Fiscal Uncertainty and Currency Crises

• Published date: 01 August 2016
• Date: 01 August 2016
• Author: Inci Gumus
• DOI: http://doi.org/10.1111/rode.12136

Fiscal Uncertainty and Currency Crises

Inci Gumus*

Abstract

Fiscal deficits have been put forward as the main factor in the occurrence of currency crises by the first-

generation currency crisis models. While most papers within this framework consider a fiscal deficit that

occurs with certainty, in reality an increase in the government’s fiscal burden may be an uncertain outcome.

This paper introduces a model where there is uncertainty about the occurrence of a fiscal deficit for a finite

number of periods, and studies the effects of such uncertainty on the evolution of currency crises. If the

fiscal deficit materializes, the government has to abandon the fixed exchange rate regime, as in the standard

case. However, the paper shows that the peg becomes unsustainable even if the fiscal deficit never materi-

alizes. Therefore, a speculative attack occurs and the fixed exchange rate regime collapses with the mere

possibility of a deficit, independently of whether this outcome actually occurs or not.

1. Introduction

Emerging market economies quite often experience significant depreciation of their

currencies. Fiscal imbalances and unsustainable fiscal policies have been put forward

as the main factor in the occurrence of currency crises by the first-generation currency

crisis models, based on classic papers by Krugman (1979) and Flood and Garber

(1984). In these models, the government runs a persistent fiscal deficit, which leads to

sustained reserve losses under a fixed exchange rate regime. In the absence of fiscal

reforms, the government must eventually leave the peg since it has to finance the

deficit by printing money to raise seigniorage revenue. In more recent variants of

these models, future deficits that will be financed by seigniorage revenues lead to the

collapse of the fixed exchange rate regime before these deficits materialize and before

the government starts to print money (Corsetti et al., 1999; Burnside et al., 2001).

These papers are motivated by the fact that currency crises are not necessarily pre-

ceded by fiscal deficits, a typical example being the Asian crisis of 1997.

Most of the papers within the first-generation framework consider a fiscal deficit as

a certain outcome, whether it is a current deficit or a future one. However, in reality,

the occurrence of a fiscal imbalance is oftentimes an uncertain event. The possibility

of a future change in fiscal policy can generate a reaction in financial markets, even if

there may be no change in fiscal policy eventually. This paper studies the effects of

uncertainty about a fiscal deficit on the evolution of currency crises, and shows that a

currency crisis of a fiscal origin can occur without any change in the fiscal stance of the

government, only through expectations of a fiscal expansion.

In order to explore the effects of fiscal uncertainty on the evolution of currency

crises, this paper considers uncertainty about future fiscal policy that lasts for a finite

time period, which is meant to capture a period of financial turmoil. During this

* Gumus: Sabanci University, Faculty of Arts and Social Sciences, Orhanli, Tuzla, 34956, Istanbul, Turkey.

Tel: +90-216-4839318; Fax: +90-216-4839250; E-mail: incigumus@sabanciuniv.edu. The author would like to

thank the participants at Bogazici University and Bilkent University economics seminars, the INFINITI

Conference on International Finance (2009) and the Royal Economic Society Conference (2010). All

errors are those of the author.

© 2015 John Wiley & Sons Ltd

Review of Development Economics, 20(3), 637–650, 2016

DOI:10.1111/rode.12136