In the 1990s and most notably during the Asian crisis in 1997-98 a number of countries experienced problems in the banking sector and simultaneously in the balance of payments. The literature soon created the term "twin crisis" to describe this phenomenon which induced extensive research on the possible causal links between these two types of crises. Far less attention has been turned to a second type of twin crisis, a simultaneous currency and sovereign debt crisis. So far the extensive literature on currency crises and sovereign defaults has treated these two types of crises as separated issues.
The basic question of the sovereign debt literature was why governments repay their debt at all. There are only few legal institutions to apply or sanctions to impose for creditors to enforce their claims. The common answer is that governments repay their debt because they want to avoid a loss of reputation that would make it impossible or at least very expensive to issue new debt in the future. Recent research has focused on the question whether sovereign debt crises are mainly driven by economic fundamentals or private creditors’ default expectations.
Cole and Kehoe (1998) identify the level and the maturity structure of the debt to be important factors that can cause self-fulfilling debt crises. They find that multiple equilibria become possible as soon as the debt exceeds a crucial level. Lengthening the maturity increases this crucial debt level, i.e. with a longer maturity structure a higher debt level can be maintained without risking a financial crisis.
The currency crisis literature evolved in several steps. In the so-called first generation models the breakdown of a fixed exchange rate is explained as an inevitable result of an inappropriately excessive fiscal or monetary policy which is fundamentally inconsistent with the exchange rate regime (e.g. Krugman (1979) and Flood and Garber (1984)). In the so-called second generation or escape clause models the abandonment of an exchange rate peg is seen as a deliberate and strategic policy choice of a government, that aims to maximize public welfare by weighing the costs and benefits of the fixed exchange rate (e.g. Obstfeld (1986), Obstfeld (1994), Obstfeld (1996), and Ozkan and Sutherland (1998)). The government is prepared to sacrifice the peg if she expects to enhance public welfare by doing so. Sudden shifts in private expectations play a crucial role in these models since they enter the government’s welfare function in various ways, e.g. via an expectations augmented Phillips curve or via interest rate premiums. The government’s policy choice becomes endogenous in so far as it depends to a certain extend on the private expectations. This feature typically allows for multiple equilibria solutions in which devaluation expectations emerge to be self-fulfilling and speculative attacks turn out to be successful even though they may seem to be fundamentally not justified. Nevertheless, fundamentals still play a decisive role in these models, since multiple equilibria only exist for certain ranges of fundamentals. With regard to the state of the fundamental variables these models distinguish between three kinds of situations. There are situations in which the fundamentals are sufficiently good so that the government keeps the exchange rate peg irrespective of the privates’ expectations. There also exist situations with very bad fundamentals in which regardless of the private expectations the government in any event chooses to devalue. Only in between these two extreme cases there is a zone with multiple equilibria, a "grey area" in terms of Krugman (1996), in which changes in the private beliefs lead to self-fulfilling currency crises. Jeanne (2000) calls these three scenarios heaven, hell, and purgatory. As it is quite helpful in describing several characteristic situations in our analysis as well, we will refer to this metaphor below.
While currency and debt crises have been treated separately in the literature so far, it is important to investigate their interrelations. Empirically, these two types of crises occur contemporaneously quite often. Reinhart (2002) explores the connections between sovereign credit ratings, currency crashes and financial crises. She finds that 84 percent of the defaults in her emerging markets sample are linked with currency crises and almost half of the currency crises in the sample are associated with defaults. Herz and Tong (2003) find that 32 percent of all debt crises in their sample are related to currency crises, while 20 percent of the currency crises are linked to debt crises. Recent examples of simultaneous currency and debt crises include Russia (1998) and Argentina (2001). Reinhart (2002) conjectures that in addition to their exchange rate disturbances countries such as Mexico, South Korea, Thailand and Turkey would most likely have experienced a sovereign default as well if they had not obtained vast international rescue packages.
