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THE GLOBAL CAPITAL MARKET: Market Failures and the Policy Response 4

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The attempt to assure fixed exchange rates (or a preannounced ceiling on exchange depreciation) can lead to the very vulnerabilities that raise the possibility of an international credit crisis. When domestic banks and corporate borrowers are (over)confident in an exchange rate, they may borrow dollars or yen without adequately hedging against the risk that the domestic currency will be devalued, sharply raising the ratio of their domestic-currency liabilities to their assets. They may believe that even if a crisis occurs, the government’s promise to peg the exchange rate represents an implicit promise that they will be bailed out in one way or another. Borrowers may face little risk of personal loss even if a bailout does not materialize.

This problem has been especially severe in developing countries, where prudential regulation is looser, financial institutions are weaker, and even the government’s credit may be questionable. When market sentiment turns against the exchange rate peg, the government is effectively forced to assume the short foreign-currency positions in some way — or else to allow a cascade of domestic bankruptcies. Since the government at the same time has used its foreign exchange reserves (in a vain attempt to peg the exchange rate) and cannot borrow more in world credit markets, national default becomes imminent.11 Diaz-Alejandro (1985), describing Chile‚Äôs experience in the early 1980s, gave a classic account of this process.

The exchange crises of the 1990s have underlined the problem anew. In Mexico, domestic financial institutions in the early 1990s borrowed (or took short positions) at low interest rates in U.S. dollars so as to profit from higher Mexican interest rates. In many cases they did this through special instruments designed to circumvent Mexican prudential regulations (Garber and Lall, 1998). When the peso crisis struck at the end of 1994, Mexico’s government found itself facing both a private-sector financial crisis along with the problems arising from the government’s own dollar-linked foreign borrowing. It saw no choice but to provide foreign reserves and liquidity to banks, thus fueling the peso’s further depreciation.