worry about steadily growing global imbalances in international financial markets. Es- pecially for the United States the current account deficit increased and reflects the fact that capital from foreign countries has flown into American financial markets. At the same time central banks in emerging countries have built up large foreign reserves[1] [7].

So far the literature has discussed different motives for the accumulation of foreign reserves, in particular in Asian countries[15]. Some frameworks explain the accumula- tion of foreign reserves as the result of managed exchange rate regimes to induce export led growth. An alternative explanation focuses on the role of sovereign wealth funds. These funds are set up to save revenues mainly generated from natural resources for future generations and invest national savings in more efficient financial markets[2]. Revenues from these funds clearly benefited from increased demand for resources dur- ing the last years. A third explanation strengthens the importance of foreign reserves to self-insure against situations when agents withdraw domestic currency holdings and switch to foreign (hard) currencies. This scenario can be triggered by a sudden stop where foreign investors stop lending to (mainly) emerging countries[3] [13]. To stabi- lize the domestic banking system in these situations of extreme currency depreciation, central banks build up foreign reserves.

Central banks and governmental investors like sovereign wealth funds seek to maximize the risk adjusted returns on these assets and heavily invest in efficient and stable financial markets. Since only Western countries established liquid financial markets where investors can easily sell their assets, large amounts of capital flow into financial markets in the USA and other Western countries.

Increased Risk Sharing in Emerging Economies

The framework presented in this research proposal focuses on increasing risk sharing in emerging countries to reduce vulnerability to shifts in global risk aversion including sudden stops. The policy to self-insure against increasing risks in international financial markets can be interpreted as a reaction to the financial crises in 1997 when (especially) Asian countries were hit by a break down of international capital flows[11] [12] [4].

During the financial crises in Asia in 1997, investors stopped lending to emerging countries because they feared an increasing risk for investments[5]. As a consequence the domestic currency devaluated and domestic lenders were unable to repay their cred- its denominated in the foreign currency. Then there was a flight first from bank deposits into cash and then from domestic currencies into hard currencies. This behavior induced bank runs and finally a run on the foreign reserves of central banks. In the end the central banks were no longer able to provide the domestic banking system with foreign exchange liquidity. In this framework the first step describes a classical bank run.

[...]

^* Research Proposal for Financial Crisis (European University Institute, Florence)