Government Guarantees and Self-Fulfilling Speculative Attacks

This paper explores the role played by government guarantees to banks’ foreigncreditors as a root cause of self-fulfilling twin banking-currency crises. We developa general equilibrium model in which such guarantees lead to these types of crises.Absent government guarantees, such crises are not possible. The model has threekey properties. First, in the presence of government guarantees banks willingly exposethemselves to exchange rate risk: they borrow foreign currency, lend domestic currencyand do not hedge the resulting exchange rate risk. In effect this provides a theoryof debt denomination that rationalizes a key maintained assumption of the recentliterature on currency crises: banks are exposed to unhedged currency risk. Second,banks renege on their foreign debts and declare bankruptcy when a devaluation occurs.Third, the government is either unable or unwilling to fully fund the costs associatedwith bank guarantees via an explicit fiscal reform. Taken together these three propertiesimply that government guarantees lead to self-fulfilling banking-currency crises.