Abstract:
This paper explores the role played by government guarantees to banks’ foreign
creditors as a root cause of self-fulfilling twin banking-currency crises. We develop
a general equilibrium model in which such guarantees lead to these types of crises.
Absent government guarantees, such crises are not possible. The model has three
key properties. First, in the presence of government guarantees banks willingly expose
themselves to exchange rate risk: they borrow foreign currency, lend domestic currency
and do not hedge the resulting exchange rate risk. In effect this provides a theory
of debt denomination that rationalizes a key maintained assumption of the recent
literature on currency crises: banks are exposed to unhedged currency risk. Second,
banks renege on their foreign debts and declare bankruptcy when a devaluation occurs.
Third, the government is either unable or unwilling to fully fund the costs associated
with bank guarantees via an explicit fiscal reform. Taken together these three properties
imply that government guarantees lead to self-fulfilling banking-currency crises.
