Introduction

Based on my readings, I have found that currency crises often accompanied by banking crises or banking crises preceded by currency crises or even has no significant relationship between the two. So, why are currency crises often accompanied by banking crises? In this paper, I will discuss on how such problem may occur based on historical perspective, in which the countries that have experienced Twin Crises. The next issue is the effectiveness and desirability of capital controls as a means by which developing countries can manage sudden capital inflows and/or outflows. This is where the credibility of capital controls are being challenged whether such restriction should be taken into a serious consideration for the policymakers to implement. It is important to analyse these economic situations due to past economic disasters in which the issues stated were significant in the 1994 Mexican peso crisis, 1997 Asian Financial crisis and the 1998 Russian financial crisis.

Twin Crisis

The simultaneous occurrence of currency crises and banking crises is known in economic term as Twin Crises, introduced by economists Carmen Reinhart and Graciela Kaminsky in the late 1990s. This phenomenon became a common problem in financially liberalized emerging market economies in the 1990s which started with the 1994 Mexican crisis, followed with the 1997 Asian financial crisis and the 1998 Russian financial crisis. Kaminsky and Reinhart (1999) did an extensive research on the relationship between financial and banking crises for 20 countries and over a 25-year sample and found that banking crises often precede currency crises. The mechanism basically relies on two features. Firstly, governments hold a fixed exchange rate system and secondly, a mismatch between domestic assets and foreign liabilities by domestic banks, thus, exposing to exchange rate risks( Goldstein, Itay 2005 ).

A currency crises, also known as the Balance of Payment crises,is a situation in which a nation is suffering from a chronic balance of payment deficit. This problem exists when a nation is unable to finance the imports and debt repayments. The country’s central bank would be in a doubtful position whether, given the fixed exchange rate, it has sufficient foreign exchange reserves to maintain the value of domestic currency. Government often intervenes by using the country’s own currency reserves or its foreign reserves to satisfy the excess demand for a given currency ( Wikipedia, 2014 ). It came to a period when these emerging market economies were experiencing rapid economic growth, creating massive capital inflows, which will then lead to the crises.

A banking crises, however, is a financial crisis that affects banking activity which includes bank runs, banking panics and systemic banking crises, in which a country experiences a large number of defaults and financial institutions face difficulties repaying contracts. A bank run occurs when depositors believe that the bank may fail which led them to withdraw all of their deposits from that bank. This causes the banking system to be insolvent if it cannot pay its debts as they fall due. Insolvency can be defined as the inability to pay ones debts. Cash flow insolvency, or a ‘lack of liquidity’ may occur as well when the bank might end upowingmore than itowns or is owed ( postivemoney.org, n.d ).