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News Release

Currency Mismatches at Center of Financial Crises in Emerging Economies

April 22, 2004

Contact:    Morris Goldstein    (202) 328-9000

Washington, DC ―All prominent financial crises in emerging economies over the past decade—Mexico (1994), the Asian financial crises (1997–98), Russia (1998), Brazil (1998, 2002), Turkey (2000–01), and Argentina (2001–02)—share one striking characteristic. In each crisis, the country had a large “currency mismatch.” A currency mismatch occurs when residents of the country are not adequately hedged against a change in the exchange rate so that a large depreciation generates a large fall in the economy’s net worth, usually accompanied by a large fall in output and insolvencies on the part of firms and banks. Currency mismatches can also constrain the scope for interest rate cuts during a crisis and can contribute to a “fear of floating” in the conduct of exchange rate policy.

In this new study, Dennis Weatherstone Senior Fellow and former IMF Deputy Research Director Morris Goldstein and Philip Turner, a member of the senior staff at the Bank for International Settlements, provide a comprehensive analysis of the currency mismatch problem in emerging economies. They discuss how to measure currency mismatches, what causes these mismatches, and how best to control them.

Goldstein and Turner show that it will generally not be possible to get a reliable picture of an emerging economy’s aggregate currency mismatch by looking solely at the currency composition of cross-border bank loans and international bonds—the measures that have been emphasized in the literature on “original sin” (the inability of a country to borrow abroad in its own currency). A good measure of currency mismatch has to consider the asset as well as the liability side of the balance sheet, along with the potential response of noninterest flows (like exports) to a change in the exchange rate. The authors argue persuasively that, in assessing the likely output effects of an exchange rate change, it is likewise necessary to account for the ability of a country to borrow at home in its own currency. Domestic bond markets in developing countries tend to be denominated mainly in domestic currency and they have become the largest single source of financing—larger (in flow terms) than domestic bank loans and much larger than international bonds.

Drawing these strands together, the authors construct a new measure—what they call “aggregate effective currency mismatch,” or AECM—and indicate how it behaved for 22 emerging economies over 1994–2002. Goldstein and Turner find that Argentina in 2001–02 recorded the largest aggregate currency mismatch in their sample.

Goldstein and Turner also present evidence that emerging economies differ significantly in their capacity to cope with potential currency mismatches, as revealed in the liquidity and maturity of their foreign exchange, bond, and derivative markets. The economies in the top tier (that is, the best equipped) include Hong Kong, Singapore, South Africa, Mexico, Korea, and Poland.

In contrast to some earlier studies that depicted the origins of currency mismatch as lying primarily in imperfections in international capital markets and network effects, the authors highlight past and present weaknesses in economic policies and institutions within emerging markets themselves.

Goldstein and Turner’s action plan to control currency mismatches in emerging economies emphasizes the following policies:

  • a managed floating currency regime (to produce an awareness of currency risk and an incentive to control it);
  • an inflation targeting regime for monetary policy (to produce the stability in long-run inflation expectations so important in building a healthy domestic bond market);
  • regular publication of data on currency mismatches at the sectoral and economywide levels (to enhance market discipline);
  • stepped-up supervision and monitoring of currency mismatches in banks and in their loan customers, particularly when the latter have little foreign currency revenue (to limit losses to tolerable levels);
  • changes in official safety nets and in IMF policy conditionality (to produce greater incentives to limit bailouts of losses stemming from currency mismatches and to reduce the size of mismatches);
  • implementation of more prudent debt and reserve management policies in emerging economies (including discouraging heavy recourse to foreign currency–denominated and foreign currency–linked government debt); and
  • according higher priority in emerging economies to developing domestic bond markets, encouraging the availability of hedging instruments, and reducing barriers to entry of foreign-owned banks.

About the Authors

Morris Goldstein, Dennis Weatherstone Senior Fellow since 1994, has held senior staff positions at the International Monetary Fund (1970–94), including deputy director of its Research Department. He has written extensively on international economic policy and on international capital markets. He is author, coauthor, or coeditor of numerous Institute books, including Managed Floating Plus (2002), Assessing Financial Vulnerability: An Early Warning System for Emerging Markets with Graciela Kaminsky and Carmen Reinhart (2000), Asian Financial Crisis: Causes, Cures, and Systemic Implications (1998), The Case for an International Banking Standard (1997), Private Capital Flows to Emerging Markets After the Mexican Crisis with Guillermo Calvo (1996), and The Exchange Rate System and the IMF: A Modest Agenda (1995). In addition, he was project director of Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture (1999) for the Council on Foreign Relations Task Force on the International Financial Architecture.

Philip Turner has been at the Bank for International Settlements (BIS) since 1989, where he is head of the secretariat group in the monetary and economics department, responsible for economic papers produced for central bank meetings at the BIS. His published research includes papers on financial stability in emerging markets, banking systems, and bank restructuring in the developing world. He was a member of the Financial Stability’s Working Group on Capital Flows. Between 1976 and 1989, he held various positions, including head of division in the economics department of the Organization for Economic Cooperation and Development in Paris. In 1985–86, he was a visiting scholar at the Bank of Japan’s Institute for Monetary and Economic Studies.

About the Institute

The Institute for International Economics, whose director is C. Fred Bergsten, is the only major research center in the United States that is devoted to global economic policy issues. The Institute's staff of about 50 focuses on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and covers all key regions—especially Europe, Asia, and Latin America. The Institute averages one or more publications per month; holds one or more meetings, seminars, or conferences almost every week; and is widely tapped over its popular Web site.