Twin crises.

• Author: Tornell, Aaron
• Position: Financial crises in Mexico and Thailand

Aaron Tornell (*)

Many recent crises, including the Tequila and Asian crises, have been different from earlier periods when currency crises coincided with banking crises, and fiscal deficits were not the main villains. My research with Jeffrey D. Sachs and Andres Velasco indicates that these "new" crises do not spread randomly across countries, but typically are preceded by a real exchange rate appreciation and a lending boom, along with debts denominated in foreign currency. (1)

When the crisis hits, a real depreciation takes place. Since many agents, including those in nontradable sectors, had denominated their debts in foreign currency during the boom years, the real depreciation implies dramatic balance sheet effects. Many agents see the value of their debt mushroom, while their revenues remain flat. This results in a reduction in their ability to service debt as well as in plummeting net worth.

In subsequent work with Anne O. Krueger, I studied the evolution of Mexico and other emerging economies in the aftermath of crisis. (2) Typically, after a short-lived recession, aggregate GDP recuperates quite quickly. However, a long lasting credit crunch develops. This crunch affects mainly small and medium firms in the nontradable sector, and has made evident the central role played by bank credit for such groups of firms. Developed economies typically experience neither such pronounced asymmetrical sectoral patterns nor such dramatic boom-bust cycles. The objective of my theoretical research in this area has been to develop a framework to explain these facts, as well as to evaluate the effects of monetary and fiscal policies in emerging economies. (3) In this article, I briefly describe the stylized facts and then present an overview of my theoretical research.

The boom-bust cycle experienced by Mexico around the Tequila crisis, and Thailand around the Asian crisis, is typical of countries undergoing twin currency and banking crises. Typically, prior to such a twin crisis an economy experiences: 1) a lending boom, along which bank credit to the private sector grows unusually quickly; and 2) an appreciation of the real exchange rate. When a twin crisis occurs, the real exchange rate depreciates, and the banking system "goes under." Typically, that failure is not caused by a run on banks by depositors, but rather by a sharp deterioration in the banks' loan portfolio; many borrowers are unable to service their debt. To save the banking system...