Capital-Markets Crises and Economic Collapse in Emerging Markets: An Informational-Frictions Approach

1 The Mexican crisis of 1994 and its unprecedented international spillover through global financial markets signaled the dawn of a new era in capital-markets crises that challenged, and defeated, both economists' theories and practitioners' policies. Around that time, there was heated debate as to whether this crisis differed from previous Mexican crises triggered by fiscal indiscipline and real-exchange-rate appreciation (see Rudiger Dornbusch and Alejandro Werner (1994) and Guillermo A. Calvo and Enrique G. Mendoza (1996)). The debate ended abruptly in 1997 with the epidemic of crises that swept through high-saving South East Asia and again spilled-over across emerging markets world wide. Even skeptics that viewed these crises as a disease particular to developing countries were shocked later in 1998, when the Russian default nearly crashed the financial centers of the industrial world. The liquidity crisis that did occur forced the Federal Reserve to relax U.S. monetary policy and to coordinate the rescue of hedge fund Long Term Capital Management (LTCM). The recent crises were characterized by the following phenomena: Financial Vulnerability: instead of being preceded by expansionary policies (traditional culprits of currency crises), the crises were preceded by growing ratios of short-term liabilities (public and/or private) relative to foreign reserves and by increasing banking fragility. Moreover, as Figure 1 shows, the crises were preceded by the unprecedented surge in portfolio capital inflows that started