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The World Bank
M A'Y
* ; NSt@$ ) NUMBER 6 8
ECONOMIC POLICY
Currency crises and government
finances
Government finances are a key cause of currency crises-but also suffer their effects.
Understanding these relationships is crucial to understanding fiscal sustainability.
Recent currency crises have caused severe rather than debt, used to finance the gov-
depreciations of national currencies, even ernment's deficit.
in countries that had budget surpluses or Traditional discussions of fiscal sustain-
very small deficits before the crises occurred. ability are consistent with the basic princi- Fiscal policy plays a
These depreciations have led some analysts ples of these models. A government running
to downplay the role of fiscal policy in caus- a large deficit under a fixed exchange rate big role in currency
ing currency crises. But for several reasons, can either take corrective action to improve
policymakers should not underestimate the its fiscal balance and contain inflation, or it crises-before and
importance of fiscal policy: can avoid taking corrective action-an
* The realization of large contingent lia- approach that ultimately forces the gov- after they occur i
bilities can quickly and dramatically alter ernment to abandon the fixed exchange
government finances-leading to a cur- rate and allow higher inflation. Studies of
rency crisis. fiscal sustainability measure the primary sur-
* The effects of a currency crisis on gov- plus needed to contain inflation as well as
ernment finances depend on the struc- the cost of not taking such action, as indi-
ture of government revenue, spending, cated by the increase in debt if fiscal pol-
and debt. icy remains unchanged.
* The fiscal policies adopted in response to At first glance, several recent currency
a crisis influence economic outcomes- crises do not appear to fit the basic model.
especially inflation and depreciation. For example, most of the East Asian coun-
tries that experienced severe depreciations
Trdllitional crisis mofl s a1nXd in 1997-98 were not running large mea-
SfisCEIl sustailGbtDity sured deficits before their crises. In fact, all
Traditional models of currency crises but one (the Philippines) were running sur-
explain them as a consequence of unsus- pluses (table 1).
tainable fiscal policy. In these models a The reason these crises may appear to
government that fixes or heavily rmanages have little to do with. fiscal policy follows
its exchange rate will accumulate debt (or from the basic logic of the traditional mod-
run down reserves) if its primary surplus els. A government is assumed to have a bud-
is not large enough. Eventually the gov- get constraint that, in simplified form, is:
ernment will no longer be able or will-
ing to maintain the exchange rate peg. (1) change in debt = interest payments -
A currency crisis then develops, with the primary surplus - seigniorage.
central bank floating the currency and
monetary policy eventually becoming A government's finances are usually con-
more accommodating-with seigniorage, sidered sustainable if it can stabilize its debt
FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY AND POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK
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TABLE 1 FISCAL BALANCES IN SELECTED EAST ASIAN COUNTRIES, 1995-97
(percentage of GDP)
Country 1995 1996 1997
Indonesia 0.0 0.8 1.2
Korea, Rep. of 1.0 1.3 1.0
Malaysia 3.3 2.2 2.1
Philippines -1.8 -1.4 -0.4
Thailand 1.9 3.0 2.5
Source BuLrnside, Eichenbauim, and Rebelo 2001b
relative to GDP without resorting to infla- discusses the importance of examining con-
Traditional models tionaryfiscal and monetary policies. When tingent liabilities when studying fiscal
the GDP growth rate (g), inflation rate (i), sustainability.)
of currency crises real interest rate (r),and debt-GDP ratio (b) Focusing on bank bailouts, Burnside,
are all constant, equation 1 implies that the Eichenbaum, and Rebelo (2001b) argue that
are applicable to primary surplus relative to GDP (s) is con- traditional models of currency crises are
stant and equal to: applicable to the East Asian crisis countries.
the East Asian crisis The authors suggest that the deficits after
(2) s = (r- g) b - (it + g) m, the crises could have been anticipated given
countries the region's deteriorating banking systems.
where mis the ratio of the monetary base to Regardless, there is little doubt that gov-
GDP. Equation 2 shows that for debt to sta- ernment finances had important economic
bilize at some level of b, the government has consequences once the currency crises were
to set the primary surplus to a sufficiently set in motion. The restructuring and recap-
high level. The greater is the initial debt, the italization of failed banks had massive fis-
larger is the required surplus. Equation 2 cal costs-in effect, contingent liabilities
also shows how, with a fixed exchange rate, were converted into actual liabilities during
the government can typically raise only small the crises. Avoiding the crises would have
amounts through seigniorage-the (tc + g) m required financing these costs through large
term-and so must be more disciplined in explicit fiscal reforms.
terms of its primary surplus.
This type of analysis would not have indi- Crisis responses and
cated that East Asian countries had prob- consequences
lems with debt sustainability. Initial debt To better understand the role of fiscal pol-
levels were generally low, real growth was icy in recent crises in emerging markets, it
rapid, and primary surpluses-at least as is important to see how governments in
measured-were adequate. Thus the most these countries paid for bank and corpo-
visible signs suggested that fiscal policy was rate bailouts. Different financing methods
sound. have different implications for inflation and
depreciation after crises.
Why does fiscal policy still The standard fiscal sustainability analysis
matter? reflected in equation 2 revolves around a
That fiscal policy still matters is clear from restatement of the government's long-term
the fact that East Asian crisis countries- budget constraint, derived from equation 1:
and others before them, such as Mexico
in 1994-95-suffered significant fiscal (3) initial debt = present value of future
shocks at the same time as their crises. These primary surpluses and seigniorage.
shocks stemmed from the realization of con-
tingent liabilities associated with failing The standard analysis, which works with
banking systems. (See PR.EMnote 9, which long-run steady state conditions, is not well
PREMNOTE 68
MAY 2002
suited to thinking about crises. To be use- TABLE 2 FINANCING FOR RECENT BANKING CRISES IN THE
ful in understanding the possible effects REPUBLIC OF KOREA AND MEXICO
of a banking crisis, the analysis needs to (percentage of GDP)
reflect how governments tend to respond Indicator Korea, Rep. of Mexico
to crises.
Fiscal cost of the crisis 24.0 15.0
For example, standard theory implies that New fns ra sie 6.0 4.3
New funds raised 6.0 4.3
a government in a long-run steady state, with Seigniorage 1.1 1.5
a sustainable fixed exchange rate, could Debt depreciation 2.9 2.0
weather a banking crisis without abandoning Fiscal reforms 7.2 1.4
the exchange rate. It could do so if it could Costs of recession -5.2 -0.5
credibly announce its intention and ability to Yet to be paid for 18.0 10.7
finance any fiscal costs resulting from the cri- Note. New funds raised represent the present value of esimated net changes in finanicing
sis through explicit fiscal reforms-that is, by from the crisis year (1997 for Korea, 1994 for Mexico) through the end of 2000.
cutting primary spending or raising taxes. Source. Burnside, Eichenbaim, and Rebelo 2001a.
But governments usually do not take such
actions, presumably because they are too and a money demand function-to inves-
costly economically or politically. tigate how financing affects economic out-
Thus crisis costs are often financed comes. They use examples in which the
through other means. Fiscal reforms in the exchange rate is initially assumed to be sus-
Republic of Korea (starting in 1997) and tainable. By definition this means that the
Mexico (1994) were modest relative to the government's fiscal plans are consistent with
fiscal costs of banking crises (table 2). Other equation 3, where the amount of seignior-
sources of financing included seigniorage age being raised is consistent with main-
and the depreciation of debt denominated taining the fixed exchange rate.
in local currency. Debt sustainability analy- The authors then imagine that the econ-
sis needs to reflect the extent to which gov- omy is hit by a banking crisis. This increases
ernments can and are likely to resort to these the left-hand side of equation 3 by the size
sources of financing. It also needs to reflect of the resulting bank bailout. As noted, the
the fact that crises are often associated with government can finance this bailout
economic downturns that impose additional through a combination of additional
fiscal costs through lost revenue. This factor seigniorage, explicit fiscal reforms, and
was especially important in Korea. implicit fiscal reforms. Implicit reforms
Debt sustainability analysis also needs occur without direct government action but
to show how financing affects economic out- only if the fixed exchange rate is aban-
comes. Theory suggests that depreciation doned. Examples include inflating away the
and inflation after a crisis depend on three value of local currency debt or other nom-
factors related to financing. One is the fis- inal spending commitments, or decreasing
cal cost of the crisis net of the value of the dollar value of public sector wages that
explicit fiscal reforms. The second is the might be indexed to the consumer price
amount of additional seigniorage revenue index and not the exchange rate.
the government raises. The third factor is Economic outcomes depend on the mix
how much revenue the government can of financing. Suppose that the government
raise implicitly-which depends on the finances the entire fiscal cost of the bank
degree of exchange rate pass-through to bailout with explicit fiscal reforms. Then a
local prices, the amount of the government's currency crisis can be averted because the
nominal debt, and the structure of the gov- government does not need additional
ernment's spending and revenue base. seigniorage or implicit revenue-both of
Burnside, Eichenbaum, and Rebelo which would require it to abandon the fixed
(2001a) use the simple monetary models exchange rate-to finance its new liabilities.
from fiscal sustainability analysis-built At the opposite extreme, suppose that
around the government budget constraint the government makes no explicit fiscal
PREMNOTE 68 MAY 2002
reform and raises no implicit revenue (that would have been aided, in making their pro-
is, the government has no non-indexed local jections, by detailed information on the
currency debt, fiscal policy is implicitly structure of government debt, spending,
indexed to foreign currency, and exchange and revenue, and by studies of exchange
rate pass-through is immediate). Thus it rate pass-through in Korea. This sort of
finances the entire bailout with seigniorage. information, in conjunction with the stan-
This move would imply a depreciation of dard tools of fiscal sustainability analysis,
the currency matched by an equal increase would have allowed them to assess the
in inflation. effects of alternative government policies.
In Korea neither scenario occurred. There
was a currency crisis-implying incomplete Further reading
explicit fiscal reform-yet inflation was very Burnside, Craig, Martin Eichenbaum, and
Economic outcomes low-implying that some implicit revenue Sergio Rebelo. 2001a. "On the Fiscal
was raised to finance the cost of bailing out Implications of Twin Crises." Working
depend on the mix banks, estimated by Standard and Poor's to Paper 8277. National Bureau of Eco-
have been about 24 percent of GDP. Burn- nomic Research, Cambridge, Mass.
of financing side, Eichenbaum, and Rebelo (2001a) con- . 2001b. '"rospective Deficits and the
struct an example in which a country facing Asian Currency Crisis." Journal of Politi-
such a cost pays for about two-thirds of it with cal Economy 109 (6): 1155-97.
explicit fiscal reforms and for one-third in CaprioJr., Gerard, and Daniela Klingebiel.
roughly equal parts by generating additional 1996. "Bank Insolvencies: Cross-Country
seigniorage revenue, inflating away part of Experience." Policy Research Working
its nominal debt, and relying on other Paper 1620. World Bank, Washington,
implicit fiscal reforms. Together these D.C.
assumptions on financing, along with mod- Frydl, Edward. 1999. 'The Length and Cost
est domestic price stickiness, imply a 60 per- of Banking Crises." Working Paper 99/30.
cent depreciation of the exchange rate in International Monetary Fund, Washing-
the first year of the crisis, but only 15 percent ton, D.C.
inflation. Furthermore, they imply little Kharas, Homi, and Deepak Mishra. 1999.
depreciation or inflation thereafter. These "Hidden Deficits and Currency Crises."
outcomes are similar to those in Korea except World Bank, PREM Network,Washing-
for the exchange rate overshooting that ton, D.C.
occurred there.
The jury is still out on whether Korea will This note was written by Craig Burnside (Lead
use seigniorage or explicit fiscal reforms to Economist, Economic Policy Group, PREM Net-
finance the remaining fiscal cost of its bank- work).
ing crisis. Economists performing fiscal sus- Ifyou are interested in similar topics, consider
tainability analyses at the time of the crisis joining the Qyality ofFiscal Adjustment Thematic
would not have been able to fully anticipate Group. Contact Craig Burnside, x39607, or click
the government's future actions. But they - on Thematic Groups on PREMnet.
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