The third generation model of currency crises

In the third generation model of currency crises, the problem is liquidity. The economy is working well without large deficits and high inflation. However, it has accumulated substantial amounts of foreign debt. Even worse, it has accumulated a lot of short-term foreign debt, i.e. debt that matures in one year or less. If foreign creditors demand immediate repayment on these credits, the country does not have enough foreign exchange to pay them off.

Therefore, the warning sign for this type of a currency crisis is having more short-term debt than foreign exchange reserves. If the reserves are less than the short-term debt, then the country would not be able to pay its obligations if creditors pull out. Notice on the chart that the short-term debt of Thailand exceeded its foreign exchange reserves before the 1997 currency crisis.

We should point out, however, that the large short-term debt is not enough to trigger a crisis. A crisis would unfold only if the lenders decide to pull out their investments.

Why do countries accumulate so much short-term foreign debt? For one, credit denominated in dollars is cheaper compared to credit in the local currency. The local money is riskier and lenders require a risk premium. Second, short-term debt is cheaper than long-term debt as lenders do not commit their funds for a long time. So, at times when interest rates are low and economies are growing, lenders and borrowers become tempted to lend and borrow, perhaps too much when we look in retrospect.

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