Balance SHeet Effects, Bailout Guarantees and Financial Crises

Abstract

Several recent twin' currency and banking crises were preceded by lending booms during which the banking system financed rapid growth of the nontradable (N) sector by borrowing in foreign currency. They were followed by recessions during which a sharp decline in credit especially hurt the N-sector. This paper presents a model that accounts for these stylized facts. A crucial element is that we model a banking system that is simultaneously subject to two distortions typical of international credit markets: bailout guarantees and the imperfect enforceability of contracts. The interaction of these distortions produces unusually fast N-sector growth, together with a real appreciation, during the boom. However, it is also responsible for self-fulfilling twin crises, which have persistent adverse effects on N-sector output.