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Liquidity crises in emerging markets: Theory and policy

  • Roberto Chang
  • Andres Velasco

We build a model of financial sector illiquidity in an open economy. Illiquidity is defined as a situation in which a country's consolidated financial system has potential short-term obligations that exceed the amount of foreign currency available on short notice. We show that illiquidity is key in the generation of self-fulfilling bank and/or currency crises. We discuss the policy implications of the model and study issues associated with capital inflows and the maturity of external debt, the role of real exchange depreciation, options for financial regulation, fiscal policy, and exchange rate regimes.

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Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 99-15.

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Date of creation: 1999
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Handle: RePEc:fip:fedawp:99-15
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  1. Velasco, A. & Chang, R., 1998. "The Asian Liquidity Crisis," Working Papers 98-27, C.V. Starr Center for Applied Economics, New York University.
  2. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  3. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
  4. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
  5. Dani Rodrik & Andres Velasco, 1999. "Short-Term Capital Flows," NBER Working Papers 7364, National Bureau of Economic Research, Inc.
  6. Maurice Obstfeld & Kenneth Rogoff, 1995. "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 73-96, Fall.
  7. Guillermo A. Calvo, 1995. "Varieties of Capital-Market Crises," Research Department Publications 4008, Inter-American Development Bank, Research Department.
  8. Roberto Chang & Andres Velasco, 1998. "Financial crises in emerging markets: a canonical model," Working Paper 98-10, Federal Reserve Bank of Atlanta.
  9. Velasco, Andres, 1987. "Financial crises and balance of payments crises : A simple model of the southern cone experience," Journal of Development Economics, Elsevier, vol. 27(1-2), pages 263-283, October.
  10. Corsetti, G. & Pesenti, P. & Roubini, N., 1998. "What Caused the Asian Currency and Financial Crisis?," Papers 343, Banca Italia - Servizio di Studi.
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  12. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
  13. Dornbusch, Rudi, 1999. "After Asia: New Directions for the International Financial System," Journal of Policy Modeling, Elsevier, vol. 21(3), pages 289-299, May.
  14. Demirguc-Kent, Asli & Detragiache, Enrica, 1998. "Financial liberalization and financial fragility," Policy Research Working Paper Series 1917, The World Bank.
  15. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
  16. Reinhart, Carmen & Kaminsky, Graciela, 1999. "The twin crises: The causes of banking and balance of payments problems," MPRA Paper 14081, University Library of Munich, Germany.
  17. Roberto Chang & Andres Velasco, 1998. "Financial Crises in Emerging Markets," NBER Working Papers 6606, National Bureau of Economic Research, Inc.
  18. Philippe Aghion & Philippe Bacchetta & Abhijit Banerjee, 1999. "Capital Markets and the Instability of Open Economies," Working Papers 99.01, Swiss National Bank, Study Center Gerzensee.
  19. Diaz-Alejandro, Carlos, 1985. "Good-bye financial repression, hello financial crash," Journal of Development Economics, Elsevier, vol. 19(1-2), pages 1-24.
  20. Giancarlo Corsetti & Paolo Pesenti & Nouriel Roubini, 1998. "What Caused the Asian Currency and Financial Crisis? Part II: The Policy Debate," NBER Working Papers 6834, National Bureau of Economic Research, Inc.
  21. Enrica Detragiache, 1996. "Rational Liquidity Crises in the Sovereign Debt Market; In Search of a Theory," IMF Working Papers 96/38, International Monetary Fund.
  22. Chang, Roberto & Velasco, Andres, 2000. "Financial Fragility and the Exchange Rate Regime," Journal of Economic Theory, Elsevier, vol. 92(1), pages 1-34, May.
  23. Damm, Anna Piil, 2006. "Ethnic Enclaves and Immigrant Labour Market Outcomes: Quasi-Experimental Evidence," Working Papers 06-4, University of Aarhus, Aarhus School of Business, Department of Economics.
  24. Feldstein, Martin, 1999. "A Self-Help Guide for Emerging Markets," Scholarly Articles 2961700, Harvard University Department of Economics.
  25. Montiel, Peter & Reinhart, Carmen M., 1999. "Do capital controls and macroeconomic policies influence the volume and composition of capital flows? Evidence from the 1990s," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 619-635, August.
  26. Steven Radelet & Jeffrey Sachs, 1998. "The Onset of the East Asian Financial Crisis," NBER Working Papers 6680, National Bureau of Economic Research, Inc.
  27. Rudger Dornbusch & Ilan Goldfajn & Rodrigo O. Valdés, 1995. "Currency Crises and Collapses," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(2), pages 219-294.
  28. Ilan Goldfajn & Rodrigo O. Valdés, 1997. "Capital Flows and the Twin Crises ; The Role of Liquidity," IMF Working Papers 97/87, International Monetary Fund.
  29. Haldrup, Niels Prof. & Lildholdt, Peter, 2000. "On the Robustness of Unit Root Tests in the Presence of Double Unit Roots," University of California at San Diego, Economics Working Paper Series qt2k0780sh, Department of Economics, UC San Diego.
  30. Jason Furman & Joseph E. Stiglitz, 1998. "Economic Crises: Evidence and Insights from East Asia," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 1-136.
  31. Neil Wallace, 1996. "Narrow banking meets the Diamond-Dybvig model," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-13.
  32. Paul R. Krugman & Kenneth S. Rogoff & Stanley Fischer & William J. McDonough, 1999. "Currency Crises," NBER Chapters, in: International Capital Flows, pages 421-466 National Bureau of Economic Research, Inc.
  33. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, vol. 41(1), pages 27-38, February.
  34. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
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