Hedging and Financial Fragility in Fixed Exchange Rate Regimes
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 …xed exchange rate is abandoned
in favor of a crawling peg banks go bankrupt, the domestic interest
rate rises, real wages fall and output declines.
