Private Sector Involvement and International Financial Crises: An Analytical Perspective

224 Pages·2005·1.059 MB·English

by  Michael Chui, Prasanna Gai

PRIVATE SECTOR INVOLVEMENT AND
INTERNATIONAL FINANCIAL
CRISES
ToOurParents
Private Sector
Involvement and
International
Financial Crises: An
Analytical Perspective
MICHAEL CHUI AND PRASANNA GAI
1
3
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Foreword
Howshouldtheinternationalfinancialarchitecturebedesigned?This
bookprovidesatheoreticalframeworktoanswerthisimportantques-
tion. It starts with an accessible account of the literature on financial
crises.Therearetwotypesofexplanationfortheoccurrenceoffinancial
crises. These are the sunspot-based and fundamentals-based explana-
tions. According to the sunspot-based approach, there are multiple
equilibria. If people believe there will be no crisis then this belief is
self-fulfilling.Ontheotherhandifpeoplebelievetherewillbeacrisis
then these beliefs will also be self-fulfilling. What determines which
equilibrium will occur? One way of modelling this is to suggest that
anexogenouseventsuchasasunspotwillbethecoordinatingdevice.
Thisisnotaverysatisfactoryexplanationofequilibriumselection.The
second approach is based on the business cycle. If people believe the
economy is going to enter a recession they worry about the ability of
banksandotheragentstomakepaymentsondebtcontracts.Inorder
to ensure that they can receive the full amount they are owed they
demandearlypaymentandthisleadstoacrisis.
Thebookdoesanicejobofshowinghowthesetwoapproachescan
be reconciled using developments in the recent literature on global
games. The weakness of the sunspot-based approach is the equilib-
rium selection mechanism. If there is a lack of common knowledge
about future economic prospects then it can be shown that a unique
equilibriumexistsevenwhenthereexistcommonknowledgemultiple
equilibria.Whenonaveragesignalsaboutfutureeconomicprospects
are above some critical level there will not be a crisis, but when they
are below there will be. This approach underlines the importance of
leading economic indicators for crisis prediction. The first part of the
bookcloseswithacriticalexaminationofthisliterature.
Thesecondpartofthebookconsidershowtheinternationalfinancial
architectureshouldbereformed.Sovereignbankruptcyisatthecentre
of this debate. Ex ante it is desirable to provide good incentives for
debtors to repay creditors by having tough penalties in the event of
default. Ex post it is desirable to try and work out defaults with the
minimumwasteofresourcespossible.Thesetwogoalsareusuallyin
conflict and the policy problem is to balance them in a sensible way.
vi Foreword
Similarlytothemodelsinthefirstpartofthebook,animportantaspect
oftheexpostproblemiscreditorcoordinationintheeventoffinancial
distress.Therearetwoapproaches.Thecontractualapproachrelieson
collectiveactionclausesthatallowaqualifiedmajorityofcreditorsto
changethecontractualtermsofsovereigndebtcontractsintheevent
of repayment problems. The statutory approach involves the creation
ofinstitutionalstructurestodeterminewhetheradebtorcanloweror
ceasedebtrepaymentsasinUSchapter11bankruptcylaw.Theauthors
provide an excellent explanation of the subtleties and complications
involvedinchoosingbetweenthetwoapproaches.Astheymakeclear
therearenoeasyanswers.
Oneoftheinterestingissuesunderlyingtheexistenceoftheproblem
of default on sovereign debt is the use of foreign currency denomin-
ated debt. This is the so-called problem of ‘original sin’. If sovereign
debtwasindomesticcurrencyacountrycouldalwaysprintmoneyto
satisfyitsobligations.Theproblemofinflationriskifcountriesborrow
significantamountsindomesticcurrencyisaddressedatlength.
This book should be read by all those who wish to understand the
nature of the debate about the international financial architecture at
a serious level. It does not shy away from explaining the ideas that
underliethedebatewhileatthesametimehighlightingtheimportant
issues.
FranklinAllen
Preface
This monograph offers an analytical perspective on recent debates
aboutthedesignandreformoftheinternationalfinancialarchitecture.
Itisaimedatgraduatestudentstakingcoursesininternationalfinance,
policymakersincentralbanksandsimilarinstitutionswithsometech-
nical background, and at researchers interested in a more organised
treatment of the literature on financial crisis management. Existing
booksintheareaoftenadoptanon-technicalapproach,concentrating
on policy issues without elucidating the underpinnings necessary
for a solid understanding of the architecture debate. Alternatively,
there is a tendency to focus on a particular type of model in ways
that are not readily amenable to the overall policy discussion. We
attempt to bridge this gap by drawing together the key theoretical
strands and highlighting their relevance for crisis management. The
material stems from our own research while at the Bank of England,
and from a course of lectures given to Masters students in eco-
nomics at the Australian National University and the University of
Oxford.
We owe a great many thanks to friends and colleagues at the
Bank of England for the intellectual environment and support that
has extended far beyond the ideas in this monograph. In particu-
lar, we are deeply grateful to Andy Haldane, Simon Hall, Simon
Hayes, Adrian Penalver, Ashley Taylor, and Paul Tucker for advice
and stimulus. Our intellectual debt to Hyun Song Shin deserves spe-
cial mention—his steadfast encouragement and guidance has been
invaluable to our research and to the development of the manu-
script. WeshouldalsoliketothankPatriziaBaudino, StefanGerlach,
Paul Levine, Warwick McKibbin, Joe Pearlman, Georges Pineau,
Kang Yong Tan, and David Vines for helpful comments and sug-
gestions. It has been a pleasure for us to work with the Oxford
University Press, and we are grateful to Andrew Schuller for his
help throughout this enterprise. Last, but not least, we would
like to express our gratitude to the Research School of Pacific and
viii Preface
Asian Studies of the Australian National University, the European
Central Bank, and the Hong Kong Monetary Authority for their
support. The views expressed, and the errors that remain, are ours
alone.
M.K.F.C.andP.S.G.
CanberraandHongKong
Contents
ListofFigures xi
ListofTables xiii
1. Introduction 1
1.1. Themoderndebateontheinternationalfinancialarchitecture 1
1.2. Settingthescene—Korea,1997–98 3
1.3. Methodandplan 9
PART I. THE ANALYTICS OF CRISIS
2. Overview:Causes,Costs,andPrediction 15
3. Sunspot-BasedModels 23
3.1. Basicsofcoordinationgames 23
3.2. Currencycrises 25
3.3. Bankruns 29
4. Fundamentals-BasedModels 35
4.1. Timingofcrises 35
4.2. Optimalcrises 38
4.3. Theroleofcostlyliquidation 44
5. ReconcilingtheTwoViews 47
5.1. Basicsofglobalgames 47
5.2. Sovereignliquiditycrises 51
5.3. Costsofcoordinationfailure 55
6. CrisisCostsandIncentivestoRepay
SovereignDebt 61
6.1. Willingnesstopay 61
6.2. Exclusionfromfutureaccessto
credit 63
6.3. Directsanctionsandreputation 65