Liquidity Crises in Emerging Markets: Theory and Policy

Abstract

International illiquidity-defined as a situation in which a country's consolidated financial system has potential short-term obligations in foreign currency that exceed the amount of foreign currency to which it has access on short notice-was a common element in recent financial and exchange-rate crises in Mexico, East Asia, Russia, Eduador, and Brazil. Illiquidity can render economies vulnerable to self-fulfilling panics. If creditors lose confidence and stop rolling over existing loans-whether to the private sector as in Asia or to the government as in Mexico or Brazil-the collapse of the currency or the financial system or both is the likely outcome. We build a model of crashes driven by illiquidity and show how and in what circumstances self-fulfilling collapses can occur. Vulnerability depends on a host of factors, such as the maturity and currency denomination of debts, the health of the banking sector, the fiscal stance, and the exchange-rate regime. We also use the model to analyze options for crisis prevention and crisis management. Certain kinds of capital controls, stringent bank regulation, and flexible exchange rates are among the policies that can reduce illiquidity and limit financial fragility.