The Institute for Economic Development at Boston University                                                                    Research Review Spring 2000

“Credits, Crises, and Capital Controls: A Microeconomic Analysis”

Zvika Neeman and Gerhard O. Orosel

IED Discussion Paper 100, January 2000

Recent currency and financial crises in ‘emerging market’ developing countries have typically been viewed in terms of policy failures in the debtor countries themselves. This paper considers an alternative perspective in which the problem may stem instead from lending policies followed by the international financial community.

The authors accordingly study a model where foreign banks finance local long-term projects by short-term credits denominated in foreign currency. The foreign banks face two kinds of risk: the macro-economic risk of a currency crisis, and the micro-economic risk of project failure. There are no bailout guarantees against either of these risks. Foreign banks move sequentially, obtain a private signal about the micro risk associated with the projects they consider financing, and observe the actions of all previous foreign

Neeman and Orosel subsequently demonstrate how the imposition of capital controls through taxes and subsidies on short-term foreign credit can improve the situation. Their analysis differs from other papers on currency crises in at least two respects: they do not assume that foreign banks enjoy bailout guarantees, and concentrate on foreign banks’ prior incentives for providing credit rather than on their incentives to withdraw the credit provided once a crisis is anticipated. The paper is relevant to current debates concerning ‘globalization’, as it provides a clearly identified set of situations where imposing controls on short-term capital inflows can be beneficial, even in the absence of any policy failures within debtor countries or availability of bailout guarantees for foreign banks.