DP2171 Hedging and Financial Fragility in Fixed Exchange Rate Regimes

Author(s): A Craig Burnside , Martin Eichenbaum , Sérgio Rebelo

Publication Date: June 1999

Keyword(s): Fixed Exchange Rate Systems , Government Guarantees , Hedging

JEL(s): F31 , F41 , G15 , G21

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP2171.asp

Currency crises that coincide with banking crises tend to share four elements. First, governments provide guarantees to domestic and foreign bank creditors. Second, banks do not hedge their exchange rate risk. Third, there is a lending boom before the crises. Finally, when the currency/banking collapse occurs interest rates rise and there is a persistent decline in output. This paper proposes an explanation for these regularities. We show that government guarantees lower interest rates, and generate an economic boom. But they also lead to a more fragile banking system: banks choose not to hedge exchange rate risk. When the fixed exchange rate is abandoned in favor of a crawling peg banks go bankrupt, the domestic interest rate rises, real wages fall and output declines.