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«A MODEL OF CRISES IN EMERGING MARKETSÃ Michael P. Dooley This paper presents a perfect foresight model of speculative attacks on emerging markets. ...»

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The Economic Journal, 110 ( January), 256±272. # Royal Economic Society 2000. Published by Blackwell

Publishers, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.


Michael P. Dooley

This paper presents a perfect foresight model of speculative attacks on emerging markets.

Credit constrained governments are assumed to have two objectives: to accumulate liquid assets in order to self-insure against shocks to national consumption and to insure poorly regulated domestic ®nancial markets. This policy regime generates endogenous ®scal de®cits de®ned to include the growth of contingent liabilities. The model sets out a sequence of yield differentials consistent with capital in¯ows followed by anticipated speculative attacks. The model suggests that a common shock generated capital in¯ows to emerging markets in Asia and Latin America after 1989.

Exchange market and banking crises in Latin America and, more recently, in Asia and Russia have renewed interest in the economics of speculative attacks.

Two types of models have dominated formal analysis. First generation models, reviewed in Agenor et al. (1992) interpret speculative attacks as the natural and anticipated demise of an inconsistent policy regime. Proponents of this approach emphasise the con¯ict between objectives for nominal exchange rate stability and a monetary/®scal policy that is inconsistent with this objective.

Con®dence in these models as complete explanations of speculative attacks has been eroded by the observation that, in many cases, the underlying policy con¯ict seems to be missing.1 The ERM crisis in 1992 and the Mexican crisis of 1994 have been cited as examples of crises not preceded by policy con¯icts.

Moreover, an important empirical regularity associated with recent crises in emerging markets is that speculative attacks are preceded by very large private capital in¯ows into the country. This seems to suggest that bullish market sentiment collapsed at the time of the attack.

These observations have inspired models that identify conditions under which a regime is vulnerable to shifts in private expectations. Second generation models, reviewed in Eichengreen et al. (1996), explain speculative attacks in terms of the fundamentals identi®ed in ®rst generation models, but the fundamentals are themselves sensitive to shifts in private expectations about the future. While a shift in market expectations about future policies could à I am grateful to Robert Flood, Dale Henderson and anonymous referees for helpful comments on earlier drafts. Some of the work on this paper was done while the author was employed by the International Finance Division, Board of Governors of the Federal Reserve System. The views in this paper are solely the responsibility of the author and should not be interpreted as re¯ecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.

See Frankel and Rose (1996) for evidence that fundamental con¯icts emphasised in ®rst generation models are not apparent preceding recent crises. Krugman (1996) argues that ®rst generation models are useful in understanding recent crises. He emphasises the fact that a range of policy con¯icts that are dif®cult to measure can trigger an attack. For example, an extended period of high unemployment can con¯ict with the government's commitment to a ®xed exchange rate and the associated constraint on monetary policy. Moreover, he argues that in some models multiple equilibria are ruled out because an attack will occur on the ®rst day it could occur. Kehoe (1996) and Obstfeld (1996) argue that multiple equilibria are possible in a wide variety of theoretical models.

[ 256 ] [ J A N U A R Y 2000] 257


trigger an attack in ®rst generation models, the spirit of the approach would demand that they have a good reason to change their minds in terms of perhaps unobservable fundamentals.2 The objective of this paper is to set out a ®rst generation model based on an alternative set of fundamentals. The general structure of the model is drawn from Diaz-Alejandro (1985), Velasco (1987) and Dooley (1994, 1996a). The primary appeal of ®rst generation models is that they relate fundamentals that evolve smoothly to discrete changes in regimes and asset holdings. The mechanism that accomplishes this is an anticipated sequence of yields on real or ®nancial assets that shapes the behaviour of competitive and rational investors.3 The model developed in this paper is in this tradition. The policy con¯ict in the background of our model is between the desire of a creditconstrained government to hold reserve assets as a form of self-insurance and the government's desire to insure ®nancial liabilities of residents. The ®rst objective is met by the accumulation of liquid assets. The second objective generates incentives for investors to acquire the government's assets when yield differentials make this optimal.

These ingredients provide a perfect foresight capital in¯ow/crisis sequence.

The availability of free insurance raises the market yield on a set of liabilities issued by residents for a predictable time period. The yield differential relative to international returns generates a private gross capital in¯ow (a sale of domestic liabilities to nonresidents) that continues until the day of attack. The gross private capital in¯ow is necessarily associated with some combination of an increase in the government's international reserve assets, a current account de®cit and a gross private capital out¯ow. An accumulation of international reserves delays the crisis, but when the government's marketable assets are exactly matched by its contingent insurance liabilities, the expected yield on domestic liabilities falls below international rates and investors sell the insured assets to the government, exhausting its assets. The speculative attack is fully anticipated and, at the time of the attack, nothing special happens to the fundamentals or expectations about the fundamentals.

We argue that this is a unifying framework for understanding recent crises in emerging markets. The fall in international interest rates after 1989 generated capital gains on external debt of governments of developing countries. As a result many governments became credible insurers and this initiated capital in¯ows into developing countries that had little else in common. The coincident in¯ows were followed by crises, the timing of which was determined by Garber (1996) points out that ®rst and second generation models are observationally equivalent if expectations for fundamentals change for good reasons not observed by the econometrician.

Salant and Henderson (1978) extend Hotelling's (1931) paper on the economics of exhaustible resources to consider a situation in which the government distorts the real return on stocks of gold by ®xing its nominal price. The private sector knows that if a speculative attack exhausts the government's gold reserves stock, and ends the price ®xing regime, the price of gold will henceforth rise at the real interest rate. This sequence of expected yields implies that the government will hold all stocks prior to the attack and that private investors will buy the entire stock of government holdings in a speculative attack. Krugman (1979) and Flood and Garber (1984) adapted the idea to a ®xed exchange rate system.

# Royal Economic Society 2000 258 [JANUARY


country speci®c factors. The model developed in the next section suggests that crises occur ®rst in countries with poorly-regulated and open ®nancial markets and then in well-regulated and relatively closed economies. Crises might be bunched together in time but this does not re¯ect contagion but the fact that observed crises generate revisions about the size of credit lines available to governments of emerging markets. Economic reform programmes in developing and formerly planned economies also have generated country speci®c shocks to governments' assets that may have triggered capital in¯ow/crisis sequences. These episodes are more dif®cult to identify empirically and are a topic for further research.

An appealing feature of the model is that an anticipated crisis need not be preceded by an exchange rate-policy con¯ict or by expectations that a currency peg will be maintained during the capital in¯ow phase or abandoned as a result of the crisis. It follows that interest differentials across currencies are not always associated with anticipated crises. Moreover, in contrast to existing ®rst generation models, private capital in¯ows always precede the crisis and are an integral part of a sequence that ends in an anticipated speculative attack against the government's stock of assets.

1. An Insurance Model The essential nature of the capital in¯ow/attack sequence is captured by the following simple model. We assume there are no unsecured and incentive compatible debt contracts for government borrowing from the private sector.

Thus, the government faces a credit ceiling and cannot borrow from the private sector against future tax receipts. It is also assumed that the government can credibly offer marketable assets as collateral against liabilities to private lenders. This collateral consists primarily of international reserve assets and lines of credit from other governments and international organisations.4 We assume that there is no market in which the private sector can neutralise the government's decision to accumulate marketable net assets.

In addition to the above assumptions about government ®nance, assume a small open economy that uses an international money. The economy is in a steady state equilibrium with no growth. Financial intermediation is carried out by commercial banks that are competitive and costless. Banks issue deposits and make loans to residents and nonresidents. Banks also appropriate deposits subject to monitoring by depositors and a regulatory agency. Appropriation is any activity that bene®ts the intermediary or its principle at the expense of asset values. For example, governments might instruct banks owned One interpretation of these assumptions is that international organisations can enforce unsecured contracts but the private sector cannot. For simplicity there is no distinction between domestic and external private debt. If the government could borrow from residents without collateral we would add this credit line to that available from the of®cial sector in order to calculate net assets. In this case private residents would lose in the event of a crisis since their claims on the government will not be honoured. This may explain the severe and lasting depression of asset prices and economic activity following recent crises.

# Royal Economic Society 2000 2000] 259


or controlled by the government to lend to ®rms that do not earn the competitive rate of interest in order to promote exports or employment or subsidise its constituents. More directly, the managers of a bank might book a new loan at more than its market value and invest the difference offshore. The offshore investment is, of course, not recorded on the bank's books or in the balance of payments accounts. Once the funds are offshore, they are beyond the reach of depositors and the regulatory agency.

Resident and nonresident depositors have perfect foresight and can monitor banks' appropriation without cost. Although not necessary for the main results, it is realistic to assume that domestic bank deposits are imperfect substitutes for other assets so that residents' and nonresidents' demand for the stock of deposits is,5 D ˆ D(R À R à À RP ), D9. 0, D 0, 0, (1) where R is the domestic deposit rate, R à is the international risk-free rate and RP is the additional yield necessary to offset anticipated losses on the marginal deposit net of insurance if a crisis should occur. A crisis is de®ned as an event in which depositors force the bank to sell its assets and collect deposit insurance from the government.6 As long as depositors earn expected yields consistent with (1) there is no incentive for an attack on the government's assets.

Depositors will hold insured liabilities and allow the government to hold reserves that earn R Ã.

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