Credits, Crises, and Capital Controls: A Microeconomic Analysis

We analyze a model where foreign banks finance local long-term projects by short-term credits that are denominated in foreign currency. The foreign banks face two kinds of risk: the macro-economic risk of a currency crisis, and the micro-economic risk of project failure. There are no bailout guarantees against either of these risks. We assume that the foreign banks move sequentially, obtain a private signal about the micro risk associated with the projects they consider financing, and observe the actions of all previous foreign banks. We analyze the equilibrium of this model and show that it is generally inefficient. In particular, for a wide range of parameter values, foreign banks provide too many credits too easily and thus generate an inefficiently high risk of a currency crisis. For other parameter values, they inefficiently provide no credits at all. We demonstrate how the imposition of capital controls through taxes and subsidies on short-term foreign credit can improve the situation. Our analysis differs from other papers on currency crises in at least two regards: we do not assume that foreign banks enjoy bailout guarantees, and we concentrate on the foreign banks' incentives for providing credit rather than on their incentives to withdraw the credit provided once a crisis is anticipated.