Twin crises

In economics, twin crises are simultaneous crises in banking and currency (also called a balance of payments crisis). The term was introduced in the late 1990s by economists Graciela Kaminsky and Carmen Reinhart, after the occurrence of several episodes with this characteristic around the globe. In economics, twin crises are simultaneous crises in banking and currency (also called a balance of payments crisis). The term was introduced in the late 1990s by economists Graciela Kaminsky and Carmen Reinhart, after the occurrence of several episodes with this characteristic around the globe. The wave of twin crises in the 1990s, which started with the 1994 Mexican crisis, also known as the 'Tequila crisis', and followed with the 1997 Asian financial crisis and the 1998 Russian financial crisis, gave rise to a huge discussion on the relations between banking and currency crises. And although the literature on financial crises provided several theoretical Economic models that tried to understand the linkages between these two types of crises, the causality direction was not unambiguous. While one research stream argued that currency crises could cause banking crises, another stream argued that banking-sector problems could cause currency crises, Moreover, there was yet a third stream of researchers that defended the idea that there would not be a causality relation between banking and currency crises, arguing that both types of crises would be caused by common factors. To address this ambiguity in the theory, Kaminsky and Reinhart (1999) conducted an extensive empirical work for 20 countries over a 25-year sample and found that banking-sector problems not only are generally followed by a currency crisis, but also help to predict them. A currency crisis, on the other hand, does not help to predict the beginning of a banking crisis, but does help to predict the peak of a banking crisis. That is, although it doesn't cause the beginning of a banking crisis, a Balance-of-Payment crisis may help to deepen an existing banking crisis, creating thus a 'vicious cycle'. This result is supported by Goldstein (2005), who found that with the existence of strategic complementarities between speculators and creditors in the model, an increase in the probability of one type of crisis generates an increase in the probability of the other type. This 'vicious cycle' would be responsible for the severity of twin crises if compared to single crises, resulting in much higher fiscal costs for the affected economy. If on the one hand the frequency of currency crises has been relatively constant over time, on the other hand the relative frequency of individual banking and twin crises has significantly increased, specially during the 1980s and the 1990s. In fact, during the 1970s, when financial markets were highly regulated, banking crises were rare, but as the world experienced several episodes of financial liberalization, the occurrence of banking crises more than quadruplicated, giving rise to the 'twin crises' phenomenon. Goldfajn and Valdes (1997) gives theoretical support to this idea by showing that financial intermediaries (that would arise as a consequence of financial liberalization) can generate large capital inflows, as well as increase the risk of massive capital outflows, which could lead to higher probabilities of twin crises. Moreover, in a sample that goes from 1970 to 1995, Kaminsky and Reinhart (1999) documented that the majority of the twin crises happened in the aftermath of financial liberalization events. More specifically, the pattern shows that financial liberalization generally preceded banking crises (this happened in 18 out of 26 banking crises in the sample!), which would be followed by currency crises in most of the times, completing the link between financial liberalization and twin crises, and thus pointing to possible common causes to banking and Balance-of-Payment crises. Since one stream of the literature on currency crises argues that some of those events are actually self-fulfilling crisis, this idea could be naturally expanded to the twin crises at first. However, the linkage between financial liberalization and twin crises gives a clue on which economic fundamentals could possibly be common causes to both types of crises. In this spirit, Kaminsky and Reinhart (1999) analyzed the behavior of 16 macroeconomic and financial variables around the time that the crises took place, aiming to capture any pattern that would indicate a given variable to be a good signal to the occurrence of such crises. That is, the goal was to create signals that, by surpassing some threshold, would alarm policymakers about upcoming crises, in order to prevent them from happening (or at least to diminish their effects) by making use of adequate economic policy. The results show that there are actually several 'good' signals for both types of crises, with variables related to capital account (foreign-exchange reserves and real interest-rate differential), financial liberalization (M2 multiplier and real interest rate) and current account (exports and terms of trade) being the best signals, and the fiscal-sector variable (budget deficit/GDP) being the worst signal. All the variables previous cited as good indicators sent a pre-crisis signal in at least 75% of the crises, getting up to 90% for some variables, while the fiscal-sector variable only sent a signal in 28% of the crises. In fact, the real interest rate sent a signal for 100% of the banking crises, which supports the idea that financial liberalization may cause banking crises, since financial deregulation is associated with high interest rates. The real-sector variables (output and stock prices) are an interest case, as they are not very good signals to currency crises but are excellent signals to banking crises, suggesting that the bursting of asset-price bubbles and bankruptcies associated with economic downturns seem to be linked to problems in the domestic financial system.