Financial Crises

Traditional models of currency crises explain them as a consequence of unsustainable fiscal policy. In these models a government that fixes or heavily manages its exchange rate will accumulate debt (or run down reserves) if its primary surplus is not large enough. Eventually the government will no longer be able or willing to maintain the exchange rate peg. A currency crisis then develops, with the central bank floating the currency and monetary policy eventually becoming more accommodating – with seigniorage,  rather than debt, used to finance the government's deficit.

Fiscal policy plays a big role in currency crises - before and after they occur

Traditional discussions of fiscal sustain-ability are consistent with the basic princi­ples of these models. A government running a large deficit under a fixed exchange rate can either take corrective action to improve its fiscal balance and contain inflation, or it can avoid taking corrective action – an approach that ultimately forces the gov­ernment to abandon the fixed exchange rate and allow higher inflation. Studies of fiscal sustainability measure the primary sur­plus needed to contain inflation as well as the cost of not taking such action, as indi­cated by the increase in debt if fiscal pol­icy remains unchanged.

At first glance, several recent currency crises do not appear to fit the basic model. For example, most of the East Asian coun­tries that experienced severe depreciations in 1997-98 were not running large mea­sured deficits before their crises. In fact, all but one (the Philippines) were running sur­pluses (table 1).

The reason these crises may appear to have little to do with fiscal policy follows from the basic logic of the traditional mod­els. A government is assumed to have a bud­get constraint that, in simplified form, is:

(1) change in debt = interest payments –
primary surplus – seigniorage.

TABLE 1  FISCAL BALANCES IN SELECTED EAST ASIAN COUNTRIES, 1995 - 97 (percentage of GDP)

A government's finances are usually considered sustainable if it can stabilize its debt relative to GDP without resorting to inflationary fiscal and monetary policies. When the GDP growth rate (g) , inflation rate (π), real interest rate (r), and debt-GDP ratio (b) are all constant, equation l implies that the primary surplus relative to GDP (s) is constant and equal to:

(2)    s = (r   -   g) b -  (π + g) m,

where m is the ratio of the monetary base to GDP. Equation 2 shows that for debt to stabilize at some level of b, the government has to set the primary surplus to a sufficiently high level. The greater is the initial debt, the larger is the required surplus. Equation  2 also shows how, with a fixed exchange rate, the government can typically raise only small amounts through seigniorage – the (π+ g)m term – and so must be more disciplined in terms of its primary surplus.

This type of analysis would not have indicated that East Asian countries had problems with debt sustainability. Initial debt levels were generally low, real growth was rapid, and primary surpluses – at least as measured – were adequate. Thus the most visible signs suggested that fiscal policy was sound.