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Hedging and Financial Fragility in Fixed Exchange Rate Regimes

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Author Info
Burnside, A Craig
Eichenbaum, Martin
Rebelo, Sérgio

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Abstract

Currency crises that coincide with banking crises tend to share four elements. First, governments provide guarantees to domestic and foreign bank creditors. Second, banks do not hedge their exchange rate risk. Third, there is a lending boom before the crises. Finally, when the currency/banking collapse occurs interest rates rise and there is a persistent decline in output. This paper proposes an explanation for these regularities. We show that government guarantees lower interest rates, and generate an economic boom. But they also lead to a more fragile banking system: banks choose not to hedge exchange rate risk. When the fixed exchange rate is abandoned in favor of a crawling peg banks go bankrupt, the domestic interest rate rises, real wages fall and output declines.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2171.

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Date of creation: Jun 1999
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Handle: RePEc:cpr:ceprdp:2171

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Related research
Keywords: Fixed Exchange Rate Systems Government Guarantees Hedging

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages

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  1. Peter M. Garber & Subir Lall, 1996. "Derivative products in exchange rate crises," Proceedings, Federal Reserve Bank of San Francisco, pages 206-231.
  2. Chang, R. & Velasco, A., 1999. "Liquidity Crises in Emerging Markets: Theory and Policy," Working Papers 99-14, C.V. Starr Center for Applied Economics, New York University. [Downloadable!]
  3. Roberto Chang & Andrés Velasco, 1999. "Liquidity Crises in Emerging Markets: Theory and Policy," Documentos de Trabajo 59, Centro de Economía Aplicada, Universidad de Chile. [Downloadable!]
  4. Sebastian Edwards & Carlos A. Vegh, 1997. "Banks and Macroeconomics Disturbances under Predetermined Exchange Rates," NBER Working Papers 5977, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  5. Ricardo J. Caballero & Arvind Krishnamurthy, 1998. "Emerging Market Crises: An Asset Markets Perspective," NBER Working Papers 6843, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  6. Gavin, M. & Hausmann, R., 1996. "The Roots of Banking Crises: The Macroeconomic Context," RES Working Papers 318, Inter-American Development Bank, Research Department.
  7. Maurice Obstfeld, 2006. "The Global Capital Market: Benefactor or Menace?," Center for International and Development Economics Research, Working Paper Series 1026, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley. [Downloadable!]
    Other versions:
  8. George A. Akerlof & Paul M. Romer, 1993. "Looting: The Economic Underworld of Bankruptcy for Profit," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(1993-2), pages 1-74. [Downloadable!]
    Other versions:
  9. Chari, V V & Christiano, Lawrence J & Eichenbaum, Martin, 1995. "Inside Money, Outside Money, and Short-Term Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1354-86, November. [Downloadable!] (restricted)
    Other versions:
  10. Roberto Chang & Andres Velasco, 1999. "Liquidity crises in emerging markets: Theory and policy," Working Paper 99-15, Federal Reserve Bank of Atlanta. [Downloadable!]
    Other versions:
  11. Atish R. Ghosh & A. Javier Hamann & Timothy D. Lane & Steven Phillips & Marianne Schulze-Gattas & T. M. Tsikata, 1999. "IMF-Supported Programs in Indonesia, Korea and Thailand," IMF Occasional Papers 178, International Monetary Fund. [Downloadable!]
  12. Gavin, M. & Hausmann, R., 1996. "The Roots of Banking Crises: The Macroeconomic Context," RES Working Papers 318, Inter-American Development Bank, Research Department.
  13. repec:cup:macdyn:v:2:y:1998:i:4:p:443-55 is not listed on IDEAS
  14. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," Journal of Business, University of Chicago Press, vol. 51(3), pages 413-38, July. [Downloadable!] (restricted)
  15. Rui Albuquerque, 2004. "Optimal Currency Hedging," Finance 0405010, EconWPA. [Downloadable!]
  16. Graciela L. Kaminsky & Carmen M. Reinhart, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June. [Downloadable!] (restricted)
    Other versions:
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