Government Guarantees and Self-Fulfilling Speculative Attacks

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.