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Hedging and Financial Fragility in Fixed Exchange Rate Regimes

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  • Craig Burnside
  • Martin Eichenbaum
  • Sergio Rebelo

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. 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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7143.

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Date of creation: May 1999
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Publication status: published as Burnside, Craig, Martin Eichenbaum and Sergio Rebelo. "Hedging And Financial Fragility In Fixed Exchange Rate Regimes," European Economic Review, 2001, v45(7,Jun), 1151-1193.
Handle: RePEc:nbr:nberwo:7143

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