DISCUSSION PAPER SERIES

No. 2565

ON THE FUNDAMENTALS OF SELF-FULFILLING SPECULATIVE ATTACKS Craig Burnside, Martin Eichenbaum and Sérgio Rebelo INTERNATIONAL MACROECONOMICS

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ISSN 0265-8003

ON THE FUNDAMENTALS OF SELF-FULFILLING SPECULATIVE ATTACKS Craig Burnside, The World Bank Martin Eichenbaum, Northwestern University and Federal Reserve of Chicago Sérgio Rebelo, Kellogg Graduate School of Management, Northwestern University and CEPR Discussion Paper No. 2565 September 2000 Centre for Economic Policy Research 90–98 Goswell Rd, London EC1V 7RR, UK Tel: (44 20) 7878 2900, Fax: (44 20) 7878 2999 Email: [email protected], Website: www.cepr.org This Discussion Paper is issued under the auspices of the Centre’s research programme in International Macroeconomics. Any opinions expressed here are those of the author(s) and not those of the Centre for Economic Policy Research. Research disseminated by CEPR may include views on policy, but the Centre itself takes no institutional policy positions. The Centre for Economic Policy Research was established in 1983 as a private educational charity, to promote independent analysis and public discussion of open economies and the relations among them. It is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions. Institutional (core) finance for the Centre has been provided through major grants from the Economic and Social Research Council, under which an ESRC Resource Centre operates within CEPR; the Esmée Fairbairn Charitable Trust; and the Bank of England. These organizations do not give prior review to the Centre’s publications, nor do they necessarily endorse the views expressed therein. These Discussion Papers often represent preliminary or incomplete work, circulated to encourage discussion and comment. Citation and use of such a paper should take account of its provisional character. Copyright: Craig Burnside, Martin Eichenbaum and Sérgio Rebelo

CEPR Discussion Paper No. 2565 September 2000

ABSTRACT On the Fundamentals of Self-Fulfilling Speculative Attacks* This Paper proposes a theory of twin banking-currency crises in which both fundamentals and self-fulfilling beliefs play crucial roles. Fundamentals determine whether crises will occur. Self-fulfilling beliefs determine when they occur. The fundamental that causes ‘twin crises’ is government guarantees to domestic banks’ foreign creditors. When these guarantees are in place twin crises inevitably occur, but their timing is a multiple equilibrium phenomenon that depends on agents’ beliefs. So while self-fulfilling beliefs have an important role to play, twin crises do not happen just anywhere. They happen in countries where there are fundamental problems, such as guarantees to the financial sector. JEL Classification: F31, F41, G15 and G21 Keywords: fixed exchange rate regimes, government guarantees, hedging and speculative attacks Craig Burnside DECRG The World Bank, Room MC3-363 1818 H Street NW Washington DC 20433 USA Tel: (1 202) 473 9607 Fax: (1 202) 522 3518 Email: [email protected] Sérgio Rebelo Northwestern University Leverone Hall 2001 Sheridan Road Evanston, IL 60208-2001 USA Tel: (1 847) 467 2329 Fax: (1 847) 491 5719 Email: [email protected]

Martin Eichenbaum Department of Economics Northwestern University 2003 Sheridan Road Evanston IL 60208-2014 USA Tel: (1 847) 491 8232 Fax: (1 847) 491 7001 Email: [email protected]

*We are grateful to Kellogg’s Banking Research Center for financial support. Burnside thanks the Hoover Institution for its support through a National Fellowship. The opinions in this Paper are those of the authors and not necessarily those of the Federal Reserve Bank of Chicago or the World Bank. We are thankful to Larry Christiano and Olivier Jeanne for their comments. Submitted 02 May 2000

NON-TECHNICAL SUMMARY The past decade has witnessed dramatic collapses of fixed exchange rate regimes in countries as diverse as Sweden, Mexico, Thailand and Korea. This has led to a resurgence of interest in the causes of currency crises. While there is disagreement about the source of these crises, there is widespread agreement that banking crises have become increasingly linked to currency crises. This is the ‘twin crises’ phenomenon emphasized by Kaminsky and Reinhart (1999). This Paper proposes a theory of such crises in which both fundamentals and self-fulfilling beliefs play crucial roles. Fundamentals determine whether crises will occur. Self-fulfilling beliefs determine when they occur. The fundamental that causes ‘twin crises’ is government guarantees to domestic banks’ foreign creditors. When these guarantees are in place twin crises inevitably occur. But their timing is a multiple equilibrium phenomenon that depends on agents’ beliefs. So while self-fulfilling beliefs have an important role to play, twin crises do not happen just anywhere. They happen in countries where there are fundamental problems, countries such as Sweden, Mexico, Thailand and Korea. Our small open economy is populated by four different sets of agents: banks, firms, households and a government. Banks borrow dollars from abroad and make loans to domestic firms. By assumption these domestic loans are denominated in local currency, so that banks face foreign exchange rate risk. This risk can be hedged in forward currency markets. We characterize banks’ optimal hedging strategy when the government guarantees that foreign creditors will be repaid in the event of devaluation. In addition we consider the case in which these guarantees are absent. Firms borrow funds to hire labour and produce output using constant returns to scale technology. Households supply labour inelastically and derive utility from consumption and domestic real balances. Because they have access to international capital markets they have a non-trivial forward-looking portfolio problem. In particular, the amount of domestic real balances that they hold depends on their beliefs about the longevity of the fixed exchange rate regime. The government faces an intertemporal budget constraint that must hold for every realization of the state of the economy. To simplify the analysis we assume, as in Krugman (1979), that the government follows a threshold rule according to which it abandons fixed exchange rates when its reserves reach a certain lower bound. The only source of uncertainty in this economy is agents’ beliefs about the collapse of the fixed exchange rate regime. We model these beliefs by assuming that agents coordinate on an exogenous signal which takes on the value one with probability q and zero with probability (1-q). When the signal equals one, agents believe that the exchange rate regime will collapse before

the end of the period. When it equals zero, they believe that the fixed exchange rate will persist for at least one more period. In our model the government guarantees the repayment of banks’ foreign loans in the event of devaluation. These guarantees lead banks to expose themselves to exchange rate risk and to declare bankruptcy when devaluation occurs. Consequently, devaluation transforms potential government liabilities into actual liabilities. This transformation is the key mechanism by which government is guaranteed to create the possibility of self-fulfilling currency crises. To understand our basic argument, assume that there is a limit on the amount of reserves that the government is willing to lose in defence of its currency. Now suppose that market participants believe that devaluation is imminent and that the government will finance bank bailouts, at least in part, via seignorage revenues. Then private agents will exchange domestic money for foreign reserves to the point where the fixed exchange rate regime is abandoned. The resulting devaluation leads banks to declare bankruptcy and activates the government’s obligations to foreign creditors. As a consequence, the government will validate agents’ expectations by partially financing the bailout with seignorage revenues. Thus government is guaranteed to trigger a self-fulfilling, rational run on the domestic currency, devaluation and a banking crisis. Paradoxically, government guarantees make banks and the economy less stable, not more so. How can the government prevent these self-fulfilling twin crises? The two most obvious routes are: eliminate government guarantees or (somehow) credibly commit to financing post-devaluation bank bailouts without recourse to seignorage revenues. Our analysis suggests a third route related to a recent proposal by Feldstein (1999): the government must obtain and be willing to use a ‘sufficient’ amount of reserves to fend off a speculative attack. But what does ‘sufficient’ mean? In our model it means a fraction of the money supply that is an increasing function of the inflation rate that would result if a speculative attack succeeded. Finally, we analyse a fourth possibility: imposing a state-contingent Tobin tax on exchange rate transactions.

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Γ −τ D

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R −1 q

SI SD

Figure 2 Diagram for Proposition 4

c

c 2 (σ ; q > 0)

c (σ ; q = 0) 1

cS c 2 (σ ; q = 0) c1 (1; q > 0) c 2 (1)

c1 (σ ; q > 0)

0

σ (0)

σ (q)

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σ

Figure 3 Diagram for Proposition 3

c 3 (γ < γ * ; q )

c c 3 (γ * ; q )

C 1 (γ ;0)

c 3 (γ > γ * ; q )

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C 1 (γ * ; q ) C 1 (γ * ; q (γ * )) C 1 (γ > γ * ; q ) C 1 (γ > γ * ; q (γ ))

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