Rudiger Dornbusch, "A Primer on Emerging Markets Crises"

Abstract

This paper attempts to set out a few propositions that summarize what is known and accepted about emerging markets crises. A useful distinction can be drawn between old-style or slow motion crises focussing on the financing of the current account in a financially repressed economy and the new-style balance sheet crises of a financially opened economy. Old-style crises involve a cycle of overspending and real appreciation that worsens increasingly the current account; while resources are ample and before real appreciation bites into growth the process is politically popular. In time resources become more limited, and ultimately devaluation comes and the process starts all over again. A new-style crisis involves doubt about credit worthiness of the balance sheet of a significant part of the economy --private or public-- and the exchange rate. The central part of the new-style crisis is the focus on balance sheets and capital flight. Depreciation, in a mismatch situation, works in an unstable fashion to increase the prospect of insolvency and hence the urgency of capital flight. There are three central sources of vulnerability: a substantially misaligned exchange rate, nonperforming loans, or exposure in the form of mismatches. At some point a speculative attack occurs. At that point currency depreciation interacts with balance sheet issues. There is no hard rule about the timing of crises. It is surprising how long basically unsustainable situations can be given extra lives, notably if an election is in sight.

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