Currency crises and contingent liabilities

Abstract

A contingent liability is a future spending commitment that is realized with some probability. International organizations emphasize the dangers of contingent liabilities when providing advice. Why? One answer is obvious-if significant contingent liabilities are realized they commit governments to substantial fiscal costs. There is a further reason: by taking on a contingent liability the government can increase the probability of the underlying shock taking place. This paper describes how the issuance of government guarantees and the methods by which they are financed affect the probability of crises taking place. It also discusses the determinants of post-crisis inflation and depreciation. D

Fiscal and Financial Crises

“…Laeven and Valencia (2013) provide a crude measure that separates out the rise in debt due to bailouts and resolution activity and a remaining portion due to discretionary and automatic fiscal expansion. In their sample, the 14 Other papers that model the Asian crisis and place emphasis on government guarantees include: Arellano and Kocherlakota (2014) Burnside, Eichenbaum and Rebelo (2001), Burnside (2004), and Schneider and Tornell (2004). median rise in the debt-to-GDP ratio after a crisis is 12 (percentage points) with the majority (6.8) attributable to fiscal rescue packages.…”

Debt and financial market contagion

“…The data for domestic credit and external debt is collected from Datastream The second crisis indicator that we consider is related to fiscal and current account balances. We hypothesize that, if a country has a larger either fiscal deficit or current account deficit, the probability it will suffer from a crisis will be higher (see also Burnside 2004 ; Edward, 2006; Rose and Spiegel 2012 ; and Manasse and Zavalloni 2013 ). Tables 15 and 16 present the percentile of the fiscal account balance, current account balance and both account balance for 44 countries in 2006 and 2009, respectively.…”

Debt, deficits and inflation on the road to the EU: the case of Turkey

“…Another important mechanism led to self-fulfilling currency crises: contingent liabilities. Burnside (2004) and Burnside et al (2003) strongly highlighted the risk that government guarantees, contingent on an event like a steep currency depreciation, may change the behaviour of banks in anticipation of this likely event and, therefore, may increase rather than decrease their fragility as they would face little incentive to reduce their risk exposure. Hence, governments bear an indirect and important responsibility in the domestic financial turmoil: the insurance against contingent risk they provide to banks may produce a vicious circle that eventually leads banks to make bad loans or dissuade them from hedging against exchange-rate risk.…”

“…This clause behaves like a contingent liability and is thus intended to drive DEBT, DEFICITS AND INFLATION: THE CASE OF TURKEY governments' behaviour. Burnside (2004) precisely defines the underlying mechanisms at work: "Once a contingent liability has been realised, a government must take one or more of the following actions: (i) explicitly default on some portion of its debt, (ii) receive greater transfers from abroad, (iii) increase its seigniorage revenue, (iv) deflate the real value of local currency debt or (v) implement fiscal reforms that result in a higher primary surplus." (p. 27) Burnside argues that only the three latter points are of interest and he discusses their impact on the probability of a crisis driven by self-fulfilling expectations.…”

“…The fiscal cost of the recent banking crisis is understood to have modified fiscal policy at that time and given rise to a deliberate policy of inflating and depreciating the currency in order to provoke a debt deflation-a debt relief to cover the fiscal costs. This explanation (see Burnside, 2004;Burnside et al, 2003) is quite appealing, though it lacks an empirical investigation of the causality between fiscal policy and inflation. We thus turn towards the Fiscal Theory of the Price Level (FTPL, hereafter) and the recent empirical methodology developed by Canzoneri et al (2001) to give an assessment of this likely policy change and of its causality.…”