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.
Table of Contents
1. Global Imbalances in Financial Markets
1.1 Increased Risk Sharing in Emerging Economies
2. Theoretical Approach and Model
2.1 Simple Model
3. Conclusion and Policy Implications
Objectives & Topics
The research proposal aims to analyze the link between sudden stops in international financial markets and the accumulation of foreign reserves in emerging economies, specifically examining how a firm-level run on central bank reserves can lead to liquidity crises.
- Analysis of global imbalances and the accumulation of foreign reserves.
- Theoretical investigation of the "sudden stop" theory and its impact on emerging markets.
- Modeling the behavioral decisions of firms facing currency depreciation and insolvency risks.
- Examining the role of central banks as lenders of last resort during financial turbulence.
- Discussing policy implications for risk sharing and international liquidity management.
Excerpt from the Book
Theoretical Approach and Model
The introduction described how sudden stops hit an economy and what follows the decision of foreign investors to stop investments. Next we put this framework into a model to learn more about the underlying mechanism. We focus on the behavior of firms as they seem to be the main drivers within this process. Households are not considered to hold large amounts of liabilities denominated in a foreign currency.
1st step: The negative shock to investors’ expectations about the economic development in country A implies an increasing risk for investments to country A. Thus investors start withdrawing money from this country and the exchange rate depreciates. Firms in country A observe this so called sudden stop (in investment) and start changing their bank deposits into domestic currency since they doubt the stability of the national banking system.
2nd step: The sudden stop of foreign investment implies that the exchange rate of country A devaluates relatively to the currency in which liabilities are denominated. For firms in country A the real value of foreign liabilities increases. Firms form expectations about the future exchange rate and then decide if they close down today or if they continue production. In the case of insolvency they run on the central bank and change the liquidation value of the firm into a hard currency.
Summary of Chapters
1. Global Imbalances in Financial Markets: This chapter introduces the macroeconomic context of current account deficits and the accumulation of foreign reserves by emerging countries as a self-insurance mechanism against financial volatility.
2. Theoretical Approach and Model: This section develops a stochastic optimization model that illustrates how firms react to exchange rate shocks and how their decisions impact central bank liquidity and systemic risk.
3. Conclusion and Policy Implications: The final chapter summarizes the findings regarding endogenous insolvency risks and discusses the potential for external institutional support and the need for new policy frameworks to manage financial crises.
Keywords
Bank run, Financial Crises, Global Imbalances, Lender of Last Resort, Sudden Stop, Exchange Rate, Foreign Reserves, Risk Sharing, Emerging Economies, Insolvency, Liquidity, Sovereign Wealth Funds, Currency Depreciation.
Frequently Asked Questions
What is the fundamental objective of this research paper?
The paper seeks to establish a mechanism linking sudden stops in foreign capital inflows to bank runs and the depletion of foreign currency reserves at central banks in emerging markets.
Which thematic areas are primarily addressed?
The core themes include global financial imbalances, the role of central bank reserves, firm-level decision-making under uncertainty, and the mechanics of systemic financial crises.
What is the central research question?
The research explores how and why firms, when faced with sudden stops and expected currency devaluation, trigger a run on central bank reserves, thereby challenging the central bank's ability to act as a lender of last resort.
What scientific method is employed to analyze the problem?
The author employs a discrete time, recursive, and stochastic optimization model to simulate firm behavior under varying states of the world and exchange rate scenarios.
What specific topics are covered in the main section of the paper?
The main section covers the macro-level context of foreign reserve accumulation, the two-step mechanism of sudden stops, and the formal mathematical modeling of firm insolvency decisions.
Which keywords best characterize this academic work?
Key terms include Sudden Stop, Bank Run, Lender of Last Resort, Global Imbalances, Foreign Reserves, and Exchange Rate Volatility.
How does the model incorporate the "state of the world" variable?
The model uses an index 'z' to represent a finite number of future states of the world, each with a probability distribution, to determine the firm's optimal decision between continuing production or defaulting.
What role does the central bank play in the described scenario?
The central bank is initially viewed as a lender of last resort, but the model shows that if private actors panic and switch to hard currencies, the central bank may reach a point where it can no longer provide sufficient foreign exchange liquidity.
What does the author conclude regarding international policy?
The author suggests that relying solely on national reserve accumulation is insufficient and implies a need for international institutions to provide insurance to emerging markets to mitigate moral hazard and systemic risk.
- Arbeit zitieren
- Moritz Meyer (Autor:in), 2009, Sequential Financial Crisis Scenario, München, GRIN Verlag, https://www.grin.com/document/182527
