Question:

Why are currency crises often accompanied by banking crises?

Answer:

The coincidence of the banking and currency crisis related with the Asian financial crisis has drawn the attention towards the similar factors, which has connected the two major phenomenons. The phenomenon of twin crisis is quite common in the financial liberalization within the emerging markets. Banking and the currency crises has appeared to occur virtually at the same period in Indonesia, Thailand, Korea and Malaysia in the year 1997-98 (Sebastian 1999). In fact, the twin crisis evidences are widespread that occurred in different parts of the world, in which it spread in Latin America during mid-1980s and in 1990s it occurred in Scandinavia.

The strong relation existing between the currencies and banking crisis within the emerging markets is quite robust, even after controlling the financial structure variables and host of microeconomics as well as expected simultaneity bias (Sebastian 1999). It is also explored that the occurrence of banking crisis offers better indicators of the currency crisis that too in emerging markets. The openness of the emerging markets towards the global capital flow combines with the financial structure makes vulnerable in twin crisis. The connection of banking and currency crisis and the twin crisis could be attributed with the various causation channels, such as banking crisis leads to the currency crisis; currency crisis leads to banking crisis or joint casualty (Sebastian 1999).

There are different theoretical models that have explained the connection between the banking and currency crisis. One causation chain emphasize over the Stanley (2004) that runs by the issues of balance-of-payments in banking crises. A starting external shock, like increase in the foreign interest rates, and its coupled with the commitment towards the fixed parity might result in the reserve loss. If it’s not sterilized then it might result into the credit crunch, and increase bankruptcy and financial crisis (Stanley 2004). 

According to the third family of models, it was mentioned that the banking and currency crises holds similar causes. An example for this could be explored in the dynamics of the stabilization plan of the exchange rate based inflation, such as Mexico crisis in 1987. The facts and theories have suggested that the plan should have the well explained dynamics. As the coverage of inflation at global level is only gradual, there exists the marked cumulative appreciation of real exchange rate (Stanley 2004). Along with this, in the starting stages of the plan, there was a boom in the activities of import and export that were financed through the borrowing abroad. As the current account deficiencies were happening continuously, financial markets were convinced that the program of stabilization should be unsustainable, and fuel the attack against the local currency. As the boom is financed through the surge in the bank credit, as the banks borrow from overseas, when the inflow of capital becomes capital outflow and the asset market gets crash, then banking system give up (Stanley 2004).

Twin crisis leads to:

Insolvency of banking system

Banking issues could be traced easily, if there is a decrease in bank assets value. Asset value deterioration might occur, if there is a collapse in the prices of real estate or either increase in the bankruptcies in the nonfinancial sector. During twin crisis, values of asset also reduced substantially, and bank ends up with liabilities, which are more than assets, which means that banks has the negative capital and many banks went insolvent (Christopher 1999). There were some banks that had some capital, but it was less as required by the regulations. 

During twin crisis, the insolvency increased in the banking system as well as in corporate and fiscal sectors. GDP measured in dollars also become highly unstable that tumbled from around US$20 billion each year in the 4th quarter of 1998 to around US$8 billion every year in 2000, and this even lead to collapse in the actual exchange rate. The debt-to-GDP ratio in public sector also increased from 81% in 1998 and 156% in 2000, but the 76% of increase was resulted due to the shrink in GDP (Christopher 1999). Solvency of banking system was also fast in 2000, and there were around 16 financial institutions that accounted to around 65% of the assets that were closed and even taken by the government. The issues of insolvency in the household and corporate debtors also pushed the government in June 2000 in order to restructure the debt (Christopher 1999).

Banks' losses on foreign currency denominated assets

Defaults might also get triggered through the local currency devaluation, when the huge fraction of the sovereign debt was denominated in the overseas currency and its revenue also depends on the non-tradable goods taxation (Kaminsky and Reinhart 1999). The magnitude of the crisis also triggered through the local currency devaluation and the same could be amplified through household’s currency mismatch; banking sector, and non-financial corporate sector.

Outflows of deposits as foreigners withdraw funds

In the starting stages of the plan; there was a boom in the activities of import and export that resulted due to the borrowed finance from abroad. As the deficit in the current account continued to get broaden, financial market got convinced that the program of stabilization was unsustainable, and fueled attacked against the domestic currency (Kaminsky and Reinhart 1999). As the boom was mainly financed through the surge in the bank credit, banks started borrowing from overseas market, and that leads to capital outflow and crash of asset market, and the same resulted into the cave of banking system. 

High interest rates as authorities try to support the currency

One of the most challenging questions in front of monetary authorities is how to conduct the monetary policy during crisis. On one side, tightening monetary policy increased domestic interest rates that made it more attractive for holding the domestic currency and also increase the cost of speculation against the currency (Kaminsky and Reinhart 1999). Therefore, increase in interest rate holds the potential to provide the relief to the currency that was under pressure. During the period of Asian financial crises, 1997, the prescription of policy in various crisesstricken countries was related to conduct the tight monetary policy for all these reasons (Kaminsky and Schmukler 2002). However, there were various negative consequences related to tightening of monetary policy. High interest rates reduce the asset value held through the backings system by higher flow of discounting in future, but more crucially by the financial distress to the borrowers and banks and it resulted into economic loss and distressed liquidity. 

Various forms capital control scan and discuss the conventional view on capital mobility before offering reasons why controls on some types of capital flow may nonetheless be desirable

Conventional wisdom recommends that permitting the international capital flow enhances the domestic investment and leads towards growth through providing the extra resources by the international capital markets, yet the flow could be misallocated to the low quality domestic investment or finance speculative (Alberto, Grilli and Milesi 1994). Applying the dataset of panel, that covers 78 countries between 1995-2009, mentions that policies of capital control can promote the economic growth by applying the countries de facto capital flow level; controls the capital flow that could support in economic growth of the country, but also controls the outflows; and put restrictions on various types of asset that could impact growth in different ways (Alberto, Grilli and Milesi 1994). Capital controls placed on the equity type of flow are not that effective than the controls placed on debt type flow or the direct investment. Just like various issues discussed in the global economics, the focus is placed over the capital controls and it has only one reborn with the market liberalization failure (Alberto, Grilli and Milesi 1994). 

The capital movement control could be analyzed through the economic policy for limiting the international capital mobility and to bring change in the state of capital account in context of financial transactions (Eswar, Rogoff, Wei and Kose 2003). If one talks about the various types of capital controls, it might take the taxation types, quality and price restrictions or the direct international operations prohibition with the different financial assets (Robert and SalaI-Martin 1995). The international capital flow control is distinguished into direct and administrative controls, and the same can be indirect or market based controls. When countries face the issues of large scale movements of financial resources, then in that case capital controls are helpful tool of economic policy (Eswar, Rogoff, Wei and Kose 2003). The administrative control tries to limit the operations with the related payments along with transfers of monetary funds through the way of quantitative limitation, direct prohibition or through the procedure of the official approval (Robert and Sala-I-Martin 1995).