Regional Banking and Twin Crises: The Effect of an Inefficient Banking Sector on the Likelihood of Currency Attacks

Abstract

This paper discusses the costs of a fixed-exchange rate regime for an open emerging market economy when financial markets are sufficiently developed that currency speculators can use the domestic interbank market for their attack. The strength of the speculative attack derives from an inefficiency in the banking sector that the Central Bank can correct by using an expansionary monetary policy. As speculators can aggravate the cost of such inefficiency, they can force the Central Bank to adopt an expansionary monetary policy even when the true cost of the inefficiency is low in comparison to the cost of the loss of the exchange rate peg. Speculators can not only produce a devaluation, but also affect its size because they make the Central Bank lose control of the domestic money supply. As a consequence, flexible exchange rates can be used to prevent such costly currency attacks.

Keywords: exchange rates, interbank market

JEL Classification: F31, F32, G21