The Twin Crises : The Causes of Banking and Balance-of-Payments Problems

In the wake of the Mexican and Asian currency turmoil, the subject of financial crises has come to the forefront of academic and policy discussions. This paper analyzes the links between banking and currency crises. We find that: problems in the banking sector typically precede a currency crisis--the currency crisis deepens the banking crisis, activating a vicious spiral; financial liberalization often precedes banking crises. The anatomy of these episodes suggests that crises occur as the economy enters a recession, following a prolonged boom in economic activity that was fueled by credit, capital inflows and accompanied by an overvalued currency. (JEL F30, F41) * Graciela L. Kaminsky, George Washington University, Washington, D.C. 20552. Carmen M. Reinhart, University of Maryland, College Park, Maryland 20742. We thank two anonymous referees for very helpful suggestions. We also thank Guillermo Calvo, Rudiger Dornbusch, Peter Montiel, Vincent Reinhart, John Rogers, Andrew Rose and seminar participants at Banco de México, the Board of Governors of the Federal Reserve System, Florida State University, Harvard, the IMF, Johns Hopkins University, Massachusetts Institute of Technology, Stanford University, SUNY at Albany, University of California, Berkeley, UCLA, University of California, Santa Cruz, University of Maryland, University of Washington, The World Bank, and the conference on “Speculative Attacks in the Era of the Global Economy: Theory, Evidence, and Policy Implications,” (Washington, DC, December 1995), for very helpful comments and Greg Belzer, Kris Dickson, and Noah Williams for superb research assistance. 1 Pervasive currency turmoil, particularly in Latin America in the late 1970s and early 1980s, gave impetus to a flourishing literature on balance-of-payments crises. As stressed in Paul Krugman’s (1979) seminal paper, in this literature crises occur because a country finances its fiscal deficit by printing money to the extent that excessive credit growth leads to the eventual collapse of the fixed exchange rate regime. With calmer currency markets in the midand late 1980s, interest in this literature languished. The collapse of the European Exchange Rate Mechanism, the Mexican peso crisis, and the wave of currency crises sweeping through Asia have, however, rekindled interest in the topic. Yet, the focus of this recent literature has shifted. While the earlier literature emphasized the inconsistency between fiscal and monetary policies and the exchange rate commitment, the new one stresses self-fulfilling expectations and herding behavior in international capital markets. In this view, as Guillermo A.Calvo (1995, page 1) summarizes “If investors deem you unworthy, no funds will be forthcoming and, thus, unworthy you will be.” Whatever the causes of currency crises, neither the old literature nor the new models of self-fulfilling crises have paid much attention to the interaction between banking and currency problems, despite the fact that many of the countries that have had currency crises have also had full-fledged domestic banking crises around the same time. Notable exceptions are: Carlos Diaz-Alejandro (1985), Andres Velasco (1987), Calvo (1995), Ilan Goldfajn and Rodrigo Valdés (1995), and Victoria Miller (1995). As to the empirical evidence on the potential links between what we dub the twin crises, the literature has been entirely silent. The Thai, Indonesian, and Korean crises are not the first examples of dual currency and banking woes, they are only the recent additions to a long list of casualties which includes Chile, Finland, Mexico, Norway, and Sweden. In this paper, we aim to fill this void in the literature and examine currency and banking crises episodes for a number of industrial and developing countries. The former include: Denmark, Finland, Norway, Spain, and Sweden. The latter focus on: Argentina, Bolivia, Brazil, Chile, Colombia, Indonesia,